Cash Flow Estimation

Topics to be covered

 Discount Flow, Not Profit  Discount Incremental - Include all direct effects. - Forget Sunk - Include Opportunity Costs - Recognize the Investment in Working Capital - Beware of Allocated Overhead Costs  Discount Nominal Cash Flow by the Nominal of Capital If you use a nominal cost of capital, you should forecast the nominal cash flows-that is, cash flows that recognize the effect of inflation. In evaluating a proposed investment, we pay attention to deciding what information is relevant to the decision at hand and what is not.  Separate Investments and financing decisions  Calculating Cash flow

How should a financial manager prepare cash flow estimates for use in NPV analysis? The 4 steps in deciding whether to take a project are 1. Forecast the projected cash flow 2. Estimate the opportunity cost of capital 3. Calculate PV 4. Calculate NPV

Discount cash flow, not profits  Income Statement measure historical performance according to generally accepted accounting principle, not in cash-flow terms.  Cash flow, when they occur, discounted at the opportunity rate of return is the proper method for net present value.  Focus of capital budgeting should be on the cash flow not on profits. If you are in doubt about what is a cash flow, simply count the $s coming in and the $s going out.  When making capital budgeting decision companies pretend that all cash flow occurs at one-year interval.

Example 1: Using Cash Flows:

Given the following cash flow and the discount rate of 10% compute the NPV of the project.

T = 0 T = 1 T =2 -2,000 +1,500 + 500

NPV = [1,500/(1.10) + 500/(1.10)2]-2,000 = -223.14

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Example 2: Using Accounting Income

The cost of the project $2,000 today is not treated as an immediate expense. Rather, the accountant depreciate $2,000 over 2 years

T = 1 T = 2 Cash Inflow + 1,500 + 500 - Depreciation - 1,000 - 1,000 Accounting Income + 500 - 500

NPV = [500/(1.10) + (-500)/ (1.10)2] = $41.32

The difference between and cash flow 1. Depreciation: Net income is calculated by subtracting depreciation expense which is a non-cash expense. 2. Taxes: do not cause net cash flow to differ from net income. 3. Credit Sales and Accrued Liabilities: Income Statement recognizes when the sale is made, but not when the bill is paid.

Discount Incremental Cash Flow o To evaluate a proposed investment, we must consider the changes in the firm’s cash flows and then decide whether or not they add value to the firm. o The first step is to decide which cash flows are relevant and which are not. o A relevant cash flow for a project is a change in the firm’s overall future cash flow that comes about as a direct consequence of the decision to take that project. So, it is called incremental cash flow. o An incremental cash flow = Cash flow with the project – Cash flow without the project. o Hence, cash flow that exists regardless of whether or not a project is undertaken is not relevant. o We are concerned only with those cash flows that are incremental to a project.

How to decide whether a cash flow is incremental or not? o Include all indirect effects. o Incremental cash flow for a project includes all the changes in the firm’s future cash flows. o It would not be unusual for a project to have side or spillover effects, both good and bad. o Such as if the Intelligent Motors Company (IMC) introduces a new car, some of the sales might come at the expense of other IMC cars.

1) Forget sunk costs: o A cost that has already been incurred and cannot be removed and therefore should not be considered in an investment decision.

2 o In other words, sunk cost is the cost that cannot be changed by the decision to accept or reject a project. The firm will have to pay this cost no matter what.

2) Include opportunity cost: the most valuable alternative that is given up if a particular investment is undertaken. o Such as the value of land which you could otherwise sell, will be a relevant cost of an investment project. o Or converting an old rustic cotton mill into condominiums. Using the mill for condo complex has an opportunity cost since we give up the valuable opportunity to do something else with it (selling). o When resources can be freely traded, its opportunity cost is simply its market price

4) Recognize the investment in working capital o The incremental net working capital, (change in current assets – change in current liabilities), represents relevant cash-flow cost of initiating a project. o Working capital recovered at the end of project is a relevant cash flow.

Cash flow from operation = Net Profit + Depreciation Expense -  in NWC

Net Working Capital = Current Assets – Current Liabilities

Current Assets Current Liabilities Cash Accounts Payable Accounts Receivable Short-term Inventory, etc. Notes Payable Salaries Payable Current Assets => Use of fund  Current Liabilities => Source of fund

NWC > 0 => Current Assets > Current Liabilities => Use of fund =>  Cash flow from operation

NWC < 0 => Current Assets < Current Liabilities => Source of fund =>  Cash flow from operation

When working capital decreases, cash is freed up, so cash flow increases.

Example 3: A computer business had of $64,000 and expenses of $36,000. The depreciation expense is $5,000 and tax rate of 35%. Beginning Ending Accounts Receivable $4,800 $9,000 Inventory $1,200 $1,000 Accounts Payable $1,200 $400 (1) What is the net income? ($14,950) Net Income = (Revenue-expenses-depreciation) * (1-Tax) = (64000-36000-5000) (1-0.35) =$ 14950

3 (2) What is the total change in current assets and current liabilities? (+4,000, -800) ∆CA=∆AR+∆Inventory = (9000-4800) + (1000-1200) =$4000 ∆CL=∆AP= (400-1200) = -800 (3)What is the change in NWC? (+4,800) ∆NWC=∆CA-∆CL= 4800 - (-800) =4800

(4)What is net cash flow for the business for this period? ($15,150) NCF= NI + depreciation-∆NWC = 14950 + 5000 – 4800 = $15150

Why should depreciation be considered in the calculation of incremental cash flows for a project?

o Depreciation is not a cash flow. o Depreciation expenses reduce taxable income; hence it reduces taxes. o The tax reduction is called depreciation tax shield. o Accelerated Cost Recovery System (ACRS) depreciation method allows the deprecation to be taken in early years than under straight-line method. This increases the present value of tax shield and increases cash flow.

