Relevant cash flows Working capital treatment Unequal project lives Abandonment value Inflation

1. CHAPTER 11 Project Cash Flow Analysis • Relevant cash flows • Working capital treatment • Unequal project lives • Abandonment value • Inflation

2. CAPITAL BUDGETING: Principles of Cash Flow Estimation • Five principles: • 1. The most important step in analyzing a capital budgeting project is estimating the incrementalafter tax cash flows the project will produce.

3. 2. NET OPERATING CASH FLOWS CONSIST OF : • SALES REVENUES MINUS CASH OPERATING COSTS, REDUCED BY TAXES, PLUS A DEPRECIATION CASH FLOW EQUAL TO THE AMOUNT OF DEPRECIATION TAKEN DURING THE PERIOD MULTIPLIED BY THE TAX RATE.

4. I.e. CFt = (Rt - Ct - Dt)(1-T) + Dt, or • CFt = (Rt - Ct)(1-T) + TDt • n.b. the higher the tax rate T, the greater the benefits from depreciation. • In most situation, net operating cash flows are estimated by constructing cash flow statements.

5. 3. In determining incremental cash flows, opportunity costs (the cash flow foregone by using an asset) must be included, but sunk costs (cash outlays that have been made and that cannot be recouped) are not included. Any externalities (effects of a project on other parts of the firm) should also be included in the analysis.

6. 4. Capital projects often require an additional investment in net operating working capital (NOWC). An increase in NOWC must be included in the year zero initial cash outlay (or year in which it occurs), and then shown as a cash inflow in the final year of the project (or year in which it occurs).

7. Net Operating Working Capital • All current assets that do not pay interest - all current liabilities that do not charge interest

8. Current assets Cash & equiv. S.t. investments Accts Recvbl. Inventories Current liabilities Accts Payable Notes Payable Accruals Net working capital/NOWC

9. 5. Salvage value St • StN = St - T(St - Bt) • If St = Bt; firm has depreciated the asset just the correct amount. • If St > Bt; firm has depreciated the asset to a Book Value less than the salvage value. Firm has taken excess depreciation and avoided taxes. Firm must declare this excess as income and pay taxes on it. Known as recapture of depreciation. • If St <Bt; firm has paid too much taxes (I.e. has taken too little depreciation) and should get a tax refund.

10. Indian River Citrus Case

11. Indian River Citrus Case

12. Depreciation Basics Basis = Cost + Shipping + Installation $570,000

13. Annual Depreciation Expense (000s) Year 1 2 3 4 % 0.33 0.45 0.15 0.07 x Basis = Depr. $188.1 $256.5 $ 85.5 $ 39.9 $570 $570K

14. What if you terminate a project before the asset is fully depreciated? Cash flow from sale = Sale proceeds - taxes paid. Taxes are based on difference between sales price and tax basis, where: Basis = Original basis - Accum. deprec.

15. Example: If Sold After 3 Years (000s) • Original basis = $570. • After 3 years = $39.9 remaining. • Sales price = $50. • Tax on sale = 0.4($50-$39.9) = $4.0 • Cash flow = $50-$4.0=$46.

16. Should CFs include interest expense? Dividends? • NO. The costs of capital are already incorporated in the analysis since we use them in discounting. • If we included them as cash flows, we would be double counting capital costs.

17. Suppose $100,000 had been spent last year to improve the production line site. Should this cost be included in the analysis? • NO. This is a sunk cost. Focus on incremental investment and operating cash flows.

18. Suppose the plant space could be leased out for $25,000 a year. Would this affect the analysis? • Yes. Accepting the project means we will not receive the $25,000. This is an opportunity cost and it should be charged to the project. • A.T. opportunity cost = $25,000 (1 - T) = $15,000 annual cost.

19. CANNIBALIZATION

20. If this were a replacement rather than a new project, would the analysis change? Yes. The key word is INCREMENTAL!

21. Incremental Revenues. • Incremental Costs. • The relevant depreciation would be the INCREMENTAL change with the new equipment. • Also, Salvage Value Changes: • Old machine sale • New machine sale • Not having old machine at time T.

22. Notation • Let Xij stand for any of the relevant variables (Rev., Costs, Dep., etc.) • i is the first subscript • =0 for old • =1 for new • j is the second subscript, representing time, …0, 1, 2,….t

23. Replacement Project • For every time, t, CFt = • [(R1t - R0t) - (C1t - C0t) - (D1t - D0t)]*(1-T) + (D1t - D0t) + Salvage terms • or • [(R1t - R0t) - (C1t - C0t)(1-T)] +(D1t - D0t)]*T + salvage terms • Note the incremental nature of the cash flows.

24. Replacement project • OR: • CFt = (Rt -  Ct-  Dt)(1-T) +  Dt + Salvage value terms; • OR: • CFt = ( Rt -  Ct)(1-T) + T  Dt + salvage value terms

25. SALVAGE TERMS • Old machine sale (at time 0): • S00 -T(S00 - B00) • New machine salvage value: • S1t - T(S1t - B1t) • Not having old machine value at time N: • -[S0N - T(S0N-B0N)]

26. What is the role of the financial staff in the cash flow estimation process? • Coordination with other departments • Maintaining consistency of assumptions • Elimination of biases in the forecasts

27. What is cash flow estimation bias? • CF’s are estimated for many future periods. • If company has many projects and errors are random and unbiased, errors will cancel out (aggregate NPV estimate will be OK). • Studies show that forecasts often are biased (overly optimistic revenues, underestimated costs).

