© Prentice Hall, 2000 1 Chapter 9 The Art and Science of Estimating Project Cash Flows Shapiro and...

© 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

Learning Objectives

Explain the importance of using incremental reasoning in identifying a project’s cash flows.

Identify a project’s initial investment, incremental operating cash flows, and terminal value and use these estimates to calculate the project’s NPV.

Describe how the failure to deal with inflation and other biases in capital budgeting can lead to inappropriate investment decisions.

Discuss the importance of properly assessing the effects of product line cannibalization in a new product introduction.

Use the principle of purchasing power parity to properly evaluate an overseas project.


3

Learning Objectives (Cont.)

Describe how the failure to identify managerial options can systematically undervalue an investment project

Explain the importance of creating barriers to entry by potential competitors is important to the generation of positive NPV projects.

Indicate how an option valuation approach can be used to evaluate R&D projects.

Describe how techniques such as sensitivity analysis, simulation, and decision trees can help managers to understand the sources of project risk.


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Guidelines for Estimating Project Cash Flows

Apply incremental reasoning

Ignore fictional accounting flows

Be careful about transfer prices

Ignore sunk costs

Don’t ignore opportunity costs

Don’t forget working capital requirements

Don’t forget abandonment costs or terminal value


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Incremental Cash Flows for a Project

Initial investment

Operating cash flows

Terminal or salvage values

Abandonment costs


6

Initial Investment

A project’s initial investment may consist of three

components:

Cost of acquiring and placing the asset in service

Net proceeds from the sale of the existing equipment

Tax consequences of selling an existing asset


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

Terminal or Salvage Values

A project’s terminal, or salvage value may consist

of one or more of the following elements:

Salvage value of equipment

Recovery of working capital

Cash flows beyond some initial evaluation period


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

The Replacement Problem

A class of investments where a company

is looking to replace an existing piece of

equipment with a new “model.”

The motivation for these projects is either

cost reduction or quality improvement or

both.


11

Spectrum Manufacturing Company

Existing Equipment

Cost = $120,000 Depreciation = $12,000/Year Book Value = $60,000

Salvage Value Today = 10,000 Salvage Value in 5 Years = $0

New Equipment

Cost = $100,000 Depreciation = $20,000/Year

Cash Savings = $24,000/Year Salvage Value in 5 Years = $0


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

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


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Spectrum Manufacturing Company- The Project’s NPV

NPV = $17,600 [PVIFA 5,10] -$70,000

= $17,600(3.7908) - 70,000

= -$3,282


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.


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Inflation Biases- An ExampleYear 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

Biases in Capital Budgeting

Inflation

Projects with overestimated cash flows are

more likely to be chosen

Manager overoptimism

Manager pessimism


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

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

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


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Post-Evaluation Period Cash Flow Estimation

The following equation can be used to estimate the cash flows beyond some initial evaluation period:

CFn+1

TVn = ——— (k-g)


22

Smith and CompanyNEW 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

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

Smith and Company- Sensitivity Analysis

(ALL FIGURES IN $1,000)

GROWTH TERMINAL PRESENT VALUE OFRATE % 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

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:

What matters is the incremental effect of cannibalization; the sales lost that can be solely attributable to the new product introduction

Be sensitive to the competitive environment; it is always better to lose volume to your own entry than to one of your competitor’s


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

Evaluation of Foreign Projects - Purchasing Power Parity

e1 1 + ih = eo 1 + if

Where:

ih = price level increases (rates of inflation) for the home country

if = price level increases (rates of inflation) for the foreign country

eo = the current dollar value of one unit of the foreign currency

e1 = the end-of-period exchange rate.


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Evaluation of Foreign Projects- ACS EnterprisesASSUMPTIONS:10 percent Annual Inflation

Exchange Rate : Puff Declines by 10% a Year Against Dollar

YEARS 0 1 2 3 4 5 6Sales 200 220 242 266 292 0Net Working Capital 30 33 36 40 44 0Depreciation Expense 40 40 40 40 40 0Profit After Taxes 20 24 28 33 39 0

Cash Flow AnalysisInvestment 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 0Period Cash Flows ( in puffs) (200) 30 61 65 69 75 44Period 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%


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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.


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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


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Strategic Options- Bubbly Beverage

Traditional capital budgeting analysis

ignores the potential for:

Add-on products

Vertical integration

Related diversification


32

Value of Projects With Strategic Options

VPROJ = VDCF + VSTRAT

Where:

VDCF = the project’s value using traditional DCF techniques

VSTRAT = the value of the strategic options


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Sources of Positive NPV Projects

Projects that create economies of scale or scope

Projects that create cost advantage

Projects that allow firms to differentiate products or services

Projects that build or enhance channels of distribution

Government policy

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