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13 Chapter Cash Flow Estimation Slides Developed by: Terry Fegarty Seneca College
© 2006 by Nelson, a division of Thomson Canada Limited 2 Chapter 13 – Outline Cash Flow Estimation Capital Budgeting Process Project Cash FlowsAn Overview and Some specifics The General Approach to Cash Flow Estimation A Few Specific Issues Terminal Values Accuracy and Estimates CCAA Note on Amortization for Tax Purposes Capital Cost Allowance System CCA Tax Shield Estimating Cash Flows for Replacement Projects
© 2006 by Nelson, a division of Thomson Canada Limited 3 Capital Budgeting Process Consists of the following steps: 1.Determine (estimate) expected cash flows of available projects 2.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
© 2006 by Nelson, a division of Thomson Canada Limited 4 The General Approach to Cash Flow Estimation Consider each expected impact of project on firms 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
© 2006 by Nelson, a division of Thomson Canada Limited 5 The General Approach to Cash Flow Estimation General outline for estimating new venture cash flows Pre-start-up, the initial outlayeverything that has to be spent before the project is started Sales forecastunits and revenues Cost of sales and expenses Assetsnew assets to be acquired, including changes in working capital Amortizationnon-cash expense but affects income taxes Taxes and earnings Summarize and combineadjust earnings for amortization and combine result with balance sheet items to arrive at a cash flow estimate
© 2006 by Nelson, a division of Thomson Canada Limited 6 The General Approach to Cash Flow Estimation Expansion projectstend to require the same elements as new ventures But less new equipment and facilities Replacement projectsgenerally expected to save costs without generating new revenue Estimating process tends to be somewhat less elaborate
© 2006 by Nelson, a division of Thomson Canada Limited 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 wouldnt occur if we left it undone and continued business as before?
© 2006 by Nelson, a division of Thomson Canada Limited 8 A Few Specific Issues Sunk Costs Costs that have already occurred and cannot be recovered should not be included in projects 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
© 2006 by Nelson, a division of Thomson Canada Limited 9 A Few Specific Issues Impacts on Other Parts of Company 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 linenegative 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 projects net income
© 2006 by Nelson, a division of Thomson Canada Limited 10 A Few Specific Issues Working Capital 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)
© 2006 by Nelson, a division of Thomson Canada Limited 11 A Few Specific Issues
© 2006 by Nelson, a division of Thomson Canada Limited 12 Table 13.1: Cash Flow Estimation : Example
© 2006 by Nelson, a division of Thomson Canada Limited 13 Table 13.1 : Cash Flow Estimation. Example
© 2006 by Nelson, a division of Thomson Canada Limited 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
© 2006 by Nelson, a division of Thomson Canada Limited 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
© 2006 by Nelson, a division of Thomson Canada Limited 16 CCAA 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 projects life and less later on Total amortization remains the same Larger tax deductions happen earlier Present value of tax savings is greater
© 2006 by Nelson, a division of Thomson Canada Limited 17 CCAA Note on Amortization for Tax Purposes Companies generally dont 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
© 2006 by Nelson, a division of Thomson Canada Limited 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)
© 2006 by Nelson, a division of Thomson Canada Limited 19 Table 13.2 : Some Capital Cost Allowance Classes
© 2006 by Nelson, a division of Thomson Canada Limited 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
© 2006 by Nelson, a division of Thomson Canada Limited 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.
© 2006 by Nelson, a division of Thomson Canada Limited 22 CCA Tax Shield CCA tax shieldtax savings from deducting CCA on capital assets For capital budgeting purposes, we need to calculate present value of tax shield
© 2006 by Nelson, a division of Thomson Canada Limited 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
© 2006 by Nelson, a division of Thomson Canada Limited 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.
© 2006 by Nelson, a division of Thomson Canada Limited 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 × 0.6355 = $2,542 The present value of the CCA tax shield: Example
© 2006 by Nelson, a division of Thomson Canada Limited 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 dont 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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