Presentation on theme: "Estimating Cash Flows on Capital Budgeting Projects"— Presentation transcript:
1 Estimating Cash Flows on Capital Budgeting Projects Chapter 12Fin 325, Section 04 - Spring 2010Washington State University
2 IntroductionFirms often face capital budgeting decisions: when a potential project arises, a firm needs to decide to carry on or forgo the project.Estimating project cash flowspro forma analysis: - “what is this project’s impact on the firm’s cash flows if we go forward?”
3 Sample Project (a game development company) Computer GamePrice = $39.99Projected unit sales:Variable cost per game = $4.25Fixed costs per year = $150,000Startup costs:Software duplicating machine costing $75,000Shipping and installation costs of $2,000YearUnit Sales115,000227,00035,000
4 Duplicating machine will be depreciated straight-line to $5,000 over the life of the project We expect to be able to sell the machine for $2,000 after we are done with itThe new game will cut into sales of an older game currently on the marketThe old game will lose sales of 2,000 units per year throughout the life of the new gameOld game sells for $19.99 and has variable costs of $3.50 per unit
5 Game development costs for the new game totaled $150,000 Net Working Capital requirements at the beginning of each year will be 10% of the projected sales during the coming yearThe marginal tax rate is 34 percentThe appropriate discount rate for projects of this risk is 15 percent
6 Guiding Principles for Cash Flow Estimation We are interested in incremental cash flowsCash flow changes that we expect as a result of accepting the projectSome incremental cash flows are not obviousOpportunity costsSunk costsSubstitutionary and Complementary effects
7 Opportunity costs Sunk costs Example: if we did not use an existing resource for our project, it could have been used to generate cash flows for another project, so our project must be charged for those foregone cash flowsE.g. Existing machinerySunk costsIf a firm has already paid an expense or is obligated to pay one in the future regardless of whether the project is undertaken, it is a sunk cost and should never be considered in the project cash flowsE.g. Development costs
8 Substitutionary Effects New project causes reduction in both sales and variable costs of existing projectsComplementary EffectsNew project causes increases in both sales and variable costs of existing projectsIf a new project will reduce or increase cash flows for existing products or services then those changes are incremental to the project and should be included in the project cash flows
9 Total Project Cash Flow We will use Free Cash Flow as our measureof the cash flow available from a projectSince we are considering potential projects, the inputs are estimates rather than actual historical numbers
10 Calculating Depreciation The depreciable basis for real property is calculated as:Cost + sales tax + freight charges + installation and testingFor our project:Purchase price$75,000Shipping and installation$2,000Total depreciable basis$77,000
11 Since initially we are assuming straight-line depreciation for our project: = ($77,000 - $5,000) / 3= $24,000 per year
12 Calculating Operating Cash Flow OCF = EBIT – Taxes + DepreciationIt is useful to use a pro-forma income statement approach to calculate operating cash flow.
13 Calculating the Change in Gross Fixed Assets For most projects we need to calculate the change in gross fixed assets at the beginning of the project (time 0) and at the end of the projectAt the beginning of the project the changein gross fixed assets equals the asset’s depreciable basisFor our project: $77,000
14 At the end of the project: We need to consider the tax consequences of the sale of the assetIf we sell the asset for more than its book value we have a gain on the saleIf we sell the asset for less than book value we have a loss on the saleAfter-Tax Cash Flow (ATCF)ATCF = Book Value + (Market Value – Book Value) x (1 – TC)In our example:ATCF = 5,000 + (2,000 – 5,000) x (1-.34)= $3,020
15 Calculating Changes in Net Working Capital For some projects we might assume that NWC increases at time zero (resulting in a negative cash flow) and decreases at the end of the project (resulting in a positive cash flow)For our project, NWC changes each year
17 Accelerated Depreciation Our FCF calculation used a simplistic assumption about depreciationStraight LineIn reality, firms want to use accelerated depreciationMore of the depreciation expense occurs earlier in the asset’s life, lowering taxes and increasing cash flow
18 The IRS allows businesses to use the Modified Accelerated Cost Recovery System (MACRS) to depreciate assetsIncorporates the half-year conventionUses the double-declining balance depreciation methodThe ultimate accelerated depreciation method would be to expense it immediatelyIRS Section 179 deduction allows this for assets up to $108,000Geared toward small businesses
19 Differing Asset Lives If we decide to go ahead with a project, but we have to choose between two alternative assets, each with a different life, we can use the Equivalent Annual Cost (EAC) method to make the choiceFind the sum of the present values of the cash flows for one iteration of asset A and asset BTreat each sum as the present value of an annuity with life equal to the life of the respective asset, and solve for each asset’s paymentChoose the asset with the least negative EAC
20 EAC ExampleSuppose that your company has won a bid for a new project—painting highway signs for the local highway department. Based on past experience, you’re pretty sure that your company will have the contract for the foreseeable future, and now you have to decide whether to use machine A or machine B to paint the signs: machine A costs $20,000, lasts five years, and will generate annual after-tax net expenses of $2,500. Machine B costs $12,000, lasts three years, and will have after-tax net expenses of $3,500 per year. Assume that, in either case, each machine will simply be junked at the end of its useful life, and the firm faces a cost of capital of 12 percent. Which machine should you choose?
21 EAC Example - SolutionOne iteration of each machine will consist of the sets of cash flows shown below:The sum of the PVs of machine A’s cash flowsThe sum of the PVs of machine B’s cash flows
22 EAC Example - SolutionTreating A as the present value of a 5-period annuity, setting i to 12 percent, and solving for payment will yield a payment of −$8,048, which is machine A’s EAC.Treating B as the present value of a three-period annuity, setting i to 12 percent, and solving for payment will yield a payment of −$8,496, which is machine B’s EAC.Since machine A’s EAC is less negative than machine B’s, your firm should choose machine A.