CHAPTER 11
Cash Flow Estimation
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Topics

Estimating cash flows:

Initial investment
Operating cash flows

Non-operating cash flows

2
4-step procedure

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Initial investment outlay
Operating cash flows in the following
years
Non-operating cash flows in the last
year
apply NPV and other methods to
evaluate the project
3
Estimating cash flows
guidelines 1
All project cash flows must be incremental
For initial outlay
 Include opportunity costs
 Include changes in net working capital
 Ignore sunk costs
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Estimating cash flows
guidelines 1
All project cash flows must be incremental
For operating cash flow
 Include opportunity costs
 Add back depreciation to net income
 Ignore interest expense
 Ignore allocated costs
5
Estimating cash flows
guidelines 3
All project cash flows must be incremental

non-operating cash flows in the last year
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All cash flows must be incremental
To evaluate a project, we look at the cash flows which
it contributes towards the firm’s existing cash flows. In
other words, we look at project’s incremental cash
flows.
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Opportunity costs wrt initial
outlay



Suppose the project requires the use of some
asset owned by the firm.
If the asset is not used by the project, the
firm can sell the asset for $X. This $X is the
opportunity cost of the asset. Such a cost
should be included in the project’s cost.
An asset’s opportunity cost is the money that
the firm can receive if the asset is put to the
next best use. The ‘next best’ use may be to
sell the asset.
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Changes in net working capital


Very often, a project will require an initial
increase in net working capital. This increase in
net working capital must be added to the
project’s costs. (changes in AR, Inv, AP,
accruals, minimum cash balance)
This additional working capital is recovered at
the end of the project’s life, which is a nonoperating cash inflow in the last year.
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Sunk costs 1
costs which cannot be recovered regardless of
whether the firm undertakes the project.
Examples: R&D expenses, consultant fees incurred
already
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Sunk Costs 2


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.
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Cannibalization



Net sales after cannibalization
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. Net CF loss per year on other lines
would be a cost to this project.
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Depreciation


Depreciation is a non-cash charge and
must be added to net income to
estimate cash flow.
Operating Cash flow = net income +
depreciation expense
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Opportunity Costs wrt
operating cash flows



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.
After-tax opportunity cost = $25,000 (1 – T)
= $15,000 annual cost.
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Ignore allocated costs


Allocated costs: current rent, supervisory
salaries, administrative costs, and various
overhead expenses.
These costs are not incremental. Thus, they
should not be considered in estimating the
project’s incremental cash flows.
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Ignore interest expense


WACC includes the interest expenses.
In determining a project’s cash flows,
we ignore it’s financing cost, i.e., the
interest expense.
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Non-operating cash flows


The incremental net working capital at
t=0 is recovered at the end of the
project’s life, which is a non-operating
cash inflow in the last year.
After-tax salvage value
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After-tax salvage cash flow
Salvage Value
Book Value
Gain or loss
Tax(40%)
$25
0
$25
10
$15
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Question 1
Thompson Company has to decide whether to build a new factory. Management
has collected various cost data to use to make the decision. Some of the items
collected are listed below. Which of the following should Thompson consider as
being relevant for computing cash flows for the new factory project?
A.
B.
C.
D.
E.
$500,000 was spent last year to upgrade a piece of property on which the
company is planning to build the new factory.
It will cost $10,000,000 to construct the factory and new equipment costing
$3,250,000 will need to be purchased and installed to begin production of the
product to be sold.
The factory construction costs of $10,000,000 will be financed entirely with new
long-term debt (specifically a new bond issue). The company estimates that the
interest costs of this new debt will be $850,000 per year.
The variable cost of production is estimated to be 65% of annual sales.
The accounting department plans to allocate supervisory and management costs
of $25,000 per year to the project. No new supervisory or management
personnel will be required.
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Question 2
Investment in land and building: 200,000
Changes in net working capital: 8,000 increase in
inventory, 3,500 increase in minimum cash balance,
18,000 increase in account receivable, 2,500 increase
in account payable, 500 increase in accruals. The
total amount will be recovered at the end of life of
project. What is the initial change in net working
capital?
Answer: 8000+3500+18000-2500-500=26,500
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Capital budgeting example 1
You are given the responsibility of conducting
the project selection analysis in your firm.
You have to calculate the NPV of a given
project. The appropriate cost of capital is 12
percent and the firm is in the 30 percent tax
bracket. You are provided the following
pieces of information regarding the project:
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Details




The project is going to be built on a piece of
land that the firm already owns. The market
value of the land is $1 million.
If the project is undertaken, prior to
construction, an amount of $100,000 would
have to be spent to make the land usable for
construction purposes.
In order to come up with the project concept,
the company had hired a marketing research
firm for $200,000.
The firm has spent another $250,000 on R&D
for this project.
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Details



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The project will require an initial outlay of $20
million for plant and machinery.
The sales from this project will be $15 million
per year of which 20 percent will be from lost
sales of existing products.
The variable costs of manufacturing for this
level of sales will be $9 million per year.
The company uses straight-line depreciation.
The project has an economic life of ten years
and will have a before-tax salvage value of 3
million at the end.
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Details



