Valuation Cash Flow

Finance

Professor Jaime F. Zender

Incremental Project Cash FlowIncremental Project Cash Flow

Incremental project cash flow for a given period is the company’s total cash flow if it undertakes a proposed project less the company’s total cash flow without the project. Some issues that arise: Sunk costs. These are costs, perhaps related to the

project, that have already been incurred. Opportunity costs. What else could be done? Capital expenditures versus depreciation expense. Side effects. Does the new project affect existing firm

cash flow? Taxes. Increased investment in working capital.

Sunk Costs vs. Opportunity CostsSunk Costs vs. Opportunity Costs

A short time ago you purchased a plot of land for $2.5 million.

Currently, its market value is $2.0 million.

You are considering placing a new retail outlet on this land. How should the land cost be evaluated for purposes of projecting the cash flows that will become part of the NPV analysis?

Sunk Costs vs. Opportunity Costs

Sunk costs should never be evaluated as part of the incremental cash flow of a project. These are costs faced by the firm, regardless of whether the firm undertakes the project. They are usually easy to measure as they have already been incurred.The opportunity costs generated by a project should always be included in the incremental cash flow for that project.The most valuable opportunity forgone due to the decision to undertake a project is the lost opportunity. Often these are difficult to measure and sometimes difficult to recognize.

Side Effects

A further difficulty in determining project cash flow comes from affects the proposed project may have on other parts of the firm.

The most important side effect is called erosion: cash flow transferred from existing operations to the project. Chrysler’s introduction of the minivan.Chrysler’s introduction of the minivan. What if a competitor would introduce the new What if a competitor would introduce the new

product if your company does not?product if your company does not?

TaxesTaxes

Typically, Revenues are taxable when accrued, Expenses are deductible when accrued, Capital expenditures are not deductible, but

depreciation can be deducted as it is accrued, tax depreciation can differ from that reported on

public financial statements, Sale of an asset for a price other than its tax basis

(original price less accumulated tax depreciation) leads to a capital gain/loss with tax implications.

Working CapitalWorking Capital

Increases in Net Working Capital should typically be viewed as requiring a net cash outflow. An increase in inventory (and/or the cash balance)

requires an actual use of cash. An increase in receivables means that accrued revenues

exceeded actual cash collections. If you are using accrued revenues you need a

correcting adjustment. If you are using cash revenues then no adjustment is

required.

EXAMPLE: The Story of BK Industries

BK Industries has been producing publishing equipment for some time now and the CEO believes that he has stumbled upon a valuable product innovation that embeds new features in text editing systems. BK’s cost advantages and vast skill in marketing mean it would be difficult for competitors to undertake such a project.

• So, last year BK Inds. spent $6.0 million on R&D and a test marketing of the TES (text editing system). Now BK must evaluate the project.

BK Industries

Costs and benefits are summarized as follows:

The TESs will be produced in a vacant building owned by BK near LA. The current market value is $15.0 million. The adjusted basis (purchase price less accumulated depreciation) of the building and land is also $15.0 million.

The equipment required to produce the TES costs $10.0 million and after five years of production has an estimated sale value of $3.0 million.

BK Industries

• Production and sales are expected to be 500 units in 2005, 800 units in 2006, 1200 units in 2007, 1000 units in 2008, and 600 units in 2009.

• Price of TESs will be $20,000 in 2005 and will grow only at 2% (compared to 5% general inflation).

• Costs which start at $10,000 a unit are expected to increase at 10% a year.

BK needs added working capital to run the project and believes that the various sources of working capital will require a total investment of $1.0 million in the year prior to the first year of production, i.e. now, ten percent of yearly sales for 2005 to 2008, and zero in 2009 as the project is terminated and working capital is recovered.The levels of working capital are therefore forecast to be $1.0 million today, and {$1.0 million, $1.632 million, $2.497 million, $2.122 million, $0} in 2005 through 2009, respectively.

BK Industries – Working Capital

BK Industries

(1) Year

(2) Units

(3) Price/Unit

(4) Sales

(5) Cost/Unit

(6) Op. Costs

2005 500 $20,000 $10,000,000 $10,000 $5,000,000

2006 800 $20,400 $16,320,000 $11,000 $8,800,000

2007 1200 $20,810 $24,972,000 $12,100 $14,520,000

2008 1000 $21,220 $21,220,000 $13,310 $13,310,000

2009 600 $21,650 $12,990,000 $14,640 $8,784,000

Depreciation for BK Industries

Recovery Period ClassYear 3 years 5 years 7 years1 $3,334,000 $2,000,000 $1,428,0002 $4,444,000 $3,200,000 $2,449,0003 $1,481,000 $1,920,000 $1,749,0004 $741,000 $1,152,000 $1,250,0005 $1,152,000 $892,0006 $576,000 $892,0007 $892,0008 $448,000Total $10,000,000 $10,000,000 $10,000,000

Assume a 5 year recovery period is appropriate.Tax Rate: BK Inds. marginal tax rate is 34%.

