Presentation on theme: "Chapter 11 Cash Flow Estimation"— Presentation transcript:
1 Chapter 11 Cash Flow Estimation Capital Budgeting decisions must be based on cash flows not on accounting incomeIdentify and use relevant cash flows, and ignore irrelevant ones.
2 Picking up Relevant Cash Flows Examples of Relevant Cash FlowsOpportunity costsThe most valuable alternative that is given up if a particular investment is undertaken. These are relevant costs.Erosion (or Cannibalization)The cash flows of a new project that come at the expense of a firm’s existing projects. These are relevant costs.Shipping and Installation costsThese are relevant costs. They also increase the depreciable basis of the purchased equipment.
3 An Example of Irrelevant Cash Flows Sunk costA cost that has already been incurred and cannot be removedand therefore should not be considered in an investment decision
4 Incremental cash flows The difference between a firm’s future cash flows with a project orwithout the project.In general, they consist of:a. Operating Cash Flowb. Capital Spendingc. Change in Net working capital
5 Operating Cash FlowOCF=Net Income (excluding financing expense) + DepreciationDepreciation Noncash expense. So it will be added back in finding OCF.Financing costs The aim is to find the cash flows generated by aproject before paying any interest or dividend.The effect of financing mixture used will beconsidered in the cost of capital calculation.
6 Capital Spending (purchase of fixed assets) Both purchase price and installation costs are used in calculatingthe depreciable amount. At the termination of project, assets willbe sold and there occurs some cash inflow.We either use straight-line or modified accelerated cost recoverysystem (MACRS). The latter accelarates cost recovery. You paylower taxes in early years.Straight-line:
7 MACRS MACRS Depreciation Allowances Annual Dep = Depreciation Allowance * (Purchase Price + Shipping & Installation)Note: It may appear odd that e.g. a five-year property is depreciated over six years. The tax accounting reason is that it is assumed we only have the asset for six months in the first year and, consequently, six months in the last year. As a result, there are five 12-month periods, but we have some depreciation in six different tax years.
8 Calculating Salvage Value Consider an asset that costs $100,000 and is depreciated straight-line to 40,000 over its eight-year tax life. The asset is to be used ina five-year project; at the end of the project, the asset can be soldfor $20,000. If the relevant tax rate is 35 percent, what is theafter-tax cash flow from the sale of this asset (i.e. net salvage value)?SV5=20,000BV5=62,500NSV5=20,000-(20,000-62,500)*35%=34,875
9 Net working capital In our analysis, we will use change in NWC figures Firm’s investment in project net working capital resembles a loan.The firm supplies working capital at the beginning (and perhapsalso during the life of the project) and recovers it towards the end.The cost arises due to time value of money.Information about a project can either give NWC requirement peryear or change in NWC per year directly. If we have the former, wehave to calculate change in NWC per year.Consider a three-year projectIn our analysis, we will use change in NWC figures
10 Alternative definitions of operating cash flows The Bottom-up ApproachOCF = Net Income + DepreciationThe Top-down ApproachOCF = Sales-Costs -TaxesThe Tax-shield ApproachOCF = (Sales-Costs)*(1-T) + Depreciation*T
11 Alternative definitions of operating cash flows Verify the Tax-shield ApproachOCF = (Sales-Costs- Depreciation)(1-T)+ Depreciation= (Sales-Costs)(1-T)+ Depreciation TVerify the Top-down ApproachTax =(Sales-Costs- Depreciation) TOCF= Sales-Costs-(Sales-Costs- Depreciation) T=(Sales-Costs)(1-T)+ Depreciation T
12 Types of projectsCost-cutting projects: a project to upgrade existing facilities to make them more cost-efficientExpansion projects: a project that is intended to increase salesReplacement projects: a project that replaces an existing asset with a new one
13 ExamplesCost-Cutting Proposals Wally’s Water Works is looking at a newpiping system with an installed cost of $180,000. This cost will bedepreciated straight-line to zero over the project’s five-year life, atthe end of which the piping system can be scrapped for $25,000.The piping system will save the firm $65,000 per year in pretaxoperating costs, and the system requires an initial investment innet working capital of $17,500. If the tax rate is 38 percent andthe discount rate is 10 percent, what is the NPV of this project?See extra problems for examples on expansion and replacementprojects
14 Risk AnalysisWe used our best guesses for parameter values to forecast NPVe.g. projected unit sales orprojected savings in costs orprojected salvage value etc.But realizations of parameter values will be different than our bestguessesWe can measure stand-alone riskIt is the worst of 3 risk measures.But it is easiest to measure and all 3 measures are highly correlated.
15 Sensitivity AnalysisHow a change in one parameter value affects project’s NPVe.g. Parameter=realized salvage value- best guess salvage value
16 Scenario Analysis Calculate NPV under several scenarios Unlike the sensitivity analysis, where we measure the effect of achange in a single parameter value, we measure the effect ofsimultaneous change in several parameter values.
17 Monte Carlo Simulation Rather than using a single value for each parameter, you canspecify a distribution for each parameter. Randomly sampledvalues are used to compute NPV over and over again. At the end,you get a distribution for NPV.This is analogous to scenario analysis, where we have possiblescenarios. We sample a finite number of these scenarios.