11_LasherIM_Ch11

CHAPTER 11

CASH FLOW ESTIMATION OBJECTIVE Subjective FOCUS Cash flow estimation focuses on the numerical methodology used in putting together an estimate of a capital project. We keep the question of accuracy and risk in mind throughout, and continue in the next chapter with a discussion of the methods available to incorporate risk into the process. PEDAGOGY This chapter contains an important pedagogical point with respect to practicality. Most texts present capital budgeting as more accurate and reliable than it is, and students can get the incorrect impression finance has the precision of engineering. In real companies, the cash flow estimates associated with capital projects are generally very fluid. If an analysis results in an unfavorable IRR, the people behind the project often change the input numbers until they get the result they want. This reality creates a problem and a challenge at the same time. The problem is bias and inaccuracy. The challenge lies in the role created for finance in ensuring that estimated cash flows are reasonable and likely to come true. This chapter provides a thorough discussion of the sources of error and vagueness in estimated figures. TEACHING OBJECTIVES At the end of this chapter students should be fully aware of the difficulties and uncertainties associated with making cash flow estimates in a capital budgeting context. They should also be able to make estimates in fairly complex situations. OUTLINE I.

CASH FLOW ESTIMATION A. Capital Budgeting Processes Conceptually divides capital budgeting into the calculation process and the more arbitrary and difficult estimation process.

II. PROJECT CASH FLOWS - AN OVERVIEW AND SOME SPECIFICS A. The General Approach to Cash Flow Estimation A general outline. Consider the initial investment first, then periodic revenues, costs and expenses, or savings. Include tax effects and plan to acquire the required assets. B. A Few Specific Issues The typical cash flow pattern, the incremental concept, sunk costs, opportunity costs, impacts on the rest of the company, overheads, taxes, working capital, financing costs, and old equipment. C. Estimating New Venture Cash Flows A comprehensive example in a manufacturing context. D. Terminal Values Treating cash flows that can be expected to continue indefinitely. E. Accuracy and Estimates

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4

Chapter 11 NPV and IRR give answers to several decimal places, but the accuracy isn't real, because the results are no better than input estimates of the future. This section contains an important discussion of the practical sources of error in capital budgeting including wellmeaning biases. F. Estimating Cash Flow for Replacement Projects Replacements are usually simpler projects, but the cash flows can be trickier to properly identify and quantify. A comprehensive example.

QUESTION 1. The typical cash flow pattern for business projects involves cash outflows first, then inflows. However, it's possible to imagine a project in which the pattern is reversed. For example, we might receive inflows now in return for guarantying to make payments later. Would the Payback, NPV, and IRR methods work for such a project? What would the NPV profile look like? Would the NPV and IRR methods give conflicting results? ANSWER: Payback wouldn't make sense for such a product, because there would be no initial outlay to recover. The NPV and IRR methods would work because they're based on the present value of future cash flows regardless of their pattern. The NPV profile would slope upward, because higher rates would reduce the present values of the negative flows in the distant future more than those of the positive short-term flows. This would result in a more positive NPV as the interest rate rose. NPV and IRR could give conflicting results if the up-sloping profiles crossed in the first quadrant just as in the case of the traditional patterns. BUSINESS ANALYSIS 1. You are a new financial analyst at Belvedere Corp, a large manufacturing firm that is currently looking into diversification opportunities. The vice president of marketing is particularly interested in a venture that is only marginally connected with what the firm does now. Other managers have suggested enterprises in more closely related fields. The proponents of the various ideas have all provided you with business forecasts from which you have developed financial projections including project cash flows. You have also calculated each project's IRR with the following results: Project IRR A 19.67%

Comments Marketing's project, an almost totally new field

B

19.25%

Proposed by manufacturing, also a very different field.

C

18.05%

Proposed by engineering, a familiar field.