BK Industries WorksheetInvestments

($ Millions) Year 0 Year 1 Year 2 Year 3 Year 4 Year 5Investments: 2004 2005 2006 2007 2008 2009(1)Purchase and Salvage of TES-Making PPE (Property, Plant, and Equipment) 0 0 0 0(2) Accumulated Depreciation 0 2 5.2 7.12 8.272 9.424(3) Adjusted Basis of Machine After Depreciation 10 8 4.8 2.88 1.728 0.576(4) Capital Gain on Sale of PPE 0 0 0 0 0(5) Cash Flow: Tax on PPE Capital Gain 0 0 0 0 0(6) Opportunity Cost (warehouse) 0 0 0 0(7) Net Working Capital (year end) 1 1 1.632 2.497 2.122 0(8) Cash Flow: Minus Change in NWC -1 0 -0.632(9) Aggregated Cash Flows of Investment [(1)+(5)+(6)+(8)] 0 -0.632 0.375

BK Industries WorksheetInvestments

($ Millions) Year 0 Year 1 Year 2 Year 3 Year 4 Year 5Investments: 2004 2005 2006 2007 2008 2009(1)Purchase and Salvage of TES-Making PPE (Property, Plant, and Equipment) -10 0 0 0 0 3(2) Accumulated Depreciation 0 2 5.2 7.12 8.272 9.424(3) Adjusted Basis of Machine After Depreciation 10 8 4.8 2.88 1.728 0.576(4) Capital Gain on Sale of PPE 0 0 0 0 0(5) Cash Flow: Tax on PPE Capital Gain 0 0 0 0 0(6) Opportunity Cost (warehouse) 0 0 0 0(7) Net Working Capital (year end) 1 1 1.632 2.497 2.122 0

(8) Cash Flow: Minus Change in NWC -1 0 -0.632(9) Aggregated Cash Flows of Investment [(1)+(5)+(6)+(8)] 0 -0.632 0.375

BK Industries WorksheetInvestments

($ Millions) Year 0 Year 1 Year 2 Year 3 Year 4 Year 5Investments: 2004 2005 2006 2007 2008 2009(1)Purchase and Salvage of TES-Making PPE (Property, Plant, and Equipment) -10 0 0 0 0 3(2) Accumulated Depreciation 0 2 5.2 7.12 8.272 9.424(3) Adjusted Basis of Machine After Depreciation 10 8 4.8 2.88 1.728 0.576(4) Capital Gain on Sale of PPE 0 0 0 0 0 2.424(5) Cash Flow: Tax on PPE Capital Gain 0 0 0 0 0 -0.82(6) Opportunity Cost (warehouse) 0 0 0 0(7) Net Working Capital (year end) 1 1 1.632 2.497 2.122 0

(8) Cash Flow: Minus Change in NWC -1 0 -0.632(9) Aggregated Cash Flows of Investment [(1)+(5)+(6)+(8)] 0 -0.632 0.375

BK Industries WorksheetInvestments

($ Millions) Year 0 Year 1 Year 2 Year 3 Year 4 Year 5Investments: 2004 2005 2006 2007 2008 2009(1)Purchase and Salvage of TES-Making PPE (Property, Plant, and Equipment) -10 0 0 0 0 3(2) Accumulated Depreciation 0 2 5.2 7.12 8.272 9.424(3) Adjusted Basis of Machine After Depreciation 10 8 4.8 2.88 1.728 0.576(4) Capital Gain on Sale of PPE 0 0 0 0 0 2.424(5) Cash Flow: Tax on PPE Capital Gain 0 0 0 0 0 -0.82(6) Opportunity Cost (warehouse) -15 0 0 0 0 15(7) Net Working Capital (year end) 1 1 1.632 2.497 2.122 0

(8) Cash Flow: Minus Change in NWC -1 0 -0.632(9) Aggregated Cash Flows of Investment [(1)+(5)+(6)+(8)] 0 -0.632 0.375

