Chapter 3 Estimating Project Cash Flows

1
Chapter 3Estimating Project Cash Flows

• Capital Budgeting and Investment Analysis by Alan
  Shapiro

2
Incremental CFs

• Shareholders are interested in how many
  additional dollars they will receive in the
  future for the dollars they lay out today
• What matters to them is not the projects total CF
  per period but the incremental CFs generated by
  the project relative to the additional dollars
  they must invest today

3
Incremental vs. Total CFs

• Incremental CFs can differ from total CFs for the
  following reasons
• Cannibalization
• Sales creation
• Opportunity cost
• Sunk cost
• Transfer pricing
• Allocated overhead
• Accounting for Intangible benefits

4
Cannibalization

• A new product taking sales away from the firms
  existing products.
• To the extent that sales of a new product or
  plant just replaced other corporate sales, the
  new projects estimated profits must be reduced
  by the earnings on the lost sales
• It is often difficult to assess the true
  magnitude of cannibalization because of the need
  to determine what would have happened to the
  sales in the absence of the new product
  introduction

5
Cannibalization cont.

• The incremental effects of cannibalization, which
  is the relevant measure for capital budgeting
  purposes equals the lost profit on lost sales
  that would not otherwise have been lost had the
  new product not been introduced.

6
Sales creation

• This is the opposite of cannibalization
• An investment created or expected to create
  additional sales for other products
• In calculating the projects CFs, the additional
  sales and incremental CFs should be attributed to
  the project.

7
Opportunity cost

• Project costs must include the true economic cost
  of any source required for the project regardless
  of whether the firm already owns the source or
  has to go out and acquire it
• Opportunity cost is the cash the asset could
  generate for the firm should it be sold or put to
  some other productive use

8
Sunk costs

• Sunk cost fallacy is the idea that past
  expenditure on a project should influence the
  decision whether to continue or terminate the
  project.
• Instead the decision should be based on future
  costs and benefits alone
• Example Feasibility study

9
Transfer Pricing

• Transfer prices is the prices at which goods and
  services are traded within a company
• It can significantly distort the profitability of
  a proposed investment
• The prices used to evaluate project inputs or
  outputs should be market prices where possible
• Transfer price adjustments are often made to
  reduce taxes

10
Allocated overhead

• The project should be charged only for the
  additional expenditures that can be attributed to
  the project Those overhead expenses that are not
  affected by the project should not be included
  when estimating project CFs

11
Getting the Base Case Right

• A projects incremental CFs can be found only by
  subtracting worldwide corporate CFs without the
  investment (the base case) from post-investment
  corporate CFs
• What will happen if we do not make this
  investment?
• Do not ignore competitor behavior and assume that
  the base case was the status quo

12
Getting the base case right cont.

• Sales could be lost any way but what if they are
  lost to a competitor
• If you must be the victim of cannibal, make sure
  the cannibal if a member of your family

13
Accounting for Intangible Benefits

• Intangibles like better quality, higher customer
  satisfaction, valuable learning experience, quick
  order processing can have tangible impact on
  corporate CFs
• Adopting practices, products, and technologies
  discovered overseas can improve a companys
  competitive position worldwide

14
The Replacement Problem

• A situation when the firm is looking at replacing
  an existing piece of equipment with a new piece
  of equipment
• Cost reduction
• Quality improvement

15
Data on Quantum system investment in a new
extrusion press
Old machine New machine
Cost of machine 1,000,000 2,000,000
Development cost 750,000
Straight line depreciation 10 years 5 years
Annual depreciation charge 100,000 300,000
Depreciated value 500,000 -
Salvage value ? 500,000
Marginal tax rate 35 35
Additional sales 150,000
Net increase in Working capital 45,000
16
Estimating the initial investment

• It is the projects net cash outlay. Includes any
  opportunity cost
• The cost of acquiring and placing into service
  the necessary assets
• The necessary increase in working capital
• The net proceeds from the sale of existing assets
  in the case of a replacement decision
• The tax effects associated with the sale of
  existing assets and their replacement with new
  assets

17
Initial cost of new extrusion press Four
scenarios
Case 1 2 3 4
Cost of new machine 2,000,000 2,000,000 2,000,000 2,000,000
Inc. in WC 45,000 45,000 45,000 45,000
- Sales Price of old machine 500,000 400,000 700,000 1,100,000
Pretax investment 1,545,000 1,645,000 1,345,000 945,000
Tax on proceeds of old machine 0 -35,000 70,000 210,000
Initial cost of new machine 1,545,000 1,610,000 1,415,000 1,155,000
18
Multiyear investments

• Time 0, firm spends 18 million to acquire land
• Year 1, build a plant at a cost of 7 million
• Year 2, Buy and install equipment at a cost of
  20 million
• Cost of capital 10
• Calculate PV in millions

