2 Capital budgeting process consists of: Cash Flow EstimationCapital budgeting process consists of:Estimating the cash flows associated with projects, and thenEvaluating the estimates using NPV and IRRForecasting cash flows accurately is by far the more difficult and error prone process
3 The General Approach to Cash Flow Estimation A sales forecast leads to an estimate of cash inflows from customersA cost/expense projection leads to a pattern of outflows to employees and vendorsAn equipment plan leads to a series of outflows for capital assets
4 The General ApproachThink through the events a project will bring about, and write down the financial implications of eachForecasts for new ventures tend to be the most complexPre-startup, the initial outlay:Enumerate pre-start expenses (after tax) and all assetsthat must be purchased.Some are tax deductible, some are not.Sales ForecastForecast incremental units over time in spreadsheet formExtend by prices for revenues
5 The General Approach Cost of Sales and Expenses: Base costs and expenses on a relationship with incremental revenues or units sold.Assets:Plan new assets when neededInclude working capitalDepreciation:Plan depreciation for new and old assetsA non-cash item but it impacts taxesTaxes and EarningsSummarize tax deductible items in each period to calculate impact on taxes and earningsTreat incremental taxes like any other cash flow item
6 The General Approach to Cash Flow Estimation Expansion ProjectsRequire the same elements as new venturesUsually need less new equipment and facilitiesReplacement ProjectsGenerally saves on cost without generating new revenueEstimating process may be less elaborate
7 Regardless of the project, the basic process is the same Project Cash FlowsRegardless of the project, the basic process is the sameThe Typical PatternRequires an initial outlaySubsequent cash flows tend to be positiveProject Cash Flows Are IncrementalSeparable from the existing business
8 Project Cash Flows Sunk Costs Opportunity Costs Have already been spent and are ignoredOpportunity CostsThe value of a resource in its best alternative useThe cost of a resource is whatever is given up to use it
9 Project Cash Flows Impacts on other parts of company Overhead levels TaxesCash v. accounting resultsWorking capitalIgnore financing costsOld equipment
10 Estimating New Venture Cash Flows New venture projects tend to be larger and more elaborate than expansions or replacementsBut incremental cash flows can be easier to isolate
11 Concept Connection Example 11-1 New Venture Cash Flows Wilmont Bicycle is considering a new business proposal to produce off-road bikes. The following information is forecast:
12 Concept Connection Example 11-1 New Venture Cash Flows Last year purchased a gearshift design for $50,000.Facilities are at capacity, so a new shop is required.Company owns land nearbyNew building will cost $60,000Land purchased 10 years ago for $30,700Market value is now $150,000.
13 Concept Connection Example 11-1 New Venture Cash Flows Three percent of new units sold will come from the old line.Prices and direct costs in the two lines are the same.General overhead is about 5% of revenue.Incremental overhead is estimated at 2% of revenues.
14 Concept Connection Example 11-1 New Venture Cash Flows Revenues collected in 30 days.Incremental inventories$12,000 at startup and for the first year.Then inventory turnover = 12 XPayables will be 25% of inventories.Losses result in tax credits.Marginal tax rate is 34%.
15 Concept Connection Example 11-1 New Venture Cash Flows Initial Outlay costs of hiring, training and advertising are tax deductible:
16 Concept Connection Example 11-1 New Venture Cash Flows Add operating items and assets for the total pre-start-up outlay:Net after tax expenses $95.7Assets subtotal $272.0Actual pre-start-up outlay $367.7Opportunity cost of landMarket value $150,000Cost $30,700Capital gain $119,300Tax $40,600Opportunity cost $150,000 - $40,600 = $109,400C0, the initial outlay, is$367,700 + $109,400 = $477,100.
17 Concept Connection Example 11-1 New Venture Cash Flows Sales are forecasted to grow for 4 years before leveling off. We’ll estimate for 6 years—for a longer forecast repeat the last year as.The building is depreciated over 39 years while the equipment is depreciated over 5 years.
18 Concept Connection Example 11-1 New Venture Cash Flows Assume that the $12,000 of initial inventory was acquired prior to start-up.Represents the subtotal after adding depreciation less the change in working capital.
20 Terminal ValuesCash flows forecast to continue forever are compressed into finite terminal values using perpetuity formulasA common but very aggressive assumption with new venturesA repetitive cash flow starting in year 7 is valued as a perpetuity
21 Accuracy and Estimates NPV and IRR techniques give the impression of great accuracyCapital budgeting results are no more accurate than the projections used as inputsUnintentional biases are a problem in capital budgeting
22 MACRS—A Note on Depreciation U.S. government allows accelerated tax depreciationMACRS sorts assets (equipment) into categoriesSpecifies depreciation for each
23 Estimating Cash Flows for Replacement Projects Fewer elements than new venturesIdentifying what is incremental can be trickyDifficult to determine what will happen if you don’t do the project
24 Concept Connection Example 11-3 Replacement Projects Harrington purchased a machine five years ago for $80,000.Depreciated straight-line over eight yearsNew machinery depreciated straight line over five years.Considering replacing with a new one costing $150,000.Old unit can be sold for $45,000Old machine - three operators $25,000/year eachNew machine - two operators $25,000/year each
25 Concept Connection Example 11-3 Replacement Projects The old machine has the following history of high maintenance cost and significant downtime.Manufacturing managers estimate every hour of downtime costs the $500, but have no backup data.
26 Concept Connection Example 11-3 Replacement Projects New machine claimsMaintenance will cost $15,000/year and annualDowntime about 30 hours.However, no guarantee after warranty.The new machine is expected to produce higher quality output resulting in better customer satisfaction and sales, but no one can quantify this result.
27 Concept Connection Example 11-3 Replacement Projects Harrington is currently profitable with a 34% tax rate. Estimate the incremental cash flows over the next five years associated with buying the new machine.Solution:There are two kinds of cash flows in this problem—those that can be estimated fairly objectively and those that require some degree of subjective guesswork.First consider the objective items.
28 Objective Items - Initial Outlay Selling an Old Asset
29 Concept Connection Example 11-3 Replacement Projects Objective Items: Depreciation and Labor
30 Concept Connection Example 11-3 Replacement Projects The subjective benefits (involve opinion) are hard to quantify and lead to biases when estimated by people who want project approval. The financial analyst should ensure reasonability.The question is: Should we assume maintenance on the old machine would have remained at $90.0 or increase as the machine gets older? Also, will maintenance on the new machine rise as it ages?
31 Concept Connection Example 11-3 Replacement Projects Downtime: The new machine promises savings of 100 hours. But, how reliable are those estimates?And how much does each hour of downtime savings cost? Arguments range from nothing to $1,000 an hour.A middle-of-the-road approach of $400 an hour yields an estimated savings of $40,000 per year.
32 Concept Connection Example 11-3 Replacement Projects Combining these with the initial outlays yields the project’s estimated cash flow stream.