Session 10 Cash Flow Esimation

8/12/2019 Session 10 Cash Flow Esimation

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Session 10

Cash FlowEstimation


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Learning Objectives

1. Understand the importance of cash flow and

the distinction between cash flow and profits.. !dentif" incremental cash flow.

#. Calc$late depreciation and cost recover".

%. Understand the cash flow associated with thedisposal of depreciable assets.

&. Estimate incremental cash flow for capital

b$dgeting decisions.


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10.1 'he !mportance of Cash

Flow

Cash flow meas$res the act$al inflow ando$tflow of cash( while profits represent merel"an acco$nting meas$re of periodicperformance.

) firm can spend its operating cash flow b$tnot its net income.

Some firms have net losses *d$e to highdepreciation write+offs, and "et can pa"dividends from cash balances( while othersshow profits and ma" not have the cashavailable.

'h$s( cash flow is broader than net income.


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10.1 'he !mportance of Cash

Flow *contin$ed,

Figure 10.2 -- modified income -- it only considers the cash flow arising from operations.Interest expense (which is a financing cash flow) is not included, and depreciation (whichhad been deducted in Figure 10.1 mainly for tax purposes) is added back.OCF = EBIT Taxes +Depreciation=Net Income + Interest +Depreciation

$4,603 =$5,046 - $1,555 + $1,112 = $3313+$178+$1,112

Figure 10.1Figure 10.2


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10. Estimating Cash Flow for

-rojects !ncremental Cash Flow

For e/pansion( replacement or new projectanal"sis( incremental effects on reven$es ande/penses m$st be considered.

Caref$l estimation and eval$ation of the timing andmagnitude of incremental cash flows is ver"important.

7important iss$es to be ept trac of

s$n costs( opport$nit" cost(

erosion( s"nerg" gains( woring capital( capital e/pendit$res( and

depreciation or cost recover" of assets.


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10. *), S$n costs

E/penses that have alread" been inc$rred( or

that will be inc$rred( regardless of the decisionto accept or reject a project.

For e/ample( a mareting research st$d"e/ploring b$siness possibilities in a regionwo$ld be a s$n cost( since its e/pendit$re hasbeen done prior to $ndertaing the project andwill have to be paid whether or not the project

is taen on. 'hese costs altho$gh part of the income

statement( sho$ld not be considered as part ofthe relevant cash flows when eval$ating a

capital b$dgeting proposal.


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10. *, Opport$nit" costs

Costs that ma" not be directl" observable orobvio$s( b$t res$lt from benefits being lost asa res$lt of taing on a project.

For e/ample( if a firm decides to $se an idle

piece of e2$ipment as part of a new b$siness(the val$e of the e2$ipment that co$ld bereali3ed b" either selling or leasing it wo$ld bea relevant opport$nit" cost.

'hese costs sho$ld be incl$ded.


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10. *C, Erosion costs

Costs that arise when a new prod$ct or

service competes with reven$e generatedb" a c$rrent prod$ct or service offered b" afirm.

For e/ample( if a store offers two t"pes ofphoto+cop"ing services( a newer( moree/pensive choice and an older economicalone.

Some of the reven$es from the older repeatc$stomers will be lost and sho$ld thereforebe acco$nted for in the incremental cash

flows.


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*contin$ed,

E/ample 1 Erosion costs.

Frost" 4esserts c$rrentl" sell 100(000 of itsStrawberr"+Shortcae 4elight *SS4, each "ear for5#.&0 per serving.

!ts cost per serving is 51.6&.

!ts chef has come $p with a newer( richer concoction(7E/tra+Cream" Strawberr" 8onder *ES8,(9 whichcosts 5.00 per serving( will retail for 5%.&0 andsho$ld bring in 1#0(000 c$stomers.

!t is estimated that after the la$nch the sales for theoriginal variet" will drop b" 1&:.

Estimate the erosion cost associated with thisvent$re.


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*contin$ed,E/ample 1 )nswer

'o calc$late the erosion cost we m$st

consider the amo$nt of lost contrib$tionmargin i.e.

