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Cash Flow Estimation
Slides Developed by:

Terry Fegarty
Seneca College

2006 by Nelson, a division of Thomson Canada Limited

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Chapter 13 Outline
Cash Flow Estimation
Capital Budgeting Process
Project Cash FlowsAn Overview and Some
specifics
The General Approach to Cash Flow Estimation
A Few Specific Issues
Terminal Values
Accuracy and Estimates
CCAA Note on Amortization for Tax Purposes
Capital Cost Allowance System
CCA Tax Shield
Estimating Cash Flows for Replacement Projects


2006 by Nelson, a division of Thomson Canada Limited

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Capital Budgeting Process
Consists of the following steps:
1. Determine (estimate) expected cash flows of
available projects
2. Evaluate estimates using decision criteria such as
NPV and IRR
People tend to take forecasted cash flows for
granted, but they are subject to error
Estimating project cash flows is the most difficult
and error-prone part of capital budgeting

2006 by Nelson, a division of Thomson Canada Limited

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The General Approach to Cash
Flow Estimation
Consider each expected impact of project
on firms cash flows
Cash estimates are done on spreadsheets
Enumerate the issues that impact cash and forecast each
over time
Forecasts for new ventures tend to be the
most complex

2006 by Nelson, a division of Thomson Canada Limited

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The General Approach to Cash
Flow Estimation
General outline for estimating new venture cash flows
Pre-start-up, the initial outlayeverything that has to be
spent before the project is started
Sales forecastunits and revenues
Cost of sales and expenses
Assetsnew assets to be acquired, including changes in
working capital
Amortizationnon-cash expense but affects income taxes
Taxes and earnings
Summarize and combineadjust earnings for amortization and
combine result with balance sheet items to arrive at a cash flow
estimate

2006 by Nelson, a division of Thomson Canada Limited

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The General Approach to Cash
Flow Estimation
Expansion projectstend to require
the same elements as new ventures
But less new equipment and facilities
Replacement projectsgenerally
expected to save costs without
generating new revenue
Estimating process tends to be somewhat
less elaborate

2006 by Nelson, a division of Thomson Canada Limited

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A Few Specific Issues
The Typical Pattern
At beginning of the project, some amount must be spent to
invest in the project (Initial outlay)
Subsequent cash flows tend to be positive

Project Cash Flows Are Incremental
What cash flows will occur if we undertake this project that
wouldnt occur if we left it undone and continued business as
before?


2006 by Nelson, a division of Thomson Canada Limited

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A Few Specific Issues
Sunk Costs
Costs that have already occurred and cannot be recovered
should not be included in projects cash flows
Only future costs are relevant

Opportunity Costs
What is given up to undertake the new project
The opportunity cost of a resource is its value in its best
alternative use
For instance, if firm needs a new warehouse, it could either:
Lease warehouse space
Buy warehouse
Build warehouse on land they currently own (but could
sell for $1,000,000)the $1,000,000 represents an
opportunity cost

2006 by Nelson, a division of Thomson Canada Limited

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A Few Specific Issues
Impacts on Other Parts of Company
Sales erosion (cannibalization)when firm sells a product that
competes with other products within the same firm (Diet Coke
vs. Coke Classic)
Margin lost in other linenegative cash flow for project

Taxes
Cash outflow
Use after-tax cash flows

Cash Versus Accounting Results
Capital budgeting deals only with cash flows; however
business managers want to know projects net income


2006 by Nelson, a division of Thomson Canada Limited

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A Few Specific Issues
Working Capital
New project often requires investment in working capital
inventory, for instance
Increasing net working capital means cash outflow
Ignore Financing Costs
Do not include interest expense on debt (or dividends on
shares) as cash outflow
Addressed via discount rate when determining NPV or
evaluating IRR
Old Equipment
If this is replacement project, old equipment can be sold
(thereby generating a cash inflow)


2006 by Nelson, a division of Thomson Canada Limited

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A Few Specific Issues

2006 by Nelson, a division of Thomson Canada Limited

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Table 13.1: Cash Flow Estimation
:
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 of sales 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 Expenses
SG&A expense 120.0 $ 120.0 $ 120.0 $ 120.0 $ 120.0 $ 120.0 $
Amortization 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 $
Profit Impact and Tax
EBT 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 $
NI impact (77.5) $ (19.2) $ 68.3 $ 112.0 $ 112.0 $ 138.4 $
Add Amortization 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 $
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Table 13.1: Cash Flow Estimation
Working Capital
Accounts receivable 10.0 $ 30.0 $ 60.0 $ 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 19.0 $ 43.5 $ 87.0 $ 108.8 $ 108.8 $ 108.8 $
Change in working capital (7.0) $ (24.5) $ (43.5) $ (21.8) $ - $ - $
Net Cash Flow
Net cash (42.9) $ (2.1) $ 66.3 $ 131.8 $ 153.5 $ 139.9 $
Net cash - Year 7 139.9 $
Net cash - Year 8 139.9 $
Net cash - Year9 139.9 $
Net cash - Year 10 139.9 $
Initial Outlay -$497.40
Discount rate (k) 8%
NPV $95.14
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2006 by Nelson, a division of Thomson Canada Limited

