Transcript Chapter 10

Chapter 10
Cash Flow
Estimation
Slides developed by:
Pamela L. Hall, Western Washington University
Capital Budgeting Processes
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Capital budgeting process consists of the
following steps:
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Determine (estimate) the expected cash flows of
available projects
Apply decision criteria such as NPV and IRR
People tend to take forecasted cash flows for
granted but they are subject to error
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Estimating project cash flows is the most difficult and
error-prone part of capital budgeting
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The General Approach to Cash
Flow Estimation
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Conceptually quite simple
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Every event in which a project is expected to
impact a firm’s cash flows is considered
• Cash estimates are done on spreadsheets
• Enumerate the issues that impact cash and forecasting
each over time

Forecasts for new ventures tend to be the
most complex
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The General Approach to Cash
Flow Estimation
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General outline for estimating new venture cash flows
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Pre-start-up, the initial outlay—everything that has to be spent
before the project is truly started
Sales forecast, units and revenues
Cost of sales and expenses
Assets—new assets to be acquired, don’t forget working capital
Depreciation
Taxes and earnings
Summarize and combine—adjust earnings for depreciation and
combine it with the balance sheet items to arrive at a cash flow
estimate
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The General Approach to Cash
Flow Estimation
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Expansion projects tend to require the
same elements as new ventures
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Generally require less new equipment and
facilities
Replacement projects generally expected
to save costs without generating new
revenue
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Estimating process tends to be somewhat
less elaborate
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A Few Specific Issues
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Regardless of the type of project, the basic
process is the same
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The Typical Pattern
• At the beginning of the project, some amount must be spent
to invest in the project (Initial outlay)
• Subsequent cash flows tend to be positive
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Project Cash Flows Are Incremental
• What cash flows will occur if we undertake this project that
wouldn’t occur if we left it undone and continued business as
before?
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A Few Specific Issues
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Sunk Costs
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Costs that have already occurred and cannot be recovered—
should not be included in project’s cash flows
Opportunity Costs
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What is given up to undertake the new project
The opportunity cost of a resource is its value in its best
alternative use
For instance, if firm needs a new warehouse, it could either:
• Lease warehouse space
• Buy warehouse
• Build warehouse on land they currently own (but could sell for
$1,000,000)—the $1,000,000 represents an opportunity cost
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A Few Specific Issues
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Impacts on Other Parts of Company
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Taxes
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Must net all cash flows of taxes (because taxes paid represent a cash
outflow)
Cash Versus Accounting Results
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Sales erosion (cannibalization)—when a firm sells a product that
competes with other products within the same firm (Diet Pepsi vs.
Pepsi One)
Capital budgeting deals only with cash flows; however business
managers want to know a project’s net income
Working Capital
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A new project many times requires investment in working capital—
inventory, for instance
Increasing net working capital means a cash outflow
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A Few Specific Issues
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Ignore Financing Costs
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Even though a project may be financed with debt (or
a combination of debt/equity) we do not include the
interest expense (or dividends) as a cash outflow
This issue is addressed via the discount rate when
determining NPV or evaluating IRR
Old Equipment
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If this is a replacement project, old equipment can be
sold (thereby generating a cash inflow)
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Estimating New Venture Cash
Flows
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New venture projects tend to be larger
and more elaborate than expansions or
replacements
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However, incremental cash flows can be
easier to isolate
• Because whole project is easily seen as distinct
and separate from the rest of the company
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Example
Estimating New Venture Cash
Flows
Q: The Wilmont Bicycle Company manufacturers a line of traditional multi-speed road bicycles.
Management is considering a new business proposal to produce a line of off-road mountain
bikes. The proposal has been studied carefully and the following information is forecast:
Cost of new production equipment and machinery including
freight and setup …………………………………………… $200,000
Expense of hiring and training new employees…………….. $125,000
Pre-start-up advertising and other miscellaneous
expenses……………………………………………………..
$20,000
Additional selling and administrative expense per year
after start-up………………………………………………… $120,000
Unit sales forecast
Year 1……………………………………………….
Year 2……………………………………………….
Year 3……………………………………………….
Year 4 and beyond…………………………………
200
600
1,200
1,500
Unit price…………………………………………….
