1. CHAPTER 11
Cash Flow Estimation

2. Topics Estimating cash flows: Initial investment Operating cash flows
Non-operating cash flows

3. 4-step procedure 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

4. Estimating cash flows guidelines 1
FI Corporate Finance Leng Ling
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

5. 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

6. Estimating cash flows guidelines 3
All project cash flows must be incremental
non-operating cash flows in the last year

7. All cash flows must be incremental
FI Corporate Finance Leng Ling
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.

8. Opportunity costs wrt initial outlay
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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.

9. Changes in net working capital
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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 non-operating cash inflow in the last year.

10. Sunk costs 1
costs which cannot be recovered regardless of whether the firm undertakes the project.
Examples: R&D expenses, consultant fees incurred already

11. 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.

12. 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.

13. FI 3300 - Corporate Finance Leng Ling
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

14. 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.

15. Ignore allocated costs
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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.

16. Ignore interest expense
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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.

17. 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

18. After-tax salvage cash flow
Salvage Value
$25
Book Value
Gain or loss
Tax(40%) 10
$15

19. FI 3300 - Corporate Finance Leng Ling
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?
$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.

20. 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: =26,500

21. 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:

22. 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.

23. Details
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.

24. 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.

25. Calculate initial cost
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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, ,000,000
= $22,100,000

26. Calculate the annual incremental cash flow: step 1
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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

27. Calculate the annual incremental cash flow: step 2
FI Corporate Finance Leng Ling
Calculate the annual incremental cash flow: step 2
Draw up the incremental income statement
Incremental sales
12,000,000
Less Incremental variable cost
9,000,000
Less Incremental managerial salaries
200,000
Less Incremental depreciation
1,700,000
Equals Incremental taxable income
1,100,000
Less Incremental
330,000
Equals Incremental net income
770,000
Add back depreciation
Incremental cash flow
$2,470,000

28. Step 3: non-operating cash flows
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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, ,100,000
= $3,100,000

29. 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, ,100,000 = $5,570,000

30. Step 4 NPV = -$7,145,832.09 Decision: reject the project.
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.

31. 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.

32. 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).

33. 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.

34. 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%.

35. 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 non-operating cash flow?

36. Q1: initial investment To answer Q1, you need points 2 & 3.
= 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

37. Q2: 3rd incremental operating cash flow
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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

38. Q2: 3rd incremental operating cash flow
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Q2: 3rd incremental operating cash flow
Incremental sales
4,000,000
Less Incremental operating cost
2,250,000
Less Incremental depreciation
800,000
Equals Incremental taxable income
950,000
Less Incremental
285,000
Equals Incremental net income
665,000
Add back depreciation
Incremental cash flow
$1,465,000

39. Q3: 5th year incremental non-operating cash flow
FI Corporate Finance Leng Ling
Q3: 5th year incremental non-operating cash flow
Very simple. The only incremental non-operating 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

40. Homework assignment
Problems: 1, 2, 3, 7.