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Terminal Values
Possible to assume that incremental cash flows
last forever
Especially common with new ventures
Compressed into terminal values using
perpetuity formulas
For instance, a repetitive cash flow starting at time 7
would be a perpetuity beginning at year 7
The present value at time 6 would be represented as

Very sensitive to discount rate
May be preferable to set a time limit, say 10 years
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2006 by Nelson, a division of Thomson Canada Limited

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Accuracy and Estimates
NPV and IRR techniques give impression of
great accuracy
However, capital budgeting results no more
accurate than projections of the future used as
inputs
Unintentional biases probably biggest problem
in capital budgeting
Projects generally proposed by people who want to
see them approved which leads to favourable biases
Tend to overestimate benefits and underestimate costs

2006 by Nelson, a division of Thomson Canada Limited

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CCAA Note on Amortization for
Tax Purposes
CRA requires that firms use capital cost
allowance (CCA) to calculate
amortization for income tax purposes
Provides for accelerated amortization
Amortization is shifted forward
More is taken early in projects life and less later
on
Total amortization remains the same
Larger tax deductions happen earlier
Present value of tax savings is greater

2006 by Nelson, a division of Thomson Canada Limited

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CCAA Note on Amortization for
Tax Purposes
Companies generally dont use
accelerated methods for earnings
reported to the public
Reported earnings are lower
If accelerated methods are used for tax
calculations, accelerated methods should be
used for cash flow projections

2006 by Nelson, a division of Thomson Canada Limited

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Capital Cost Allowance System
The Income Tax Act dictates exactly how
tax amortization (CCA) to be done
CCA divides capital assets into different
classes (categories) and assigns a CCA
rate for each
Most classes call for declining balance CCA
(accelerated amortization)


2006 by Nelson, a division of Thomson Canada Limited

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Table 13.2: Some Capital Cost
Allowance Classes

2006 by Nelson, a division of Thomson Canada Limited

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Capital Cost Allowance System
When asset is purchased, purchase
price added to appropriate class
Any increases in a class are usually eligible
for only half of the normal CCA in year they
are added (the half-year rule)
Once capital asset has been added to a CCA
class, capital cost allowance is calculated on
the undepreciated capital cost (UCC) of
the pool of assets, rather than on
individual assets

2006 by Nelson, a division of Thomson Canada Limited

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Capital Cost Allowance System
When asset is sold, lower of the sale price
or its original cost is deducted from the pool.
If asset sold for more than its original cost,
difference is capital gain for tax purposes.
Only 50% of capital gain is added to taxable income
for the year.
If sale of asset leaves no assets in the class,
resulting positive balance, if any, is terminal
loss
deductible for tax purposes.
Any negative balance in the class at the end of
the year is recapture
taxed as income.

2006 by Nelson, a division of Thomson Canada Limited

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CCA Tax Shield
CCA tax shieldtax savings from
deducting CCA on capital assets

For capital budgeting purposes, we need
to calculate present value of tax shield


2006 by Nelson, a division of Thomson Canada Limited

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Example 13.2: Capital Cost Allowance
and Tax Shield
A vehicle costing $30,000 is added to Class 10 (30%).
It will be sold in 4 years for $4,000. The tax rate is 39%.
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CCA Tax Shield
Formula: PV of CCA tax shield


Where: C = Cost of the new asset (less any proceeds on
disposal of assets replaced)
d = CCA rate for the asset class
T = Tax rate
k = Discount rate (cost of capital)
Spv= Present value of the salvage value of the new asset

n is the number of years until we
salvage the asset


n = Number of years until we sell the asset.
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2006 by Nelson, a division of Thomson Canada Limited

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Example 13.2: Capital Cost Allowance
and Tax Shield
We purchase a truck for $30,000
We will trade it in four years for $4,000
The CCA rate is 30%
Our tax rate is 39%
Our cost of capital is 12%

The present value of the salvage is $4,000 0.6355 = $2,542
The present value of the CCA tax shield:
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1 0.05 0.12
0.30 0.39
$30, 000 $2, 542 $7, 239
0.12 0.30 1.12
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Estimating Cash Flows for
Replacement Projects
Generally have fewer elements than new
ventures
Identifying what is incremental can be trickier
Can be difficult to determine what will happen if
you dont do the project
For example, if replacing old production machine,
Do you compare expected cash flows for the new machine to
current cash flows for the old?
Or do you compare cash flows for the new machine to
expected cash flows for the old machine if it continues to
deteriorate?