Slides developed by: Pamela L. Hall, Western Washington University Cash Flow Estimation Chapter 10

2 Capital Budgeting Processes Capital budgeting process consists of the following steps: 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 Estimating project cash flows is the most difficult and error-prone part of capital budgeting

3 The General Approach to Cash Flow Estimation Conceptually quite simple 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

4 The General Approach to Cash Flow Estimation General outline for estimating new venture cash flows 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

5 The General Approach to Cash Flow Estimation Expansion projects tend to require the same elements as new ventures Generally require less new equipment and facilities Replacement projects generally expected to save costs without generating new revenue Estimating process tends to be somewhat less elaborate

6 A Few Specific Issues Regardless of the type of project, the basic process is the same 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 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?

7 A Few Specific Issues Sunk Costs Costs that have already occurred and cannot be recovered— should not be included in project’s cash flows Opportunity Costs 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

8 A Few Specific Issues Impacts on Other Parts of Company Sales erosion (cannibalization)—when a firm sells a product that competes with other products within the same firm (Diet Pepsi vs. Pepsi One) Taxes Must net all cash flows of taxes (because taxes paid represent a cash outflow) Cash Versus Accounting Results Capital budgeting deals only with cash flows; however business managers want to know a project’s net income Working Capital A new project many times requires investment in working capital— inventory, for instance Increasing net working capital means a cash outflow

9 A Few Specific Issues Ignore Financing Costs 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 If this is a replacement project, old equipment can be sold (thereby generating a cash inflow)

10 Estimating New Venture Cash Flows New venture projects tend to be larger and more elaborate than expansions or replacements 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

11 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……………………………………………….200 Year 2……………………………………………….600 Year 3……………………………………………….1,200 Year 4 and beyond…………………………………1,500 Unit price…………………………………………….$600 Unit cost to manufacture (60% of revenue)………$360 Example

12 Estimating New Venture Cash Flows 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. Example

13 Estimating New Venture Cash Flows Q: Wilmont’s general overhead includes personnel, finance, and executive functions, and runs about 5% of revenue. Small one- time 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%. Example

14 Estimating New Venture Cash Flows 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$125.0 Advertising and miscellaneous 20.0 Deductible expense$145.0 Tax Net after tax expenses$95.7 Next we’ll add the cash needed for physical assets: Equipment$200.0 New construction$60.0 Initial inventory12.0 Assets subtotal$272.0 Example

15 Estimating New Venture Cash Flows A:Adding the operating items and physical assets gives us the total, actual pre-start-up outlay: Net after tax expenses$95.7 Assets subtotal$272.0 Actual pre-start-up outlay$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 C 0, is $367,700 + $109,400, or $477,100. Example

16 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. The building is depreciated over 39 years while the equipment is depreciated over 5 years.

17 Estimating New Venture Cash Flows Example 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.

18 Terminal Values It’s possible to assume that incremental cash flows last forever Especially common with new ventures Cash flows forecast to continue forever are compressed into finite terminal values using perpetuity formulas 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 C 7  discount rate Very sensitive to the discount rate

19 Accuracy and Estimates 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 Projects are generally proposed by people who want to see them approved which leads to favorable biases Tend to overestimate benefits and underestimate costs

20 MACRS—A Note on Depreciation U.S. government allows companies the use of accelerated depreciation for income tax purposes 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 Companies generally don’t use accelerated methods for earnings reported to the public because reported earnings are lower If accelerated methods are used for tax calculations, accelerated methods should be used for cash flow projections

21 Modified Accelerated Cost Recovery System 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 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 Buildings are depreciated using straight-line over 27.5 years (residential) and 39 years (otherwise) Land isn’t depreciated

22 Estimating Cash Flows for Replacement Projects 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 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

23 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. Example

24 Estimating Cash Flows for Replacement Projects—Example Q:The old machine has the following history of high maintenance cost and significant downtime. 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. Example $45$42$35$10 In warranty Maintenance expense ($000) Hours down 5432`1 Year

25 Estimating Cash Flows for Replacement Projects—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. Example

26 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. Objective Cash Flows: The initial outlay is relatively straightforward: Example $110.1Initial outlay 39.9 Less proceeds from sale of old machine $150.0Cost of new machine 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).

27 Estimating Cash Flows for Replacement Projects—Example A:Depreciation and labor savings are straightforward as well: Example $25.0 Labor savings $10.2 $6.8 Cash tax 34% $30.0 $20.0 Net increase in depreciation 10.0 Old depreciation $30.0 New depreciation Year Represent the cost savings from needing only two employees rather than three.

28 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 $30.0 $45.0Savings 15.0 In warranty New machine maintenance $45.0 Old machine maintenance Year 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?

29 Estimating Cash Flows for Replacement Projects—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. Example $49.5 $59.4Net after tax $75.0 $90.0Total $20.0 Downtime savings $30.0 $45.0Maintenance savings $25.0 Labor savings $59.7 $56.3 $66.2Cash flow Tax savings on depreciation Tax Year