*Selling price ; $nit cost, from SS4 *Selling -rice ; Unit Cost,Erosion cost = *100(000 ; ?&(000,>*5#.&0+51.6&,

= 5@(&0


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*contin$ed,Alternative way to measure erosion: Eam!le 1 AnswerAargin contrib$ted b" ES8 = *5%.&0+5.00,B1#0(000

= 5#&(000Aargin prior to new la$nch=100(000B*5#.&0 + 51.6&,= 516&(000

Aargin after la$nch =*5#.&0 +

51.6&,B?&(0005#&(000= 5%6#(6&0Det change in margin = 5%6#( 6&0 + 516&(000

= 5?(6&0

Erosion cost =ES8


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10. *4, S"nerg" gains'he imp$lse p$rchases or salesincreases for other e/isting prod$ctsrelated to the introd$ction of a newprod$ct.

For e/ample( if a gas station with aconvenience store attached( adds a lineof fresh don$ts and bagels( the sales ofcoffee and mil( wo$ld res$lt in s"nerg"gains.


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10. *E, 8oring capital )dditional cash flows arising from changes

in c$rrent assets s$ch as inventor" and

receivables *$ses, and c$rrent liabilities s$chas acco$nts pa"ables *so$rces, that occ$r as ares$lt of a new project.

enerall"( at the end of the project( these

additional cash flows are recovered and m$stbe accordingl" shown as cash inflows.

Even tho$gh the net cash o$tflows ++ d$e toincrease in net woring capital at the start ++ma" e2$al the net cash inflow arising from theli2$idation of the assets at the end( the timeval$e of mone" effects mae these costs

relevant.


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10.# Capital Spending and

4epreciation

Capital e/pendit$res are allowed to bee/pensed on an ann$al basis and can be$sed as ta/ shields.

'he portion written off in the income

statement( each "ear( is called thedepreciation expenseG and the acc$m$latedtotal ept trac of in the alance sheet isnown asAccumulated Depreciation.

'h$s( the boo val$e of an asset e2$als itsoriginal cost less its acc$m$lateddepreciation.


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10.# Capital Spending and

4epreciation *contin$ed,'he two reasons we need to deal

with depreciation when doing capital

b$dgeting problems are*1,the ta/ flow implications from the operating

cash flow and

*,the gain or loss at disposal of a capitalasset.

Firms have a choice of $sing either

straight line depreciation rates( ormodified accelerated cost recover"s"stem *A)CHS, rates for allocating theann$al depreciation e/pense( arising

from an asset ac2$isition.


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10.# *), Straight+Line

depreciation

'he ann$al depreciation e/pense is

calc$lated b" dividing the initial costpl$s installation min$s the e/pectedresid$al val$e *at termination, e2$all"

over the e/pected prod$ctive life of theasset.

'he ann$al depreciation e/penses are

the same for each "ear.


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10.# *, Aodified )ccelerated

Cost Hecover" S"stem

A)CHS rates are established b" the

federal government( since 1?1( as awa" to allow for firms to accelerate thedepreciation write+off in earl" "ears of

the asset


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10.# *, A)CHS *contin$ed,'able 10.# -ropert" Classes $nder A)CHS


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10.# *, A)CHS *contin$ed,

'able 10.%A)CHS Fi/ed

)nn$al E/pense-ercentages b"Hecover" Class


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10.# *, A)CHS *contin$ed,

Each class life( has one additional "ear ofdepreciation than the class+life states( e.g. a #+"ear

class life asset is depreciated over % "ears. 'his is beca$se the government ass$mes that the

asset is p$t into $se for onl" half a "ear at the start*half-year convention,( and thereb" allowed I

depreciation( with the last "ear *Jear %, beingallowed the balance re2$ired to reach 100: *whichamo$nts to I the prior "ear


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10.# *, A)CHS *contin$ed,Eam!le 2: "A#$% &e!re'iation

'he rand K$nction F$rnit$re Compan" hasj$st bo$ght some specialt" tools to be $sedin the man$fact$re of high+end f$rnit$re.

'he cost of the e2$ipment is 5%00(000 withan additional 5#0(000 for installation.

!f the compan" has a marginal ta/ rate of

#0:( compare its ann$al ta/ savings thatwo$ld be reali3ed from $sing A)CHSdepreciation rates.