BK Industries WorksheetInvestments

($ Millions) Year 0 Year 1 Year 2 Year 3 Year 4 Year 5Investments: 2004 2005 2006 2007 2008 2009(1)Purchase and Salvage of TES-Making PPE (Property, Plant, and Equipment) -10 0 0 0 0 3(2) Accumulated Depreciation 0 2 5.2 7.12 8.272 9.424(3) Adjusted Basis of Machine After Depreciation 10 8 4.8 2.88 1.728 0.576(4) Capital Gain on Sale of PPE 0 0 0 0 0 2.424(5) Cash Flow: Tax on PPE Capital Gain 0 0 0 0 0 -0.82(6) Opportunity Cost (warehouse) -15 0 0 0 0 15(7) Net Working Capital (year end) 1 1 1.632 2.497 2.122 0

(8) Cash Flow: Minus Change in NWC -1 0 -0.632 -0.865 0.375 2.122(9) Aggregated Cash Flows of Investment [(1)+(5)+(6)+(8)] 0 -0.632 0.375

BK Industries WorksheetInvestments

($ Millions) Year 0 Year 1 Year 2 Year 3 Year 4 Year 5Investments: 2004 2005 2006 2007 2008 2009(1)Purchase and Salvage of TES-Making PPE (Property, Plant, and Equipment) -10 0 0 0 0 3(2) Accumulated Depreciation 0 2 5.2 7.12 8.272 9.424(3) Adjusted Basis of Machine After Depreciation 10 8 4.8 2.88 1.728 0.576(4) Capital Gain on Sale of PPE 0 0 0 0 0 2.424(5) Cash Flow: Tax on PPE Capital Gain 0 0 0 0 0 -0.82(6) Opportunity Cost (warehouse) -15 0 0 0 0 15(7) Net Working Capital (year end) 1 1 1.632 2.497 2.122 0

(8) Cash Flow: Minus Change in NWC -1 0 -0.632 -0.865 0.375 2.122(9) Aggregated Cash Flows of Investment [(1)+(5)+(6)+(8)] -26 0 -0.632 -0.865 0.375 19.3

BK Industries WorksheetOperating Cash Flows

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5Cash Flow From Operations: 2004 2005 2006 2007 2008 2009(10) Cash Flow: Sales Revenue 0 10 16.32 24.97 21.22 12.99(11) Cash Flow: Operating Costs 0 -5 -8.8 -14.5 -13.31 -8.785(12) Depreciation 0 -2 -3.2 -1.92 -1.152 -1.152(13) Cash Flow: Taxes (Operations) -1.02 -1.47(14) Cash Flow From Operations [(10)+(11)+(13)] 3.98 6.051

BK Industries WorksheetOperating Cash Flows

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5Cash Flow From Operations: 2004 2005 2006 2007 2008 2009(10) Cash Flow: Sales Revenue 0 10 16.32 24.97 21.22 12.99(11) Cash Flow: Operating Costs 0 -5 -8.8 -14.5 -13.31 -8.785(12) Depreciation 0 -2 -3.2 -1.92 -1.152 -1.152(13) Cash Flow: Taxes (Operations) 0 -1.02 -1.47 -2.9 -2.299 -1.038(14) Cash Flow From Operations [(10)+(11)+(13)] 3.98 6.051

BK Industries WorksheetOperating Cash Flows

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5Cash Flow From Operations: 2004 2005 2006 2007 2008 2009(10) Cash Flow: Sales Revenue 0 10 16.32 24.97 21.22 12.99(11) Cash Flow: Operating Costs 0 -5 -8.8 -14.5 -13.31 -8.785(12) Depreciation 0 -2 -3.2 -1.92 -1.152 -1.152(13) Cash Flow: Taxes (Operations) 0 -1.02 -1.47 -2.9 -2.299 -1.038(14) Cash Flow From Operations [(10)+(11)+(13)] 0 3.98 6.051 7.551 5.615 3.166

BK IndustriesIncremental Cash Flows

NPV (@ r=10%) =

-26.00 + 3.98/(1.10) + 5.42/(1.10)2 + 6.69/(1.10)3 +

5.99/(1.10)4 + 22.46/(1.10)5 = $5.159 Million

($ Millions) Year 0 2004

Year 1 2005

Year 2 2006

Year 3 2007

Year 4 2008

Year 5 2009

(A) Cash Flow From Investment

-26.0 0.0 -0.632 -0.865 0.375 19.298

(B) Cash Flow From Operations

0.0 3.98 6.051 7.550 5.615 3.167

Project Cash Flow [(A) + (B)]

-26.00 3.98 5.42 6.69 5.99 22.46

For a Firm as a Whole

When you are interested in valuing an entire firm rather than a project the relevant concept is Free Cash Flow.FCF: Start with: Net Income (from Operations) Add back: Depreciation & Amortization Subtract: Change in NWC*

Add: Change in deferred income tax Subtract: Net Capital Expenditures Add: After tax interest – (1-Tc)Interest