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Practical financial managment 7e LASHER chapter 11

Chapter 11 Cash Flow Estimation


Cash Flow Estimation
Capital budgeting process consists of:
– Estimating the cash flows associated with
projects, and then
– Evaluating the estimates using NPV and
IRR

Forecasting cash flows accurately is by
far the more difficult and error prone
process
2


The General Approach to
Cash Flow Estimation
A sales forecast leads to an estimate of
cash inflows from customers
A cost/expense projection leads to a

pattern of outflows to employees and
vendors
An equipment plan leads to a series of
outflows for capital assets
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The General Approach
Think through the events a project will bring about, and
write down the financial implications of each
Forecasts for new ventures tend to be the most complex
Pre-startup, the initial outlay:
Enumerate pre-start expenses (after tax) and all assets
that must be purchased.
• Some are tax deductible, some are not.
Sales Forecast
Forecast incremental units over time in spreadsheet form
Extend by prices for revenues


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 needed
Include working capital
Depreciation:
Plan depreciation for new and old assets
A non-cash item but it impacts taxes
Taxes and Earnings
Summarize tax deductible items in each period to calculate
impact on taxes and earnings
Treat incremental taxes like any other cash flow item


The General Approach to Cash Flow
Estimation
Expansion Projects
– Require the same

elements as new ventures
– Usually need less new
equipment and facilities
Replacement Projects
– Generally saves on cost without generating new
revenue
– Estimating process may be less elaborate

6


Project Cash Flows
Regardless of the project, the basic
process is the same
– The Typical Pattern
Requires an initial outlay
Subsequent cash flows
tend to be positive

– Project Cash Flows Are Incremental
Separable from the existing business
7


Project Cash Flows
Sunk Costs
– Have already been spent and are ignored

Opportunity Costs
– The value of a resource in its best
alternative use
– The cost of a resource is whatever is given
up to use it

8


Project Cash Flows
Impacts on other parts of company
Overhead levels
Taxes
Cash v. accounting results
Working capital
Ignore financing costs
Old equipment

9


Estimating New Venture
Cash Flows
New venture projects tend to be larger
and more elaborate than expansions or
replacements
– But incremental cash flows can be easier to
isolate

10


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:

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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 nearby
New building will cost $60,000
Land purchased 10 years ago for $30,700
Market value is now $150,000.



12


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.


Concept Connection Example 11-1 New
Venture Cash Flows
Revenues collected in 30 days.
Incremental inventories
at startup and for the first year.
Then inventory turnover = 12 X

$12,000

Payables will be 25% of inventories.
Losses result in tax credits.
Marginal tax rate is 34%.

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Concept Connection Example 11-1 New
Venture Cash Flows
Initial Outlay costs of hiring, training and advertising are tax
deductible:

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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
Assets subtotal
Actual pre-start-up outlay

$95.7
$272.0
$367.7

Opportunity cost of land
Market value
$150,000
Cost
$30,700
Capital gain
$119,300
Tax
$40,600
Opportunity cost $150,000 - $40,600 = $109,400
C0, the initial outlay, is
$367,700 + $109,400 = $477,100.
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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.

17


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.

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Terminal Values
Cash flows forecast to continue forever
are compressed into finite terminal
values using perpetuity formulas
– A common but very aggressive assumption
with new ventures
– A repetitive cash flow starting in year 7 is
valued as a perpetuity

20


Accuracy and Estimates
NPV and IRR techniques give the
impression of great accuracy
Capital budgeting results are no more
accurate than the projections used as
inputs
Unintentional biases are a problem in
capital budgeting
21


MACRS—A Note on Depreciation
U.S. government allows accelerated tax depreciation
MACRS sorts assets (equipment) into categories
– Specifies depreciation for each

22


Estimating Cash Flows for
Replacement Projects
Fewer elements than new ventures
Identifying what is incremental can be tricky
Difficult to determine what will happen if you don’t do
the project

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Concept Connection Example 11-3
Replacement Projects
Harrington purchased a machine five years ago for $80,000.
Depreciated straight-line over eight years
New machinery depreciated straight line over five years.
Considering replacing with a new one costing $150,000.
Old unit can be sold for $45,000
Old machine - three operators $25,000/year each
New machine - two operators $25,000/year each

24


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.


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