28. What steps can management take to eliminate the incentives for cash flow estimation bias? • Routinely compare CF estimates with those actually realized and reward managers who are forecasting well, penalize those who are not. • When evidence of bias exists, the project’s CF estimates should be lowered or the cost of capital raised to offset the bias.

29. What is option value? • Investment in a project may lead to other valuable opportunities. • Investment now may extinguish opportunity to undertake same project in the future. • True project NPV = NPV + value of options.

30. Real vs. Nominal Cash flows • In IRC case, were cash flows real or nominal? • In DCF analysis, k includes an estimate of inflation. • If cash flow estimates are not adjusted for inflation (i.e., are in today’s dollars), this will bias the NPV downward. • Be consistent in using real or nominal.

31. THE END

32. CHAPTER 11 Cash Flow Estimation and Risk Analysis • Estimating cash flows: • Relevant cash flows • Working capital treatment • Inflation • Risk Analysis: Sensitivity Analysis, Scenario Analysis, and Simulation Analysis

33. Proposed Project • Cost: $200,000 + $10,000 shipping + $30,000 installation. • Depreciable cost $240,000. • Economic life = 4 years. • Salvage value = $25,000. • MACRS 3-year class.

34. Annual unit sales = 1,250. • Unit sales price = $200. • Unit costs = $100. • Net operating working capital (NOWC) = 12% of sales. • Tax rate = 40%. • Project cost of capital = 10%.

35. Incremental Cash Flow for a Project • Project’s incremental cash flow is: • Corporate cash flow with the project Minus • Corporate cash flow without the project.

36. Should you subtract interest expense or dividends when calculating CF? • NO. We discount project cash flows with a cost of capital that is the rate of return required by all investors (not just debtholders or stockholders), and so we should discount the total amount of cash flow available to all investors. • They are part of the costs of capital. If we subtracted them from cash flows, we would be double counting capital costs.

37. Suppose $100,000 had been spent last year to improve the production line site. Should this cost be included in the analysis? • NO. This is a sunk cost. Focus on incremental investment and operating cash flows.

38. Suppose the plant space could be leased out for $25,000 a year. Would this affect the analysis? • Yes. Accepting the project means we will not receive the $25,000. This is an opportunity cost and it should be charged to the project. • A.T. opportunity cost = $25,000 (1 - T) = $15,000 annual cost.

39. If the new product line would decrease sales of the firm’s other products by $50,000 per year, would this affect the analysis? • Yes. The effects on the other projects’ CFs are “externalities”. • Net CF loss per year on other lines would be a cost to this project. • Externalities will be positive if new projects are complements to existing assets, negative if substitutes.

40. What is the depreciation basis? Basis = Cost + Shipping + Installation $240,000

41. Annual Depreciation Expense (000s) Year 1 2 3 4 % 0.33 0.45 0.15 0.07 x Basis = Depr. $ 79.2 108.0 36.0 16.8 $240

42. Annual Sales and Costs Year 1Year 2Year 3Year 4 Units 1250 1250 1250 1250 Unit price $200 $206 $212.18 $218.55 Unit cost $100 $103 $106.09 $109.27 Sales $250,000 $257,500 $265,225 $273,188 Costs $125,000 $128,750 $132,613 $136,588

43. Why is it important to include inflation when estimating cash flows? • Nominal r > real r. The cost of capital, r, includes a premium for inflation. • Nominal CF > real CF. This is because nominal cash flows incorporate inflation. • If you discount real CF with the higher nominal r, then your NPV estimate is too low. Continued…

44. Inflation (Continued) • Nominal CF should be discounted with nominal r, and real CF should be discounted with real r. • It is more realistic to find the nominal CF (i.e., increase cash flow estimates with inflation) than it is to reduce the nominal r to a real r.

45. Operating Cash Flows (Years 1 and 2) Year 1Year 2 Sales $250,000 $257,500 Costs $125,000 $128,750 Depr. $79,200$108,000 EBIT $45,800 $20,750 Taxes (40%) $18,320$8,300 NOPAT $27,480 $12,450 + Depr. $79,200$108,000 Net Op. CF $106,680$120,450

46. Operating Cash Flows (Years 3 and 4) Year 3Year 4 Sales $265,225 $273,188 Costs $132,613 $136,588 Depr. $36,000$16,800 EBIT $96,612 $119,800 Taxes (40%) $38,645$47,920 NOPAT $57,967 $71,880 + Depr. $36,000$16,800 Net Op. CF $93,967$88,680

47. Cash Flows due to Investments in Net Operating Working Capital (NOWC) NOWC Sales(% of sales)CF Year 0 $30,000 -$30,000 Year 1 $250,000 $30,900 -$900 Year 2 $257,500 $31,827 -$927 Year 3 $265,225 $32,783 -$956 Year 4 $273,188 $32,783

48. Salvage Cash Flow at t = 4 (000s) Salvage value Tax on SV Net terminal CF $25 (10) $15

49. What if you terminate a project before the asset is fully depreciated? Cash flow from sale = Sale proceeds - taxes paid. Taxes are based on difference between sales price and tax basis, where: Basis = Original basis - Accum. deprec.

50. Example: If Sold After 3 Years (000s) • Original basis = $240. • After 3 years = $16.8 remaining. • Sales price = $25. • Tax on sale = 0.4($25-$16.8) = $3.28. • Cash flow = $25-$3.28=$21.72.