Example 4: If the firm’s tax bracket is 35%, each additional dollar of depreciation reduces taxable income by $1 and tax owed by 35 cents. This tax reduction is called the depreciation tax shield.

Depreciation Tax Shield = Depreciation Expense x Tax Rate

Example 5: Paul’s Pumpkin Patch bought a new tractor for $175,000 that will be depreciated using the five year straight line schedule. If the tractor is sold after 2 years for $125,000, what will be the after-tax proceeds on the sale if the firm’s tax bracket is 35%? Solution: 2nd Year: Straight line depreciation Book Value = 105,000 175000/5 = 35000/year Sale = 125,000 Book value of machine = 105000 Tax effect 20,000 @ 35%

Sale Price = 125000 After Tax proceed 125000 Book gain= 20,000 - 7000 Extra Tax @ 35% = 7000 118,000

5) Beware of allocated overhead costs o Overhead costs, such as heat and lights, incurred whether the project investment is made or not, are irrelevant to the project cash-flow analysis. o Include only the additional or incremental cash-flow cost, only when they occur, in the project analysis.

Separate Investment and Financing Decisions:

4 1. Regardless of the actual financing view the project as if it were all equity financed (All cash outflows for project come from shareholders and all cash inflows go to them) 2. Separate the analysis of the investment decision from financial decisions 3. First measure if the project has positive NPV 4. Then undertake separate analysis for financial decision.

Calculating Cash Flow: 1. The Investment Cash Flow 2. Operating Cash Flow Method: CF = net profits + depreciation – change in WC 3. Terminal Cash flow The sum of the above three cash flows for any given year is the net cash flow. We have to compute the net cash flow for each year in the life of the project.

Example 6: Year 0 1 2 3 Capital investment -15,000 Working capital 2,000 4,100 3,800 0 Revenues 30,000 35,000 Depreciation 7,500 7,500 EBIT 9,500 12,500 EBT 7,500 10,300 Taxes (40%) 3,000 4,120 Net Profits 4,500 6,180

a. Calculate the total cash flow in year 0, 1, 2 and 3. Year 0 Year 1 Year 2 Year 3 EBIT 0 9500* 12500* 0 (1-0.4)=5700 (1-0.4)=7500 Depreciation 0 7500 7500 0 ∆NWC 2000 2100 -300 -3800 Capital 15000 0 0 0 -17000 11,100 15,300 3800

5 b. Would you undertake the project, if the discount rate were 12%? Use your calculator and input CF0=-17000 C1=11100, C2=15300, C3=3800 Then compute the NPV by using I value of .12. You will get NPV=$7812.55. You will accept the project.

Example 7: ERL Company bought a machine 5 years ago for $15,000. The machines’ expected life is 12 years with no salvage value (ERL follows straight line depreciation). Now, ERL plans to buy a new machine for $17,500 with 7 years of expected life and no resale value. Old machine will be salvaged at $10,000. The new machine will increase sales from $20,000 to $22,000 and the operating costs will be reduced from $12,000 to $10,000. If the cost of capital is 15% should ERL buy the new machine? Solution: Book value of old machine = 0 Net Outlay Sale Price = 1000 Price of new machine= 17500 Book gain =1000 Sale of old machine = -1000 Tax = $ 400 Tax = 400 Net Outlay= $16900 Cash Flows: BT AT Life ∆ Revenues 2000 @ 60 % 1200 7 Years ∆ Cuts 2000 @ 60% 1200 7 Years Depreciation New 3500 @ 40% 1400 5 Years

NPV = 2400 [(1/1.15)…. (1/1.157)] + 1400 [(1/1.15)…… (1/1.155)]-16900 = - 2222 (Don’t Buy New machine) Example 8: Smith is buying new equipment which will save $40,000 (two workers!) and the revenues will go up by $5000. It will cost $125,000 and will last 8 years (no salvage value). The old equipment which was purchased 4 years ago at a price of $30,000 will be sold for $15,000. If the cost of capital is 10% and the tax rate is 40% should Smith buy the new machine? Solution: Net Outlays Book Value of old Machine = 6000 Price of New Machine = 125,000 Sale Price =15000 Sale of Old Machine = - 15,000 Book Gain = 9000 Tax effect = 3600 Extra tax = 3600 113, 600

6 Cash Flows: BT AT Life ∆ Revenues 5000@ 60% 3000 8 years ∆ Cuts 40,000 @ 60% 24,000 8 years Depreciation new 25,000 @ 40% 10,000 5 years Depreciation old -6000 @ 40% - 2400 1 year NPV = $ 66169 Smith should buy the new machine. Example 9: GM purchased a machine 3years ago for $30,000. The machine will last for 6 more years but can be sold now for $10,000. The salvage value of the old machine at the end of its life is $5000. New improved machine will cost $40,000 and will reduce the energy cost by $10,000 per year. The new machine will last for 6years and will have a resale value of $1000. If the cost of capital is 10% and the tax rate is 40% should GM buy the new machine?

Solution: Book value of Old machine = 12000 Net outlays: Sale Price = 10,000 Price of New Machine = 40,000 Book Loss = 2000 Sale of Old machine = -10,000 Tax Rebate = 800 Tax = 800 $ 29,200 Cash Flow: BT AT Life ∆ Revenue ------∆ Costs 10,000 @ 60 % 6000 6 years Depreciation New Mach. 8,000 @ 40% 3200 5 years Depreciation Old Mach. -6000 @ 40 % -2400 2 years Salvage new machine 1000 @ 60% 600 End of Yr 6 Salvage old machine -5000 @ 60% -3000 End of yr 6

NPV = 3542 GM Should buy the new machine

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