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10.# *, A)CHS *contin$ed,Eam!le 2 Answer)ccording to 'able 10.#( specialt" tools falls $nder a #+

"ear class asset with rates in Jears 1+% of ##.##:(

%%.%&:( 1%.?1:( and 6.%1: respectivel".4epreciable basis = Cost !nstallation = 5%00(000

5#0(000 = 5%#0(000

'he ann$al depreciation e/penses *i.e. ann$al rateB4ep.

asis, are shown below

YearMACRS

rate Dep. Exp1 33.33% $ 143,3192 44.45% $ 191,1353 14.81% $ 63,6834 7.41% $ 31,863

Total 100.00% $ 430,000


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10.% Cash Flow and the

4isposal of Capital E2$ipment8hen a depreciable asset is sold( the cash inflow thatres$lts can be higher than( e2$al to( or lower than the

act$al selling price of the asset( depending onwhether it was sold above *ta/able gain,( at *3ero+gain, or below *ta/ credit, boo val$e.

!f the sale res$lts in a ta/able gain( then the cashinflow is red$ced b" the amo$nt of the ta/es

i.e. *'a/ rateB*Selling -ricei.e. *'a/ rateB*Selling -rice ;;oo al$e,.oo al$e,.

!f the selling price is e/actl" e2$al to boo val$e thecash inflow e2$als the sale price.


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10.% Cash Flow and the 4isposal of

Capital E2$ipment *contin$ed,

!f the asset is sold below its boo val$e( a lossres$lts( and can be written off ta/es for the "ear(res$lting effectivel" in an addition to cashinflows e2$al to

*oo al$e*oo al$e++Selling -rice,B'a/ rateSelling -rice,B'a/ rate.

'h$s( the cash flow res$lting from after+ta/salvage val$e of a depreciable asset is calc$latedas follows

)fter)fter++ta/ Salvage al$e = Selling -riceta/ Salvage al$e = Selling -rice ;; 'a/ rate'a/ rate

B *Selling priceB *Selling price ;; oo al$e,oo al$e,OH

Selling -rice 'a/ rate B *oo al$eSelling -rice 'a/ rate B *oo al$e ;; SellingSelling-rice,-rice,


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Eam!le 3: (a e))e'ts )rom &is!osal 'as* )low

Let


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Eam!le 3 Answer4epreciable basis = 5%#0(000

Jear 1 depreciation rate = ##.##:Jear depreciation rate = %%.%&:'otal depreciation taen so far = 5%#0(000 B *##.##:

%%.%&:, = 5##%( %&%

oo al$e = 4epreciable basis ; )cc$m$lated depreciationoo al$e = 5%#0(000 + 5##%(%&% = 5&(&%@

Selling price = 51&(000 oo al$e 'a/able gain on thesale

'a/able gain = 51&(000+5&(&%@ = 5(%&%)fter+ta/ Salvage al$e= Selling -rice ; *'a/ rateB'a/able

gain ,=51&(000 + .#&B*5(%&%, =51&(000+510(#0?.

=511%(@1.1


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10.& -rojected Cash Flow for a

Dew -roject

% steps are t"picall" involved

1. 4etermination of the initial capitalinvestment for the project

+ur'*ase 'ost

, nstallation,nitial n'rease in net worin/ 'a!ital

-A)ter-ta salva/e value )rom &is!osal o)

ol& asset i) any


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Dew -roject *contin$ed,Fig$re 10.%


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Dew -roject *contin$ed,. Estimation of the ann$al operating cash flows

*incremental, generated b" the project(

ignoring s$n costs and incl$ding erosion costsand side+effects.

OCF = E!' ; 'a/es 4epreciation

!n the terminal "ear( besides the $s$al OCF wehave to acco$nt for an" salvage val$e that isreceived( which re2$ires the calc$lation of ooval$e and ta/es *or ta/ credits, on sale of theasset.

'erminal Jear Cash flow = OCF )fter+ta/Salvage al$e


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)lternative approaches to find OCF

'he 'a/+Shield )pproach

OCF = *S + C + 4, 4 + *S + C + 4, '

= *S + C, *1 + ', *4 ',

= *S + C, *1 + ', depreciation / '

'he ottom+Up )pproach

OCF =*S + C + 4, 4 + *S + C + 4, '

= *S + C + 4, *1 + ', 4= Det !ncome 4epreciation

'he 'op+4own )pproach

OCF = *S + C + 4, 4 + *S + C + 4, '

= *S + C, + *S + C + 4, '= sales+ costs; ta/es

OCF =

operating cashflows

S = sales

C = operatingexpenses

D =depreciation

T = corporatetaxes


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Dew -roject *contin$ed,

'able 10.@ 4epreciation of E2$ipment for Cogswell Cola


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#. 4etermination of the change in net

woring capital which is $s$all" anincrease *o$tflow, at the beginningand a red$ction *inflow, at the end.

