Practical financial managment 7e LASHER chapter 11

Cash Flow EstimationCapital budgeting process consists of: – Estimating the cash flows associated with projects, and then – Evaluating the estimates using NPV and IRR Forecasting cash fl

Chapter 11 Cash Flow Estimation

Cash Flow Estimation

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

The General Approach to Cash Flow Estimation

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

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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

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

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

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Project Cash Flows

Project Cash Flows

Impacts on other parts of company

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

Concept Connection Example 11-1

New Venture Cash Flows

11

Wilmont Bicycle is considering a new business proposal to produce off-road bikes The following information is forecast:

Concept Connection Example 11-1

New Venture Cash Flows

required

New building will cost $60,000

Land purchased 10 years ago for $30,700

Market value is now $150,000

Concept Connection Example 11-1

New Venture Cash Flows

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%

Concept Connection Example 11-1 New

Venture Cash Flows

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Initial Outlay costs of hiring, training and advertising are tax deductible:

Concept Connection Example 11-1

New Venture Cash Flows

Add operating items and assets for the total pre-start-up outlay:

Opportunity cost of land

Concept Connection Example 11-1

New Venture Cash Flows

Sales are forecasted to grow

for 4 years before leveling off

We’ll estimate for 6 years—

for a longer forecast repeat

the last year as.

Concept Connection Example 11-1

New Venture Cash Flows

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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

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 depreciationMACRS sorts assets (equipment) into categories

– Specifies depreciation for each

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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Concept Connection Example 11-3

Replacement Projects

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

Concept Connection Example 11-3

Replacement Projects

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

Concept Connection Example 11-3

Replacement Projects

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

Concept Connection Example 11-3

Replacement Projects

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

First consider the objective items

Objective Items - Initial Outlay

Selling an Old Asset

Concept Connection Example 11-3

Replacement Projects

– Objective Items: Depreciation and Labor

Concept Connection Example 11-3

Replacement Projects

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?

Concept Connection Example 11-3

A middle-of-the-road approach of $400 an hour yields an estimated

savings of $40,000 per year

Concept Connection Example 11-3

Replacement Projects

Combining these with the initial outlays yields the project’s estimated cash flow stream.