Transcript Chapter 11 Cash Flow Estimation

Chapter 11
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Cash Flow Estimation
Capital Budgeting decisions must be based on cash flows not on
accounting income
Identify and use relevant cash flows, and ignore irrelevant ones.
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Picking up Relevant Cash Flows
Examples of Relevant Cash Flows
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Opportunity costs
The most valuable alternative that is given up if a particular
investment is undertaken. These are relevant costs.
Erosion (or Cannibalization)
The cash flows of a new project that come at the expense of a
firm’s existing projects. These are relevant costs.
Shipping and Installation costs
These are relevant costs. They also increase the depreciable
basis of the purchased equipment.
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An Example of Irrelevant Cash Flows
Sunk cost
A cost that has already been incurred and cannot be removed
and therefore should not be considered in an investment decision
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Incremental cash flows
The difference between a firm’s future cash flows with a project or
without the project.
In general, they consist of:
a. Operating Cash Flow
b. Capital Spending
c. Change in Net working capital
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Operating Cash Flow
OCF=Net Income (excluding financing expense) + Depreciation
Depreciation
Noncash expense. So it will be added back in
finding OCF.
Financing costs The aim is to find the cash flows generated by a
project before paying any interest or dividend.
The effect of financing mixture used will be
considered in the cost of capital calculation.
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Capital Spending (purchase of fixed assets)
Both purchase price and installation costs are used in calculating
the depreciable amount. At the termination of project, assets will
be sold and there occurs some cash inflow.
We either use straight-line or modified accelerated cost recovery
system (MACRS). The latter accelarates cost recovery. You pay
lower taxes in early years.
Straight-line:
Annual Dep=
PurchasePrice Shipping& Installation costs BookValueat termina
tion
asset life in years
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MACRS
MACRS Depreciation Allowances
Annual Dep = Depreciation Allowance * (Purchase Price + Shipping & Installation)
Note: It may appear odd that e.g. a five-year property is depreciated over six
years. The tax accounting reason is that it is assumed we only have the asset for
six months in the first year and, consequently, six months in the last year. As a
result, there are five 12-month periods, but we have some depreciation in six
different tax years.
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Calculating Salvage Value
Consider an asset that costs $100,000 and is depreciated straightline to 40,000 over its eight-year tax life. The asset is to be used in
a five-year project; at the end of the project, the asset can be sold
for $20,000. If the relevant tax rate is 35 percent, what is the
after-tax cash flow from the sale of this asset (i.e. net salvage value)?
SV5=20,000
BV5=62,500
NSV5=20,000-(20,000-62,500)*35%=34,875
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Net working capital
Firm’s investment in project net working capital resembles a loan.
The firm supplies working capital at the beginning (and perhaps
also during the life of the project) and recovers it towards the end.
The cost arises due to time value of money.
Information about a project can either give NWC requirement per
year or change in NWC per year directly. If we have the former, we
have to calculate change in NWC per year.
Consider a three-year project
In our analysis, we will use change in NWC figures
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Alternative definitions of operating cash flows
The Bottom-up Approach
OCF = Net Income + Depreciation
The Top-down Approach
OCF = Sales-Costs -Taxes
The Tax-shield Approach
OCF = (Sales-Costs)*(1-T) + Depreciation*T
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Alternative definitions of operating cash flows
Verify the Tax-shield Approach
OCF = (Sales-Costs- Depreciation)(1-T)+ Depreciation
= (Sales-Costs)(1-T)+ Depreciation T
Verify the Top-down Approach
Tax =(Sales-Costs- Depreciation) T
OCF= Sales-Costs-(Sales-Costs- Depreciation) T
=(Sales-Costs)(1-T)+ Depreciation T
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Types of projects
Cost-cutting projects: a project to upgrade existing facilities to
make them more cost-efficient
Expansion projects:
a project that is intended to increase
sales
Replacement projects: a project that replaces an existing asset
with a new one
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Examples
Cost-Cutting Proposals Wally’s Water Works is looking at a new
piping system with an installed cost of $180,000. This cost will be
depreciated straight-line to zero over the project’s five-year life, at
the end of which the piping system can be scrapped for $25,000.
The piping system will save the firm $65,000 per year in pretax
operating costs, and the system requires an initial investment in
net working capital of $17,500. If the tax rate is 38 percent and
the discount rate is 10 percent, what is the NPV of this project?
See extra problems for examples on expansion and replacement
projects
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Risk Analysis
We used our best guesses for parameter values to forecast NPV
e.g.
projected unit sales or
projected savings in costs or
projected salvage value etc.
But realizations of parameter values will be different than our best
guesses
We can measure stand-alone risk
It is the worst of 3 risk measures.
But it is easiest to measure and all 3 measures are highly correlated.
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Sensitivity Analysis
How a change in one parameter value affects project’s NPV
NPV
Param eter
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e.g. Parameter=realized salvage value- best guess salvage value
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Scenario Analysis
Calculate NPV under several scenarios
Unlike the sensitivity analysis, where we measure the effect of a
change in a single parameter value, we measure the effect of
simultaneous change in several parameter values.
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Monte Carlo Simulation
Rather than using a single value for each parameter, you can
specify a distribution for each parameter. Randomly sampled
values are used to compute NPV over and over again. At the end,
you get a distribution for NPV.
This is analogous to scenario analysis, where we have  possible
scenarios. We sample a finite number of these scenarios.
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