Financial Management Exam 3 Conceptual Study Guide Chapter 10 Estimation of the incremental CFATs of a project Purpose to develop an understanding of how to estimate a projects relevant expected CFATs and then to combine these estimates with the decision criteria from Chapter 9 Note we will still assume that the required rate of return is a given Incremental CFATs refers to any and all CFATs cash flow after taxes that are a direct consequence of undertaking the project These are the CFATs that should be included in capital budgeting when analyzing a project Ex Disney adding a theme park looks at existing park and estimates CFATs and see the difference 1 Suck cost expenditures that have ALREADY been made on items related to the project being considered that will not be recovered regardless of whether the project is undertaken or not These cost should NOT be included in the CB analysis Ex doing bad on exam 1 nothing you can do about it its suck Ex Test marketing expenses incurred prior to the decision as to whether or not to launch a new project Ex Say we are considering a restaurant and pay a consultant 50 000 to access likely demand and to find good location that cost is already sunk 2 Spillover or Side Effects Influences that accepting the project being considered might have on the revenues or costs associated with existing products or services offered by the firm Bothe BENEFITS and COSTS should be included in the CB analysis Ex suppose Wal Mart is considering opening another store in Tallahassee have to consider the lost revenues to the existing stores Positive Synergies Negative Cannibalization A negative impact on the cash flows of an existing product from the introduction of a new product is called EROSION 3 Opportunity Costs Generally arise when the firm considers using an asset it acquired at an earlier date in an investment project that it is considering at present The dollar figure included in the capital budgeting analysis should reflect the CURRENT Market value of the assets the cash flow the firm could net by selling the asset today We included opportunity costs because we want to be sure that the project being evaluated can beat alternative uses of the capital The required return on a project represents the opportunity cost to the firm for a project Ex buy land for 200 000 now worth 500 000 which would be the value included in the CB analysis REMEMBER Spill over or side effect cost Opportunity costs SHOULD be in the CB analysis Sunk Costs SHOULD NOT be in the CB analysis Net Working Capital Current assets current liabilities A project will usually need an initial investment in inventories and accounts receivable to cover credit sales CA Some of the financing for this will be n the form of amounts owed al to suppliers accounts payable CL but the firm will have to supply the balance This balance represents the investment in net working capital Whenever we have an investment in net working capital that same investment has to be recovered the same number needs to appear sometime in the future terminal CFAT Cash Flow vs Accounting Income Costs of fixed assets When a company starts a new project they need to invest in fixed assets in order to getting project up and running They have to show the purchase of the fixed asset in some way so instead they deduct a yearly depreciation expense throughout the life of the project Noncash Charges accountants do not subtract the cost of a fixed asset from accounting income but they do take out a depreciation expense each year Deprecation is a noncash expense no money is changing hands when depreciation occurs Since deprecation s subtracted out before taxes depreciation can create a tax shelter for a company But deprecation must be added back to net income in order to estimate the cash flows of a project Chang in Net Working Capital Change in current assets change in current liabilities We need to find the cash flow from the new project if we buy 100 un inventory CA and put 20 on credit CL then we need to come up with 80 out of my own pocket this is a cash outflow Interest expense interest expense should not be subtracted when finding projects cash flows The way we deal with financing costs is by discounting at the required return If interest expense were deducted and the resulting Cash Flows were then discounted then this would DOUBLE count the interest expense Interest paid is a component of cash flow to creditors not cash flow from assets CFAT Estimation Procedure The bottom line is the CFATs associated with the project have to be estimated for each year of the projects estimated useful life 1 Begin by estimating the INITIAL OUTLAY required for the project 2 Estimate the net CFAT we expect to generate each year of the projects expected life operating CFATs 3 Estimate the TRMINAL CFATs associated with terminating the project Typical CFATs that is associated with each stage of the estimation process 1 INITIAL OUTLAY cash flows frequently included The purchase price of buildings land equipment etc Installation shipping modification of existing facilities etc Increases in NET WORKING CAPTIAL current assets liabilities required if the project in undertaken Legal Fees permits etc associated with starting up the project CFAT from disposal of old assets if a replacement problem not going to deal with this Net Capital Spending NCS machinery including shipping installation ect Traning if required PPE Net Working Capital NWC CA CL CA typically includes Cash AR Inventory CL typically includes accounts payable and accruals 2 OPERATING CFATs EXAMPLE Project revenues associated with the project for the year less the estimated costs of generating the revenues for the year Cash flow before tax CFBT for the year Less depercaiation expense for the year Taxable income for the year Less taxes Net income Add back change in depreciation expense Change in CFAT for the year A pro forma projected income statement is constructed for each year of the projects expected useful life and then depreciation expense associated with the project is added to net income figure to obtain the estimated operation CFAT for each year Only the revenues costs depreciation taxes etc that are relevant for the project being analyzed are considered Why do you add back in Depreciation expense Depreciation is tax deductible so it must be deducted from the CFBT each year to correctly figure taxes However Depreciation does NOT involve a cash outflow We are interested in estimating
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