1. Cash Flow Estimation Chapter 10 © 2003 South-Western/Thomson Learning

2. 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. 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. 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. 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. 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. 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. 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. 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. 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. 11 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

12. 12 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

13. 13 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

14. 14 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

15. 15 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