chapter 11 cash flow estimation. cash flow estimation capital budgeting process consists of:...

Chapter 11 Cash Flow Estimation

Cash Flow Estimation

Capital budgeting process consists of:– Estimating the cash flows associated with

projects, and then– Evaluating the estimates using NPV and

IRR

Forecasting cash flows accurately is by far the more difficult and error prone process

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The General Approach to Cash Flow Estimation

A sales forecast leads to an estimate of cash inflows from customers

A cost/expense projection leads to a pattern of outflows to employees and vendors

An equipment plan leads to a series of outflows for capital assets

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The General Approach

Think through the events a project will bring about, and write down the financial implications of each Forecasts for new ventures tend to be the most complex

Pre-startup, the initial outlay: Enumerate pre-start expenses (after tax) and all assets that must be purchased. • Some are tax deductible, some are not.

Sales ForecastForecast incremental units over time in spreadsheet formExtend by prices for revenues

The General Approach

Cost of Sales and Expenses:Base costs and expenses on a relationship with incremental revenues or units sold.

Assets:Plan new assets when neededInclude working capital

Depreciation: Plan depreciation for new and old assets

A non-cash item but it impacts taxes

Taxes and Earnings Summarize tax deductible items in each period to calculate impact on taxes and earningsTreat incremental taxes like any other cash flow item

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The General Approach to Cash Flow Estimation

Expansion Projects – Require the same

elements as new ventures

– Usually need less new equipment and facilities

Replacement Projects – Generally saves on cost

without generating new revenue

– Estimating process may be less elaborate

Project Cash Flows

Regardless of the project, the basic process is the same– The Typical Pattern

Requires an initial outlay

Subsequent cash flows tend to be positive

– Project Cash Flows Are IncrementalSeparable from the existing business

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Project Cash Flows

Sunk Costs– Have already been spent and are ignored

Opportunity Costs– The value of a resource in its best

alternative use – The cost of a resource is whatever is given

up to use it

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Project Cash Flows

Impacts on other parts of company

Overhead levels

Taxes

Cash v. accounting results

Working capital

Ignore financing costs

Old equipment

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Estimating New Venture Cash Flows

New venture projects tend to be larger and more elaborate than expansions or replacements– But incremental cash flows can be easier to

isolate

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Concept Connection Example 11-1New Venture Cash Flows

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Wilmont Bicycle is considering a new business proposal to produce off-road bikes. The following information is forecast:

Concept Connection Example 11-1 New Venture Cash Flows

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Last year purchased a gearshift design for $50,000.

Facilities are at capacity, so a new shop is required.

Company owns land nearby New building will cost $60,000 Land purchased 10 years ago for $30,700Market value is now $150,000.


Three percent of new units sold will come from the old line. – Prices and direct costs in the two lines are the same.

General overhead is about 5% of revenue. – Incremental overhead is estimated at 2% of revenues.


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Revenues collected in 30 days. Incremental inventories

$12,000 at startup and for the first year. Then inventory turnover = 12 X

Payables will be 25% of inventories.

Losses result in tax credits. Marginal tax rate is 34%.


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Initial Outlay costs of hiring, training and advertising are tax deductible:


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Add operating items and assets for the total pre-start-up outlay:

Net after tax expenses $95.7Assets subtotal $272.0Actual pre-start-up outlay $367.7

Opportunity cost of landMarket value $150,000 Cost $30,700 Capital gain $119,300Tax $40,600

Opportunity cost $150,000 - $40,600 = $109,400

C0, the initial outlay, is

$367,700 + $109,400 = $477,100.


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1 2 3 4 5 6+Revenue and Gross MarginUnits 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$

Tax Deductible ExpensesSG&A expense 120.0$ 120.0$ 120.0$ 120.0$ 120.0$ 120.0$ Depreciation 41.5$ 41.5$ 41.5$ 41.5$ 41.5$ 1.5$ General overhead 2.4$ 7.2$ 14.4$ 18.0$ 18.0$ 18.0$ Loss old line 1.4$ 4.3$ 8.6$ 10.8$ 10.8$ 10.8$ Total 165.4$ 173.1$ 184.6$ 190.3$ 190.3$ 150.3$

Wilmont Bicycle CompanyEstimated Cash Flows

Mountain Bike Project ($000s)

The building is depreciated

over 39 years while the

equipment is depreciated over 5 years.

