Practical financial management lasher 7th ed chapter 011

Chapter 11 Cash Flow Estimation


Cash Flow Estimation

Capital budgeting process consists of:

– Estimating the cash flows associated with projects, and then
– Evaluating the estimates using NPV and IRR
Forecasting cash flows accurately is by far the more difficult and error
prone process

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The General Approach to
Cash Flow Estimation
A sales forecast leads to an estimate of cash inflows from customers
A cost/expense projection leads to a pattern of outflows to employees
and vendors
An equipment plan leads to a series of outflows for capital assets

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The General Approach
Think through the events a project will bring about, and write down the financial implications of each
Forecasts for new ventures tend to be the most complex
Pre-startup, the initial outlay:
Enumerate pre-start expenses (after tax) and all assets
that must be purchased.

•

Some are tax deductible, some are not.

Sales Forecast
Forecast incremental units over time in spreadsheet form
Extend by prices for revenues


The General Approach
Cost of Sales and Expenses:
Base costs and expenses on a relationship with incremental revenues or units sold.

Assets:
Plan new assets when needed
Include working capital

Depreciation:
Plan depreciation for new and old assets
A non-cash item but it impacts taxes

Taxes and Earnings
Summarize tax deductible items in each period to calculate impact on taxes and earnings
Treat incremental taxes like any other cash flow item


The General Approach to Cash Flow Estimation

Expansion Projects

– Require the same elements as
new ventures

– Usually need less new

equipment and facilities

Replacement Projects

– Generally saves on cost
without generating new
revenue

– Estimating process may be
less elaborate

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Project Cash Flows

Regardless of the project, the basic process is the same

– The Typical Pattern
Requires an initial outlay
Subsequent cash flows

tend to be positive

– Project Cash Flows Are Incremental
Separable from the existing business

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Project Cash Flows

Sunk Costs

– Have already been spent and are ignored
Opportunity Costs

– The value of a resource in its best alternative use
– The cost of a resource is whatever is given up to use it

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Project Cash Flows

Impacts on other parts of company
Overhead levels
Taxes
Cash v. accounting results
Working capital
Ignore financing costs
Old equipment

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Estimating New Venture
Cash Flows
New venture projects tend to be larger and more elaborate than
expansions or replacements

– But incremental cash flows can be easier to isolate

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Concept Connection Example 11-1
New Venture Cash Flows
Wilmont Bicycle is considering a new business proposal to produce off-road bikes. The
following information is forecast:

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Concept Connection Example 11-1
New Venture Cash Flows




Last year purchased a gearshift design for $50,000.

Facilities are at capacity, so a new shop is required.
Company owns land nearby

New building will cost $60,000
Land purchased 10 years ago for $30,700
Market value is now $150,000.

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Concept Connection Example 11-1
New Venture Cash Flows
Three percent of new units sold will come from the old line.

–

Prices and direct costs in the two lines are the same.

General overhead is about 5% of revenue.

–

Incremental overhead is estimated at 2% of revenues.


Concept Connection Example 11-1 New Venture Cash Flows

Revenues collected in 30 days.
Incremental inventories
$12,000 at startup and for the first year.
Then inventory turnover = 12 X
Payables will be 25% of inventories.
Losses result in tax credits.

Marginal tax rate is 34%.

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Concept Connection Example 11-1 New Venture Cash Flows

Initial Outlay costs of hiring, training and advertising are tax deductible:

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Concept Connection Example 11-1

New Venture Cash Flows

Add operating items and assets for the total pre-start-up outlay:
Net after tax expenses $95.7
Assets subtotal $272.0
Actual pre-start-up outlay

$367.7

Opportunity cost of land
Market value
Cost

$150,000
$30,700

Capital gain
Tax

$119,300
$40,600

Opportunity cost $150,000 - $40,600 = $109,400

C0, the initial outlay, is

$367,700 + $109,400 = $477,100.

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Concept Connection Example 11-1

New Venture Cash Flows

Sales are forecasted to grow for 4 years before
leveling off. We’ll estimate for 6 years—for a longer
forecast repeat the last year as.

The building is
depreciated over 39 years
while the equipment is
depreciated over 5 years.

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Concept Connection Example 11-1
New Venture Cash Flows

Assume that the
$12,000 of initial
inventory was
acquired prior to
start-up.

Represents the subtotal after adding depreciation less the change in working capital.

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Terminal Values

Cash flows forecast to continue forever are compressed into finite
terminal values using perpetuity formulas

– A common but very aggressive assumption with new ventures
– A repetitive cash flow starting in year 7 is valued as a perpetuity

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Accuracy and Estimates

NPV and IRR techniques give the impression of great accuracy
Capital budgeting results are no more accurate than the projections
used as inputs
Unintentional biases are a problem in capital budgeting

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MACRS—A Note on Depreciation

U.S. government allows accelerated tax depreciation
MACRS sorts assets (equipment) into categories

–

Specifies depreciation for each

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Estimating Cash Flows for
Replacement Projects
Fewer elements than new ventures
Identifying what is incremental can be tricky
Difficult to determine what will happen if you don’t do the project

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Concept Connection Example 11-3 Replacement Projects

Harrington purchased a machine five years ago for $80,000.
Depreciated straight-line over eight years
New machinery depreciated straight line over five years.

Considering replacing with a new one costing $150,000.
Old unit can be sold for $45,000
Old machine - three operators $25,000/year each
New machine - two operators $25,000/year each

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Concept Connection Example 11-3 Replacement Projects

The old machine has the following history of high maintenance cost and significant downtime.

Manufacturing managers estimate every hour of downtime costs the $500, but have no backup data .