Chapter 11 May 041Cash Flow Estimation2Chapter Outline Cash Flows in General Estimating Cash Flows Compute Project’s NPV3Cash Flows in GeneralCash flows should be measured on an incremental basisIncremental cash flows are cash flows that will occur if a capital budgeting project is accepted, but that will not occur if the investment is rejected.The cash flows of the firm with the project minus the cash flows of the firm without the project.Cash flows should be measured after-taxAll the indirect effects of a project should be included in the cash flow calculationsSunk costs should NOT be considered The value of resources used in the project should be measured in terms of their opportunity costs.Ignore interest payments. Separate the investment and the financing decision.Measuring Incremental Cash Flows4Asking the Right QuestionYou should always ask yourself “Will this cash flow occur ONLY if we accept the project?”If the answer is “yes”, it should be included in the analysis because it is incrementalIf the answer is “no”, it should not be included in the analysis because it will occur anywayIf the answer is “part of it”, then we should include the part that occurs because of the projectChapter 11 May 045DepreciationDefinition: “the means by which an asset’s value is expensed over its useful life for federal tax purposes.”Depreciation is a non-cash expenseOnly relevant because affects taxesWe will use MACRSAll US companies use MACRS for tax purposes6Calculation of DepreciationDepreciable basisTotal amount to be depreciated over the accounting life of the asset.Equal to cost of the asset plus any setup and delivery costs incurred.MACRS (Modified Accelerated Cost Recovery System) Specified percent charged each year.7DepreciationMACRS DepreciationModified Accelerated Cost Recovery SystemAssets assigned to a class based on estimated economic lifeDepreciation expense is the depreciable basis (cost) of the asset times the MACRS% for the current year of service1 33.33% 20.00% 14.29%2 44.44% 32.00% 24.49%3 14.82% 19.20% 17.49%4 7.41% 11.52% 12.49%5 11.52% 8.93%6 5.76% 8.93%7 8.93%8 4.45%Year 3 yr 5yr 7yrClass9DepreciationMACRS ExampleCrawley Enterprises recently purchased a new delivery truck for $100,000. The truck is assigned to the 5 year MACRS class1 33.33% 20.00% 14.29%2 44.44% 32.00% 24.49%3 14.82% 19.20% 17.49%4 7.41% 11.52% 12.49%5 11.52% 8.93%6 5.76% 8.93%7 8.93%8 4.45%Year 5yrClassx $100,000 = $20,000x $100,000 = $32,000x $100,000 = $19,200x $100,000 = $11,520x $100,000 = $11,520x $100,000 = $ 5,760Depreciable BasisTruck has been fully depreciated over 6 years $100,000Chapter 11 May 0410DepreciationMACRS ExampleCrawley Enterprises recently purchased a new delivery truck for $100,000. The truck is assigned to the 5 year MACRS classBook Value1 33.33% 20.00% 14.29%2 44.44% 32.00% 24.49%3 14.82% 19.20% 17.49%4 7.41% 11.52% 12.49%5 11.52% 8.93%6 5.76% 8.93%7 8.93%8 4.45%Year 5yrClassx $100,000 = $20,000x $100,000 = $32,000x $100,000 = $19,200x $100,000 = $11,520x $100,000 = $11,520x $100,000 = $ 5,76080,00048,00028,80017,2805,7600Book Value = Basis – Accumulated Depreciation11DepreciationWhy the additional year? An asset in the 3 year class is depreciated over 4 years1 33.3%2 44.5%3 14.8%47.4%Year 3 yrClassTable is prepared using the ½ YEAR CONVENTION01/01/01 01/01/02 01/01/03 01/01/04 01/01/05On average asset is placed into service 6 months into year.1styear depreciation2ndyear depreciation3rdyear depreciationThe annual depreciation expense affects 4 tax years.12Estimating Cash FlowsCapital SpendingOperating Cash Flows Net Working CapitalThree Types of Cash Flows13Estimating Cash FlowsCapital SpendingCapital spent and recovered for the purchase/sale of fixed assetsTime0 1 2 3 ΝSourceCash Flow from the sale of“used” Machine, net of TaxesNCash Flow for the purchase of Machine0Chapter 11 May 0414Estimating Cash FlowsNet Working CapitalWorking Capital Investments required to support the project0 1 2 3 ΝRecover Sum of NWC for yrs 0→NInitial NWCN01 → N-1Changes in NWCTimeSource15Estimating Cash FlowsOperating Cash FlowAnnual Cash flows realized from the operation of the projectIncremental Revenuet– Incremental Variable Costst– Incremental Fixed Costst–DepreciationtEBITt– Tax Rate x EBITt+DepreciationtOperating Cash FlowtWhere t = 1 → N:16Estimating Cash FlowsTotal Project Cash FlowSum of the Cash Flows by YearOperating Cash Flowt+NWCtCash Flow+ Capital SpendingtCash FlowTotal Project Cash FlowtWhere t = 0 → N:17Estimating Cash FlowsExample:Click & Clack are considering a new project producing self-help car repair manuals. They are expecting to sell 10,000 units the first year for $20 each, then increasing production to 12,500 units in years 2 and 3. Variable costs are $4 a unit and fixed costs are $15,000. To produce these manuals Tom & Ray will buy a new printing press costing $300,000 today. This machine will be depreciated according to the MACRS 3 year schedule. The machine will be sold for $30,000 upon termination in 3 years.Net Working Capital requirements on the new machine are 10% of sales, so $20,000 in time 0 for sales in year 1 and increases of $5,000 in year 1 for sales in years 2 and 3. All working capital will be recovered in year 3. Tom & Ray have a marginal tax rate of 40%.Chapter 11 May 0419Estimating Cash FlowsCapital Spending“This machine will be depreciated according to the MACRS 3 year schedule. The machine will be sold for $30,000 in 3 years”0 1 2 3Time$300,0000Cash Flow3Selling Price $30,000Book Value 22,230Gain on Sale 7,770Tax on Gain 3,108Net Cash Flow 26,892– 300,000 +26,89221Estimating Cash FlowsRecover NWC of $25,0003NWC ↑ $20,00001NWC ↑ $5,000TimeCash Flow“Net Working Capital requirements on the new machine are 10% of sales, so $20,000 in time 0 for sales in year 1 and increases of $5,000 in year 1 for sales in years 2 and 3. All working capital will be recovered in year 3”0 1 2 3Net Working Capital+25,000–5,000–20,00022“They are expecting to sell 10,000 units the first year for $20 each, then increasing production to 12,500 units in years 2 and 3. Variable costs are $4 a unit and fixed costs are