Chapter 3Estimating Project Cash Flows

Capital Budgeting and Investment Analysis by Alan Shapiro

Incremental CFs

• Shareholders are interested in how many additional dollars they will receive in the future for the dollars they lay out today

• What matters to them is not the projects total CF per period but the incremental CFs generated by the project relative to the additional dollars they must invest today

Incremental vs. Total CFs

• Incremental CFs can differ from total CFs for the following reasons:– Cannibalization– Sales creation– Opportunity cost– Sunk cost– Transfer pricing– Allocated overhead– Accounting for Intangible benefits

Cannibalization

• A new product taking sales away from the firm’s existing products.

• To the extent that sales of a new product or plant just replaced other corporate sales, the new project’s estimated profits must be reduced by the earnings on the lost sales

• It is often difficult to assess the true magnitude of cannibalization because of the need to determine what would have happened to the sales in the absence of the new product introduction

Cannibalization cont.

• The incremental effects of cannibalization, which is the relevant measure for capital budgeting purposes equals the lost profit on lost sales that would not otherwise have been lost had the new product not been introduced.

Sales creation

• This is the opposite of cannibalization• An investment created or expected to create

additional sales for other products• In calculating the project’s CFs, the additional

sales and incremental CFs should be attributed to the project.

Opportunity cost

• Project costs must include the true economic cost of any source required for the project regardless of whether the firm already owns the source or has to go out and acquire it

• Opportunity cost is the cash the asset could generate for the firm should it be sold or put to some other productive use

Sunk costs

• Sunk cost fallacy is the idea that past expenditure on a project should influence the decision whether to continue or terminate the project.

• Instead the decision should be based on future costs and benefits alone

• Example: Feasibility study

Transfer Pricing

• Transfer prices is the prices at which goods and services are traded within a company

• It can significantly distort the profitability of a proposed investment

• The prices used to evaluate project inputs or outputs should be market prices where possible

• Transfer price adjustments are often made to reduce taxes

Allocated overhead

• The project should be charged only for the additional expenditures that can be attributed to the project; Those overhead expenses that are not affected by the project should not be included when estimating project CFs

Getting the Base Case Right

• A project’s incremental CFs can be found only by subtracting worldwide corporate CFs without the investment (the base case) from post-investment corporate CFs

• What will happen if we do not make this investment?

• Do not ignore competitor behavior and assume that the base case was the status quo

Getting the base case right cont.

• Sales could be lost any way but what if they are lost to a competitor

• If you must be the victim of cannibal, make sure the cannibal if a member of your family

Accounting for Intangible Benefits

• Intangibles like better quality, higher customer satisfaction, valuable learning experience, quick order processing can have tangible impact on corporate CFs

• Adopting practices, products, and technologies discovered overseas can improve a company’s competitive position worldwide

The Replacement Problem

• A situation when the firm is looking at replacing an existing piece of equipment with a new piece of equipment – Cost reduction– Quality improvement

Data on Quantum system investment in a new extrusion press

Old machine New machine

Cost of machine $1,000,000 $2,000,000

Development cost $750,000

Straight line depreciation 10 years 5 years

Annual depreciation charge $100,000 $300,000

Depreciated value $500,000 -

Salvage value ? $500,000

Marginal tax rate 35% 35%

Additional sales $150,000

Net increase in Working capital

$45,000

Estimating the initial investment

• It is the project’s net cash outlay. Includes any opportunity cost:– The cost of acquiring and placing into service the

necessary assets– The necessary increase in working capital– The net proceeds from the sale of existing assets

in the case of a replacement decision– The tax effects associated with the sale of existing

assets and their replacement with new assets

Initial cost of new extrusion press: Four scenarios

Case 1 2 3 4

Cost of new machine

$2,000,000 $2,000,000 $2,000,000 $2,000,000

+ Inc. in WC 45,000 45,000 45,000 45,000

- Sales Price of old machine

500,000 400,000 700,000 1,100,000

= Pretax investment

$1,545,000 $1,645,000 $1,345,000 $945,000

+ Tax on proceeds of old machine

0 -35,000 70,000 210,000

= Initial cost of new machine

$1,545,000 $1,610,000 $1,415,000 $1,155,000

Multiyear investments

• Time 0, firm spends $18 million to acquire land

• Year 1, build a plant at a cost of $7 million• Year 2, Buy and install equipment at a cost of