%. Eval$ation of the proposed project$sing an appropriate disco$nt or

h$rdle rate and either the D- or !HHapproach.


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'able 10.6 !ncremental Cash Flow of -$lsar Cola


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Fig$re 10.@ Spreadsheet application for -$lsar Cola Calc$lating

D-( !HH( and A!HH.


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)dditional -roblems with )nswers

-roblem 1

Erosion 'ost: olvo is looing to introd$ce anew 7h"brid9 car in the US. 'heir anal"sts

estimate that the" will sell 0(000 of thesenew cars per "ear.

'he $nit cost per car is 51?(000 and the" planon selling the vehicle for 5(000.

!f the c$rrent sales of olvo Ps sedan( whichcosts 51&(000 to prod$ce and sells for50(000( go down from &(000 $nits per "earto 1?(000 $nits( is this a worthwhile move forolvoN

Calc$late the amo$nt of the erosion cost andthe incremental cash flow that will res$lt if

the" go ahead with the la$nch.


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-roblem 1 *)nswer,

OLD SEDANCurrent EBIT = # of cars sold *(Price Cost

= !"$$$*(%!$$$$-%&"$$$= %&!"$$$$$$= %&!"$$$$$$

') (after launch = &+$$$ *(%"$$$ =%,$$$$$$$

ost ') = %&!"$$$$$$ - %,$$$$$$$= %"$$$$$$= 'rosion Cost

HYBRID') = !$$$$ * (%!!$$$-%&+$$$ = %+$$$$$$$

COMBINED EBIT= %+$$$$$$$ / %,$$$$$$$ = %&0$$$$$$$%&0$$$$$$$Since the Combined EBIT i higher than the current EBIT

b! "#$%&&&% &&& it 'ou(d be a 'orth'hi(e mo)e *or+o()o,


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-roblem

e!re'iation rates: H.Q. oats !nc. has j$st installed a new

h"dra$lic lift s"stem which is being categori3ed as a &+"ear

class+life asset $nder A)CHS.

'he total p$rchase cost pl$s installation amo$nted to 56&0(000.

HQ has alwa"s $sed straight+line depreciation in the past( b$t

their acco$ntant is p$shing the owner to $se the A)CHS rates this

time aro$nd.

'he owner seems to thin that it reall" doesn


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-roblem *)nswer,-nder traight.(ine de/reciation0

Annua( de/,e1/, 2 Cot 3 Inta((ation 4 Li*e 2 "7$&%&&&4$ 2

"5$&%&&&-ing 6ha(*.!ear con)ention the com/arion o* !ear(!de/reciation under the 8 method i a *o((o'0

YearMACRS

rateMACRS

Dep.St. Line

Dep Diff. Tax Gain

1 20% 150000 75,000 75,000 22500

2 32% 240000 150000 90,000 27000

3 19.20% 144000 150000 -6,000 -1800

4 11.52% 86400 150000 -63,600 -19080

5 11.52% 86400 150000 -63,600 -19080

6 5.76% 43200 75000 -31,800 -9540

Total 100% 750000 750000 0 0NPV@10% $2,265.82

So clearly, with the tax advantages coming in earlier i.e. in the first two years, thetime value of money advantages makes it a positive NPV move.


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-roblem #Di/oa( Cah 9(o'0

Hedd" Laboratories had p$rchased some

man$fact$ring e2$ipment five "ears ago for atotal cost of 5#(000(000( and has beendepreciating it $sing the A)CHS ; 6 "ear class+life rates.

C$rrentl"( newer( more efficient e2$ipment isavailable and Hedd" has fo$nd a b$"er who iswilling to pa" 55&00(000 for the old

e2$ipment.

