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 firm’s existing products. • To the extent that sales of a new product or plant just replaced other corporate sales, the new project’s 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 project’s 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 project’s 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 company’s 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

16. Estimating the initial investment • It is the project’s 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

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 CF=Change 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

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 DEP*TAX • TAX is the firm’s marginal income tax rate

22. Year by Year Depreciation Tax shield under MACRS

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 ($100,000*0.35) 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

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 = 384,800*0.35 = $134,680 • After tax Salvage value = $500,000 - $134,680 • Recapture of working capital = $45,000 • Terminal value=$365,320+$45,000 = $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

32. 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$)

35. Smith corporation summary of CFs for new product introduction

36. 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 project’s working capital • CFs beyond the initial evaluation period

38. Smith corporation New product #2 financial forecasts

39. Smith corporation summary of CF for new product #2 introduction

40. Smith Corporation TV sensitivity analysis

41. 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