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Chapter 12Fin 325, Section 04 -

Spring 2010Washington State

University

Estimating Cash Flows on Capital Budgeting Projects

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IntroductionFirms often face capital budgeting

decisions: when a potential project arises, a firm needs to decide to carry on or forgo the project.

Estimating project cash flows

pro forma analysis: - “what is this project’s impact on the firm’s cash flows if we go forward?”

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Sample Project (a game development company)

Computer GamePrice = $39.99Projected unit sales:

Variable cost per game = $4.25Fixed costs per year = $150,000Startup costs:

Software duplicating machine costing $75,000 Shipping and installation costs of $2,000

Year Unit Sales

1 15,000

2 27,000

3 5,000

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Duplicating machine will be depreciated straight-line to $5,000 over the life of the project

We expect to be able to sell the machine for $2,000 after we are done with it

The new game will cut into sales of an older game currently on the marketThe old game will lose sales of 2,000 units

per year throughout the life of the new game

Old game sells for $19.99 and has variable costs of $3.50 per unit

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Game development costs for the new game totaled $150,000

Net Working Capital requirements at the beginning of each year will be 10% of the projected sales during the coming year

The marginal tax rate is 34 percentThe appropriate discount rate for projects

of this risk is 15 percent

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Guiding Principles for Cash Flow Estimation

We are interested in incremental cash flowsCash flow changes that we expect as a

result of accepting the project

Some incremental cash flows are not obviousOpportunity costsSunk costsSubstitutionary and Complementary effects

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• Opportunity costs Example: if we did not use an existing resource for

our project, it could have been used to generate cash flows for another project, so our project must be charged for those foregone cash flows

E.g. Existing machinery

• Sunk costs If a firm has already paid an expense or is obligated

to pay one in the future regardless of whether the project is undertaken, it is a sunk cost and should never be considered in the project cash flows

E.g. Development costs

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• Substitutionary Effects• New project causes reduction in both sales

and variable costs of existing projects

• Complementary Effects• New project causes increases in both sales

and variable costs of existing projects• If a new project will reduce or increase

cash flows for existing products or services then those changes are incremental to the project and should be included in the project cash flows

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Total Project Cash FlowWe will use Free Cash Flow as our

measure of the cash flow available from a project

Since we are considering potential projects, the inputs are estimates rather than actual historical numbers

Capital Operatingin Investment-FlowCash OperatingFCF

capital] workingoperatingNet assets fixed Gross[ -

on]DepreciatiTaxes-[EBIT

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Calculating DepreciationThe depreciable basis for real property is

calculated as:Cost + sales tax + freight charges +

installation and testingFor our project:

Purchase price $75,000

Shipping and installation $2,000

Total depreciable basis $77,000

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Since initially we are assuming straight-line depreciation for our project:

= ($77,000 - $5,000) / 3 = $24,000 per year

Life eDepreciabl

ValueBook Ending - ValueBook Beginning on Depreciati

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Calculating Operating Cash FlowOCF = EBIT – Taxes + Depreciation

It is useful to use a pro-forma income statement approach to calculate operating cash flow.

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Calculating the Change in Gross Fixed AssetsFor most projects we need to calculate the

change in gross fixed assets at the beginning of the project (time 0) and at the end of the project

At the beginning of the project the change in gross fixed assets equals the asset’s depreciable basisFor our project: $77,000

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At the end of the project:We need to consider the tax consequences of

the sale of the asset If we sell the asset for more than its book value we

have a gain on the sale If we sell the asset for less than book value we have a

loss on the sale

After-Tax Cash Flow (ATCF)ATCF = Book Value + (Market Value – Book Value) x (1 –

TC)

In our example: ATCF = 5,000 + (2,000 – 5,000) x (1-.34) = $3,020

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Calculating Changes in Net Working CapitalFor some projects we might assume that NWC

increases at time zero (resulting in a negative cash flow) and decreases at the end of the project (resulting in a positive cash flow)

For our project, NWC changes each year

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Bringing it All Together

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Accelerated DepreciationOur FCF calculation used a simplistic

assumption about depreciationStraight Line

In reality, firms want to use accelerated depreciation More of the depreciation expense

occurs earlier in the asset’s life, lowering taxes and increasing cash flow

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The IRS allows businesses to use the Modified Accelerated Cost Recovery System (MACRS) to depreciate assetsIncorporates the half-year conventionUses the double-declining balance

depreciation method

The ultimate accelerated depreciation method would be to expense it immediatelyIRS Section 179 deduction allows this for

assets up to $108,000Geared toward small businesses

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Differing Asset LivesIf we decide to go ahead with a project, but

we have to choose between two alternative assets, each with a different life, we can use the Equivalent Annual Cost (EAC) method to make the choice

1. Find the sum of the present values of the cash flows for one iteration of asset A and asset B

2. Treat each sum as the present value of an annuity with life equal to the life of the respective asset, and solve for each asset’s payment

3. Choose the asset with the least negative EAC

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Suppose that your company has won a bid for a new project—painting highway signs for the local highway department. Based on past experience, you’re pretty sure that your company will have the contract for the foreseeable future, and now you have to decide whether to use machine A or machine B to paint the signs: machine A costs $20,000, lasts five years, and will generate annual after-tax net expenses of $2,500. Machine B costs $12,000, lasts three years, and will have after-tax net expenses of $3,500 per year. Assume that, in either case, each machine will simply be junked at the end of its useful life, and the firm faces a cost of capital of 12 percent. Which machine should you choose?

EAC Example

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EAC Example - SolutionOne iteration of each machine will consist of the sets of cash flows shown below:

The sum of the PVs of machine A’s cash flows

The sum of the PVs of machine B’s cash flows

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EAC Example - Solution1. Treating A as the present value of a 5-period

annuity, setting i to 12 percent, and solving for payment will yield a payment of −$8,048, which is machine A’s EAC.

2. Treating B as the present value of a three-period annuity, setting i to 12 percent, and solving for payment will yield a payment of −$8,496, which is machine B’s EAC.

3. Since machine A’s EAC is less negative than machine B’s, your firm should choose machine A.