1. Chapter 11 Cash Flow Estimation

2. Capital budgeting process consists of:
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

3. 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

4. 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 Forecast
Forecast incremental units over time in spreadsheet form
Extend by prices for revenues

5. 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 needed
Include 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 earnings
Treat incremental taxes like any other cash flow item

6. 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

7. Regardless of the project, the basic process is the same
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 Incremental
Separable from the existing business

8. Project Cash Flows Sunk Costs Opportunity 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

9. Project Cash Flows Impacts on other parts of company Overhead levels
Taxes
Cash v. accounting results
Working capital
Ignore financing costs
Old equipment

10. 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

11. Concept Connection Example 11-1 New Venture Cash Flows
Wilmont Bicycle is considering a new business proposal to produce off-road bikes. The following information is forecast:

12. Concept Connection Example 11-1 New Venture Cash Flows
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 $30,700
Market value is now $150,000.

13. Concept Connection Example 11-1 New Venture Cash Flows
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.

14. Concept Connection Example 11-1 New Venture Cash Flows
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%.

15. Concept Connection Example 11-1 New Venture Cash Flows
Initial Outlay costs of hiring, training and advertising are tax deductible:

16. Concept Connection Example 11-1 New Venture Cash Flows
Add operating items and assets for the total pre-start-up outlay:
Net after tax expenses $95.7
Assets subtotal $272.0
Actual pre-start-up outlay $367.7
Opportunity cost of land
Market value $150,000
Cost $30,700
Capital gain $119,300
Tax $40,600
Opportunity cost $150,000 - $40,600 = $109,400
C0, the initial outlay, is
$367,700 + $109,400 = $477,100.

17. Concept Connection Example 11-1 New Venture Cash Flows
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.
The building is depreciated over 39 years while the equipment is depreciated over 5 years.

18. Concept Connection Example 11-1 New Venture Cash Flows
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.

20. 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

21. 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

22. MACRS—A Note on Depreciation
U.S. government allows accelerated tax depreciation
MACRS sorts assets (equipment) into categories
Specifies depreciation for each

23. 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

24. Concept Connection Example 11-3 Replacement Projects
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 each
New machine - two operators $25,000/year each

25. Concept Connection Example 11-3 Replacement Projects
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.

26. Concept Connection Example 11-3 Replacement Projects
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.

27. Concept Connection Example 11-3 Replacement Projects
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.

28. Objective Items - Initial Outlay Selling an Old Asset

29. Concept Connection Example 11-3 Replacement Projects
Objective Items: Depreciation and Labor

30. Concept Connection Example 11-3 Replacement Projects
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?

31. Concept Connection Example 11-3 Replacement Projects
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.

32. Concept Connection Example 11-3 Replacement Projects
Combining these with the initial outlays yields the project’s estimated cash flow stream.