1. © Prentice Hall, 2000 1 Chapter 9 The Art and Science of Estimating Project Cash Flows Shapiro and Balbirer: Modern Corporate Finance: A Multidisciplinary Approach to Value Creation Graphics by Peeradej Supmonchai

2. © Prentice Hall, 2000 2 Learning Objectives è Explain the importance of using incremental reasoning in identifying a project’s cash flows. è Identify a project’s initial investment, incremental operating cash flows, and terminal value and use these estimates to calculate the project’s NPV. è Describe how the failure to deal with inflation and other biases in capital budgeting can lead to inappropriate investment decisions. è Discuss the importance of properly assessing the effects of product line cannibalization in a new product introduction. è Use the principle of purchasing power parity to properly evaluate an overseas project.

3. © Prentice Hall, 2000 3 Learning Objectives (Cont.) è Describe how the failure to identify managerial options can systematically undervalue an investment project è Explain the importance of creating barriers to entry by potential competitors is important to the generation of positive NPV projects. è Indicate how an option valuation approach can be used to evaluate R&D projects. è Describe how techniques such as sensitivity analysis, simulation, and decision trees can help managers to understand the sources of project risk.

4. © Prentice Hall, 2000 4 Guidelines for Estimating Project Cash Flows è Apply incremental reasoning è Ignore fictional accounting flows è Be careful about transfer prices è Ignore sunk costs è Don’t ignore opportunity costs è Don’t forget working capital requirements è Don’t forget abandonment costs or terminal value

5. © Prentice Hall, 2000 5 Incremental Cash Flows for a Project è Initial investment è Operating cash flows è Terminal or salvage values è Abandonment costs

6. © Prentice Hall, 2000 6 Initial Investment A project’s initial investment may consist of three components: è Cost of acquiring and placing the asset in service è Net proceeds from the sale of the existing equipment è Tax consequences of selling an existing asset

7. © Prentice Hall, 2000 7 Operating Cash Flows The incremental operating cash flows (  OCF), per period, can be expressed as  OCF = (  REV -  COST -  DEP)(1 - TAX) +  DEP -  WC Where:  REV = the change in revenues  COST= the change in operating costs  DEP = the change in depreciation  WC = the annual increase in working capital TAX = the marginal tax rate faced by the firm

8. © Prentice Hall, 2000 8 Terminal or Salvage Values A project’s terminal, or salvage value may consist of one or more of the following elements: è Salvage value of equipment è Recovery of working capital è Cash flows beyond some initial evaluation period

9. © Prentice Hall, 2000 9 Abandonment Costs Some projects require cash outflows when the project is terminated. For instance, firms in certain industries may have to incur high costs to meet environmental standards.

10. © Prentice Hall, 2000 10 The Replacement Problem è A class of investments where a company is looking to replace an existing piece of equipment with a new “model.” è The motivation for these projects is either cost reduction or quality improvement or both.

11. © Prentice Hall, 2000 11 Spectrum Manufacturing Company Existing Equipment Cost = $120,000 Depreciation = $12,000/Year Book Value = $60,000 Salvage Value Today = 10,000Salvage Value in 5 Years = $0 New Equipment Cost = $100,000 Depreciation = $20,000/Year Cash Savings = $24,000/YearSalvage Value in 5 Years = $0

12. © Prentice Hall, 2000 12 Spectrum Manufacturing Company- Initial Investment Installed Cost of Computerized Lathe  $100,000 Salvage Value of Old Lathe 10,000 Tax Effects from Selling Old Lathe 20,000 INITIAL INVESTMENT  $70,000

13. © Prentice Hall, 2000 13 Spectrum Manufacturing Company - Operating Cash Flows Year 1 Year 2 Year 3 Year 4 Year 5 Annual Cash Savings $24,000 $24,000 $24,000 $24,000 $24,000  Depreciation (8,000) (8,000) (8,000) (8,000) (8,000) Taxable Income $16,000 $16,000 $16,000 $16,000 $16,000 Taxes@40% (6,400) (6,400) (6,400) (6,400) (6,400) After-Tax Income $ 9,600 $9,600 $ 9,600 $9,600 $9,600 Plus:  Depreciation 8,000 8,000 8,000 8,000 8,000 Annual OCF $17,600$17,600$17,600$17,600 $17,600

14. © Prentice Hall, 2000 14 Spectrum Manufacturing Company- The Project’s NPV NPV = $17,600 [PVIFA 5,10 ] -$70,000 = $17,600(3.7908) - 70,000 = -$3,282

15. © Prentice Hall, 2000 15 Inflation Biases in Capital Budgeting Required returns in the financial markets embody inflationary expectations. Not adjusting cash flows for inflation means that firms will be discounting real cash flows by nominal interest rates. This systematically understates a project’s NPV.

