Cash Flow Estimation

Capital Budgeting Processes

 Capital budgeting process consists of:
 Estimating the cash flows associated with projects  Evaluating the estimates using NPV and IRR

 Forecasting cash flows is often taken for granted

 Estimating project cash flows is the most difficult and error-prone part of capital budgeting

The General Approach to Cash Flow Estimation

 Cash flow estimates are done in spreadsheet format by enumerating issues that impact cash and forecasting each over time
 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
3

The General Approach to Cash Flow Estimation

 General outline for estimating new venture cash flows
 Pre-Start-Up, the Initial Outlayspent before the project starts  Sales forecast, units and revenues  Cost of sales and expenses  Assetsnew assets to be acquired, including working capital  Depreciation  Taxes and Earnings  Summarize and combineadjust earnings for depreciation and combine it with the balance sheet items to arrive at a cash flow estimate

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

A Few Specific Issues

 Regardless of the project, the basic process is the same
 The Typical Pattern
  Requires an initial outlay Subsequent cash flows be positive tend to

 Project Cash Flows Are Incremental

 Separable from the existing business
6

A Few Specific Issues

  Sunk Costs
    Have already been spent and are ignored The value of a resource in its best alternative use The cost of a resource is whatever is given up to use it Example: A firm needing a new warehouse could:
   Lease warehouse space Buy a warehouse Build warehouse on land it already owns which might be sold for $1,000,000  the opportunity cost of the land is $1,000,000  It isnt free even though there was no immediate need for it

Opportunity Costs

A Few Specific Issues

Impacts on Other Parts of Company
Sales erosion: a new product may take some revenue from older lines Raw materials may be cheaper when purchased in larger volumes

Taxes
Projects that improve profitability also result in paying more tax - a current cash outflow Show cash flows in every period net of taxes

A Few Specific Issues

Cash Versus Accounting Results
Capital budgeting deals only with cash flows, but Business managers always want an estimate of a projects impact on net income

Working Capital
Projects generally require additional working capital, which requires cash
Increasing net working capital means a cash outflow Cash flow is the change in working capital

A Few Specific Issues

 Ignore Financing Costs
 Ignore interest expense when estimating incremental cash flows  NPV and IRR comprehend project financing costs
 do not include the interest as a cash outflow
 Unlike financial planning (chapter 4)

 Old Equipment
 Selling used equipment generates a cash inflow  Recognize tax on any accounting profit realized on the sale as a cash outflow

10

Estimating New Venture Cash Flows

 New venture projects tend to be larger and more elaborate than expansions or replacements
 Incremental cash flows can be easier to isolate since the whole project is viewed as distinct and separate from the rest of the company

11

Terminal Values
 Cash flows forecast to continue forever are compressed into finite terminal values using perpetuity formulas
 Most common with new ventures  A repetitive cash flow starting in year 7 is valued as a perpetuity  In Wilmonts case if k = 10% $140,000 / .10 = $1,400,000 (Note that TVs can overwhelm other figures in the cash flow estimate)
12

Accuracy and Estimates

 NPV and IRR techniques give the impression of great accuracy  Capital budgeting results are no more accurate than the projections of the future used as inputs  Unintentional biases are a problem in capital budgeting
 Favorable biases - projects are usually proposed by people who want them approved  Who tend to overestimate benefits and underestimate costs
13

MACRSA Note on Depreciation

 U.S. government allows accelerated depreciation for income tax purposes
 Depreciation is shifted so more is taken earlier in the projects life, while total depreciation remains the same
 It is advantageous to take larger tax deductions earlier because of the time value of money
 Present value of tax savings is greater

Companies generally dont use accelerated methods for earnings reported to the public
 Reported earnings are lower in the near term if accelerated depreciation is used

14

Modified Accelerated Cost Recovery System

 The tax code dictates exactly how accelerated depreciation is to be done  MACRS classifies assets into different categories and specifies a depreciation life for each
 A table shows the percentage of the assets cost that can be taken in depreciation during each year of life  Applies only to equipment
  Buildings are depreciated using straight-line over 27.5 years (residential) and 39 years (otherwise) Land isnt depreciated

15

Modified Accelerated Cost Recovery System

16

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 dont do the project
 If replacing an old production machine, do you:
  compare the performance of the new machine to the current performance of the old, or compare it to flows the current machine are expected to generate if it continues to deteriorate

17

Estimating Cash Flows for Replacement Projects

Example 11.2

Example

Q: Harrington Metals Inc. purchased a large stamping machine five years ago for $80,000. To keep the example simple well assume that the tax laws at the time permitted straight-line depreciation over eight years and that machinery purchased today can be depreciated straight line over five years. The machine has not performed well, and management is considering replacing it with a new one that will cost $150,000. If the new machine is purchased, it is estimated that the old one can be sold for $45,000. The quoted costs include all freight, installation and setup. The old machine requires three operators, each of whom earns $25,000 a year including all benefits and payroll costs. The new machine is more efficiently designed and will require only two operators, each earning the same amount.