Sales are forecasted to grow for 4 years before leveling off.

We’ll estimate for 6 years—for a longer forecast repeat

the last year as.


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Profit Impact and TaxSTET impact (117.4)$ (29.1)$ 103.4$ 169.7$ 169.7$ 209.7$ Tax (39.9)$ (9.9)$ 35.2$ 57.7$ 57.7$ 71.3$ NET impact (77.5)$ (19.2)$ 68.3$ 112.0$ 112.0$ 138.4$ Add depreciation 41.5$ 41.5$ 41.5$ 41.5$ 41.5$ 1.5$ Subtotal (35.9)$ 22.4$ 109.8$ 153.5$ 153.5$ 139.9$

Working CapitalAccounts receivable 20.0$ 45.0$ 67.5$ 75.0$ 75.0$ 75.0$ Inventory 12.0$ 18.0$ 36.0$ 45.0$ 45.0$ 45.0$ Payables 3.0$ 4.5$ 9.0$ 11.3$ 11.3$ 11.3$ Working Capital 29.0$ 58.5$ 94.5$ 108.8$ 108.8$ 108.8$ Change in working capital 17.0$ 29.5$ 36.0$ 14.3$ -$ -$

Net Cash FlowNet cash (52.9) (7.1) 73.8 139.3 153.5 139.9

Assume that the

$12,000 of initial

inventory was

acquired prior to start-up.

Represents the subtotal after adding depreciation less the change in working capital.

Terminal Values

Cash flows forecast to continue forever are compressed into finite terminal values using perpetuity formulas– A common but very aggressive assumption

with new ventures– A repetitive cash flow starting in year 7 is

valued as a perpetuity

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Accuracy and Estimates

NPV and IRR techniques give the impression of great accuracy

Capital budgeting results are no more accurate than the projections used as inputs

Unintentional biases are a problem in capital budgeting

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MACRS—A Note on Depreciation

U.S. government allows accelerated tax depreciation

MACRS sorts assets (equipment) into categories – Specifies depreciation for each

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Estimating Cash Flows for Replacement Projects

Fewer elements than new ventures

Identifying what is incremental can be tricky

Difficult to determine what will happen if you don’t do the project

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Concept Connection Example 11-3 Replacement Projects

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Harrington purchased a machine five years ago for $80,000.

Depreciated straight-line over eight years New machinery depreciated straight line over five years.

Considering replacing with a new one costing $150,000. Old unit can be sold for $45,000

Old machine - three operators $25,000/year eachNew machine - two operators $25,000/year each


The old machine has the following history of high maintenance cost and significant downtime.

Manufacturing managers estimate every hour of downtime costs the $500, but have no backup data.


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New machine claims Maintenance will cost $15,000/year and

annual Downtime about 30 hours.

However, no guarantee after warranty.

The new machine is expected to produce higher quality output resulting in better customer satisfaction and sales, but no one can quantify this result.


Harrington is currently profitable with a 34% tax rate.

Estimate the incremental cash flows over the next five years associated with buying the new machine.

Solution: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.

First consider the objective items.

Objective Items - Initial Outlay Selling an Old Asset


– Objective Items: Depreciation and Labor


The subjective benefits (involve opinion) are hard to quantify and lead to biases when estimated by people who want project approval. The financial analyst should ensure reasonability.

The question is: Should we assume maintenance on the old machine would have remained at $90.0 or increase as the machine gets older? Also, will maintenance on the new machine rise as it ages?


Downtime: The new machine promises savings of 100 hours. But, how reliable are those estimates?

And how much does each hour of downtime savings cost? Arguments range from nothing to $1,000 an hour.

A middle-of-the-road approach of $400 an hour yields an estimated

savings of $40,000 per year.


Combining these with the initial outlays yields the project’s estimated cash flow stream.

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chapter 11 cash flow estimation. cash flow estimation capital budgeting process consists of:...

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