1. Cash Flow Estimation
Byers

2. What We Will Learn Which cash flows are relevant
How to deal with depreciation
How to deal with working capital investment
How to deal with selling the equipment at the end

3. Types of Cash Flows Cash flows matter—not accounting earnings.
Sunk costs don’t matter.
Incremental cash flows matter
Every cash flow that changes as a result of our decision
Opportunity costs matter.
Side effects like cannibalism matter.
Good: synergy
Bad: cannibalism

4. Types of Cash Flows (continued)
Taxes matter
We want incremental after-tax cash flows.
Inflation matters.
Nominal cash flows and nominal discount rates
Real cash flows and real discount rates (rarely used)
Changes in net working capital
Financing costs
Not in cash flows but included in discount rate
Allocation of existing costs does not matter

5. Depreciation
The depreciation expense used for capital budgeting should be the depreciation schedule required by the IRS for tax purposes
Depreciation itself is a non-cash expense
It is only relevant because it affects taxes
Depreciation tax shield = DT
D = depreciation expense
T = marginal tax rate

6. Types of Depreciation Straight-line depreciation MACRS
D = (Initial cost – salvage) / number of years
Very few assets are depreciated straight-line for tax purposes
MACRS
Need to know which asset class is appropriate for tax purposes
Multiply percentage given in table by the initial cost
Depreciate to zero
Mid-year convention
Simplified straight-line
For learning purposes (quick and easy)

7. MACRS

8. Net Working Capital Often overlooked
NWC = Current Assets – Current Liabilities
Simple problems
investment at time 0
Disinvestment at end of project
More complex problems
NWC changes from year to year
Cash
Accounts Receivable
Inventory
Accounts Payable

9. Salvage Value
If the salvage value is different from the book value of the asset, then there is a tax effect
Gain or Loss
Book value = initial cost – accumulated depreciation
If Salvage value > book value Gain (must pay tax)
If Salvage value < book value Loss (tax refund)

10. Example Equipment cost $100,000 at time 0 5 year MACRS class
Yearly depreciation:

11. What if the machine is sold after year 4 for $40,000?
Tax rate = 40%
We would have a gain of 40,000 – 17,280 = 22,720
We would pay tax on the gain of .40 x 22,780 = 9,088
Our cash flow from the sale would be:

12. What if the machine were sold after year 3 for $20,000?
Now we have a loss of 20,000 – 28,800 = -8,800
We get a tax refund of .40 x 8,800 = $3,520
Our cash flow from the sale would be:

13. Unequal Lives
Suppose Projects S and L are Mutually Exclusive and Will Be Repeated, r = 10% 1 2 3 4
S: -100
L: -100 60
33.5
Note: CFs shown in $ Thousands

14. NPVL > NPVS, but is L better?
CF0
-100
CF1 60
33.5 NJ 2 4
I/YR 10
NPV
4.132
6.190

15. Put Projects on Common Basis
Note that Project S could be repeated after 2 years to generate additional profits.
Use replacement chain to put on common life.
Note: equivalent annual annuity analysis is alternative method.

16. Replacement Chain Approach (000s) Franchise S with Replication
NPV = $7.547. 1 2 3 4 S: 60
-100
-40

17. Now Let’s Discuss a Common Framework
Initial
outlay
Terminal
Cash flow 1 2 3 4 5 n 6
. . .
Operating Cash Flows

18. Initial Outlay (at time = 0)
(Purchase price of the asset)
+ (shipping and installation costs)
(Depreciable asset)
+ (Investment in working capital)
+ After-tax proceeds from sale of old asset
(Net Initial Outlay)

19. Operating Cash Flows (each year)
Incremental revenue
- Incremental costs
- Depreciation on project
Incremental earnings before taxes
- Tax on incremental EBT
Incremental earnings after taxes
+ Depreciation reversal
Operating Cash Flow

20. Terminal Cash Flow
Salvage value +/- Tax effects of capital gain/loss + Recapture of net working capital Terminal Cash Flow

21. Putting it All Together: Let’s walk through a simple example together
A firm is considering a new three-year expansion project that requires an initial fixed asset investment $2,700,000. The fixed asset will be depreciated straight line to zero over its three- year tax life. The project is estimated to generate $2,300,000 in annual sales, with costs of $970,000. The tax rate is 33% and the required return is 18%. The project requires an initial investment in net working capital of $400,000 and the fixed asset will have a market value of $230,000 at the end of the project. What is the NPV of the project?

22. Initial Outlay

23. Operating Cash Flow for years 1-3

24. Terminal Cash Flow

25. Cash Flow summary

26. Another Example
Your firm is contemplating the purchase of a new $875,000 computer-based order entry system. The system will be depreciated straight line to zero over its five-year life. It will be worth $75,000 at the end of that time. You will save $345,000 before taxes per year in order processing costs and you will be able to reduce working capital by $105,000 (this is a one time reduction). If the tax rate is 31%, what is the IRR for this project?

31. Now for a more complex problem
Acme Casting Company is considering adding a new line to its product mix. The production line would be set up in unused space in Acme's main plant. The machinery’s invoice price is $200,000. Another $10,000 in shipping charges would be required and it would cost an additional $30,000 to install the equipment. The machinery has an economic life of four years and will be depreciated using the MACRS three-year class. The machinery is expected to have a salvage value of $25,000 after four years of use.

32. The new line would generate incremental sales of 1,250 units per year for four years at an incremental cost of $100 per unit in the first year. Each unit can be sold for $200 in the first year. The sales price and cost are both expected to increase by 3% per year due to inflation. To handle the new line, the firm's net working capital would have to increase by an amount equal to 12% of sales revenues. The firm's tax rate is 40%, and its overall weighted average cost of capital is 10%.