cash flow estimation and capital budgeting

8/13/2019 Cash Flow Estimation and Capital Budgeting

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Cash Flow Estimation and Other Issues inCapital Budgeting (thru page 398 plus406-7) plus Appendices 12-A and 12-B

Chapter 12


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OverviewCash Flow Estimation

New or Expansion ProjectOther Cash Flow Estimation IssuesReplacement Project


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Capital Budgeting StepsFor a potential project:

1. Forecast the project cash flows.2. Estimate the cost of capital3. Discount the future cash flows at the cost of

capital.4. Find NPV of project = PV of future cash flows

required investment, and accept if NPV > 0.


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Cash Flow EstimationNeed to estimate incremental after tax cashflows that the project is expected to generate.General form: Cash Flow = Incremental NetIncome + DepreciationOther special cash flows

Initial costsExtra ending or terminal cash flows at the end of the

projects expected useful life.


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Incremental Cash Flows

IMPORTANT Ask yourself this question

Would the cash flow still exist if the project does notexist?

If yes, do not include it in your analysis.If no, include it.


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Secret Documents from Jelly Donut. The SunBlocker Project: What was Mr. Burns thinking?

In planning construction of the Sun Blocker, myengineers and I determined that the Sun Blockerwould cost $50 million to build today (t=0). Theestimated useful life for Sun Blocker is 3 years with noexpected salvage value at the end of the projects

useful life. My assistant, Smithers, thought SunBlockers cost wouldnt qualify for annual depreciationwrite offs due to its nefarious nature. Pish -posh Isaid, ordering Smithers to look into this matter further.

After further research, Smithers reports that SunBlocker qualifies for the 3-year MACRS depreciationclass. Smithers also reports that the marketingdepartment spent $1 million commissioning aelectricity demand sensitivity analysis for the project.I fire the entire department and replace them with thatSimpson chap since he always seems deep in

thought.


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Sun Blocker InfoOne of my underlings from the collectionsdepartment now informs me that we will need anincrease in working capital at the beginning of theproject of $8 million. Before I have a chance tofire him, he quickly adds that this increasedinvestment in working capital can be sold at theend of the projects life. I let him keep his job fornow, and go back to the drawing board.


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Sun Blocker InfoMy marketing and production staff estimatethat Sun Blocker will increased need forelectricity and will increase revenues andoperating costs of $80 million and $15 millionrespectively for each of the next 3 years. Ourcompanys despicable combined federal andstate income tax rate is 40%, and our

opportunity cost of capital is 11%.What are the expected cash flows for thisproject and should Mr. Burns go ahead withSun Blocker?


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Estimate Cash Flowsa) Initial Outlay: What is the cash flow at time 0? General Steps

(Purchase price of the asset)+ (shipping and installation costs)

(Depreciable asset)+ (Investment in working capital)

Net Initial Outlay


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Investment in Net Operating WorkingCapital

(Net) Working Capital = Current Assets CurrentLiabilitiesMost new projects require additional short-term(current) assets and often additional current liabilities,such as

Additional receivables from increased credit sales. Additional inventory (raw materials) necessary to produceadditional new products.

Additional trade credit (accounts payables) and taxes andwages payable.

Any needed increase in net operating working capitalis an outflow of cash, but these outflows arerecovered by the end of the project.


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Initial Outlay for Sun Blocker(t=0)


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Estimating Cash Flows Annual Operating Cash Flows: What incrementalcash flows occur over the life of the project?


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For Each Year, Calculate:

Incremental revenue- Incremental costs- Depreciation increase on project

Incremental earnings before taxes- Tax on incremental EBT

Incremental earnings after taxes+ Depreciation increase

Annual Operating Cash Flow


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Sun Blocker Annual Depreciation

Depreciable Asset (cost) = $50 million3-year MACRS depreciation.

Year MACRS% X Cost = Depreciation1 33% 50 16.52 45% 50 22.53 15% 50 7.54 7% 50 3.5 = BV3


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Annual Operating CFs ($millions) forSun Blocker


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Estimating Terminal, End of Project

Cash Flowsc) Terminal Cash Flow : What is the cash flowat the end of the projects life?

