CASH FLOW ESTIMATION

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• Chapter 12
• CASH FLOW ESTIMATION
• AND RISK ANALYSIS

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INCREMENTAL CASH FLOWS

• When estimating the cash flows for a capital
  budgeting project, our focus is on incremental
  cash flows.
• An incremental cash flow is how much the project
  adds to the companys total cash flows.

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• To make the task of estimating project cash flows
  easier, we divide the task into three segments.
• The initial investment outlay is the difference
  in cash flow at t0
• The annual operating cash flows are the annual
  cash profits
• The terminal cash flow is the residual cash flow
  at the end of the project

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Consider the Information Below for a New Project
Proposal

• Equipment Cost is 95,000 plus 5,000
  installation
• Working capital needs Inv20,000
  Acct.Rec5,000 Acct.Pay15,000
• Project 130,000 in annual sales annual variable
  costs of 30 annual fixed costs of 25,000
  (years 1-3)
• Depreciate as 3-yr MACRS property
• Expect salvage value of 35,000 (t3)

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• Tax rate on additional earnings 40
• Marketing survey cost 10,000 suggesting the new
  machines products would be well-received by
  consumers (cost has been expensed for tax
  purposes)
• Firms cost of capital (r) is 15
• Sales from the new project will not impact sales
  of other products

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I. Initial Outlay (CF0)

• The biggest component of the initial outlay is
  the equipment cost
• If working capital must be increased, this is a
  cash outflow
• What is this projects CF0?

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II. Annual Operating CF (CF1-3)

• To find the annual operating cash flows, we must
  construct an income statement for each future
  year
• Book profit (net income) is converted to cash
  profit by adding back depreciation
• Another name for annual cash profit is cash flow

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III. Terminal CF (Additional CF3)

• When the project is shut down at the end of the 3
  years, the fixed assets will be sold.
• If the fixed assets are sold above their book
  value, the company must pay tax on the gain above
  book value.

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III. Terminal CF (Additional CF3)

• Working capital will be reduced back to zero, and
  the decrease in working capital will be a cash
  inflow.
• Although the working capital may be higher or
  lower than our estimate, the default assumption
  is that the working capital will be recovered at
  original cost.

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Project CF Summary

• What are this projects totoal incremental (i.e.,
  relevant) cash flows?
• If the project has a wacc of 15, the project
  should be accepted because its NPV is greater
  than zero.

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GUIDELINES FOR ESTIMATING INCREMENTAL CASH FLOWS

• Our analysis of the project is only as accurate
  as our future estimates of sales and costs.
  (GIGO)
• As a practical matter, it is better to place
  someone in charge of the analysis who does not
  have a personal interest in the projects
  acceptance.

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• Our focus should be on cash flows rather than
  book profits because shareholder wealth is more
  closely tied to cash flow.
• Some companies will have other noncash expenses
  besides depreciation, such as amortization or
  depletion.

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• Notice that we did not deduct interest expense or
  dividend payments because financing costs are
  captured in the projects wacc.
• Notice that the cost of the marketing survey was
  omitted because it was a sunk cost a cash flow
  that is unaffected by whether the project is
  accepted or rejected.

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• If the project used a building that could
  otherwise have been rented out, the lost rent
  income would be treated as a cash outflow and
  viewed as an opportunity cost.
• If sales of the new product would reduce sales of
  other products sold by the firm, the lost sales
  would be treated as a cash outflow viewed as a
  cannibalization effect or externality.

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PROJECT RISK CONSIDERATIONS

• If the projects risk is considered above average
  for the company, then we should increase the
  wacc.
• One way to examine risk is to try different
  possible sales prices for our project and observe
  the NPV each produces. This is referred to as
  sensitivity analysis.