The Art and Science of Estimating Project Cash Flows

1
Chapter 9

• The Art and Science of Estimating Project Cash
  Flows

Shapiro and Balbirer Modern Corporate Finance
A Multidisciplinary Approach to Value
Creation Graphics by Peeradej Supmonchai
2
Learning Objectives

• Explain the importance of using incremental
  reasoning in identifying a projects cash flows.
• Identify a projects initial investment,
  incremental operating cash flows, and terminal
  value and use these estimates to calculate the
  projects NPV.
• Describe how the failure to deal with inflation
  and other biases in capital budgeting can lead to
  inappropriate investment decisions.
• Discuss the importance of properly assessing the
  effects of product line cannibalization in a new
  product introduction.
• Use the principle of purchasing power parity to
  properly evaluate an overseas project.

3
Learning Objectives (Cont.)

• Describe how the failure to identify managerial
  options can systematically undervalue an
  investment project
• Explain the importance of creating barriers to
  entry by potential competitors is important to
  the generation of positive NPV projects.
• Indicate how an option valuation approach can be
  used to evaluate RD projects.
• Describe how techniques such as sensitivity
  analysis, simulation, and decision trees can help
  managers to understand the sources of project
  risk.

4
Guidelines for Estimating Project Cash Flows

• Apply incremental reasoning
• Ignore fictional accounting flows
• Be careful about transfer prices
• Ignore sunk costs
• Dont ignore opportunity costs
• Dont forget working capital requirements
• Dont forget abandonment costs or terminal value

5
Incremental Cash Flows for a Project

• Initial investment
• Operating cash flows
• Terminal or salvage values
• Abandonment costs

6
Initial Investment

• A projects initial investment may consist of
  three components
• Cost of acquiring and placing the asset in
  service
• Net proceeds from the sale of the existing
  equipment
• Tax consequences of selling an existing asset

7
Operating Cash Flows

• The incremental operating cash flows (DOCF), per
  period, can be expressed as
• DOCF ( DREV - DCOST - DDEP)(1 - TAX) DDEP -
  DWC
• Where
• DREV the change in revenues
• DCOST the change in operating costs
• DDEP the change in depreciation
• DWC the annual increase in working capital
• TAX the marginal tax rate faced by the firm

8
Terminal or Salvage Values

• A projects terminal, or salvage value may
  consist of one or more of the following elements
• Salvage value of equipment
• Recovery of working capital
• Cash flows beyond some initial evaluation period

9
Abandonment Costs

• Some projects require cash outflows when the
  project is terminated. For instance, firms in
  certain industries may have to incur high costs
  to meet environmental standards.

10
The Replacement Problem

• A class of investments where a company is looking
  to replace an existing piece of equipment with a
  new model.
• The motivation for these projects is either cost
  reduction or quality improvement or both.

11
Spectrum Manufacturing Company

• Existing Equipment
• Cost 120,000 Depreciation
  12,000/Year Book Value 60,000
• Salvage Value Today 10,000 Salvage Value in 5
  Years 0
• New Equipment
• Cost 100,000 Depreciation 20,000/Year
  
• Cash Savings 24,000/Year Salvage Value in 5
  Years 0

12
Spectrum Manufacturing Company- Initial Investment

• Installed Cost of Computerized Lathe
  -100,000
• Salvage Value of Old Lathe
  10,000
• Tax Effects from Selling Old Lathe
  20,000
• INITIAL INVESTMENT
  -70,000

13
Spectrum Manufacturing Company - Operating Cash
Flows

• Year 1 Year 2 Year 3 Year 4
  Year 5
• Annual Cash Savings 24,000 24,000
  24,000 24,000 24,000
• D Depreciation (8,000) (8,000) (8,000)
  (8,000) (8,000)
• Taxable Income 16,000 16,000 16,000
  16,000 16,000
• Taxes_at_40 (6,400) (6,400)
  (6,400) (6,400) (6,400)
• After-Tax Income 9,600 9,600 9,600
  9,600 9,600
• Plus D Depreciation 8,000 8,000
  8,000 8,000 8,000
• Annual OCF 17,600 17,600 17,600 17,600
  17,600

14
Spectrum Manufacturing Company- The Projects NPV

• NPV 17,600 PVIFA 5,10 -70,000
• 17,600(3.7908) - 70,000
• -3,282

15
Inflation Biases in Capital Budgeting

• Required returns in the financial markets embody
  inflationary expectations. Not adjusting cash
  flows for inflation means that firms will be
  discounting real cash flows by nominal interest
  rates. This systematically understates a
  projects NPV.

