Chapter 11 Cash Flow Estimation
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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 process.

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Chapter 11 Cash Flow Estimation

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Chapter 11 cash flow estimation

Chapter 11 Cash Flow Estimation


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 process


The general approach to cash flow estimation

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


The general approach

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 approach1

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 estimation1

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


Project cash flows

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 flows1

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 flows2

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

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

Concept Connection Example 11-1New Venture Cash Flows

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 flows1

Concept Connection Example 11-1 New Venture Cash Flows

  • 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.


Concept connection example 11 1 new venture cash flows2

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 flows3

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 flows4

Concept Connection Example 11-1 New Venture Cash Flows

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


Concept connection example 11 1 new venture cash flows5

Concept Connection Example 11-1 New 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.


Concept connection example 11 1 new venture cash flows6

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.

The building is depreciated over 39 years while the equipment is depreciated over 5 years.


Concept connection example 11 1 new venture cash flows7

Concept Connection Example 11-1 New Venture Cash Flows

Assume that the $12,000 of initial inventory was acquired prior to start-up.

Represents the subtotal after adding depreciation less the change in working capital.


Terminal values

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

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


Macrs a note on depreciation

MACRS—A Note on Depreciation

  • U.S. government allows accelerated tax depreciation

  • MACRS sorts assets (equipment) into categories

    • Specifies depreciation for each


Estimating cash flows for replacement projects

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


Concept connection example 11 3 replacement projects

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 projects1

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 projects2

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 projects3

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 guesswork.

First consider the objective items.


Objective items initial outlay selling an old asset

Objective Items - Initial Outlay Selling an Old Asset


Concept connection example 11 3 replacement projects4

Concept Connection Example 11-3 Replacement Projects

  • Objective Items: Depreciation and Labor


Concept connection example 11 3 replacement projects5

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? Also, will maintenance on the new machine rise as it ages?


Concept connection example 11 3 replacement projects6

Concept Connection Example 11-3 Replacement Projects

  • 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.


Concept connection example 11 3 replacement projects7

Concept Connection Example 11-3 Replacement Projects

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


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