1. Estimating Cash Flows on Capital Budgeting Projects
Chapter 12
Fin 325, Section 04 - Spring 2010
Washington State University

2. Introduction
Firms often face capital budgeting decisions: when a potential project arises, a firm needs to decide to carry on or forgo the project.
Estimating project cash flows
pro forma analysis: - “what is this project’s impact on the firm’s cash flows if we go forward?”

3. Sample Project (a game development company)
Computer Game
Price = $39.99
Projected unit sales:
Variable cost per game = $4.25
Fixed costs per year = $150,000
Startup costs:
Software duplicating machine costing $75,000
Shipping and installation costs of $2,000
Year
Unit Sales 1
15,000 2
27,000 3
5,000

4. Duplicating machine will be depreciated straight-line to $5,000 over the life of the project
We expect to be able to sell the machine for $2,000 after we are done with it
The new game will cut into sales of an older game currently on the market
The old game will lose sales of 2,000 units per year throughout the life of the new game
Old game sells for $19.99 and has variable costs of $3.50 per unit

5. Game development costs for the new game totaled $150,000
Net Working Capital requirements at the beginning of each year will be 10% of the projected sales during the coming year
The marginal tax rate is 34 percent
The appropriate discount rate for projects of this risk is 15 percent

6. Guiding Principles for Cash Flow Estimation
We are interested in incremental cash flows
Cash flow changes that we expect as a result of accepting the project
Some incremental cash flows are not obvious
Opportunity costs
Sunk costs
Substitutionary and Complementary effects

7. Opportunity costs Sunk costs
Example: if we did not use an existing resource for our project, it could have been used to generate cash flows for another project, so our project must be charged for those foregone cash flows
E.g. Existing machinery
Sunk costs
If a firm has already paid an expense or is obligated to pay one in the future regardless of whether the project is undertaken, it is a sunk cost and should never be considered in the project cash flows
E.g. Development costs

8. Substitutionary Effects
New project causes reduction in both sales and variable costs of existing projects
Complementary Effects
New project causes increases in both sales and variable costs of existing projects
If a new project will reduce or increase cash flows for existing products or services then those changes are incremental to the project and should be included in the project cash flows

9. Total Project Cash Flow
We will use Free Cash Flow as our measure
of the cash flow available from a project
Since we are considering potential projects, the inputs are estimates rather than actual historical numbers

10. Calculating Depreciation
The depreciable basis for real property is calculated as:
Cost + sales tax + freight charges + installation and testing
For our project:
Purchase price
$75,000
Shipping and installation
$2,000
Total depreciable basis
$77,000

11. Since initially we are assuming straight-line depreciation for our project:
= ($77,000 - $5,000) / 3
= $24,000 per year

12. Calculating Operating Cash Flow
OCF = EBIT – Taxes + Depreciation
It is useful to use a pro-forma income statement approach to calculate operating cash flow.

13. Calculating the Change in Gross Fixed Assets
For most projects we need to calculate the change in gross fixed assets at the beginning of the project (time 0) and at the end of the project
At the beginning of the project the change
in gross fixed assets equals the asset’s depreciable basis
For our project: $77,000

14. At the end of the project:
We need to consider the tax consequences of the sale of the asset
If we sell the asset for more than its book value we have a gain on the sale
If we sell the asset for less than book value we have a loss on the sale
After-Tax Cash Flow (ATCF)
ATCF = Book Value + (Market Value – Book Value) x (1 – TC)
In our example:
ATCF = 5,000 + (2,000 – 5,000) x (1-.34)
= $3,020

15. Calculating Changes in Net Working Capital
For some projects we might assume that NWC increases at time zero (resulting in a negative cash flow) and decreases at the end of the project (resulting in a positive cash flow)
For our project, NWC changes each year

16. Bringing it All Together

17. Accelerated Depreciation
Our FCF calculation used a simplistic assumption about depreciation
Straight Line
In reality, firms want to use accelerated depreciation
More of the depreciation expense occurs earlier in the asset’s life, lowering taxes and increasing cash flow

18. The IRS allows businesses to use the Modified Accelerated Cost Recovery System (MACRS) to depreciate assets
Incorporates the half-year convention
Uses the double-declining balance depreciation method
The ultimate accelerated depreciation method would be to expense it immediately
IRS Section 179 deduction allows this for assets up to $108,000
Geared toward small businesses

19. Differing Asset Lives If we decide to go ahead with a project, but
we have to choose between two alternative assets, each with a different life, we can use the Equivalent Annual Cost (EAC) method to make the choice
Find the sum of the present values of the cash flows for one iteration of asset A and asset B
Treat each sum as the present value of an annuity with life equal to the life of the respective asset, and solve for each asset’s payment
Choose the asset with the least negative EAC

20. EAC Example
Suppose that your company has won a bid for a new project—painting highway signs for the local highway department. Based on past experience, you’re pretty sure that your company will have the contract for the foreseeable future, and now you have to decide whether to use machine A or machine B to paint the signs: machine A costs $20,000, lasts five years, and will generate annual after-tax net expenses of $2,500. Machine B costs $12,000, lasts three years, and will have after-tax net expenses of $3,500 per year. Assume that, in either case, each machine will simply be junked at the end of its useful life, and the firm faces a cost of capital of 12 percent. Which machine should you choose?

21. EAC Example - Solution
One iteration of each machine will consist of the sets of cash flows shown below:
The sum of the PVs of machine A’s cash flows
The sum of the PVs of machine B’s cash flows

22. EAC Example - Solution
Treating A as the present value of a 5-period annuity, setting i to 12 percent, and solving for payment will yield a payment of −$8,048, which is machine A’s EAC.
Treating B as the present value of a three-period annuity, setting i to 12 percent, and solving for payment will yield a payment of −$8,496, which is machine B’s EAC.
Since machine A’s EAC is less negative than machine B’s, your firm should choose machine A.