16
Inflation Biases- An Example

• Year 1 Year 2 Year 3 Year 4 Year
  5
• Annual Cash Savings 24,000 24,960
  25,958 26,997 28,077
• D Depreciation (8,000) (8,000) (8,000)
  (8,000) (8,000)
• Taxable Income 16,000 16,960
  17,958 18,997 20,077
• Taxes_at_40 (6,400) (6,784) (7,183)
  (7,599) (8,031)
• After-Tax Income 9,600 10,176 11,775 11,398
  12,046
• Plus D Depreciation 8,000 8,000
  8,000 8,000 8,000
• Annual OCF 17,600 18,176 18,775 19,398
  20,046
• Present Value 16,000 15,021 14,106
  13,249 12,447
• NPV 70,824 - 70,000 824

17
Biases in Capital Budgeting

• Inflation
• Projects with overestimated cash flows are more
  likely to be chosen
• Manager overoptimism
• Manager pessimism

18
New Product Introduction

• Investments related to (1) product or service
  extensions, or (2) product innovations. The
  estimates of cash flows from new product
  introductions are subject to a far greater degree
  of uncertainty than are replacement projects

19
New Product Introduction - Smith Corporation

• NEW PRODUCT FINANCIAL FORECASTS
• ( ALL FIGURES IN 1,000)
• Period
  0 1 2 3 4
  5 6
• Sales
  500 5,500 8,000 14,000 7,000
  4,000
• Operating Expenses
  800 3,410 4,960 8,680 4,340 2,480
  
• Product Promotion 3,000 1,000
• Depreciation
  1,000 1,000 1,000 1,000 1,000 1,000
• Profit Before Taxes - 3,000 - 2,300
  1,090 2,040 4,320 1.660 520
• Taxes _at_ 34 - 1,020 -
  782 371 694 1,469 564 177
• Profit After Taxes - 1,980
  -1,518 719 1,346 2,851 1,096 343
• Level of Working Capital
  250 660 960 1,680 840 480

20
New Product Introduction - Smith Corporation

• CAPITAL PROFIT AFTER TAX
  WORKING TOTAL PRESENT
• YEAR EQUIPMENT DEPRECIATION CAPITAL
  CASH FLOW VALUE _at_20
• 0 - 6,000 - 1,980
  - - 7,980
  - 1,980
• 1 - - 518
  - 250 - 768
  - 640
  
  
• 2 - 1,719
  - 410 1,309
  909
• 3 - 2,346
  - 300 2,046
  1,184
• 4 - 3,851
  - 720 3,131
  1,510
• 5 - 2,096
  840 2,936
  1,180
• 6 - 1,343
  360 1,703
  570
• 7 660 -
  480 1,140
  318
• 
  
  NPV - 2,948

21
Post-Evaluation Period Cash Flow Estimation

• The following equation can be used to estimate
  the cash flows beyond some initial evaluation
  period
• CFn1
• TVn
• (k-g)

22
Smith and Company

• NEW PRODUCT 2 FINANCIAL FORECASTS
• ( ALL FIGURES IN 1,000)
• Period 0
  1 2 3 4
  5 6
• Sales
  2,500 10,000 16,500 21,000 23,000 25,000
• Operating Expenses 1,625
  6,500 10,725 13,650 14,950 16,250
• SA Expenses 3,000 3,000
  3,000 3,000 3,000 3,000 3,000
• Depreciation
  750 750 750 750 -0-
  -0-
• Profit Before Taxes - 3,000 - 2,875
  250 2,025 3,600 5,050 5,750
• Taxes _at_ 34 - 1,020 - 978
  -85 688 1,224 1,717 1,955
• Profit After Taxes - 1,980 -1,898
  -165 1,337 2,376 3,333 3,795
• Level of Working Capital 750
  3,000 4,950 6,300 6,900 7,500

23
Smith and Company

• CAPITAL PROFIT AFTER TAX
  WORKING TOTAL PRESENT
• YEAR EQUIPMENT DEPRECIATION CAPITAL
  CASH FLOW VALUE _at_20
• 0 -3,000 - 1,980
  - - 4,980
  - 4,980
• 1 - -
  1,148 - 750 - 1,898
  - 1,531
  
• 2 -
  585 - 2,250 - 1,665
  - 1,083
• 3 -
  2,087 - 1,950 137
  72
• 4 -
  3,126 - 1,350 1,776
  751
• 5 -
  3,333 - 600 2,733
  932
• 6 -
  3,795 - 600 3,195
  879
  