18

Estimating Cash Flows for Replacement Projects

Year 1 Hours down 40 In warranty 2` 60 $10 3 100 $35 4 130 $42

Example 11.2

Q: The old machine has the following history of high maintenance cost and significant downtime.
5 128 $45

Example

Maintenance expense ($000)

Downtime on the machine is a major inconvenience, but it doesnt usually stop production unless it lasts for an extended period. This is because the company maintains an emergency inventory of stamped pieces and has been able to temporarily reroute production without much notice. Manufacturing managers estimate that every hour of downtime costs the company $500, but have no hard data backing up that figure.
19

Estimating Cash Flows for Replacement Projects

Example 11.2

Q: The makers of the replacement machines have said that Harrington will spend about $15,000 a year maintaining their product and that an average of only 30 hours of downtime a year should be expected. However, they are not willing to guarantee those estimates after the one-year warranty runs out.

Example

The new machine is expected to produce higher quality output than the old one. The result is expected to be better customer satisfaction and possibly more sales in the future. Management would like to include some benefit for this effect in the analysis, but is unsure of how to quantify it. Estimate the incremental cash flows over the next five years associated with buying the new machine. Assume Harringtons marginal tax rate is 34%, and that the company is currently profitable so that changes in taxable income result in tax changes at 34% whether positive or negative. Assume any gain on the sale of the old machine is also taxed at 34% since corporations dont receive favorable tax treatment on capital gains.

20

Estimating Cash Flows for Replacement Projects

Example 11.2

A: There are two kinds of cash flows in this problemthose that can be estimated fairly objectively and those that require some degree of subjective guesswork. Objective Cash Flows:

Example

The initial outlay is relatively straightforward:

Cost of new machine Less proceeds from sale of old machine Initial outlay $150.0 39.9 $110.1
The old machine has a current market value of $45,000 and a book value of $30,000 (initial cost of $80,000 les depreciation of $50,000). Thus, a gain on the sale of the old machine of $15,000 results in additional taxes of $5.1. The net cash proceeds on the sale of the old machine are $39.9 (or $45.0 $5.1).

21

Estimating Cash Flows for Replacement Projects Example 11.2

A: Depreciation and labor savings are straightforward as well:
Year 1 New depreciation Old depreciation $30.0 10.0 $20.0 $6.8 2 $30.0 10.0 $20.0 $6.8 3 $30.0 10.0 $20.0 $6.8 $30.0 $10.2 $30.0 $10.2 4 $30.0 5 $30.0

Example

Net increase in depreciation Cash tax savings @ 34% Labor savings

$25.0

$25.0

$25.0

$25.0

$25.0

Represent the cost savings from needing only two employees rather than three.
22

Estimating Cash Flows for Replacement Projects

Example 11.2

A: The subjective benefits (which are based on opinions) are hard to quantify and lead to biases when estimated by people who want project approval. The financial analyst should ensure that only reasonable estimates of unprovable benefits are used.
Year 1 2 $45.0 15.0 $30.0 3 $45.0 15.0 $30.0 4 $45.0 15.0 $30.0 5 $45.0 15.0 $30.0

Example

Old machine maintenance New machine maintenance Savings

$45.0 In warranty $45.0

The question is: Should we assume maintenance on the old machine would have remained at $45.0 or increase as the machine gets older? Also, will maintenance on the new machine rise as the new machine ages?
23

Estimating Cash Flows for Replacement Projects

Example 11.2

A: Another subjective estimate is that of downtime. The old machine has been
having about 130 hours of downtime while the new one promises 30 hoursa savings of 100 hours. But, argument could be made for using different assumptions for downtime hours. Another question is: How much is each hour of downtime savings worth? Arguments range from no savings (as we are unable to say exactly how much its worth) to $500 an hour. Most people favor a middle-of-the-road approachwell use $200 an hour, which yields an estimated cash flow savings of $20,000 per year.
1 $25.0 $45.0 $20.0 $90.0 30.6 $59.4 6.8 $66.2 2 $25.0 $30.0 $20.0 $75.0 25.5 $49.5 6.8 $56.3 Year 3 $25.0 $30.0 $20.0 $75.0 25.5 $49.5 6.8 $56.3 4 $25.0 $30.0 $20.0 $75.0 25.5 $49.5 10.2 $59.7 5 $25.0 $30.0 $20.0 $75.0 25.5 $49.5 10.2 $59.7

Example

Labor savings Maintenance savings Downtime savings Total Tax Net after tax Tax savings on depreciation Cash flow

24