Chapter 8 -- Estimating Incremental Cash Flows

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Chapter 8 -- Estimating Incremental Cash Flows

• Relevant Cash Flow
• A cash flow that is caused by a course of action
  or project
• Irrelevant Cash Flow
• A Cash Flow that does not change as a result of a
  course of action

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Relevant Cash Flows

• Indirect cost -- Relationship may be fuzzy but it
  should be estimated
• Indirect benefits -- Need to be estimated
• Claims by supplier of capital -- Cost is usually
  taken care of in the discount rate
• Interest Expense -- Cost is usually taken care of
  in the discount rate
• Opportunity cost -- Next best course of action
  not taken -- could be very important

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Irrelevant Cash Flows

• Sunk cost
• These are past costs and are therefore irrelevant
• Make the best use of the capacity put in place by
  past decisions
• Pure joint cost
• Are common costs that do not change as a result
  of an action and are therefore irrelevant

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11 Steps to Estimating Cash Flows From a Project

• Four groups of steps
• Estimating the Income Statement
• Estimating the Balance Sheet
• Rolling the Income Statement and Balance Sheet
  into a Cash Flow Statement
• Making the Decision

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Estimating the Income Statement

• Estimate the relevant revenues and expenses
• Assemble into an income statement
• Remember -- Accrual accounting is not the same as
  cash basis accounting

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Estimating the Balance Sheet

• Determine the balance sheet accounts that are
  impacted
• Estimate the initial size of the investment
• Determine the size and growth during operations

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Rolling the Income Statement and Balance Sheet
into a Cash Flow Statement

• Calculate depreciation
• Estimate the life of the project
• Determine terminal values for fixed assets
• Determine disposal values for working capital
• Construct the cash flow statement

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Making the Decision

• Calculate the present value
• Make the decision

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Estimating Balance Sheet Accounts

• Accounts Receivable
• This is when you extend credit to your customers
• typically occur in year 0 -- because they are
  closer to the beginning of the year than end
• typically increase with increase in sales
• credit losses are fully deductible
• often liquidated at a loss

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Estimating Balance Sheet Accounts

• Inventory
• typically occur in year 0
• typically increase with increase in sales
• inventory losses are fully deductible
• often liquidated at a loss

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Estimating Balance Sheet Accounts

• Cash Balances
• typically occur in year 0
• typically increase with increase in sales
• liquidated at full value

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Estimating Balance Sheet Accounts

• Accounts Payable
• usually associated the purchase of inventory
• typically occur in year 0
• typically increase with increase in sales
• are a source of cash (positive number) increases
  in liabilities are source of cash
• often liquidated at full value

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Estimating Balance Sheet Accounts

• Accrued Expenses
• associated with employees and others
• typically occur in year 0
• typically increase with increase in sales
• often liquidated at full value

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Estimating Depreciating Land A Balance Sheet
Account

• Land
• cannot be depreciated
• typically occur in year 0
• only increases with additional acquisitions
• may be 1250 gain or loss on disposal
• disposal gains and losses are fully taxable

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Estimating Depreciating Buildings -- A Balance
Sheet Account

• Buildings
• either classified as residential or commercial
• residential depreciated over 27.5 years
• commercial depreciated over 39 years
• must use mid-month convention
• typically occur in year 0
• often liquidated with a 1250 gain or loss
• disposal gains and losses are fully taxable

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Estimating Depreciating Equipment -- A Balance
Sheet Account

• Equipment
• are grouped into one of 6 asset classifications
  -- 3,5,7,10,15,20 year lives
• find the class, use the table rates
• typically occur in year 0
• often liquidated with a 1245 gain or loss
• disposal gains and losses are fully taxable

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Calculation of disposition stage gain or loss and
cash flow

• original purchase price - depreciation taken
  remaining basis
• Selling price - remaining basis taxable gain or
  loss
• taxable gain or loss tax rate taxes owed or
  tax refund
• Cash selling price - taxes owed or tax refund
  disposition stage cash flow

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Forecasting Sales

• trend analysis
• study of potential purchasers
• derived demand
• other methods

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Forecasting Operating Cost, and Working Capital

• Forecasting Cost
• engineering analysis
• regression analysis -- fixed and variable
• Forecasting Working Capital
• regression analysis -- from past relationships