  
• 
  
  NPV - 4,960

24
Smith and Company- Sensitivity Analysis

• (ALL FIGURES IN 1,000)
• GROWTH TERMINAL PRESENT VALUE OF
• RATE VALUE TERMINAL VALUE
  PROJECT NPV
• 3 15,671 4,311
  - 648
• 4 16,614 4,570
  - 389
• 5 17,656
  4,857 - 102
• 6 18,815
  5,176 217
• 7 20,110
  5,532 573

25
Product Line Cannibalization

• A phenomenon where a new product takes sales away
  from one or more of a firms existing products.
  Evaluating cannibalization involves the following
  considerations
• What matters is the incremental effect of
  cannibalization the sales lost that can be
  solely attributable to the new product
  introduction
• Be sensitive to the competitive environment it
  is always better to lose volume to your own entry
  than to one of your competitors

26
Evaluation of Foreign Projects - ACS Enterprises

• ASSUMPTIONS
• Zero Inflation Environment
• Exchange Rate 1 puff/dollar
• 
  YEARS
• 
  0 1 2 3
  4 5 6
• Sales
  200 200 200
  200 200 0
• Net Working Capital 30 30
  30 30 30 0
• Depreciation Expense
  40 40 40 40
  40 0
• Profit After Taxes
  20 20 20 20
  20 0
• Cash Flow Analysis
• Investment in Equipment (200)
  0 0 0 0
  0 0
• Investment in Working Capital 0 (30)
  0 0 0 0
  30
• Cash Flow From Operations 0
  60 60 60 60 60
  0
• Period Cash Flows (200)
  30 60 60 60
  60 30
• Internal Rate of Return 12.8

27
Evaluation of Foreign Projects - Purchasing
Power Parity

• e1 1
  ih
• ¾ ¾¾¾
• eo 1
  if
• Where
• ih price level increases (rates of inflation)
  for the home country
• if price level increases (rates of inflation)
  for the foreign country
• eo the current dollar value of one unit of the
  foreign currency
• e1 the end-of-period exchange rate.

28
Evaluation of Foreign Projects- ACS Enterprises

• ASSUMPTIONS
• 10 percent Annual Inflation
• Exchange Rate Puff Declines by 10 a Year
  Against Dollar
  
  
• YEARS
• 
  0 1 2 3 4
  5 6
• Sales
  200 220 242 266 292
  0
• Net Working Capital
  30 33 36 40 44 0
• Depreciation Expense
  40 40 40 40 40 0
• Profit After Taxes
  20 24 28 33 39
  0
• Cash Flow Analysis
• Investment in Equipment (200) 0
  0 0 0 0 0
• Investment in Working Capital 0 (30)
  (3) (3) (4) (4) 44
  
• Cash Flow From Operations 0 60
  64 68 73 79 0
• Period Cash Flows ( in puffs) (200) 30
  61 65 69 75 44
• Period Cash Flows ( in dollars) (200) 27
  50 49 47 47 25
• Internal Rate of Return ( in puffs)
  16.9
• Internal Rate of Return ( in dollars )
  6.2

29
Managerial Options and Capital Budgeting

• DCF techniques assume that a projects cash flows
  cannot be changed once the decision to go ahead
  is made. This is unrealistic for many projects
  since management actions can alter the initial
  cash flow estimates after implementation. Such
  managerial discretions are options.

30
Strategic Options- Bubbly Beverage

• SUMMARY OF CASH FLOWS FOR DELIGHTFULLY DELICIOUS
  LINE
• (ALL FIGURES IN MILLION)
• YEAR
  1998 1999 2000 2001 2002
• After-Tax Operating Cash Flow -140 -120
  50 100 100
• Capital Investment - 80
  - - - -
  
• Working Capital Changes - 20 - 30
  - 30 - 20 -
  
• Terminal Value -
  - - -
  500
• Net Cash Flow -240
  -150 20 80 600
  
• NPV _at_ 20 percent -15.5
  Million

31
Strategic Options- Bubbly Beverage

• Traditional capital budgeting analysis ignores
  the potential for
• Add-on products
• Vertical integration
• Related diversification

32
Value of Projects With Strategic Options

• VPROJ VDCF VSTRAT
• Where
• VDCF the projects value using traditional
  DCF techniques
• VSTRAT the value of the strategic options

33
Sources of Positive NPV Projects

• Projects that create economies of scale or scope
• Projects that create cost advantage
• Projects that allow firms to differentiate
  products or services
• Projects that build or enhance channels of
  distribution
• Government policy