You are now in a meeting with senior managers that was called to discuss the options. You have just presented your analysis ending your talk with the preceding information. After your presentation, the vice president of marketing stands, congratulates you on a fine job, and states that the figures clearly show that Project A is the best option. He also says that your financial analysis shows that project A has the full backing of the finance department. All eyes, including the CFO's, turn to you. How do you respond? ANSWER: Although A's IRR is highest it isn't likely to be the best project because of its risk. Projects of significantly different risk aren't directly comparable without risk adjustments. In this

Cash Flow Estimation

5

case Projects A and B are likely to be much riskier than C, because they're in unfamiliar fields. They should therefore be measured against a substantially higher hurdle rate than Project C. Further, the difference shown between A and B is finer than makes sense for capital budgeting techniques. Remember that a calculated IRR can be no more accurate than the estimated cash flows input to the model. Those are certainly not good to four significant figures as shown. This analysis essentially says that the three projects are about equal in terms of IRR without adjusting for risk. Part of the problem is in the presentation. The analyst should not have displayed results to a hundredth of a percent. Doing so gives the wrong impression to people unfamiliar with financial analysis techniques. 2. Most top executives are graded primarily on their results in terms of net income rather than net cash flow. Why then, is capital budgeting done with incremental cash flows rather than with incremental net income? ANSWER: Net income is an accounting construction designed to indicate the long-term health of a business rather than its immediate cash performance. Presumably, executives are graded on long term results of the business as a going concern that will last over a long period, so net income is an appropriate measure. Capital budgeting is aimed at allocating resources among competing uses as objectively as possible. It is not concerned with painting a picture of the business the way accounting results do. The best basis for resource allocation among uses is the contribution those uses make to wealth. That contribution is best measured by the present value of expected cash flows which is therefore the basis for capital budgeting. 3. Creighton Inc. is preparing a bid to sell a large telephone communications system to a major business customer. It is characteristic of the telephone business that the vendor selling a system gets substantial follow-on business in later years by making changes and alterations to that system. The marketing department wants to take an incremental approach to the bid, basically treating it as a capital budgeting project. They propose selling the system at or below its direct cost in labor and materials (the incremental cost) to ensure getting the follow-on business. They've projected the value of that business by treating future sales less direct costs as cash inflows. They maintain that the initial outlay is the direct cost to install the system, which is almost immediately paid back by the price. Future cash flows are then the net inflows from the follow-on sales. These calculations have led to an enormous NPV and IRR for the sale viewed as a project. Both support and criticize this approach. (Hint: what would happen if Creighton did most of its business this way?) ANSWER: The approach makes sense if the follow-on business is in total large relative to the initial sale. If not, the idea creates several problems. The fact that the installation is paid for immediately makes it seem as if the initial outlay for the project is zero, and the subsequent inflows are free. This results in an NPV that is just the present value of expected profits with no initial cost offset and an IRR that's virtually infinite. However, it masks the fact that the project's risk is related to the level of resource committed to the initial installation. Hence the risk may be out of proportion to the expected dollar return. For example, if the job is underbid by 10%, the loss on the installation could be impossible to make up through follow-on business. It's also important to compare the project with alternate uses of the labor and material to be spent on the installation. If they could be used on traditional sales with normal profit margins, the project isn't likely to look good regardless of its IRR. If the project takes up a large portion of the company's resources, incremental thinking may not be appropriate. This is because a firm made up of too much incrementally acceptable business may find itself without the income to support necessary overhead.