19
Estimating operating CFs

• What matters to investors are the incremental CFs
  generated by the project
• Incremental Op CFChange in (After tax income
  Depr. - WC)
• ?OCF (?REV - ?COST - ?DEP)(1- ?TAX) ?DEP - ?
  WC
• ?REV is the change in revenue
• ?COST is the change in operating costs
• ?DEP is the change in Depreciation
• ?WC is the change in Working capital
• ?TAX is the marginal income tax rate faced by the
  firm

20
Incremental Operating CF for year1
Before After Increments Cash Flows
Sales 5,000,000 5,150,000 150,000 150,000
Costs 4,000,000 3,820,000 -180,000 180,000
Depreciation 500,000 800,000 300,000 -
Profit Before Tax 500,000 530,000 30,000 -
Tax _at_ 35 175,000 185,500 10,500 -10,500
Profit After Tax 325,000 344,500 19,500 -
Depreciation 500,000 800,000 300,000 -
Cash Flow 825,000 1,144,500 319,500 319,500
21
Depreciation

• Because depreciation is a noncash charge, its
  only significance lies in the fact that it
  reduces or shields taxable income and therefore
  reduces taxes
• The value of Tax shield provided by depreciation
  charge of DEP in year t equals DEPTAX
• TAX is the firms marginal income tax rate

22
Year by Year Depreciation Tax shield under MACRS
Year Dep Base X Dep factor Dep writeoff X marginal Tax rate Dep Tax shield
1 2,000,000 0.2 400,000 0.35 140,000
2 2,000,000 0.32 640,000 0.35 224,000
3 2,000,000 0.192 384,000 0.35 134,000
4 2,000,000 0.1152 230,400 0.35 80,640
5 2,000,000 0.1152 230,400 0.35 80,640
6 2,000,000 0.0576 115,200 0.35 40,320
Totals 2,000,000 0.35 700,000
Year Dep Tax shield -Lost Dep write-off Incremental Tax shield
1 140,000 35,000 105,000
2 224,000 35,000 189,000
3 134,000 35,000 99,400
4 80,640 35,000 45,640
5 80,640 35,000 45,640
6 40,320 - 40,320
Totals 700,000 175,000 525,000
23
Depreciation cont.

• What really matters is the incremental
  depreciation tax shield
• Because Quantum Systems losses 100,000 in annual
  depreciation when the old machine is scrapped,
  incremental depreciation in each of the first
  five years is actually 100,000 less than the
  calculations indicate

24
Depreciation cont.

• As a result, the annual net Tax shield provided
  by new machine is 35,000 (100,0000.35) less
  than the gross tax shield it provided or 0.35 DEP
  - 35,000
• If it buys the new machine, Quantum systems will
  have annual incremental after tax revenue plus
  cost reductions equals to
• (150,000 180,000)(1-0.35) 214,500

25
Depreciation cont.

• Incremental Operating CF in year t will be
• 214,500 0.35 ?DEPt
• ?DEPt is the incremental depreciation charge in
  year t and 0.35 ?DEP is the value of the
  incremental depreciation tax shield provided by
  the new machine

26
Calculation of Incremental Operating CFs
Year Incremental revenues and cost reduction (After tax) Incremental Depreciation tax shield Incremental Operating CF
1 214,500 105,000 319,500
2 214,500 189,000 403,500
3 214,500 99,400 313,900
4 214,500 45,640 260,140
5 214,500 45,640 260,140
6 - 40,320 40,320
27
Financing costs

• We left out financing costs when estimating
  Operating CFs
• Usually in the form of dividends and interest
• The reason for this omission is that the cost of
  capital for the project already incorporates the
  cost of these funds
• No double counting

28
Estimating the Terminal value

• The terminal value of any asset is equal to the
  present value of future cash flows generated by
  the asset, whether it be the scrap value of the
  extrusion press or the revenue produced by a
  product
• In addition, it is assumed that any working
  capital investment will be recaptured at the
  termination of the project
• It includes any additional expenses required to
  meet environmental regulations

29
Terminal value cont.

• Salvage value end of Yr 5 is 500,000
• Book value is 115,200
• Taxable gain 500,000 115,200 384,800
• Taxes owed 384,8000.35 134,680
• After tax Salvage value 500,000 - 134,680
• Recapture of working capital 45,000
• Terminal value365,32045,000 410,320

30
Calculating the project NPV

• Old machine can be sold for 700,000
• Initial cash outflow of 1,415,000
• Discount rate of 15
• Assume a ZERO terminal value
• NPV -347,604
• The terminal value must be greater than 347,604
  (1.15)5 699,155 for the machine to have
  positive NPV

