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Capital Budgeting Part 2:Cash Flow Estimation
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Cash Flow Estimation
For project analysis (i.e., NPV, MIRR, PI), we use future cash flows
But how do we estimate these?
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Cash Flows vs. Accounting Income
Free Cash Flow
Cash flow available for distribution to all investors
Accounting Income
Total revenues minus total expenses
For capital budgeting, which one should we be concerned with?
Free Cash Flows!
Simply say project’s cash flows (CFs)
Key: focus on differences
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Incremental Cash Flows
Project’s incremental cash flow is:
Corporate cash flow with the project
Minus
Corporate cash flow without the project
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Summary of Adjustments to Cash Flows
Don’t adjust for:
Financing costs
Sunk costs
Make adjustments for:
Opportunity costs
Externalities
Depreciation
Net working capital
Inflation
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Proposed Project Data
$200,000 cost + $10,000 shipping + $30,000 installation
Economic life = 4 years
Salvage value = $25,000
Modified Accelerated Cost Recovery System (MACRS) 3-year class
Continued…
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Project Data (Continued)
Annual unit sales = 1,250
Unit sales price = $200
Unit costs = $100
Net working capital:
NWCt = 12% (Salest+1)
Tax rate = 40%
Project cost of capital = 10%
Inflation rate = 3%
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Cash Flow Table
| Year 0 | Year 1 | Year 2 | …….. | Year N | |
| Init. Cost | |||||
| Op. CF | |||||
| NWC CF | |||||
| Salvage CF | |||||
| Net CF | |||||
Fill in this table:
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Annual Sales and Costs
| Year 1 | |
| Units | 1,250 |
| Unit Price | $200 |
| Unit Cost | $100 |
| Sales | $250,000 |
| Costs | $125,000 |
| Year 2 |
| 1,250 |
| $206 |
| $103 |
| $257,500 |
| $128,750 |
| Year 3 |
| 1,250 |
| $212.18 |
| $106.09 |
| $265,225 |
| $132,613 |
| Year 4 |
| 1,250 |
| $218.55 |
| $109.27 |
| $273,188 |
| $136,588 |
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What is an asset’s depreciable basis?
Basis = Cost
+ Shipping
+ Installation
$240,000
Any cost related to making the asset operational:
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Annual Depreciation Expense (000s) Using MACRS
| Year | % X | (Initial Basis) | = Deprec. |
| 1 | 0.33 | $240 | $79.2 |
| 2 | 0.45 | 108.0 | |
| 3 | 0.15 | 36.0 | |
| 4 | 0.07 | 16.8 |
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Operating Cash Flows (Year 1)
| Year 1 | |
| Sales | $250,000 |
| Costs | -125,000 |
| Deprec. | -79,200 |
| EBIT | $ 45,800 |
| Taxes (40%) | -18,320 |
| EBIT(1 – T) | $ 27,480 |
| + Deprec. | 79,200 |
| Net Op. CF | $106,680 |
We add back depreciation because it does not affect our actual cash flows!
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What if we didn’t account for depreciation tax savings?
| Year 1 | |
| Sales | $250,000 |
| Costs | -125,000 |
| Deprec. | -79,200 |
| EBIT | $ 45,800 |
| Taxes (40%) | -18,320 |
| EBIT(1 – T)+ Deprec.Net Op. CF | $ 27,480 79,200 $106,680 |
| Year 1 | |
| Sales | $250,000 |
| Costs | -125,000 |
| EBITDA | $125,000 |
| Taxes (40%) | -50,000 |
| EBITDA(1 – T)Net Op. CF | $ 75,000$ 75,000 |
Accounting for Depreciation
Ignoring Depreciation
Diff = $106,680 – $75,000 = $31,680 = $79,200 x 0.4
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Operating Cash Flows(Years 2, 3, and 4)
| Year 2 | Year 3 | Year 4 | |
| Sales | $257,500 | $265,225 | $273,188 |
| Costs | -128,750 | -132,613 | -136,588 |
| Deprec. | -108,000 | -36,000 | -16,800 |
| EBIT | $ 20,750 | $ 96,612 | $119,800 |
| Taxes (40%) | -8,300 | -38,645 | -47,920 |
| EBIT(1 – T) | $ 12,450 | $ 57,967 | $ 71,880 |
| + Deprec. | 108,000 | 36,000 | 16,800 |
| Net Op. CF | $120,450 | $ 93,967 | $ 88,680 |
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Cash Flows Due to Investments in Net Working Capital (NWC)
| Sales | NWC(% of sales) | CF Due to Investment in NWC | |
| Year 0 | $30,000 | -$30,000 | |
| Year 1 | $250,000 | 30,900 | -900 |
| Year 2 | 257,500 | 31,827 | -927 |
| Year 3 | 265,225 | 32,783 | -956 |
| Year 4 | 273,188 | 0 | 32,783 |
Additional NWC = 12% of next year’s sales:
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Salvage Cash Flow at t = 4 (000s)
| Salvage Value | $25 |
| Book Value | 0 |
| Gain or loss | $25 |
| Tax on SV | 10 |
| Net Terminal CF | $15 |
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What if you terminate a project before the asset is fully depreciated?