16. © Prentice Hall, 2000 16 Inflation Biases- An Example Year 1 Year 2 Year 3 Year 4 Year 5 Annual Cash Savings$24,000$24,960 $25,958$26,997$28,077  Depreciation (8,000) (8,000) (8,000) (8,000) (8,000) Taxable Income $16,000 $16,960 $17,958 $18,997 $20,077 Taxes@40% (6,400) (6,784) (7,183) (7,599) (8,031) After-Tax Income $ 9,600 $10,176$11,775$11,398 $12,046 Plus:  Depreciation 8,000 8,000 8,000 8,000 8,000 Annual OCF$17,600$18,176 $18,775 $19,398 $20,046 Present Value $16,000 $15,021 $14,106 $13,249 $12,447 NPV = $70,824  $70,000 = $824

17. © Prentice Hall, 2000 17 Biases in Capital Budgeting è Inflation è Projects with overestimated cash flows are more likely to be chosen è Manager overoptimism è Manager pessimism

18. © Prentice Hall, 2000 18 New Product Introduction Investments related to (1) product or service extensions, or (2) product innovations. The estimates of cash flows from new product introductions are subject to a far greater degree of uncertainty than are replacement projects

19. © Prentice Hall, 2000 19 New Product Introduction - Smith Corporation NEW PRODUCT FINANCIAL FORECASTS ( ALL FIGURES IN $1,000) Period 0 1 2 3 4 5 6 Sales 500 5,500 8,000 14,000 7,000 4,000 Operating Expenses 800 3,410 4,960 8,680 4,340 2,480 Product Promotion 3,000 1,000 Depreciation 1,000 1,000 1,000 1,000 1,000 1,000 Profit Before Taxes  3,000  2,300 1,090 2,040 4,320 1.660 520 Taxes @ 34%  1,020  782 371 694 1,469 564 177 Profit After Taxes  1,980  1,518 719 1,346 2,851 1,096 343 Level of Working Capital 250 660 960 1,680 840 480

20. © Prentice Hall, 2000 20 New Product Introduction - Smith Corporation CAPITAL PROFIT AFTER TAX WORKING TOTAL PRESENT + YEAR EQUIPMENT DEPRECIATION CAPITAL CASH FLOW VALUE @20% 0  $6,000  $1,980   $7,980  $1,980 1   518  250  768  640 2  1,719  410 1,309 909 3  2,346  300 2,046 1,184 4  3,851  720 3,131 1,510 5  2,096 840 2,936 1,180 6  1,343 360 1,703 570 7 $ 660  480 1,140 318 NPV =  $2,948

21. © Prentice Hall, 2000 21 Post-Evaluation Period Cash Flow Estimation The following equation can be used to estimate the cash flows beyond some initial evaluation period: CF n+1 TV n = ——— (k-g)

22. © Prentice Hall, 2000 22 Smith and Company NEW PRODUCT #2 FINANCIAL FORECASTS ( ALL FIGURES IN $1,000) Period 0 1 2 3 4 5 6 Sales 2,500 10,000 16,500 21,000 23,000 25,000 Operating Expenses 1,625 6,500 10,725 13,650 14,950 16,250 S&A Expenses 3,000 3,000 3,000 3,000 3,000 3,000 3,000 Depreciation 750 750 750 750 -0- -0- Profit Before Taxes  3,000  2,875 250 2,025 3,600 5,050 5,750 Taxes @ 34%  1,020  978 -85 688 1,224 1,717 1,955 Profit After Taxes  1,980  1,898 -165 1,337 2,376 3,333 3,795 Level of Working Capital 750 3,000 4,950 6,300 6,900 7,500

23. © Prentice Hall, 2000 23 Smith and Company CAPITAL PROFIT AFTER TAX WORKING TOTAL PRESENT + YEAR EQUIPMENT DEPRECIATION CAPITAL CASH FLOW VALUE @20% 0  $3,000  $1,980   $4,980  $4,980 1   1,148  750  1,898  1,531 2  585  2,250  1,665  1,083 3  2,087  1,950 137 72 4  3,126  1,350 1,776 751 5  3,333  600 2,733 932 6  3,795  600 3,195 879 NPV =  $4,960

