Chapter 7:
I. Estimating Cash Flows
Estimating Cash Flows
A. Rules to Follow:
1. Consider only the incremental cash flows:
- Ignore sunk costs.
- Consider the opportunity cost of assets being used.
- Include side effects (erosion, cannibalism).
2. For replacement projects, focus solely on the changes in cash flows.
3. Ignore financing (interest costs); focus on operating cash flows.
4. Focus on after tax cash flows!
5. Include changes in net working capital as a cost in any period that it may occur.
Addition (reduction) to NWC is a negative (positive) cash flow.
B. The three-stage approach to estimating project cash flows:
1. Initial Investment Outlay : Usually negative
2. Operating cash flows
: Net cash flows during project’s life
3. Terminal year cash flows : Final year adjustments
C. A Closer Look at Net Working Capital
How Changes in NWC Affect Cash Flow:
An increase in any current asset (+NWC) is a cash outflow (-Cash)
A decrease in any current asset (-NWC) is a cash inflow (+Cash)
An increase in any current liability (-NWC) is a cash inflow (+Cash)
A decrease in any current liability (+NWC) is a cash outflow (-Cash)
Fin 336: Chapter 7 - Estimating Cash Flows, p. 1

II. Three Stage Approach for Estimating Cash Flows
1. Initial Investment cash flows: Usually negative
- All initial costs necessary to bring a project up and running
- Initial changes in net working capital (cash, AR, inventory)
- Opportunity costs (alternative use for building, land, etc.)
-
If it’s a replacement project, you must consider:
* Sale of original asset
* Tax consequences of sale (book value vs selling price)
2. Annual cash flows: Net cash flows during project’s life
- All after-tax cash flows from operations
- Key Formula: OCF = (R-O-D)((1-t) +D
- Additional changes in net working capital
- If a replacement project: remember to use annual change in depreciation
3. Terminal cash flows: Final year adjustments
- Cash flows other than from operations
Salvage (sale of remaining assets)
Recovery and reclamation of property (e.g. strip mining)
Recovery of investment in net working capital
Fin 336: Chapter 7 - Estimating Cash Flows, p. 2

Sale of an Asset and the Tax Consequences ( After-tax Salvage Value )
SP = Selling Price (or “Market Value”)
BV = Book Value (or “Adjusted Basis”)
1. If an asset is sold at book value then there is no tax effect.
2. If an asset is sold for more than book value, there is a gain on the sale and taxes must be paid on the gain, reducing cash flow.
3. If an asset is sold at a loss, there is a tax write-off, which can be applied to gains in other investments, increasing cash flow.
(SP – BV) = Gain on Sale t(SP – BV) = Taxes due or tax write-off
SP – t(SP – BV) = After-tax cash flow (aka, after-tax salvage value )
Example 1: Gain on Sale
SP = $60,000 BV = $28,800 tax rate = .34
Gain on Sale: (SP – BV) = (60,000 – 28,800) = 31,200
Taxes due: t(SP – BV) = .34(31,200) = 10,608
After-tax gain: SP – t(SP – BV) = 60,000 – 10,608 = 49,392
$49,392 is the “ after-tax salvage value
” or after-tax cash flow
Example 2: Loss on Sale
SP = $28,800 BV =$60,000 tax rate = .34
Gain on Sale: (SP – BV) = (28,800 – 60,000) = -31,200
Taxes due: t(SP – BV) = .34(-31,200) = -10,608
After-tax gain: SP – t(SP – BV) = $28,800– (-10,608) = 39,408
$39,408 is the “ after-tax salvage value
” or after-tax cash flow
Fin 336: Chapter 7 - Estimating Cash Flows, p. 3

Example: Regency Integrated Chips (RIC) Expansion Project
1. Initial investment cash flows (in millions):
-
- $12,000 Cost of Building (2002)
- $8,000 Cost of Equipment (2002)
$6,000 Increase in Net Operating Working Capital (2002)
Total initial investment (2002): $26,000
2. Annual cash flows during project’s life (in millions):
Sales Revenue $60,000
Less Operating Costs
Less Depreciation
-50,000 Fixed and variable operating costs
- 1,746 Building and equipment
EBIT
Less Taxes (.40)
8,244 Operating income
- 3,298
NOPAT
Plus Depreciation
(OCF)
4,946
+ 1,746
6,702
Net Operating Profit after Taxes
Less increase in NWC
Net Cash Flow
- 120
$6,582
OCF = (R-O-D)(1-t) +D
NCF = (R-O-D)(1-t) +D +/- change in NWC
3. Terminal year cash flows (in millions): a. Recapture of NWC: + $6,367 b. After-tax salvage of Building
After-tax salvage of Equipment
Total after-tax salvage values
+ $8,863
+ 1,744
$10,607
Easy Formula: After-tax salvage value = SP - t(SP – B)
Fin 336: Chapter 7 - Estimating Cash Flows, p. 4

Example: Test Questions on Capital Budgeting
Compton Brewery (CB) is considering replacing the old oak kegs that are used in the beer making process with brand new stainless steel ones. The 5 new kegs, which cost $300,000 dollars each, will be fully depreciated over their estimated useful life of five years. Shipping, transportation, and installation will cost an additional $400,000. Net working capital will have to be immediately increased by $10,000. The company’s chief financial officer
(CFO) also estimates that the company will be able sell the new kegs at the end of year 5 for $50,000 total.
The old kegs were originally purchased for a total cost of one million dollars eight years ago and are being fully depreciated on a straight-line basis over ten years. The old kegs can be sold at salvage today for $500,000 (total!)
If the new kegs are purchased, CB’s chief financial officer estimates that annual revenues will increase from $480,000 to $620,000 and operating costs will drop from $120,000 to $110,000
In addition, the new kegs will require in infusion of additional net working capital in years 2 and 3 of $5,000 each year. The company’s marginal tax rate=.34 and its required rate of return is 15%.
1. Estimate all cash flows in years zero through 5?
2. Calculate the NPV.
3. Calculate the IRR.
4. Should the kegs be replaced?
Fin 336: Chapter 7 - Estimating Cash Flows, p. 5

Modified Accelerated Cost Recovery System for Depreciation
Year Depreciation rate for recovery period
3-year 5-year 7-year
1
2
33.33%
44.45
20.00%
32.00
14.29%
24.49
3
4
5
14.81
7.41
19.20
11.52
11.52
17.49
12.49
8.93
6
7
8
5.76 8.92
8.93
4.46
MACRS Depreciation:

Assign asset to appropriate asset-class (3-year, 5-year, etc)

Multiple percentage from table by the depreciable basis

Depreciate that amount each year of the asset’s life
Example: A 7-year asset with a $50,000 depreciable basis
Year1: Depreciate asset by $50,000 x .1429 = $7,145
Year2: Depreciate asset by $50,000 x .2449 = $12,245
Straight-line Depreciation:

Divide the cost by the number of years over which asset will be depreciated to arrive at annual depreciation

Reduce book value each year by the annual depreciation
Fin 336: Chapter 7 - Estimating Cash Flows, p. 6