31
Project CF and their PV
Year Cash Flow Present Value Factor _at_15 Present value
0 -1,415,000 1.0000 -1,415,000
1 319,500 0.8696 277,826
2 403,500 0.7561 305,104
3 313,900 0.6575 206,394
4 260,140 0.5718 148,736
5 260,140 0.4972 129,336
Total - 347,604
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Calculating Project NPV cont,

• We subtract 45,000 in recaptured WC which leaves
  after tax salvage value of 654,156
• Sale price Tax on Sale Sale price (Sale
  price BV) Tax Rate
• Given a BV of 115,200
• Gives us a Sale price of 944,366
• The value of the new machine at end of 5 years
  must exceed 944,366 to make it worthwhile for
  the company to replace its old machine today

33
The new Product Introduction Decision

• Today, the project will require capital equipment
  with an installed cost of 6 million
• During year 7, the plant will be sold for 1
  million
• Depreciation on a straight line
• Zero Salvage value
• Required return of 20

34
Smith corporation new product financial forecasts
(in thousands)
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 production 3,000 1,000
Depreciation 0 1,000 1,000 1,000 1,000 1,000 1,000
Profit before Taxes -3,000 -2,300 1,090 2,040 1,660 1,660 520
Taxes _at_35 -1,050 -805 382 714 1,512 581 182
Profit after taxes -1,950 -1,495 709 1,326 2,808 1,079 338
Level of WC 250 660 960 1,680 840 480
35
Smith corporation summary of CFs for new product
introduction
Year Capital Equipment Profit After Tax Dep Change in Working Capital Total Cash Flow PV _at_ 20
0 -6,000 -1,950 -7,950 -7,950
1 - -495 -250 -745 -621
2 - 1,709 -410 1,299 902
3 - 2,326 -300 2,026 1,172
4 - 3,808 -720 3,088 1,489
5 - 2,079 840 2,919 1,173
6 - 1,338 360 1,698 569
7 650 480 1,130 315
NPV - 2, 950
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New product introduction cont.

• Taxable gain of 1 million
• Taxes of 350,000
• An increase in WC is a use of cash which is cash
  outflow
• Decrease in WC are a source of cash

37
Estimating Terminal values for new product
introductions

• Terminal values
• The salvage value of the equipment (after tax)
• Recovery of projects working capital
• CFs beyond the initial evaluation period

38
Smith corporation New product 2 financial
forecasts
Period 0 1 2 3 4 5 6
Sales 2,500 10,000 16,500 21,000 23,000 25,000
Cost of goods sold 1,625 6,500 10,725 13,650 14,950 16,250
Selling/Admin expenses 3,000 3,000 3,000 3,000 3,000 3,000 3,000
Depreciation 750 750 750 750 - -
Profit before tax -3,000 -2,875 -250 2,025 3,600 5,050 5,750
Tax _at_35 -1,050 -1,006 -88 709 1,260 1,768 2,013
Profit after tax -1,950 -1,869 -163 1,316 2,340 3,283 3,738
Level of working capital 750 3,000 4,950 6,300 6,900 7,500
39
Smith corporation summary of CF for new product
2 introduction
Year Capital Equipment Profit After Tax Dep Working capital Total CF PV _at_ 24
0 3,000 -1,950 - -4,950 -4,950
1 - -1,119 -750 -1,869 -1,507
2 - 588 -2,250 -1,663 -1,081
3 - 2,066 -1,950 116 61
4 - 3,090 -1,350 1,740 736
5 - 3,283 -600 2,683 915
6 - 3,738 -600 3,138 863
NPV - 4,963
40
Smith Corporation TV sensitivity analysis
Growth rate() Terminal value PV of TV Project NPV
3 15,391,143 4,233,902 (729,098)
4 16,317,600 4,488,758 (474,242)
5 17,341,579 4,770,441 (192,559)
6 18,479,333 5,083,422 120,422
7 19,750,941 5,433,225 470,225
8 21,181,500 5,826,753 863,753
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Biases in project CF Estimation

• Several factors contribute to the tendency that
  accepted projects do less well than expected
• Overoptimism
• Lack of consistency
• Natural Bias
• Postinvestment audit

42
OverOptimism

• Project sponsors are generally optimistic about
  the prospects of the projects they advocate
• Spent great deal of time and effort
• Emotionally involved in the acceptance of the
  project
• Optimistic rather than realistic
• Greatly underestimated costs and inflated
  benefits

43
Overoptimism

• Estimates of project CFs are likely to be biased
  upwards, resulting in an overstated expected NPV
• Tend to ignore the consequences of future
  competitive entry into their markets.
• Successful products are likely to attract
  competitors who will drive down prices and
  returns
• Revising upwards or downwards if someone is known
  to be overly optimistic or pessimistic

44
Lack of consistency

• When estimating cash flows, it is necessary to be
  consistent with the information contained in the
  discount rate
• Projected inflation-adjusted price increases
  should NOT exceed real interest rates
• Prices of Oil (Commodity) cannot be expected to
  rise by more than the real interest rate plus
  storage costs
• Arbitrage opportunity?!