$20 million • Cost of capital = 10%• Calculate PV in millions

Estimating operating CFs

• What matters to investors are the incremental CFs generated by the project

• Incremental Op CF=Change in (After tax income + Depr. - WC)• ∆OCF = (∆REV - ∆COST - ∆DEP)(1- ∆TAX) + ∆DEP - ∆ WC• ∆REV is the change in revenue• ∆COST is the change in operating costs• ∆DEP is the change in Depreciation• ∆WC is the change in Working capital• ∆TAX is the marginal income tax rate faced by the firm

Incremental Operating CF for year1Before After Increments Cash Flows

Sales 5,000,000 5,150,000 150,000 +$150,000

Costs 4,000,000 3,820,000 -180,000 +$180,000

Depreciation 500,000 800,000 300,000 -

Profit Before Tax

500,000 530,000 30,000 -

Tax @ 35% 175,000 185,500 10,500 -10,500

Profit After Tax 325,000 344,500 19,500 -

Depreciation 500,000 800,000 300,000 -

Cash Flow 825,000 1,144,500 319,500 +$319,500

Depreciation

• Because depreciation is a noncash charge, its only significance lies in the fact that it reduces or shields taxable income and therefore reduces taxes

• The value of Tax shield provided by depreciation charge of DEP in year t equals DEP*TAX

• TAX is the firm’s marginal income tax rate

Year by Year Depreciation Tax shield under MACRSYear Dep Base X Dep factor =Dep writeoff X marginal

Tax rate= Dep Tax shield

1 2,000,000 0.2 400,000 0.35 140,000

2 2,000,000 0.32 640,000 0.35 224,000

3 2,000,000 0.192 384,000 0.35 134,000

4 2,000,000 0.1152 230,400 0.35 80,640

5 2,000,000 0.1152 230,400 0.35 80,640

6 2,000,000 0.0576 115,200 0.35 40,320

Totals 2,000,000 0.35 700,000

Year Dep Tax shield -Lost Dep write-off =Incremental Tax shield

1 140,000 35,000 105,000

2 224,000 35,000 189,000

3 134,000 35,000 99,400

4 80,640 35,000 45,640

5 80,640 35,000 45,640

6 40,320 - 40,320

Totals 700,000 175,000 525,000

Depreciation cont.

• What really matters is the incremental depreciation tax shield

• Because Quantum Systems losses $100,000 in annual depreciation when the old machine is scrapped, incremental depreciation in each of the first five years is actually $100,000 less than the calculations indicate

Depreciation cont.

• As a result, the annual net Tax shield provided by new machine is $35,000 ($100,000*0.35) less than the gross tax shield it provided or 0.35 DEP - $35,000

• If it buys the new machine, Quantum systems will have annual incremental after tax revenue plus cost reductions equals to

[(150,000 + 180,000)*(1-0.35)] = $214,500

Depreciation cont.

• Incremental Operating CF in year t will be• $214,500 + 0.35 ∆DEPt• ∆DEPt is the incremental depreciation charge

in year t and 0.35 ∆DEP is the value of the incremental depreciation tax shield provided by the new machine

Calculation of Incremental Operating CFs

Year Incremental revenues and cost reduction (After tax)

+ Incremental Depreciation tax shield

= Incremental Operating CF

1 214,500 105,000 319,500

2 214,500 189,000 403,500

3 214,500 99,400 313,900

4 214,500 45,640 260,140

5 214,500 45,640 260,140

6 - 40,320 40,320

Financing costs

• We left out financing costs when estimating Operating CFs

• Usually in the form of dividends and interest• The reason for this omission is that the cost of

capital for the project already incorporates the cost of these funds

• No double counting

Estimating the Terminal value• The terminal value of any asset is equal to the

present value of future cash flows generated by the asset, whether it be the scrap value of the extrusion press or the revenue produced by a product

• In addition, it is assumed that any working capital investment will be recaptured at the termination of the project

• It includes any additional expenses required to meet environmental regulations

Terminal value cont.

• Salvage value end of Yr 5 is $500,000• Book value is $115,200• Taxable gain = 500,000 – 115,200 = $384,800• Taxes owed = 384,800*0.35 = $134,680• After tax Salvage value = $500,000 - $134,680• Recapture of working capital = $45,000• Terminal value=$365,320+$45,000 = $410,320

Calculating the project NPV

• Old machine can be sold for $700,000• Initial cash outflow of $1,415,000• Discount rate of 15%• Assume a ZERO terminal value• NPV = -$347,604• The terminal value must be greater than

347,604 * (1.15)5 = $699,155 for the machine to have positive NPV

Project CF and their PVYear Cash Flow Present Value

Factor @15%Present value

0 -1,415,000 1.0000 -1,415,000

1 319,500 0.8696 277,826

2 403,500 0.7561 305,104

3 313,900 0.6575 206,394

4 260,140 0.5718 148,736

5 260,140 0.4972 129,336

Total - 347,604

Calculating Project NPV cont,• We subtract $45,000 in recaptured WC which

leaves after tax salvage value of $654,156• Sale price – Tax on Sale = Sale price – (Sale price –

