1. 13 Chapter Cash Flow Estimation Terry Fegarty Seneca College
Slides Developed by:
Terry Fegarty
Seneca College

2. Chapter 13 – Outline Cash Flow Estimation
Capital Budgeting Process
Project Cash Flows—An Overview and Some specifics
The General Approach to Cash Flow Estimation
A Few Specific Issues
Terminal Values
Accuracy and Estimates
CCA—A Note on Amortization for Tax Purposes
Capital Cost Allowance System
CCA Tax Shield
Estimating Cash Flows for Replacement Projects
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3. Capital Budgeting Process
Consists of the following steps:
Determine (estimate) expected cash flows of available projects
Evaluate estimates using decision criteria such as NPV and IRR
People tend to take forecasted cash flows for granted, but they are subject to error
Estimating project cash flows is the most difficult and error-prone part of capital budgeting
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4. The General Approach to Cash Flow Estimation
FMDS 341--Principles of Finance
Consider each expected impact of project on firm’s cash flows
Cash estimates are done on spreadsheets
Enumerate the issues that impact cash and forecast each over time
Forecasts for new ventures tend to be the most complex
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Chapter 1: Foundations, Practical Financial Management, by W. Lasher

5. The General Approach to Cash Flow Estimation
General outline for estimating new venture cash flows
Pre-start-up, the initial outlay—everything that has to be spent before the project is started
Sales forecast—units and revenues
Cost of sales and expenses
Assets—new assets to be acquired, including changes in working capital
Amortization—non-cash expense but affects income taxes
Taxes and earnings
Summarize and combine—adjust earnings for amortization and combine result with balance sheet items to arrive at a cash flow estimate
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6. The General Approach to Cash Flow Estimation
Expansion projects—tend to require the same elements as new ventures
But less new equipment and facilities
Replacement projects—generally expected to save costs without generating new revenue
Estimating process tends to be somewhat less elaborate
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7. A Few Specific Issues The Typical Pattern
At beginning of the project, some amount must be spent to invest in the project (Initial outlay)
Subsequent cash flows tend to be positive
Project Cash Flows Are Incremental
What cash flows will occur if we undertake this project that wouldn’t occur if we left it undone and continued business as before?
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8. A Few Specific Issues Sunk Costs Opportunity Costs
Costs that have already occurred and cannot be recovered—should not be included in project’s cash flows
Only future costs are relevant
Opportunity Costs
What is given up to undertake the new project
The opportunity cost of a resource is its value in its best alternative use
For instance, if firm needs a new warehouse, it could either:
Lease warehouse space
Buy warehouse
Build warehouse on land they currently own (but could sell for $1,000,000)—the $1,000,000 represents an opportunity cost
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9. A Few Specific Issues Impacts on Other Parts of Company Taxes
Sales erosion (cannibalization)—when firm sells a product that competes with other products within the same firm (Diet Coke vs. Coke Classic)
Margin lost in other line—negative cash flow for project
Taxes
Cash outflow
Use after-tax cash flows
Cash Versus Accounting Results
Capital budgeting deals only with cash flows; however business managers want to know project’s net income
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10. A Few Specific Issues Working Capital Ignore Financing Costs
New project often requires investment in working capital—inventory, for instance
Increasing net working capital means cash outflow
Ignore Financing Costs
Do not include interest expense on debt (or dividends on shares) as cash outflow
Addressed via discount rate when determining NPV or evaluating IRR
Old Equipment
If this is replacement project, old equipment can be sold (thereby generating a cash inflow)
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11. A Few Specific Issues
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12. Table 13.1: Cash Flow Estimation
Example
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13. Table 13.1: Cash Flow Estimation
Example
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14. Terminal Values
Possible to assume that incremental cash flows last forever
Especially common with new ventures
Compressed into terminal values using perpetuity formulas
For instance, a repetitive cash flow starting at time 7 would be a perpetuity beginning at year 7
The present value at time 6 would be represented as
 Very sensitive to discount rate
 May be preferable to set a time limit, say 10 years
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15. Accuracy and Estimates
NPV and IRR techniques give impression of great accuracy
However, capital budgeting results no more accurate than projections of the future used as inputs
Unintentional biases probably biggest problem in capital budgeting
Projects generally proposed by people who want to see them approved which leads to favourable biases
Tend to overestimate benefits and underestimate costs
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16. CCA—A Note on Amortization for Tax Purposes
CRA requires that firms use capital cost allowance (CCA) to calculate amortization for income tax purposes
Provides for accelerated amortization
Amortization is shifted forward
More is taken early in project’s life and less later on
Total amortization remains the same
Larger tax deductions happen earlier
Present value of tax savings is greater
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17. CCA—A Note on Amortization for Tax Purposes
Companies generally don’t use accelerated methods for earnings reported to the public
Reported earnings are lower
If accelerated methods are used for tax calculations, accelerated methods should be used for cash flow projections
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18. Capital Cost Allowance System
The Income Tax Act dictates exactly how tax amortization (CCA) to be done
CCA divides capital assets into different classes (categories) and assigns a CCA rate for each
Most classes call for declining balance CCA (accelerated amortization)
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19. Table 13.2: Some Capital Cost Allowance Classes
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20. Capital Cost Allowance System
When asset is purchased, purchase price added to appropriate class
Any increases in a class are usually eligible for only half of the normal CCA in year they are added (the half-year rule)
Once capital asset has been added to a CCA class, capital cost allowance is calculated on the undepreciated capital cost (UCC) of the pool of assets, rather than on individual assets
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21. Capital Cost Allowance System
When asset is sold, lower of the sale price or its original cost is deducted from the pool.
If asset sold for more than its original cost, difference is capital gain for tax purposes.
Only 50% of capital gain is added to taxable income for the year.
If sale of asset leaves no assets in the class, resulting positive balance, if any, is terminal loss
deductible for tax purposes.
Any negative balance in the class at the end of the year is recapture
taxed as income.
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22. CCA Tax Shield
CCA tax shield—tax savings from deducting CCA on capital assets
For capital budgeting purposes, we need to calculate present value of tax shield
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23. Example 13.2: Capital Cost Allowance and Tax Shield
A vehicle costing $30,000 is added to Class 10 (30%).
It will be sold in 4 years for $4,000. The tax rate is 39%.
Example
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24. CCA Tax Shield Formula: PV of CCA tax shield
Where: C = Cost of the new asset (less any proceeds on disposal of assets replaced)
d = CCA rate for the asset class
T = Tax rate
k = Discount rate (cost of capital)
Spv= Present value of the salvage value of the new asset
n is the number of years until we salvage the asset
n = Number of years until we sell the asset.
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25. Example 13.2: Capital Cost Allowance and Tax Shield
We purchase a truck for $30,000
We will trade it in four years for $4,000
The CCA rate is 30%
Our tax rate is 39%
Our cost of capital is 12%
The present value of the salvage is $4,000 × = $2,542
The present value of the CCA tax shield:
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26. Estimating Cash Flows for Replacement Projects
Generally have fewer elements than new ventures
Identifying what is incremental can be trickier
Can be difficult to determine what will happen if you don’t do the project
For example, if replacing old production machine,
Do you compare expected cash flows for the new machine to current cash flows for the old?
Or do you compare cash flows for the new machine to expected cash flows for the old machine if it continues to deteriorate?
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