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

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 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

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 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

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 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

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 Project Cash Flows

Impacts on other parts of company

Overhead levels
Taxes
Cash v. accounting results
Working capital
Ignore financing costs
Old equipment

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 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

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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.

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 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
$12,000 at startup and for the first year.
Then inventory turnover = 12 X
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 $95.7
Assets subtotal $272.0
Actual pre-start-up outlay $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. Wilmont Bicycle Company
We’ll estimate for 6 years— Estimated Cash Flows
for a longer forecast repeat Mountain Bike Project ($000s)
the last year as.
1 2 3 4 5 6+
Revenue and Gross Margin
Units 200 600 1,200 1,500 1,500 1,500
Revenue $ 120.0 $ 360.0 $ 720.0 $ 900.0 $ 900.0 $ 900.0
Cost $ 72.0 $ 216.0 $ 432.0 $ 540.0 $ 540.0 $ 540.0
Gross margin $ 48.0 $ 144.0 $ 288.0 $ 360.0 $ 360.0 $ 360.0

The building is Tax Deductible Expenses

depreciated SG&A expense $ 120.0 $ 120.0 $ 120.0 $ 120.0 $ 120.0 $ 120.0
over 39 years Depreciation $ 41.5 $ 41.5 $ 41.5 $ 41.5 $ 41.5 $ 1.5
while the General overhead $ 2.4 $ 7.2 $ 14.4 $ 18.0 $ 18.0 $ 18.0
equipment is
Loss old line $ 1.4 $ 4.3 $ 8.6 $ 10.8 $ 10.8 $ 10.8
depreciated
Total $ 165.4 $ 173.1 $ 184.6 $ 190.3 $ 190.3 $ 150.3
over 5 years.

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Concept Connection Example 11-1
New Venture Cash Flows
Assume
that the
Profit Impact and Tax
$12,000 of STET impact $ (117.4) $ (29.1) $ 103.4 $ 169.7 $ 169.7 $ 209.7
initial Tax $ (39.9) $ (9.9) $ 35.2 $ 57.7 $ 57.7 $ 71.3
inventory NET impact $ (77.5) $ (19.2) $ 68.3 $ 112.0 $ 112.0 $ 138.4
was Add depreciation $ 41.5 $ 41.5 $ 41.5 $ 41.5 $ 41.5 $ 1.5
acquired Subtotal $ (35.9) $ 22.4 $ 109.8 $ 153.5 $ 153.5 $ 139.9
prior to
Working Capital
start-up. Accounts receivable $ 20.0 $ 45.0 $ 67.5 $ 75.0 $ 75.0 $ 75.0
Inventory $ 12.0 $ 18.0 $ 36.0 $ 45.0 $ 45.0 $ 45.0
Payables $ 3.0 $ 4.5 $ 9.0 $ 11.3 $ 11.3 $ 11.3
Working Capital $ 29.0 $ 58.5 $ 94.5 $ 108.8 $ 108.8 $ 108.8
Change in working capital $ 17.0 $ 29.5 $ 36.0 $ 14.3 $ - $ -

Net Cash Flow

Net cash (52.9) (7.1) 73.8 139.3 153.5 139.9

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

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 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

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 MACRS—A Note on Depreciation

U.S. government allows accelerated tax depreciation

MACRS sorts assets (equipment) into categories
– Specifies depreciation for each

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 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

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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.
 Concept Connection Example 11-3
Replacement Projects

New machine claims

Maintenance will cost $15,000/year and annual
Downtime 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.

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 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.
Objective Items - Initial Outlay
Selling an Old Asset
Concept Connection Example 11-3
Replacement Projects
– Objective Items: Depreciation and Labor
 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?
 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.
Concept Connection Example 11-3
Replacement Projects
Combining these with the initial outlays
yields the project’s estimated cash flow
stream.

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A project that is expected to last six years will
generate a profit and cash flow contribution before
taxes and depreciation of $23,000 per year. It
requires the initial purchase of equipment costing
$60,000, which will be depreciated straight line
over four years. The relevant tax rate is 25%.
Calculate the project’s cash flows. Round all
figures within your computations to the nearest
thousand dollars.

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Auburn Concrete Inc. is considering the purchase
of a new concrete mixer to replace an inefficient
older model that is completely worn out. If
purchased, the new machine will cost $90,000 and
is expected to generate savings of $40,000 per year
for five years at the end of which it will be sold for
$20,000. The mixer will be depreciated to a zero
salvage value over three years using the straight
line method. Develop a five year cash flow
estimate for the proposal. Auburn’s marginal tax
rate is 30%. Work to the nearest thousand dollars.

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Replacement Projects – Sale of an Old Asset

Flextech Inc. is considering a project that will

require new equipment costing $150,000. It will
replace old equipment with a book value of
$35,000 that can be sold on the second hand
market for $75,000. The company’s marginal tax
rate is 35%. Calculate the project’s initial outlay.

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Compute for the final answer.

Mayburn Inc plans to start doing its own deliveries instead

of using an outside service for which it has been paying
$150,000 per year. To make the change Mayburn will
purchase a $200,000 truck that it will depreciate straight line
over ten years to a $40,000 salvage value. Annual operating
expenses are estimated at $80,000 including insurance, fuel
and maintenance on the truck as well as the cost of a
driver. Management plans to sell the truck after five years
for $100,000. Develop the project’s five-year cash flows
and find find the Total Year 5 Cash Flow. Mayburn’s tax
rate is 40%. Treat as a replacement project.

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