BV) * Tax Rate• Given a BV of $115,200• Gives us a Sale price of $944,366• The value of the new machine at end of 5 years

must exceed $944,366 to make it worthwhile for the company to replace its old machine today

The new Product Introduction Decision

• Today, the project will require capital equipment with an installed cost of $6 million

• During year 7, the plant will be sold for $1 million

• Depreciation on a straight line• Zero Salvage value• Required return of 20%

Smith corporation new product financial forecasts (in thousands$)

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 production

3,000 1,000

Depreciation 0 1,000 1,000 1,000 1,000 1,000 1,000

Profit before Taxes

-3,000 -2,300 1,090 2,040 1,660 1,660 520

Taxes @35% -1,050 -805 382 714 1,512 581 182

Profit after taxes

-1,950 -1,495 709 1,326 2,808 1,079 338

Level of WC 250 660 960 1,680 840 480

Smith corporation summary of CFs for new product introductionYear Capital

EquipmentProfit After Tax + Dep

Change in Working Capital

Total Cash Flow

PV @ 20%

0 -6,000 -1,950 -7,950 -7,950

1 - -495 -250 -745 -621

2 - 1,709 -410 1,299 902

3 - 2,326 -300 2,026 1,172

4 - 3,808 -720 3,088 1,489

5 - 2,079 840 2,919 1,173

6 - 1,338 360 1,698 569

7 650 480 1,130 315

NPV = - 2, 950

New product introduction cont.

• Taxable gain of $1 million• Taxes of $350,000• An increase in WC is a use of cash which is

cash outflow• Decrease in WC are a source of cash

Estimating Terminal values for new product introductions

• Terminal values:– The salvage value of the equipment (after tax)– Recovery of project’s working capital– CFs beyond the initial evaluation period

gk

CFTV n

n 1

Smith corporation New product #2 financial forecastsPeriod 0 1 2 3 4 5 6

Sales 2,500 10,000 16,500 21,000 23,000 25,000

Cost of goods sold

1,625 6,500 10,725 13,650 14,950 16,250

Selling/Admin expenses

3,000 3,000 3,000 3,000 3,000 3,000 3,000

Depreciation 750 750 750 750 - -

Profit before tax

-3,000 -2,875 -250 2,025 3,600 5,050 5,750

Tax @35% -1,050 -1,006 -88 709 1,260 1,768 2,013

Profit after tax

-1,950 -1,869 -163 1,316 2,340 3,283 3,738

Level of working capital

750 3,000 4,950 6,300 6,900 7,500

Smith corporation summary of CF for new product #2 introduction

Year Capital Equipment

Profit After Tax + Dep

Working capital

Total CF PV @ 24%

0 -3,000 -1,950 - -4,950 -4,950

1 - -1,119 -750 -1,869 -1,507

2 - 588 -2,250 -1,663 -1,081

3 - 2,066 -1,950 116 61

4 - 3,090 -1,350 1,740 736

5 - 3,283 -600 2,683 915

6 - 3,738 -600 3,138 863

NPV= - 4,963

Smith Corporation TV sensitivity analysisGrowth rate(%) Terminal value PV of TV Project NPV

3 15,391,143 4,233,902 (729,098)4 16,317,600 4,488,758 (474,242)5 17,341,579 4,770,441 (192,559)6 18,479,333 5,083,422 120,422 7 19,750,941 5,433,225 470,225 8 21,181,500 5,826,753 863,753

Biases in project CF Estimation

• Several factors contribute to the tendency that accepted projects do less well than expected

• Overoptimism• Lack of consistency• Natural Bias• Postinvestment audit

OverOptimism

• Project sponsors are generally optimistic about the prospects of the projects they advocate

• Spent great deal of time and effort• Emotionally involved in the acceptance of the

project• Optimistic rather than realistic• Greatly underestimated costs and inflated

benefits

Overoptimism• Estimates of project CFs are likely to be biased

upwards, resulting in an overstated expected NPV• Tend to ignore the consequences of future

competitive entry into their markets.• Successful products are likely to attract

competitors who will drive down prices and returns

• Revising upwards or downwards if someone is known to be overly optimistic or pessimistic

Lack of consistency

• When estimating cash flows, it is necessary to be consistent with the information contained in the discount rate

• Projected inflation-adjusted price increases should NOT exceed real interest rates

• Prices of Oil (Commodity) cannot be expected to rise by more than the real interest rate plus storage costs

• Arbitrage opportunity?!

