1. Project Earnings and Cash Flows 2/02/06

2. Investment decision revisited Acceptable projects are those that yield a return greater than the minimum acceptable hurdle rate with adjustments for project riskiness. We know now how to calculate the acceptable hurdle rate (cost of capital) and make project-specific adjustments. To enable us to calculate a project’s “return” and thus allow us to evaluate the project, the next step is to calculate project cash flows.

3. Project cash flows estimation Estimate Revenues/Operating Expenses Calculate estimated Operating Income Calculate estimated Net Income Calculate Project Cash Flows Calculate Project Incremental Cash Flows

4. Project revenue estimation process Experience and History: If a firm has invested in similar projects in the past, it can use this experience to estimate revenues and earnings on the project being analyzed. Market Testing: If the investment is in a new market or business, you can use market testing to get a sense of the size of the market and potential profitability. Ex., Home Depot Expo Stores Scenario Analysis: If the investment can be affected be a few external factors, the revenues and earnings can be analyzed across a series of scenarios and the expected values used in the analysis.

5. Scenario analysis Scenario analysis is made up of four components: Factors that determine the success of the project Analysis should focus on two or three of the most critical factors Number of scenarios to be considered Three scenarios for each factor (best, average and worst-case) tend to most useful Estimation of project revenues and/or expenses under each scenario Assigning probabilities to each scenario

6. From forecasts to operating income (EBIT)  Calculate/estimate the appropriate expenses associated with the estimated revenues  Separate projected expenses into operating and capital expenses.  Operating expenses are designed to generate benefits in the current period, while capital expenses generate benefits over multiple periods  Depreciate or amortize the capital expenses over time.  Allocate fixed expenses that cannot be traced to specific projects.

7. From forecasts to operating income (EBIT) Operating income measures the income earned on all the capital invested in a project and is calculated as EBIT=Rev – Operating expenses (COGS) – SGA Exp – Other allocated expenses - Depr.&Amort.

8. Depreciation methods Broadly speaking, depreciation methods can be classified as straight line or accelerated methods. Straight line depreciation - capital expense is spread evenly over time, Accelerated depreciation - capital expense is depreciated more in earlier years and less in later years.

9. Depreciation methods Annual depreciation expense using: Straight line: (Original asset value – salvage value) / number of years to be depreciated MACRS: Depreciation for tax purposes is determined by using the modified accelerated cost recovery system (MACRS). Under the basic MACRS procedures, the depreciable value of an asset is its full cost, including outlays for installation. No adjustment is required for expected salvage value. For tax purposes, the depreciable life of an asset is determined by its MACRS recovery predetermined period and is based on the type of asset.

10. From operating to net income Net income measures the income available to equity investors alone. To get from operating income to net income, we must determine: Debt to be used for project Interest expense associated with the project debt Net income then is: Net income = (EBIT – Interest Expense)*(1-t)

11. Why calculate accounting earnings? Cash flows ultimately determine project acceptability, however we still want to know what effect a project has on accounting earnings. This is because: firm’s overall results are reported in the form of accounting earnings taxes are calculated based on accounting earnings, and accounting measures of return are widely used as secondary measures in investment analysis. Because of accrual accounting and capital expenditure accounting, accounting earnings can differ significantly from cash flows.

12. The depreciation tax benefit While depreciation reduces taxable income and taxes, it does not reduce the cash flows. The benefit of depreciation is therefore the tax benefit. In general, the tax benefit from depreciation can be written as: Tax Benefit = Depreciation * Tax Rate This leads us to the following two conclusions: The tax benefit from depreciation and other non-cash charges is greater the higher your tax rate. Non-cash charges that are not tax deductible (such as amortization of goodwill) and thus provide no tax benefits have no effect on cash flows.

13. The capital expenditures effect Capital expenditures are not treated as accounting expenses but they do cause cash outflows. Capital expenditures can generally be categorized into two groups New (or Growth) capital expenditures are capital expenditures designed to create new assets and future growth Maintenance capital expenditures refer to capital expenditures designed to keep existing assets. Both initial and maintenance capital expenditures reduce cash flows

14. Working capital investment Intuitively, money invested in inventory or in accounts receivable cannot be used elsewhere. It, thus, represents a drain on cash flows To the degree that some of these investments can be financed using suppliers credit (accounts payable) the cash flow drain is reduced. Investments in working capital are thus cash outflows Any increase in working capital reduces cash flows in that year Any decrease in working capital increases cash flows in that year To provide closure, working capital investments need to be salvaged at the end of the project life.

15. From accounting income to cash flows To get from accounting earnings to cash flows: add back non-cash expenses (like depreciation and amortization) subtract out cash outflows which are not expensed (such as capital expenditures) Include investment in working capital. Cash flow to firm = EBIT(1-t) + Depr.&Amort. – Chg in WC – Cap Exp. Cash flow to equity = Net Income + Depr&Amort – Chg in WC – Cap Exp + (New Debt Issue – Debt Repay) – Pref. Dividends

16. To cap ex or not to cap ex Assume that you run your own software business, and that you have and expense this year of $ 100 million from producing and distribution promotional CDs in software magazines. Your accountant tells you that you can expense this item or capitalize and depreciate. Which will have a more positive effect in the current year on income?  Expense it  Capitalize and Depreciate it Which will have a more positive effect in the current year on cash flows?  Expense it  Capitalize and Depreciate it

17. From cash flows to incremental cash flows The appropriate cash flows to consider in evaluating whether a project makes a firm more valuable is the incremental cash flows generated by the project. This can differ from total cash flows (calculated previously) for three reasons: Sunk costs Opportunity costs Allocated costs that the firm would incur even if the project was not accepted.

18. Sunk costs Any expenditure that has already been incurred, and cannot be recovered (even if a project is rejected) is called a sunk cost When analyzing a project, sunk costs should not be considered since they are not incremental By this definition, market testing expenses and R&D expenses are both likely to be sunk costs before the projects that are based upon them are analyzed.

19. Opportunity costs Opportunity costs are cash flows that could be realized from the best alternative use of the asset. When analyzing a project, opportunity costs should be considered since they represent cash flows that the firm would have generated if the project is not accepted, but are lost if the project is accepted.

20. Allocated costs Firms allocate costs to individual projects from a centralized pool (such as general and administrative expenses) based upon some characteristic of the project (sales is a common choice) For large firms, these allocated costs can result in the rejection of projects To the degree that these costs are not incremental (and would exist anyway), this makes the firm worse off. Thus, it is only the incremental component of allocated costs that should show up in project analysis.