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Chapter 12

Chapter 12. Estimating Cash Flows on Capital Budgeting Projects. Introduction. Estimating project cash flows requires us to consider a number of factors: The costs and revenues The impact on existing products’ costs and revenues Whether we will use existing assets or employees

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Chapter 12

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  1. Chapter 12 Estimating Cash Flows on Capital Budgeting Projects

  2. Introduction • Estimating project cash flows requires us to consider a number of factors: • The costs and revenues • The impact on existing products’ costs and revenues • Whether we will use existing assets or employees • If we should include certain charges such as R&D associated with the project • Many other details • We will use a pro forma analysis of potential projects to answer the question: “what is this project’s impact on the firm’s cash flows if we go forward?”

  3. Sample Project Description • Computer Game • Price = $39.99 • Projected unit sales: • Variable cost per game = $4.25 • Fixed costs per year = $150,000 • Startup costs: • Software duplicating machine costing $75,000 • Shipping and installation costs of $2,000

  4. Duplicating machine will be depreciated straight-line to $5,000 over the life of the project • We expect to be able to sell the machine for $2,000 after we are done with it • The new game will cut into sales of an older game currently on the market • The old game will lose sales of 2,000 units per year throughout the life of the new game • Old game sells for $19.99 and has variable costs of $3.50 per unit

  5. Game development costs for the new game totaled $150,000 Net Working Capital requirements at the beginning of each year will be 10% of the projected sales during the coming year The marginal tax rate is 34 percent The appropriate discount rate for projects of this risk is 15 percent

  6. Guiding Principles for Cash Flow Estimation • We are interested in incremental cash flows • Cash flow changes that we expect as a result of accepting the project • Some incremental cash flows are not obvious • Opportunity costs • Sunk costs • Substitutionary and Complementary effects

  7. Opportunity costs • Example: if we did not use an existing resource for our project, it could have been used to generate cash flows for another project, so our project must be charged for those foregone cash flows • Sunk costs • If a firm has already paid an expense or is obligated to pay one in the future regardless of whether the project is undertaken, it is a sunk cost and should never be considered in the project cash flows

  8. Substitutionary and Complementary effects • If a new project will reduce or increase cash flows for existing products or services then those changes are incremental to the project and should be included in the project cash flows

  9. Financing costs • Financing costs are never included as incremental project cash flows • Interest paid on debt • Dividends paid on stock • We do include these costs in the analysis, but they are included as part of the Weighted Average Cost of Capital (WACC) that we use to discount the cash flows • If we included them in the project cash flows we would be double-counting them

  10. Total Project Cash Flow • We will use Free Cash Flow as our measure of the cash flow available from a project • Since we are considering potential projects, the inputs are estimates rather than actual historical numbers • Unlike in chapter two, we will be calculating FCF for individual projects rather than the overall firm

  11. Calculating Depreciation • The depreciable basis for real property is calculated as: Cost + sales tax + freight charges + installation and testing • For our project:

  12. Since initially we are assuming straight-line depreciation for our project: = ($77,000 - $5,000) / 3 = $24,000 per year

  13. Calculating Operating Cash Flow • OCF = EBIT – Taxes + Depreciation • It is useful to use a pro-forma income statement approach to calculate operating cash flows • Remember to leave out interest expense as we discussed earlier

  14. Calculating the Change in Gross Fixed Assets • For most projects we need to calculate the change in gross fixed assets at the beginning of the project (time 0) and at the end of the project • At the beginning of the project the change in gross fixed assets equals the asset’s depreciable basis • For our project: $77,000

  15. At the end of the project: • We need to consider the tax consequences of the sale of the asset • If we sell the asset for more than its book value we have a gain on the sale • If we sell the asset for less than book value we have a loss on the sale ATCF = Book Value + (Market Value – Book Value) x (1 – TC) In our example: ATCF = 5,000 + (2,000 – 5,000) x (1-.34) = $3,020

  16. Calculating Changes in Net Working Capital For some projects we might assume that NWC increases at time zero (resulting in a negative cash flow) and decreases at the end of the project (resulting in a positive cash flow) For our project, NWC changes each year [insert Table 12.5]

  17. Bringing it All Together

  18. Accelerated Depreciation • Our FCF calculation used a simplistic assumption about depreciation • Straight Line • In reality, firms want to use accelerated depreciation • More of the depreciation expense occurs earlier in the asset’s life, lowering taxes and increasing cash flow

  19. The IRS allows businesses to use the Modified Accelerated Cost Recovery System (MACRS) to depreciate assets • Incorporates the half-year convention • Uses the double-declining balance depreciation method • The ultimate accelerated depreciation method would be to expense it immediately • IRS Section 179 deduction allows this for assets up to $108,000 • Geared toward small businesses

  20. Differing Asset Lives • If we decide to go ahead with a project, but we have to choose between two alternative assets, each with a different life, we can use the Equivalent Annual Cost (EAC) method to make the choice • Find the sum of the present values of the cash flows for one iteration of asset A and asset B • Treat each sum as the present value of an annuity with life equal to the life of the respective asset, and solve for each asset’s payment • Choose the asset with the least negative EAC

  21. Flotation Costs Revisited • In the previous chapter we discussed how to deal with flotation costs associated with issuing securities • We adjusted the WACC upwards to incorporate the flotation costs • Another approach is to adjust the project’s initial cash flow to reflect the flotation costs

  22. Compute the weighted average flotation cost fA Compute the flotation-adjusted initial investment CF0:

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