Unit cost to manufacture (60% of revenue)………
$600
$360
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Estimating New Venture Cash
Flows
Example
Q: Last year, anticipating an interest in off-road bicycles, the company
bought the rights to a new gearshift design for $50,000.
Wilmont’s production facilities are currently being utilized to
capacity, so a new shop has to be acquired for incremental
production. The company owns a lot near the present facility on
which a new building can be constructed for $60,000. The land
was purchased 10 years ago for $30,700, and now has an
estimated market value of $150,000.
If Wilmont produces off-road bicycles, it expects to lose some of its
current sales to the new product. Three percent of the new unit
forecast is expected to come out of sales that would have been
made in the old line. Prices and direct costs are about the same in
the old line as in the new.
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Estimating New Venture Cash
Flows
Example
Q: Wilmont’s general overhead includes personnel, finance, and
executive functions, and runs about 5% of revenue. Small onetime increments in business don’t affect overhead spending, but a
major continuing increase in volume would require additional
support. Management estimates that additional spending in
overhead areas will amount to about 2% of the new project’s
revenues.
New revenues are expected to be collected in 30 days. Incremental
inventories are estimated at $12,000 at startup and for the first year.
After than an inventory turnover of 12 times based on cost of sales is
expected. Incremental payables are estimated to be 25% of
inventories.
Wilmont’s current business is profitable, so losses in the new line will
result in tax credits. The company’s marginal tax rate is 34%.
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Estimating New Venture Cash
Flows
Example
A: First we’ll consider the Initial Outlay, or those costs occurring prior to
start-up. The cost of hiring, training and advertising are tax deductible:
Hiring and training
Advertising and miscellaneous
Deductible expense
Tax credit @34%
Net after tax expenses
$125.0
20.0
$145.0
49.3
$95.7
Next we’ll add the cash needed for physical assets:
Equipment
$200.0
New construction
$60.0
Initial inventory
12.0
Assets subtotal
$272.0
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Estimating New Venture Cash
Flows
Example
A: Adding the operating items and physical assets gives us the total,
actual pre-start-up outlay:
Net after tax expenses
Assets subtotal
Actual pre-start-up outlay
$95.7
$272.0
$367.7
There is also the opportunity cost of the land of $150,000. However,
since the land initially cost only $30,700, selling the land today would
result in a capital gain of $119,300, which would result in taxes of
$40,600. Thus, the opportunity cost is $109,400, or $150,000 $40,600.
Thus, the initial outlay, or C0, is $367,700 + $109,400, or $477,100.
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Estimating New Venture Cash
Flows
A: The operating cash flows are as follows:
Example
Sales are forecasted to grow for 4
years before leveling off. We’ll
estimate for 6 years—for a longer
forecast just repeat the last year as
many times as you want.
Wilmont Bicycle Company
Estimated Cash Flows
Mountain Bike Project ($000s)
1
2
3
4
5
6+
Revenue and Gross Margin
Units
200
600
1,200
1,500
1,500
1,500
Revenue
$ 120.0 $ 360.0 $ 720.0 $ 900.0 $ 900.0 $ 900.0
Cost
$ 72.0 $ 216.0 $ 432.0 $ 540.0 $ 540.0 $ 540.0
Gross margin
$ 48.0 $ 144.0 $ 288.0 $ 360.0 $ 360.0 $ 360.0
The building is
depreciated
over 39 years
while the
equipment is
depreciated
over 5 years.
Tax Deductible Expenses
SG&A expense
Depreciation
General overhead
Loss old line
Total
$ 120.0 $ 120.0
$ 41.5 $ 41.5
$
2.4 $ 7.2
$
1.4 $ 4.3
$ 165.4 $ 173.1
$ 120.0
$ 41.5
$ 14.4
$ 8.6
$ 184.6
$ 120.0
$ 41.5
$ 18.0
$ 10.8
$ 190.3
$ 120.0
$ 41.5
$ 18.0
$ 10.8
$ 190.3
$ 120.0
$ 1.5
$ 18.0
$ 10.8
$ 150.3
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Example
Estimating New Venture Cash
Flows
Assume
that the
$12,000 of
initial
inventory
was
acquired
prior to
start-up.
