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CHAPTER 11

CHAPTER 11. Cash Flow Estimation (and Risk Analysis). Topics in Chapter. Please read sections: 11-1, 11-2abcd, 11-9, and appendix 11A. Estimating cash flows Relevant cash flows Working capital treatment Tax Depreciation Expansion Analysis Replacement Analysis. CF 2. CF 1. CF N.

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CHAPTER 11

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  1. CHAPTER 11 Cash Flow Estimation (and Risk Analysis)

  2. Topics in Chapter Please read sections: 11-1, 11-2abcd, 11-9, and appendix 11A. • Estimating cash flows • Relevant cash flows • Working capital treatment • Tax Depreciation • Expansion Analysis • Replacement Analysis

  3. CF2 CF1 CFN NPV = + + ··· + − Initial cost (1 + r )1 (1 + r)2 (1 + r)N The Big Picture: Project Valuation, Cash Flows, and Risk Analysis Project’s Cash Flows (CFt) Project’s debt/equity capacity Market interest rates Project’s risk-adjusted cost of capital (r) Market risk aversion Project’s business risk

  4. Overview: Cash Flow Estimation (and Risk Analysis) This chapter covers cash flow estimation and identify the issues a manager faces in producing relevant and realistic cash flow estimates. It is also important for a manager to incorporate uncertainty into project analysis if a company is to make informed decisions regarding project selection. (skipped)

  5. 11-1 Identifying Relevant Cash Flows • Project’s incremental cash flows: Corporate cash flows with the project Minus Corporate cash flows without the project

  6. 11-1a Cash Flow versus Accounting Income For capital budgeting purposes, it is the project’s net cash flow (free cash flow), not its accounting income, which is relevant. The differences between cash flow and accounting income: • The cash flow effect of asset purchases and depreciation: The acquisition of fixed assets results in a cash outflow; depreciation and all other noncash charges should be added back when calculating a project’s net cash flow. • Changes in net operating working capital: The difference between the required increase in operating current assets and the increase in operating current liabilities is the change in net operating working capital. So, At t = 0, the investment in NOWC results in a cash outflow (-); At t = n, the investment in NOWC will be returned which results in a cash inflow (+); There may have annual changes in NOWC during the life of the project. • Interest charges are not included in project cash flows: All financing costs including interest expenses are considered in the cost of capital (WACC), the denominator not the numerator of the valuation formula.

  7. Treatment of Financing Costs (Again) • Should you subtract interest expense or dividends when calculating CFs? • NO. • We discount project cash flows with a cost of capital that is the rate of return required by all investors (not just debtholders or stockholders), and so we should discount the total amount of cash flow available to all investors. • They are part of the costs of capital. If we subtracted them from cash flows, we would be double counting capital costs.

  8. 11-1b Timing of Cash Flows: Yearly versus Other Periods It is generally appropriate to assume that all cash flows occur at the end of the various years because it is unrealistic to estimate daily cash flows, and the analysis using daily cash flows would be no better than one using annual flows.

  9. 11-1c Expansion Projects and Replacement Projects Expansion projects: the firm makes an investment in a new project; Replacement projects: the firm replaces existing assets generally to reduce costs. Replacement analysis is complicated by the fact that most of the relevant cash flows (incremental cash flows) are the cash flow differences between the existing project and the replacement project.

  10. 11-1d Sunk Costs • Suppose FedEx spent $2 million to investigate sites for a potential new distribution center. Should it be included in the analysis when FedEx wants to make a decision now? NO. This is a sunk cost. • A sunk cost is an outlay related to the project that was incurred in the past and cannot be recovered in the future regardless of whether or not the project is accepted. Therefore, sunk costs are not incremental costs and thus are not relevant in a capital budgeting analysis.

  11. 11-1e Opportunity Costs Associated with Assets the Firm Already Owns • Suppose FedEx already owns land with a current market value of $2 million that can be used for a new distribution center. Would this affect the analysis? • Yes. Accepting the project means FedEx could not sell the land and receive a cash flow. This is an opportunity cost and it should be charged to the project. • After-tax opportunity cost = $2 million * (1 – T) • Opportunity costs should be considered in cash flow estimation.

  12. 11-1f Externalities • If the new product line would decrease sales of the firm’s other products. Would this affect the analysis? • Yes. The effects on the firm’s other projects’ CFs are “externalities.” • Net CF loss per year on other lines would be a cost to this project. • Externalities will be positive if new projects are complements to existing assets, negative if substitutes.

  13. Externalities (Continued) • Negative within-firm externalities (cannibalization): • Those lost cash flows should be considered as a cost when analyzing new products. • Positive within-firm externalities: • A new project may be complementary to existing ones, and the increased cash flows in the old operation should be considered. • Environmental Externalities: • A project’s impact on the environment should be considered.