Salvage value-/+ Tax effects of new capital gain/loss on

salvage value

+ Recovery of all increase in net operatingworking capital

= Terminal Cash Flow


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Plunge Springfield in Darkness?Year Cash Flow

0123

NPV at 11% =IRR =

MIRR =


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Todays Agenda Other Cash Flow Estimation IssuesReplacement Project Cash Flow AnalysisTop 10 List Review/3 Key Things to Remember


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Other Incremental Cash Flow IssuesSunk costs = exclude. Ask yourself if rejectingthe project affects this cost.Financing costs, such as interest expense =EXCLUDE. Already included in WACC.Opportunity Costs = INCLUDE. Generallyrevenues forgone from using land or building foranother purpose other than the project.


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Other Incremental Cash Flow Issues(continued)

Externalities = effects of a project on cash flowsin other part of the firm. Can be positive ornegative and should be INCLUDED as part of theprojects incremental cash flows. Cannibalization = INCLUDE. A negativeexternality, occurs when the introduction of a newproduct diminishes the sales of existing products.


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Replacement Project CF Analysis Assume old project is sold today and replaced bethe new one.Receive inflow from the sale of old project today,but give up any future expected inflows(opportunity costs).General form: Increase in Net Income +(Depreciation on New - Depreciation on Old)


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Imperial Defense Co. Death StarReplacement Project

Six years ago in a galaxy far, far away, theImperial Defense Co. (IDC) built the originalDeath Star at a cost of $100 billion. This originalproject is being depreciated on a straight-linebasis over a 10-year period to zero.IDC is considering building a new and improvedDeath Star at a cost of $200 billion. The olddeath star can be sold for scrap today for $20billion.


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IDC Death Star Replacement ProjectInfo (cont.)

The new Death Star is estimated to have a 4-yearuseful life and falls into the 3-yr MACRSdepreciation class. The new Death Star isexpected to increase protection revenues by

$60 billion in year 1and by $90 billion in years 2thru 4. Rebel defense expenses are expected toincrease by $10, $20, $30 and $40 billion in years1 thru 4 respectively.

The new Death Star has an estimated salvagevalue of $30 billion at the end of its 4-yr useful lifeand the original Death Star has a $6 billionsalvage value at the end of its useful life.


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Death Star Replacement ProjectTasks

Estimate the cash flows of the replacementproject assuming a marginal tax rate of 40%.Should the old Death Star be replaced if ImperialDefense Co.s cost of capital is 10%.


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Death Star Replacement Projects initialCash Flow($billion)

Sell old for $20 (original cost $100), buy new for $200Book Value of old = $100 - ($100/10 x 6) = $40

Buy New

Sale of OldTaxes on Sale of Old

Total


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Death Star Replacement ProjectDepreciation

Annual Depreciation on Old = 100/10 =$10Depr.

Year Dep% Base New Dep Old Dep Diff.

1 33% 200 66 10 562 45% 200 90 10 803 15% 200 30 10 20

4 7% 200 14 10 4


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Death Star Replacement ProjectOperating Cash FlowsYear 1 2 3 4Rev-Exp-DepDiff 56 80 20 4EBT-Tax(40%)Net Income

+DepDiffCash Flow


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Death Star Replacement Terminal Cash

Flowsat t=4, New Salvage Value = $30, New Book Value= 0Old Salvage Value = $6, Old Book Value = 0

New Salvage Value-Taxes on New SV = .4(30-0) -Old Salvage Value

+Taxes on Old SV = .4(6-0) Total Terminal CF (t = 4)


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Death Star Replacement ProjectDecision Time (Billions)Year Cash Flow0 -172.01 52.42 74.03 44.04 OCF4+TCF = 31.6+14.4 = 46.0

NPV at 10% = 1.27B, IRR = 10.4%, MIRR =10.2%


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3 Key Things to RememberGoal of the Firm is to maximize stockholderwealth (stock price).Bond prices and interest rates have an inverserelationship.To enhance wealth select positive NPVinvestments.