Profit Impact and Tax
EBT impact
Tax
EAT impact
Add depreciation
Subtotal
$ (117.4) $ (29.1) $ 103.4
$ (39.9) $ (9.9) $ 35.2
$ (77.5) $ (19.2) $ 68.3
$ 41.5 $ 41.5 $ 41.5
$ (35.9) $ 22.4 $ 109.8
$ 169.7 $ 169.7 $ 209.7
$ 57.7 $ 57.7 $ 71.3
$ 112.0 $ 112.0 $ 138.4
$ 41.5 $ 41.5 $
1.5
$ 153.5 $ 153.5 $ 139.9
Working Capital
Accounts receivable
Inventory
Payables
Working Capital
Change in working capital
$
$
$
$
$
$ 75.0 $ 75.0 $ 75.0
$ 45.0 $ 45.0 $ 45.0
$ 11.3 $ 11.3 $ 11.3
$ 108.8 $ 108.8 $ 108.8
$ 14.3 $
$
-
Net Cash Flow
Net cash
20.0
12.0
3.0
29.0
17.0
(52.9)
$
$
$
$
$
45.0
18.0
4.5
58.5
29.5
(7.1)
$
$
$
$
$
67.5
36.0
9.0
94.5
36.0
73.8
139.3
153.5
139.9
Represents the subtotal after adding
depreciation less the change in working capital.
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Terminal Values
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It’s possible to assume that incremental cash
flows last forever
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Especially common with new ventures
Cash flows forecast to continue forever are
compressed into finite terminal values using
perpetuity formulas
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For instance, a repetitive cash flow starting at time 7
would be a perpetuity beginning at year 7
• The present value at time 6 would be represented as C7 
discount rate
• Very sensitive to the discount rate
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Accuracy and Estimates
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NPV and IRR techniques give the impression of
great accuracy
However, capital budgeting results are no more
accurate than the projections of the future used
as inputs
Unintentional biases are probably the biggest
problem in capital budgeting
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Projects are generally proposed by people who want
to see them approved which leads to favorable
biases
• Tend to overestimate benefits and underestimate costs
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MACRS—A Note on
Depreciation
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U.S. government allows companies the use of
accelerated depreciation for income tax purposes
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Depreciation is shifted so that more is taken early in the project’s
life and less later on—total depreciation remains the same
• Advantageous because larger tax deductions happen earlier
• Present value of tax savings is greater
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Companies generally don’t use accelerated methods for
earnings reported to the public because reported
earnings are lower
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If accelerated methods are used for tax calculations, accelerated
methods should be used for cash flow projections
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Modified Accelerated Cost
Recovery System
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The tax code dictates exactly how accelerated
depreciation is to be done
MACRS classifies assets into different
categories and specifies a depreciation life for
each
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A table is provided showing the percentage of the
asset’s cost that can be taken in depreciation during
each year of life
Only applies to equipment
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Buildings are depreciated using straight-line over
27.5 years (residential) and 39 years (otherwise)
Land isn’t depreciated
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Estimating Cash Flows for
Replacement Projects
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Generally have fewer elements than new
ventures
Identifying what is incremental can be trickier
Can be difficult to determine what will happen if
you don’t do the project
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For example, if replacing an old production machine
do you compare the performance of the new machine
to the current performance of the old, or do you
compare it to flows the current machine are expected
to generate if it continues to deteriorate
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Example
Estimating Cash Flows for
Replacement Projects—Example
Q: Harrington Metals Inc. purchased a large stamping machine five
years ago for $80,000. To keep the example simple we’ll assume
that the tax laws at the time permitted straight-line depreciation
over eight years and that machinery purchased today can be
depreciated straight line over five years. The machine has not
performed well, and management is considering replacing it with a
new one that will cost $150,000. If the new machine is purchased,
it is estimated that the old one can be sold for $45,000. The quoted
costs include all freight, installation and setup.
The old machine requires three operators, each of whom earns
$25,000 a year including all benefits and payroll costs. The new
machine is more efficiently designed and will require only two
operators, each earning the same amount.
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Estimating Cash Flows for
Replacement Projects—Example
Q: The old machine has the following history of high maintenance cost
and significant downtime.
Year
Example
Hours down
Maintenance
expense ($000)
1
2`
3
4
5
40
60
100
130
128
In
warranty
$10
$35
$42
$45
Downtime on the machine is a major inconvenience, but it doesn’t
usually stop production unless it lasts for an extended period. This
is because the company maintains an emergency inventory of
stamped pieces and has been able to temporarily reroute
production without much notice. Manufacturing managers estimate
that every hour of downtime costs the company $500, but have no
hard data backing up that figure.