Basis = Original basis – Accum. deprec.
Taxes are based on difference between sales price and tax basis
Taxespaid
–
Saleproceeds
Cash flowfrom sale
=
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Example: If Sold After 3 Years for $25 ($ thousands)
Original basis = $240
After 3 years, basis = $16.8 remaining
1st 3 years of dep = $223.2
Sales price = $25
Gain or loss = $25 – $16.8 = $8.2
Tax on sale = 0.4($8.2) = $3.28
Cash flow = $25 – $3.28 = $21.72
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Example: If Sold After 3 Years for $10 ($ thousands)
Original basis = $240
After 3 years, basis = $16.8 remaining
Sales price = $10
Gain or loss = $10 – $16.8 = -$6.8
Tax on sale = 0.4(-$6.8) = -$2.72
Cash flow = $10 – (-$2.72) = $12.72
Sale at a loss provides a tax credit, so cash flow is larger than sales price!
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Net Cash Flows
| Year 0 | Year 1 | Year 2 | Year 3 | Year 4 | |
| Init. Cost | -$240,000 | 0 | 0 | 0 | 0 |
| Op. CF | 0 | $106,680 | $120,450 | $93,967 | $88,680 |
| NWC CF | -$30,000 | -$900 | -$927 | -$956 | $32,783 |
| Salvage CF | 0 | 0 | 0 | 0 | $15,000 |
| Net CF | -$270,000 | $105,780 | $119,523 | $93,011 | $136,463 |
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NPV= $88,030
0
1
2
3
4
(270,000)
105,780
119,523
93,011
136,463
Project Net CFs Time Line
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What does “risk” mean in capital budgeting?
Uncertainty about a project’s future profitability
Will taking on the project increase the firm’s and stockholders’ risk?
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What three types of risk are relevant in capital budgeting?
Stand-alone risk
The project’s risk if it were the firm’s only asset and there were no shareholders
Corporate risk
Reflects the project’s effect on corporate earnings stability
Market risk
Reflects the project’s effect on a well-diversified stock portfolio
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What is sensitivity analysis?
Shows how changes in a variable such as unit sales affect NPV or MIRR
Each variable is fixed except one
Change this one variable to see the effect on NPV or MIRR
Answers “what if” questions, e.g. “What if sales decline by 30%?”
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-30 -20 -10 Base 10 20 30 (%)
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NPV
($ 000s)
Unit Sales
r
Sensitivity Graph
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What are the weaknesses ofsensitivity analysis?
Does not reflect diversification
Says nothing about the likelihood of change in a variable, i.e. a steep sales line is not a problem if sales won’t fall
Ignores relationships among variables
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What is scenario analysis?
Examines several possible situations, usually worst case, most likely case, and best case
Provides a range of possible outcomes
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Best scenario: 1,600 units @ $240Worst scenario: 900 units @ $160
| Scenario | Probability | NPV(000) |
| Best | 0.25 | $279 |
| Base | 0.50 | 88 |
| Worst | 0.25 | -49 |
| E(NPV) = $101.6 | ||
| σ(NPV) = 116.6 | ||
| CV(NPV) = σ(NPV)/E(NPV) = 1.15 |
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Are there any problems with scenario analysis?
Only considers a few possible out-comes
Assumes that inputs are perfectly correlated—all “bad” values occur together and all “good” values occur together
Focuses on stand-alone risk, although subjective adjustments can be made
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What is a simulation analysis?
A computerized version of scenario analysis that uses continuous probability distributions
Computer selects values for each variabl