Because of the project the company will need
additional working capital of $1 million which
can be liquidated at the end of ten years.
The project will require additional supervisory
and managerial manpower that will cost
$200,000 per year.
The accounting department has allocated
$350,000 as allocated overhead cost for
supervisory and managerial salaries.
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Calculate initial cost

Initial cost is the sum of:
•
•
•
•
Market value of land: $1 mil (opportunity cost)
Land improvement $100 k
Plant & machinery: $20 mil
Incremental working capital: $1 mil
Initial cost
= 1,000,000 + 100,000 + 20,000,000 + 1,000,000
= $22,100,000
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Calculate the annual incremental
cash flow: step 1
Calculate the annual depreciation expense
For this project, fixed assets refer to $20mil plant &
machinery. Therefore,
Depreciation
= (20,000,000 – 3,000,000)/10
= $1,700,000

Calculate incremental sales
Incremental sales = 0.8 x 15,000,000 = $12,000,000

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Calculate the annual incremental
cash flow: step 2
Draw up the incremental income statement
Incremental sales
Less Incremental variable cost
Less Incremental managerial salaries
12,000,000
9,000,000
200,000
Less Incremental depreciation
1,700,000
Equals Incremental taxable income
1,100,000
Less Incremental tax @30%
330,000
Equals Incremental net income
770,000
Add back depreciation
1,700,000
Incremental cash flow
$2,470,000
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Step 3: non-operating cash
flows
At the end of project’s life (t=10), company
• Recovers $1 mil additional working capital
(item 9)
• Receives $3x(1-0.3)=2.1 mil after-tax
salvage value from plant & machinery
(item 8)
Additional cash flows at end of project
= 1,000,000 + 2,100,000
= $3,100,000
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Step 4


CF0 (initial cost) = $22,100,000
Annual incremental after-tax cash flow (Year
1 through Year 10) = $2,470,000
Nonoperating cash flow in Year 10 =
$3,100,000
So in year 10, the company receives a total of
= 2,470,000 + 3,100,000 = $5,570,000

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Step 4
To compute NPV, enter cash flows in this way:
CF0 = -22,100,000
C01 = 2,470,000, F01=9
C02 = 5,570,000, F02=1
Then press NPV, enter I = 12, press CPT and NPV.
NPV = -$7,145,832.09
Decision: reject the project.
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Capital budgeting example 2

ABC Corp. manufactures television sets
and computer monitors. The company
is considering introducing a new 40” flat
screen television/monitor. The
company’s CFO has collected the
following information about the
proposed product.
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Details
1) The project has an anticipated economic life of 5
years.
2) The company will have to purchase a new machine
to produce the screens. The machine has an up
front cost (t = 0) of $4,000,000. The machine will
be depreciated on a straight-line basis over 5 years.
The company anticipates that the machine will last
for five years and then have no salvage value (that
is, it will be worthless).
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Details
3) If the company goes ahead with the proposed
product, it will have to increase inventory by
$280,000 and accounts payable by $80,000. At t = 5,
the net working capital will be recovered after the
project is completed.
4) The screen is expected to generate sales revenue of
$2,000,000 the first year; $4,500,000 the second
through fourth years and $3,000,000 in the fifth year.
Each year the operating costs (excluding
depreciation) are expected to equal 50% of sales
revenue.
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Details
5) The company’s interest expense each year
will be $350,000.
6) The new screens are expected to reduce the
sales of the company’s large screen TV’s by
$500,000 per year.
7) The company’s cost of capital is 12%.
8) The company’s tax rate is 30%.
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Questions



What is the initial investment for the
project?
What is the 3rd year expected
incremental operating cash flow? (i.e.,
the incremental after tax cash flow)
What is the 5th year incremental nonoperating cash flow?
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Q1: initial investment
To answer Q1, you need points 2 & 3.
Initial investment

= machine cost + change in net working capital
= 4,000,000 + (change in current assets
– change in current liabilities)
= 4,000,000 + (280,000 – 80,000)
= $4,200,000
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Q2: 3rd incremental operating cash flow
To answer Q2, you need points 2,4,6,8.
Steps:
1) Incremental sales
= 4,500,000 – 500,000 = 4,000,000
2) Annual depreciation = (4,000,000)/5 = 800,000
3) Incremental operating cost for 3rd year
= 0.5 x 4,500,000 = 2,250,000
Next, draw up the incremental income statement

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Q2: 3rd incremental operating cash flow
Incremental sales
Less Incremental operating cost
Less Incremental depreciation
Equals Incremental taxable income
Less Incremental tax @30%
Equals Incremental net income
Add back depreciation
Incremental cash flow
4,000,000
2,250,000
800,000
950,000
285,000
665,000
800,000
$1,465,000
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Q3: 5th year incremental
non-operating cash flow


Very simple. The only incremental nonoperating cash flow is the cash flow
from liquidating the increase in net
working capital (point 3).
5th year incremental
non-operating cash flow = $200,000
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Homework assignment

Problems: 1, 2, 3, 7.
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