Project Cash Flows 04/25/07 Ch. 9
Investment decision revisited • Acceptable projects are those that yield a return greater than the minimum acceptable hurdle rate with adjustments for project riskiness. • We know now how to calculate the acceptable hurdle rate (cost of capital) and make project-specific adjustments. • To enable us to calculate a project’s “return” and thus allow us to evaluate the project, the next step is to calculate project cash flows.
Project cash flows estimation • Estimating project cash flows requires: • Estimating project revenues • Allocating appropriate expenses • Converting these projections into incremental cash flows • We need to understand the differences between: • Accounting earnings and cash flows, and • cash flows and incremental cash flows.
Accounting earnings vs. cash flows • Accrual accounting requires the recognition of expenses during the period in which the related revenue is recognized. Cash flows may not coincide. • Capital expenditures are treated as if generated over multiple periods and expensed (depreciation or amortization) rather than subtracted from revenues when the occur. • Because of accrual accounting and capital expenditure accounting, accounting earnings can differ significantly from cash flows.
Accounting earnings vs. cash flows • To go from accounting earnings (EBIT) to cash flows, we must adjust for: • Non-cash expenses, such as depreciation and amortization, • Capital expenditures, and • working capital investment
Refresher on depreciation methods • Broadly speaking, depreciation methods can be classified as straight line or accelerated methods. • Straight line depreciation - capital expense is spread evenly over time, • Accelerated depreciation - capital expense is depreciated more in earlier years and less in later years.
Refresher on depreciation methods • Annual depreciation expense using: • Straight line: (Original asset value – salvage value) / number of years to be depreciated • MACRS: • Depreciation for tax purposes is determined by using the modified accelerated cost recovery system (MACRS). • Under the basic MACRS procedures, the depreciable value of an asset is its full cost, including outlays for installation. • No adjustment is required for expected salvage value. • For tax purposes, the depreciable life of an asset is determined by its MACRS recovery predetermined period and is based on the type of asset.
The depreciation tax benefit • While depreciation reduces taxable income and taxes, it does not reduce the cash flows. • The benefit of depreciation is therefore the tax benefit. In general, the tax benefit from depreciation can be written as: Tax Benefit = Depreciation * Tax Rate
Working capital investment • Intuitively, money invested in inventory or in accounts receivable cannot be used elsewhere. It, thus, represents a drain on cash flows • To the degree that some of these investments can be financed using suppliers credit (accounts payable) the cash flow drain is reduced. • Investments in working capital are thus cash outflows • Any increase in working capital reduces cash flows in that year • Any decrease in working capital increases cash flows in that year • To provide closure, working capital investments need to be salvaged at the end of the project life.
Cash flows vs. incremental cash flows • The appropriate cash flows to consider in evaluating whether a project makes a firm more valuable is the incremental cash flows generated by the project. • This can differ from total cash flows for three reasons: • Sunk costs • Opportunity costs • Allocated costs that the firm would incur even if the project was not accepted.
Sunk costs • Any expenditure that has already been incurred, and cannot be recovered (even if a project is rejected) is called a sunk cost • When analyzing a project, sunk costs should not be considered since they are not incremental • By this definition, market testing expenses and R&D expenses are both likely to be sunk costs before the projects that are based upon them are analyzed.
Opportunity costs • Opportunity costs are cash flows that could be realized from the best alternative use of the asset. • When analyzing a project, opportunity costs should be considered since they represent cash flows that the firm would have generated if the project is not accepted, but are lost if the project is accepted.
Allocated costs • Firms allocate costs to individual projects from a centralized pool (such as general and administrative expenses) based upon some characteristic of the project (sales is a common choice) • For large firms, these allocated costs can result in the rejection of projects • To the degree that these costs are not incremental (and would exist anyway), this makes the firm worse off. • Thus, it is only the incremental component of allocated costs that should show up in project analysis.
Project revenue estimation process • Experience and History: If a firm has invested in similar projects in the past, it can use this experience to estimate revenues and earnings on the project being analyzed. • Market Testing: If the investment is in a new market or business, you can use market testing to get a sense of the size of the market and potential profitability. • Ex., Home Depot Expo Stores • Scenario Analysis: If the investment can be affected be a few external factors, the revenues and earnings can be analyzed across a series of scenarios and the expected values used in the analysis.
Scenario analysis • Scenario analysis is made up of four components: • Factors that determine the success of the project • Analysis should focus on two or three of the most critical factors • Number of scenarios to be considered • Three scenarios for each factor (best, average and worst-case) tend to most useful • Estimation of project revenues and/or expenses under each scenario • Assigning probabilities to each scenario
From forecasts to operating income (EBIT) • Calculate/estimate the appropriate expenses associated with the estimated revenues • Separate projected expenses into operating and capital expenses. • Operating expenses are designed to generate benefits in the current period, while capital expenses generate benefits over multiple periods • Depreciate or amortize the capital expenses over time. • Allocate fixed expenses that cannot be traced to specific projects.
From forecasts to operating income (EBIT) • Operating income (EBIT) measures the income earned on all the capital invested in a project and is calculated as EBIT=Rev – Cost of Goods Sold – SG&A Expenses – Other allocated expenses - Depr.&Amort.
From accounting income to cash flows • To get from EBIT to cash flows • add back non-cash expenses (like depreciation and amortization) • subtract out cash outflows which are not expensed (such as capital expenditures) • Include investment in working capital. Cash flow to firm = EBIT(1-t) + Depr.&Amort. – Chg in WC – Cap Exp.
Chapter 9 sections NOT covered • An argument for time weighted cash flows • We do not calculate the intermediate steps that the text takes, for example, calculating cash flows for the project, then the incremental cash flows. We go directly from the (incremental) operating income to the incremental cash flows for the project.