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Estimating Cash Flows for
Replacement Projects—Example
Example
Q: The makers of the replacement machines have said that Harrington will
spend about $15,000 a year maintaining their product and that an average
of only 30 hours of downtime a year should be expected. However, they
are not willing to guarantee those estimates after the one-year warranty
runs out.
The new machine is expected to produce higher quality output than the old
one. The result is expected to be better customer satisfaction and possibly
more sales in the future. Management would like to include some benefit
for this effect in the analysis, but is unsure of how to quantify it.
Estimate the incremental cash flows over the next five years associated
with buying the new machine. Assume Harrington’s marginal tax rate is
34%, and that the company is currently profitable so that changes in
taxable income result in tax changes at 34% whether positive or negative.
Assume any gain on the sale of the old machine is also taxed at 34% since
corporations don’t receive favorable tax treatment on capital gains.
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Estimating Cash Flows for
Replacement Projects—Example
A: There are two kinds of cash flows in this problem—those that can be
estimated fairly objectively and those that require some degree of
subjective guesswork.
Example
Objective Cash Flows:
The initial outlay is relatively straightforward:
Cost of new machine
Less proceeds from sale of old
machine
Initial outlay
$150.0
39.9
$110.1
The old machine has a current
market value of $45,000 and a
book value of $30,000 (initial cost
of $80,000 les depreciation of
$50,000). Thus, a gain on the sale
of the old machine of $15,000
results in additional taxes of $5.1.
The net cash proceeds on the sale
of the old machine are $39.9 (or
$45.0 – $5.1).
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Estimating Cash Flows for
Replacement Projects—Example
A: Depreciation and labor savings are straightforward as well:
Example
Year
1
2
3
4
5
New depreciation
$30.0
$30.0
$30.0
$30.0
$30.0
Old depreciation
10.0
10.0
10.0
$20.0
$20.0
$20.0
$30.0
$30.0
$6.8
$6.8
$6.8
$10.2
$10.2
$25.0
$25.0
$25.0
$25.0
$25.0
Net increase in
depreciation
Cash tax savings @
34%
Labor savings
Represent the cost savings from needing
only two employees rather than three.
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Estimating Cash Flows for
Replacement Projects—Example
A: The subjective benefits (which are based on opinions) are hard to quantify
and lead to biases when estimated by people who want project approval.
The financial analyst should ensure that only reasonable estimates of
unprovable benefits are used.
Example
Year
Old machine
maintenance
New machine
maintenance
Savings
1
2
3
4
5
$45.0
$45.0
$45.0
$45.0
$45.0
In
warranty
15.0
15.0
15.0
15.0
$45.0
$30.0
$30.0
$30.0
$30.0
The question is: Should we assume maintenance on the old
machine would have remained at $45.0 or increase as the
machine gets older? Also, will maintenance on the new
machine rise as the new machine ages?
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Estimating Cash Flows for
Replacement Projects—Example
Example
A: Another subjective estimate is that of downtime. The old machine has been
having about 130 hours of downtime while the new one promises 30 hours—a
savings of 100 hours. But, argument could be made for using different
assumptions for downtime hours. Another question is: How much is each hour
of downtime savings worth? Arguments range from no savings (as we are
unable to say exactly how much it’s worth) to $500 an hour. Most people favor a
middle-of-the-road approach—we’ll use $200 an hour, which yields an estimated
cash flow savings of $20,000 per year.
Labor savings
Maintenance savings
Downtime savings
Total
Tax
Net after tax
Tax savings on depreciation
Cash flow
1
$25.0
$45.0
$20.0
$90.0
30.6
$59.4
6.8
$66.2
2
$25.0
$30.0
$20.0
$75.0
25.5
$49.5
6.8
$56.3
Year
3
$25.0
$30.0
$20.0
$75.0
25.5
$49.5
6.8
$56.3
4
$25.0
$30.0
$20.0
$75.0
25.5
$49.5
10.2
$59.7
5
$25.0
$30.0
$20.0
$75.0
25.5
$49.5
10.2
$59.7
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