FINA 3330 - Chapter 9 (Making Capital Investment Decisions)

I. Cash Flow Estimation

A. Pro Forma Income Statements
B. Operating Cash Flow (OCF)
C. Change in Net Working Capital (∆NWC)
D. Capital Spending
E. Total Cash Flow
II. NPV

I. Cash Flow Estimation

In order to determine the cash flow for a project, the following must be included:
(1) incremental cash flows (cash flows that would not occur without the project considered).
(2) opportunity costs (the cash flows lost because of accepting the project)
(3) side effects (cannibalism)
(4) change in net working capital (NWC = CA – CL)

The following will never be included in the cash flow estimation:

(1) sunk costs (costs already incurred, which are not dependent on accepting the project)
(2) financing costs (these costs are already considered when calculating the cost of capital)

Example: Given the following information, prepare a pro-forma cash flow statement: ABC
Corp. considers buying a new piece of equipment that costs $24,000. This machine is depreciated
straight line to zero over the 3-year life of the project, and will be sold for $10,000 at the end of
the project. This company is in the 34 percent tax bracket. As a result of buying the new
equipment, sales in will grow by 5,000 units in the first year, by 8,000 units in the second year,
and by 12,000 units in the third year. The company anticipates a selling price per unit of $7. The
company also has variable costs of $4 per unit, and fixed costs of $5,000, all because of
acquiring the new machine. In order to start producing, an initial investment $2,000 in net
working capital is needed, and in the subsequent years for the life of the machine, net working
capital will be 15 percent of revenue. The company also predicts that, at the end of the project,
the entire level of inventory will be liquidated.

Solution:

A. Pro Forma Income Statement

Year 1 Year 2 Year 3
Sales (units) 5,000 8,000 12,000
Revenue ($7/unit x number of units) 35,000 56,000 84,000
less: Variable Costs (20,000) (32,000) (48,000)
less: Fixed Costs (5,000) (5,000) (5,000)
less: Depreciation (8,000) (8,000) (8,000)
EBIT 2,000 11,000 23,000
less: Taxes (34 percent) (680) (3,740) (7,820)
Net Income 1,320 7,260 15,180
B. Operating Cash Flow (OCF)
1. OCF = EBIT + Depreciation – Taxes
2. OCF = Net Income + Depreciation (bottom-up approach)
3. OCF = Sales – Costs – Taxes (top-down approach)
4. OCF = (Sales – Costs) x (1 – Tax Rate) + Depreciation x Tax Rate

Please note that the formulas above are equivalent. In other words, no matter what formula is
being used, the resulting OCF will be the same if all calculations are correct.

For our example, the bottom-up approach will be used:

Year 1 Year 2 Year 3
Net Income 1,320 7,260 15,180
Depreciation 8,000 8,000 8,000
OCF 9,320 15,260 23,180

C. Change in Net Working Capital (∆NWC)

Year 0 Year 1 Year 2 Year 3
Revenue 0 35,000 56,000 84,000
Level NWC 2,000 5,250 8,400 12,600
Liquidation Value in Year 3 (12,600)
∆NWC 2,000 3,250 3,150 (8,400)

D. Capital Spending
Year 0 Year 1 Year 2 Year 3
Purchase Price 24,000 0 0 0
After-tax Proceeds from (6,600)
Market Sale
Depreciation Tax Shield 0
Capital Spending 24,000 (6,600)

E. Total Cash Flow

Year 0 Year 1 Year 2 Year 3
OCF 0 9,320 15,260 23,180
(∆NWC) (2,000) (3,250) (3,150) 8,400
(Capital Spending) (24,000) 0 0 6,600
Total Cash Flow (26,000) 6,070 12,110 38,180

II. NPV
Year 0 Year 1 Year 2 Year 3
Total Cash Flow (26,000) 6,070 12,110 38,180
Discounted Cash Flows (r = .15) (26,000) 5,278 9,157 25,104
NPV 13,539

Because NPV>0, the project should be accepted.