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Chapter 11 Cash Flow Estimation
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
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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
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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 ForecastForecast incremental units over time in spreadsheet formExtend by prices for revenues
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 neededInclude 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 earningsTreat incremental taxes like any other cash flow item
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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
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 IncrementalSeparable from the existing business
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Project Cash Flows
Sunk 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
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Project Cash Flows
Impacts on other parts of company
Overhead levels
Taxes
Cash v. accounting results
Working capital
Ignore financing costs
Old equipment
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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
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Concept Connection Example 11-1New Venture Cash Flows
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Wilmont Bicycle is considering a new business proposal to produce off-road bikes. The following information is forecast:
Concept Connection Example 11-1 New Venture Cash Flows
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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 $30,700Market value is now $150,000.
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.
Concept Connection Example 11-1 New Venture Cash Flows
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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%.
Concept Connection Example 11-1 New Venture Cash Flows
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Initial Outlay costs of hiring, training and advertising are tax deductible:
Concept Connection Example 11-1 New Venture Cash Flows
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Add operating items and assets for the total pre-start-up outlay:
Net after tax expenses $95.7Assets subtotal $272.0Actual pre-start-up outlay $367.7
Opportunity cost of landMarket value $150,000 Cost $30,700 Capital gain $119,300Tax $40,600
Opportunity cost $150,000 - $40,600 = $109,400
C0, the initial outlay, is
$367,700 + $109,400 = $477,100.
Concept Connection Example 11-1 New Venture Cash Flows
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1 2 3 4 5 6+Revenue and Gross MarginUnits 200 600 1,200 1,500 1,500 1,500 Revenue 120.0$ 360.0$ 720.0$ 900.0$ 900.0$ 900.0$ Cost 72.0$ 216.0$ 432.0$ 540.0$ 540.0$ 540.0$ Gross margin 48.0$ 144.0$ 288.0$ 360.0$ 360.0$ 360.0$
Tax Deductible ExpensesSG&A expense 120.0$ 120.0$ 120.0$ 120.0$ 120.0$ 120.0$ Depreciation 41.5$ 41.5$ 41.5$ 41.5$ 41.5$ 1.5$ General overhead 2.4$ 7.2$ 14.4$ 18.0$ 18.0$ 18.0$ Loss old line 1.4$ 4.3$ 8.6$ 10.8$ 10.8$ 10.8$ Total 165.4$ 173.1$ 184.6$ 190.3$ 190.3$ 150.3$
Wilmont Bicycle CompanyEstimated Cash Flows
Mountain Bike Project ($000s)
The building is depreciated
over 39 years while the
equipment is depreciated over 5 years.
Sales are forecasted to grow for 4 years before leveling off.
We’ll estimate for 6 years—for a longer forecast repeat
the last year as.
Concept Connection Example 11-1 New Venture Cash Flows
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Profit Impact and TaxSTET impact (117.4)$ (29.1)$ 103.4$ 169.7$ 169.7$ 209.7$ Tax (39.9)$ (9.9)$ 35.2$ 57.7$ 57.7$ 71.3$ NET impact (77.5)$ (19.2)$ 68.3$ 112.0$ 112.0$ 138.4$ Add depreciation 41.5$ 41.5$ 41.5$ 41.5$ 41.5$ 1.5$ Subtotal (35.9)$ 22.4$ 109.8$ 153.5$ 153.5$ 139.9$
Working CapitalAccounts receivable 20.0$ 45.0$ 67.5$ 75.0$ 75.0$ 75.0$ Inventory 12.0$ 18.0$ 36.0$ 45.0$ 45.0$ 45.0$ Payables 3.0$ 4.5$ 9.0$ 11.3$ 11.3$ 11.3$ Working Capital 29.0$ 58.5$ 94.5$ 108.8$ 108.8$ 108.8$ Change in working capital 17.0$ 29.5$ 36.0$ 14.3$ -$ -$
Net Cash FlowNet cash (52.9) (7.1) 73.8 139.3 153.5 139.9
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.
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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
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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
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MACRS—A Note on Depreciation
U.S. government allows accelerated tax depreciation
MACRS sorts assets (equipment) into categories – Specifies depreciation for each
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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
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Concept Connection Example 11-3 Replacement Projects
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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 eachNew machine - two operators $25,000/year each
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.
Concept Connection Example 11-3 Replacement Projects
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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.
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.
Objective Items - Initial Outlay Selling an Old Asset
Concept Connection Example 11-3 Replacement Projects
– Objective Items: Depreciation and Labor
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?
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.
Concept Connection Example 11-3 Replacement Projects
Combining these with the initial outlays yields the project’s estimated cash flow stream.
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