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.
Chapter 11 Cash Flow Estimation
Wilmont Bicycle is considering a new business proposal to produce off-road bikes. The following information is forecast:
Revenues collected in 30 days.
$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%.
Initial Outlay costs of hiring, training and advertising are tax deductible:
Add operating items and assets for the total pre-start-up outlay:
Net after tax expenses$95.7
Actual pre-start-up outlay$367.7
Opportunity cost of land
Market value $150,000
Capital gain $119,300
Opportunity cost $150,000 - $40,600 = $109,400
C0, the initial outlay, is
$367,700 + $109,400 = $477,100.
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.
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.
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
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.
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.
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.
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?