!f the firm( which has a marginal ta/ rate of #&:(

disposes of the s"stem to the b$"er( how m$ch will the

after+ta/ cash flows add $p toN


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-roblem # *)nswer,

The 7-year MACRS rates are as follows:

After 5 years, the book value would be (0893+.0893+.0445)*$3,000,000Book value = 0.2231*$3,000,000 = $669, 300

Loss on sale = Selling Price Book value = $500,000 - $669,30= -$169,300

Tax credit = Tax rate * Loss = 0.35*$169,300 = $59,255After-tax cash inflow = Selling price + Tax credit

= $500,000 + $59,255 = $559,255


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-roblem %

!eratin/ 'as* )low /rowin/ ea'* year "A#$%. ali ent$res is

looing at a project with the following forecasted sales first+

"ear sales 2$antit" of 0(000 with an ann$al growth rate of%: over the ne/t & "ears.

the sales price per $nit is 5#&.00 and will grow at &: per "ear.

'he prod$ction costs are e/pected to be %&: of the c$rrent "ear


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-roblem % *)nswer,Based on 5-year MACRS rates, the annual depreciation expense is as follows:

Dep. Basis 2,200,000Year Rate Depreciation

1 0.2 40000

2 0.32 7040003 0.192 422400

0.1152 53440

5 0.1152 53440

6 0.0576 126720


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-roblem % *)nswer, *contin$ed,

The operating cash flow over the 5-year period is calculated as follows:

Rate Year 1 Year 2 Year 3 Year 4 Year 5Unit sales 4% 30,000 31,200 32,448 33,746 35,096

Sales price 5% $35.00 $36.75 $38.59 $40.52 $42.54

Revenues $1,050,000 $1,146,600 $1,252,087 $1,367,279 $1,493,069

Prod. Costs 45% $472,500 $515,970 $563,439 $615,276 $671,881

Fixed costs $ 285,000 $ 285,000 $ 285,000 $ 285,000 $ 285,000Depreciation 440,000 704,000 422,400 253,440 253,440

EBIT ($147,500) ($358,370) ($18,752) 213,564 282,748

Taxes 35% ($51,625) ($125,430) ($6,563) 74,747 98,962

Net Income ($95,875) ($232,941) ($12,189) 138 816 183,786Add Dep $440,000 $704,000 $422,400 $253,440 $253,440

Op. Cash Flow $344,125 $471,060 $410,211 $392,256 $437,226


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-roblem &

Let


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-roblem & *)nswer,

)n addition to the operatin3 cash flo4 for

years &-" 4e need to calculate the initialyear and terminal year cash flo4 and addthem in.

Initia( Year Cah 9(o' :Year &;

Cot o* E


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-roblem & *)nswer, *contin$ed,

Termina( Year Cah 9(o'

Reco)er! o* N=C 2 3"#7% 8$&A*ter.ta1 Sa()age +a(ue o* E :Se((ing ?rice @ Boo +a(ue;Se((ing ?rice 2 8& o* Cot 2 ,8>:8%8&&%&&&; 2 "##&%&&&

Boo +a(ue 2 Year MACRS De/, Rate > De/, Bai2 ,&$7>88&&&&& 2 "58%78&

Ta1 on ain 2 &,F$>:"##&%&&&."58,78&; 2 "5&G%#A*ter.ta1 Sa()age +a(ue 2 "##&%&&&."5&G%#2 "FF&%F$8

Tota( Termina( Year Cah 9(o' :not inc(uding OC9;2 #7%8$& 3 FF&%F$8 2 F77%&8

)ddi i l - bl i h )


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-roblem & *)nswer, *contin$ed,Year Cah9(o'

& ."8%8#7%8$&

5 "F##%58$ 8 "#75%&&

F "#5&%855

# "FG8%8$$ "#F7%883F77%&82"5#%8

N?+ 5& 2 ."#F%$,$

REJECT THE ?ROJECTK


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Fig$re 10.#

')LE 10 1 ) l ! t l


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')LE 10.1 )nn$al !ncremental

Cash Heven$es


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')LE 10. )nn$al Cash Heven$es )fterCompetitor !ntrod$ces Flavored Cola


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')LE 10.& )nn$al 4epreciation E/pense

of E2$ipment for Cogswell Cola

Documents

Session 10 Cash Flow Esimation