Topic 6 - Cashflow Estimation

Chapter Eleven – Cash Flow Estimation
Cash Flow Estimation
Project Cash Flows
Estimating new venture Cash Flows
Estimating Cash Flows for Replacement Projects
• 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
• 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
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 Forecast
Forecast incremental units over time in spreadsheet form
Extend by prices for revenues
or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐
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 needed
Include 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 earnings
Treat incremental taxes like any other cash flow item
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
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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 Incremental
• Separable from the existing business
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
Project Cash Flows
• Impacts on other parts of company
• Overhead levels
• Taxes
• Cash v. accounting results
• Working capital
• Ignore financing costs
• Old equipment
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 11‐1
New Venture Cash Flows
Wilmont Bicycle is considering a new business
proposal to produce off-road bikes. The following
information is forecast:
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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 $30,700
Market value is now $150,000.
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• 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
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%.
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Venture Cash Flows
Initial Outlay costs of hiring, training and advertising are tax
deductible:
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Venture Cash Flows
Add operating items and assets for the total pre-start-up outlay:
Net after tax expenses $95.7
Assets subtotal $272.0
Actual pre-start-up outlay $367.7
Opportunity cost of land
Market value $150,000
Cost $30,700
Capital gain $119,300
Tax $40,600
Opportunity cost $150,000 - $40,600 = $109,400
C0, the initial outlay, is
$367,700 + $109,400 = $477,100.

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Venture Cash Flows
Sales are forecasted to grow
for 4 years before leveling off. Wilmont Bicycle Company
We’ll estimate for 6 years— Estimated Cash Flows
for a longer forecast repeat Mountain Bike Project ($000s)
the last year as.
1 2 3 4 5 6+
Revenue and Gross Margin
Units 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
The building is Tax Deductible Expenses

depreciated SG&A expense $ 120.0 $ 120.0 $ 120.0 $ 120.0 $ 120.0 $ 120.0
over 39 years Depreciation $ 41.5 $ 41.5 $ 41.5 $ 41.5 $ 41.5 $ 1.5
while the General overhead $ 2.4 $ 7.2 $ 14.4 $ 18.0 $ 18.0 $ 18.0
equipment is Loss old line $ 1.4 $ 4.3 $ 8.6 $ 10.8 $ 10.8 $ 10.8
depreciated
Total $ 165.4 $ 173.1 $ 184.6 $ 190.3 $ 190.3 $ 150.3
over 5 years.
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Assume
that the
Profit Impact and Tax
$12,000 of STET impact $ (117.4) $ (29.1) $ 103.4 $ 169.7 $ 169.7 $ 209.7
initial Tax $ (39.9) $ (9.9) $ 35.2 $ 57.7 $ 57.7 $ 71.3
inventory NET impact $ (77.5) $ (19.2) $ 68.3 $ 112.0 $ 112.0 $ 138.4
was Add depreciation $ 41.5 $ 41.5 $ 41.5 $ 41.5 $ 41.5 $ 1.5
acquired Subtotal $ (35.9) $ 22.4 $ 109.8 $ 153.5 $ 153.5 $ 139.9
prior to Working Capital

start‐up. Accounts 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 Flow

Net cash (52.9) (7.1) 73.8 139.3 153.5 139.9
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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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 each

New machine - two operators $25,000/year each
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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.
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.
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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
• Objective Items: Depreciation and Labor
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?
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.
• Combining these with the initial outlays yields the project’s estimated
cash flow stream.
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Chapter Eleven – Cash Flow Estimation

Taxes and Earnings

 Facilities are at capacity, so a new shop is required.

Revenues collected in 30 days.

Opportunity cost $150,000 - $40,600 = $109,400

C0, the initial outlay, is

$367,700 + $109,400 = $477,100.

The building is Tax Deductible Expenses

prior to Working Capital

Net Cash Flow

Depreciated straight-line over eight years

Considering replacing with a new one costing $150,000.

Old machine - three operators $25,000/year each

Manufacturing managers estimate every hour of downtime costs

The new machine is expected to produce higher

The question is: Should we assume maintenance on the old machine

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