Natural bias

• Average error associated with the CF forecasts• Projects with overestimated CFs are more

likely to be chosen than those whose CFs are underestimated

• The actual NPVs of projects undertaken will be generally lower than their predicted NPVs even if the underlying CF estimates are themselves unbiased

Postinvestment Audit• Once an investment has been made, it is largely a

sunk cost and should not influence future decisions• Management should conduct a postinvestment

audit that compares actual results with exante budgeted figures

• The firm can learn from its mistakes and its successes

• Firm can include correction factors in future investment analysis

PostInvestment audit cont,

• Help the firm improve its capital budgeting process and come up with better projects

• The firm can learn how to structure projects better

• The firm can repeat its successes and avoid future mistakes

Current Rules for Depreciation

• Depreciation is the annual income tax deduction that allows a business to recover the cost or other basis of certain property over the time it uses the property

• A business can depreciate most types of tangible property (except land) such as buildings, machinery, vehicles, furniture and equipment

Depreciation Rate

• The 200% declining balance method. Also known as double declining balance method

• The 150% declining balance method• The straight line method• Modified Accelerated Cost Recovery System

(MACRS)• MACRS assumes that the property is

depreciable for half of the taxable year in which it is placed in service

Depreciation Rate Half year convention

Year 3-Year 5-Year 7-Year

1 33.33% 20% 14.29%

2 44.45% 32% 24.49%

3 14.81% 19.2% 17.49%

4 7.41% 11.52% 12.49%

5 11.52% 8.93%

6 5.76% 8.92%

7 8.93%

8 4.46%

Incorporating inflation in Capital budgeting• The nominal interest rate already incorporates the

expected rate of inflation• Fisher equation:• R = a + i + ai• R is nominal return• A is real return• I is expected inflation rate• We must nominal CFs to account for the impact of

expected inflation on anticipated revenues and costs

Contractual vs. Noncontarctual CFs

• Contractual CFs are those fixed in nominal dollar terms

• Contractual CFs arise from such commitments as debt, longterm leases, labor contracts, rents, and AR, AP.

• NonContractual means that they fluctuate inline with changing market conditions

• Noncontractual CFs move in line with inflation

Contractual CFs vs. non contractual

• Contractual CFs:– Depreciation tax shield– Working capital recaptured

• Noncontractual CFs:– Cost savings– Additional revenues to be received from investing

in the new extrusion press– Investment in WC is equal to 30% of sales.

Therefore, it will rise with sales

Example• 7% rate of inflation• Adjust incremental sales and cost savings for

inflation• Expected 1st year revenues = 150,000*1.07• Expected 1st year cost savings=180,000*1.07• With 35% marginal corporate tax rate• After tax, the nominal increase will be – 10,500*0.65 = $6,825– 12,600*0.65=$8,190

Example cont.

• Additional investment in working capital of 10,500*0.30= $3,150

• The depreciation charge is fixed in nominal terms and so remains the same regardless of the rate of inflation

• The incremental project CF in the 1st year resulting from adjustment for inflation is 6,825+8,190+3,150 = $11,865

Project analysis incorporating 7% inflationYear 0 1 2 3 4 5

Sales 160.5 171.7 183.8 196.6 210.4

Cost savings 192.6 206.1 220.5 235.9 252.5

Incremental depreciation

300 540 284 130.4 130.4

Pretax incremental profit

53.1 -162.2 120.3 302.2 332.4

Tax @35% 18.6 -56.8 42.1 105.8 116.4

Profit after tax 34.5 -105.4 78.2 196.4 216.1

Operating CF 334.5 434.6 362.2 326.8 346.5

WC 0.3*Sales 48.2 51.5 55.1 59 63.1

Change in WC 3.2 3.4 3.6 3.9 4.1

Initial Invest -1,415

Net CF -1,415 331.4 431.2 358.6 322.9 342.4

PV @15% -1,415 288.1 326.1 235.8 184.6 170.2

NPV -$210,178

Inflation and Taxation• The current tax system taxes nominal income

rather than real income• Because the tax shield associated with the

depreciation charge is fixed in nominal terms, the real value declines as the rate of inflation rises

• The net effect of combining inflation with a tax system geared toward nominal instead of real gains or losses is to reduce the real CF associated with depreciable assets

Inflation and Taxation cont.

• This distorts investment decisions by reducing the attractiveness of capital intensive projects, especially those with long economic lives, relative to other projects as well as relative to consumption.

• The end result is more consumption and less investment