45
Natural bias

• Average error associated with the CF forecasts
• Projects with overestimated CFs are more likely
  to be chosen than those whose CFs are
  underestimated
• The actual NPVs of projects undertaken will be
  generally lower than their predicted NPVs even if
  the underlying CF estimates are themselves
  unbiased

46
Postinvestment Audit

• Once an investment has been made, it is largely a
  sunk cost and should not influence future
  decisions
• Management should conduct a postinvestment audit
  that compares actual results with exante budgeted
  figures
• The firm can learn from its mistakes and its
  successes
• Firm can include correction factors in future
  investment analysis

47
PostInvestment audit cont,

• Help the firm improve its capital budgeting
  process and come up with better projects
• The firm can learn how to structure projects
  better
• The firm can repeat its successes and avoid
  future mistakes

48
Current Rules for Depreciation

• Depreciation is the annual income tax deduction
  that allows a business to recover the cost or
  other basis of certain property over the time it
  uses the property
• A business can depreciate most types of tangible
  property (except land) such as buildings,
  machinery, vehicles, furniture and equipment

49
Depreciation Rate

• The 200 declining balance method. Also known as
  double declining balance method
• The 150 declining balance method
• The straight line method
• Modified Accelerated Cost Recovery System (MACRS)
• MACRS assumes that the property is depreciable
  for half of the taxable year in which it is
  placed in service

50
Depreciation Rate Half year convention
Year 3-Year 5-Year 7-Year
1 33.33 20 14.29
2 44.45 32 24.49
3 14.81 19.2 17.49
4 7.41 11.52 12.49
5 11.52 8.93
6 5.76 8.92
7 8.93
8 4.46
51
Incorporating inflation in Capital budgeting

• The nominal interest rate already incorporates
  the expected rate of inflation
• Fisher equation
• R a i ai
• R is nominal return
• A is real return
• I is expected inflation rate
• We must nominal CFs to account for the impact of
  expected inflation on anticipated revenues and
  costs

52
Contractual vs. Noncontarctual CFs

• Contractual CFs are those fixed in nominal dollar
  terms
• Contractual CFs arise from such commitments as
  debt, longterm leases, labor contracts, rents,
  and AR, AP.
• NonContractual means that they fluctuate inline
  with changing market conditions
• Noncontractual CFs move in line with inflation

53
Contractual CFs vs. non contractual

• Contractual CFs
• Depreciation tax shield
• Working capital recaptured
• Noncontractual CFs
• Cost savings
• Additional revenues to be received from investing
  in the new extrusion press
• Investment in WC is equal to 30 of sales.
  Therefore, it will rise with sales

54
Example

• 7 rate of inflation
• Adjust incremental sales and cost savings for
  inflation
• Expected 1st year revenues 150,0001.07
• Expected 1st year cost savings180,0001.07
• With 35 marginal corporate tax rate
• After tax, the nominal increase will be
• 10,5000.65 6,825
• 12,6000.658,190

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Example cont.

• Additional investment in working capital of
  10,5000.30 3,150
• The depreciation charge is fixed in nominal terms
  and so remains the same regardless of the rate of
  inflation
• The incremental project CF in the 1st year
  resulting from adjustment for inflation is
  6,8258,1903,150 11,865

56
Project analysis incorporating 7 inflation
Year 0 1 2 3 4 5
Sales 160.5 171.7 183.8 196.6 210.4
Cost savings 192.6 206.1 220.5 235.9 252.5
Incremental depreciation 300 540 284 130.4 130.4
Pretax incremental profit 53.1 -162.2 120.3 302.2 332.4
Tax _at_35 18.6 -56.8 42.1 105.8 116.4
Profit after tax 34.5 -105.4 78.2 196.4 216.1
Operating CF 334.5 434.6 362.2 326.8 346.5
WC 0.3Sales 48.2 51.5 55.1 59 63.1
Change in WC 3.2 3.4 3.6 3.9 4.1
Initial Invest -1,415
Net CF -1,415 331.4 431.2 358.6 322.9 342.4
PV _at_15 -1,415 288.1 326.1 235.8 184.6 170.2
NPV -210,178
57
Inflation and Taxation

• The current tax system taxes nominal income
  rather than real income
• Because the tax shield associated with the
  depreciation charge is fixed in nominal terms,
  the real value declines as the rate of inflation
  rises
• The net effect of combining inflation with a tax
  system geared toward nominal instead of real
  gains or losses is to reduce the real CF
  associated with depreciable assets

58
Inflation and Taxation cont.

• This distorts investment decisions by reducing
  the attractiveness of capital intensive projects,
  especially those with long economic lives,
  relative to other projects as well as relative to
  consumption.
• The end result is more consumption and less
  investment