  14. Appendix 11A: Tax Depreciation (P498-500) • Companies may use the straight-line depreciation method for financial reporting, but they use the fastest depreciation rate permitted by law for tax purposes. • Tax Depreciation: Modified Accelerated Cost Recovery System (MACRS) • (When dealing with tax depreciation in real-world situations, always consult current IRS publications.) • Table 11A-1 on P499: Major Classes and Asset Lives for MACRS • Table 11A-2 on P500: Recovery Allowance Percentage for Personal Property • Half-Year Convention: under MACRS, it is assumed that property is placed in service in the middle of the first year.

  15. Table 11A-1: Major Classes and Asset Lives for MACRS

  16. Table 11A-2: Recovery Allowance Percentage (Depreciation Rate) for Personal Property

  17. 11-2 Analysis of an Expansion Project11-2a Base Case Inputs (Thousands of Dollars) • Equipment cost (price + shipping+ installation): $7,750 • Depreciation: MACRS 3-year class (mid-year convention so completely depreciated in 4 years) • Economic life of the project: 4 years • Salvage value at year 4: $639 • Opportunity Cost: $0 • Externalities: $0 Continued…

  18. Project Data (Continued) • Units sold at year 1: 10,000; increase by 15% after year 1; • Unit sales price at year 1: $1.50; increase by 4% after year 1; • Variable cost per unit at year 1: $1.07; increase by 3% after year 1; • Fixed cost at year 1: $2,120; increase by 3% after year 1; • Net working capital requirement • NWCt = 15%(Salest+1) • Tax rate = 40%. • Project cost of capital (WACC) = 10%.

  19. 11-2bcd Cash Flow Projections Use Excel to do cash flow projections. Please see the Excel file Chapter 11 Expansion Analysis Template for details.

  20. Annual Depreciation Expense (Thousands of Dollars):

  21. Annual Sales and Costs:

  22. Why is it important to include inflation when estimating cash flows? • Nominal r > real r. The cost of capital, r, includes a premium for inflation. • Nominal CF > real CF. This is because nominal cash flows incorporate inflation. • If you discount real CF with the higher nominal r, then your NPV estimate is too low. (Continued…)

  23. Inflation (Continued) • Nominal CF should be discounted with nominal r, and real CF should be discounted with real r. • It is more realistic to find the nominal CF (i.e., increase cash flow estimates with inflation) than it is to reduce the nominal r to a real r.

  24. Operating Cash Flows:

  25. Cash Flows Due to Investments in Net Operating Working Capital (NOWC)

  26. Salvage Cash Flow at t = 4

  27. What if you terminate a project before the asset is fully depreciated? • Basis = Original basis – Accum. deprec. • Taxes are based on difference between sales price and tax basis. Cash flowfrom sale Saleproceeds Taxespaid on gain/loss – =

  28. Example: If Sold After 3 Years for $700 • Original basis = $7,750 • After 3 years, basis = $574 remaining. • Sales price = $700 • Gain or loss = $700 – $574 = $126 • Tax on sale = 0.4($126) = $50.4 • Cash flow = $700 – $50.4 = $649.6

  29. Example: If Sold After 3 Years for $500 • Original basis = $7,750 • After 3 years, basis = $574 remaining. • Sales price = $500 • Gain or loss = $500 – $574 = -$74 • Tax on sale = 0.4(-$74) = -$29.6 • Cash flow = $500 – (-$29.6) = $529.6 • Sale at a loss effectively provides a tax credit, so cash flow is larger than sales price!

  30. Net Cash Flows:

  31. 0 1 2 3 4 1900 2700 2345 7799 (10000) TI BAII Plus: Enter CFs in CF register and I/YR = 10 CPT NPV = $1,047 IRR = 13.78 (%) Project Net CFs on Time Line

  32. 0 1 2 3 4 (10000) (10000) 1900 (8100) 2700 (5400) 2345 (3055) 7799 4744 Cumulative CFs: Payback = 3 + $3055/$7799 = 3.39 years What is the project’s payback?

  33. 11-9 Replacement Analysis • Incremental cash flows for replacement project: • The cash flow differentials between the new and old projects. • Example: Figure 11-9 on P479 • Part IV Incremental CF (Row 52): net cash flows with new machine (row 51) – net cash flows with old machine (row 38).

  34. Figure 11-9 on P479: Replacement Analysis

  35. Homework Problems Questions on P487: 11-1abc, 11-2, 11-3, 11-4, 11-5, 11-7, 11-8, 11-9.

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