24. © Prentice Hall, 2000 24 Smith and Company- Sensitivity Analysis (ALL FIGURES IN $1,000) GROWTH TERMINAL PRESENT VALUE OF RATE % VALUE TERMINAL VALUE PROJECT NPV 3 $15,671 $4,311  $ 648 4 16,614 $4,570  389 5 17,656 4,857  102 6 18,815 5,176 217 7 20,110 5,532 573

25. © Prentice Hall, 2000 25 Product Line Cannibalization A phenomenon where a new product takes sales away from one or more of a firm’s existing products. Evaluating cannibalization involves the following considerations: èWhat matters is the incremental effect of cannibalization; the sales lost that can be solely attributable to the new product introduction èBe sensitive to the competitive environment; it is always better to lose volume to your own entry than to one of your competitor’s

26. © Prentice Hall, 2000 26 Evaluation of Foreign Projects - ACS Enterprises ASSUMPTIONS: Zero Inflation Environment Exchange Rate : 1 puff/dollar YEARS 0 1 2 3 4 5 6 Sales 200 200 200 200 200 0 Net Working Capital 30 30 30 30 30 0 Depreciation Expense 40 40 40 40 40 0 Profit After Taxes 20 20 20 20 20 0 Cash Flow Analysis Investment in Equipment (200) 0 0 0 0 0 0 Investment in Working Capital 0 (30) 0 0 0 0 30 Cash Flow From Operations 0 60 60 60 60 60 0 Period Cash Flows (200) 30 60 60 60 60 30 Internal Rate of Return = 12.8%

27. © Prentice Hall, 2000 27 Evaluation of Foreign Projects - Purchasing Power Parity e 1 1 + i h  =  e o 1 + i f Where: i h = price level increases (rates of inflation) for the home country i f = price level increases (rates of inflation) for the foreign country e o = the current dollar value of one unit of the foreign currency e 1 = the end-of-period exchange rate.

28. © Prentice Hall, 2000 28 Evaluation of Foreign Projects- ACS Enterprises ASSUMPTIONS: 10 percent Annual Inflation Exchange Rate : Puff Declines by 10% a Year Against Dollar YEARS 0 1 2 3 4 5 6 Sales 200 220 242 266 292 0 Net Working Capital 30 33 36 40 44 0 Depreciation Expense 40 40 40 40 40 0 Profit After Taxes 20 24 28 33 39 0 Cash Flow Analysis Investment in Equipment (200) 0 0 0 0 0 0 Investment in Working Capital 0 (30) (3) (3) (4) (4) 44 Cash Flow From Operations 0 60 64 68 73 79 0 Period Cash Flows ( in puffs) (200) 30 61 65 69 75 44 Period Cash Flows ( in dollars) (200) 27 50 49 47 47 25 Internal Rate of Return ( in puffs) = 16.9% Internal Rate of Return ( in dollars ) = 6.2%

29. © Prentice Hall, 2000 29 Managerial Options and Capital Budgeting DCF techniques assume that a project’s cash flows cannot be changed once the decision to go ahead is made. This is unrealistic for many projects since management actions can alter the initial cash flow estimates after implementation. Such managerial discretions are options.

30. © Prentice Hall, 2000 30 Strategic Options- Bubbly Beverage SUMMARY OF CASH FLOWS FOR DELIGHTFULLY DELICIOUS LINE (ALL FIGURES IN $MILLION) YEAR 1998 1999 2000 2001 2002 After-Tax Operating Cash Flow  140  120 50 100 100 Capital Investment  80 - - - - Working Capital Changes  20  30  30  20 - Terminal Value - - - - 500 Net Cash Flow  240  150 20 80 600 NPV @ 20 percent =  $15.5 Million

31. © Prentice Hall, 2000 31 Strategic Options- Bubbly Beverage Traditional capital budgeting analysis ignores the potential for: è Add-on products è Vertical integration è Related diversification

32. © Prentice Hall, 2000 32 Value of Projects With Strategic Options V PROJ = V DCF + V STRAT Where: V DCF = the project’s value using traditional DCF techniques V STRAT = the value of the strategic options

33. © Prentice Hall, 2000 33 Sources of Positive NPV Projects è Projects that create economies of scale or scope è Projects that create cost advantage è Projects that allow firms to differentiate products or services è Projects that build or enhance channels of distribution è Government policy