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Chapter 11

4. Webley Motors, a manufacturer of small gas engines, has been working on a new design for several years. It's now considering going into the market with the new product, and has projected future sales and cash flows. The marketing and finance departments are putting together a joint presentation for the board of directors that they hope will gain approval for the new venture. Part of the presentation is a capital budgeting analysis of the project that includes only estimated future costs and revenues. Dan Eyeshade, the head of investor relations, insists that calculations shown to the board include the money spent on research in the past several years. He says that to ignore or omit those costs would be deceiving the board about the true cost of the project, which would be both unethical and legally dangerous. Comment on Dan's position. If you disagree, prepare an argument that will convince him to change his mind, and suggest an alternative presentation that will satisfy you both. ANSWER: Dan is confusing decision making with honest and open reporting. Only future revenues and costs matter to the decision, because only the future can be changed by it. Past costs are "sunk", and cannot be changed by anything. In theory that means only future costs have to be shown to the decision makers. On the other hand, Dan is right that it would be less than honest and ethical to lead the board to believe that the future costs were the only ones that went into the project. The solution is fairly obvious. Present the decision in terms of the future cash flows but make a side point about the effort that's gone on to date, being sure to point out that those costs are gone regardless of the outcome of the project. 5. The Capricorn Company is launching a new venture in a field related to, but separate from, its present business. Management is proposing that financing for the new enterprise be supplied by a local bank that it has approached for a loan. Capricorn's finance department has done a capital budgeting analysis of the venture projecting reasonable cash flows and calculating an NPV and an IRR that both look very favorable . The bank's loan officer, however, isn't satisfied with the analysis. She insists on seeing a financial projection that made which calculates interest on cumulative cash flows, incorporates that interest as a cost of the project, and shows the buildup and decline of the debt necessary to accomplish the proposal. She essentially wants a business plan complete with projected financial statements. Reconcile the bank officer's position with capital budgeting theory. ANSWER: Capital budgeting considers financing costs through the time value calculations inherent in the techniques. Conceptually, capital budgeting draws money out of and pays it into a general pool of funds maintained by the company, but isn't explicit about the size of the pool at any point in time. It also charges interest at a conceptual weighted average rate, the cost of capital, rather than a particular rate tied to a specific source of funds. This is the correct approach when evaluating projects as part of the ongoing operation of a company. The bank on the other hand is concerned about getting its money back on a specific loan at a specific rate of interest. In this case, the loan is tied to a particular project, so the bank wants to make sure the project will generate the cash flows required to pay the loan off. It also needs to know when the money will be drawn and repaid so it can calculate the outstanding balance at any time. This helps the bank forecast its own funding requirements. Both approaches are correct from the perspectives of the respective decision making parties. 6. Wilson Petroleum is a local distributor of home heating oil. The firm also installs and services furnaces and heating systems in homes and small commercial buildings. The customer service department maintains sales and service records on current customers who number about 400. Detailed customer records are kept manually in file cabinets, and a small computer system holds all

Cash Flow Estimation

7

customer names and addresses for mailing and billing purposes. One full-time clerk maintains all the records and handles all billing and customer inquiries. Customers occasionally complain if delivery or service is late, but only one or two mild complaints are received each month. Delays are primarily a result of problems in the field rather than problems in assigning calls in the service department. A consultant has proposed a new computer system that will completely automate the customer service function. It will provide on-line billing and immediate access to all customer records. The cost of the proposed system is $50,000 initially plus about $7,000 a year for maintenance and support. It will still take a person to run it. The consultant says the new system will provide faster service and superior insight into the needs of the customer base, which will result in better customer relations and more sales in the long run. Discuss the pros and cons of the consultant's proposal. What further justification should management demand before buying? Could the consultant have made the proposal for reasons that aren't in Wilson's best interest? Could the consultant be well meaning yet biased? Explain. ANSWER: The new system can be viewed as a capital budgeting project in which the costs are well known, but the benefits are hard to predict or measure. Estimating the actual increased cash flows that will come from an improved administrative system is a difficult and very subjective matter. In this case it seems that the system is unlikely to be a worthwhile project, because it doesn't save any labor and the administrative problems it would fix are minor. Such situations are very subject to overestimation of benefits. Before accepting the consultant's idea, management should demand a detailed, well-supported estimate of the expected benefits. He or she will probably be unable to provide this. If the consultant also sells the proposed system, it's likely that a conflict of interest exists. He or she could be motivated by the money to be made on the sale rather than by improving Wilson's business. It's not at all unusual for technical salespeople to propose systems that do more than their customers need in order to generate big commissions. It's also possible that the consultant honestly believes that computers are the answer to virtually all problems. People in high technology businesses are often biased toward computer solutions even when doing things by hand is cheaper. PROBLEMS

New Venture Cash Flows – Depreciation: Example 11-1 (page 502) 1. 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. SOLUTION: The initial outlay is just the cost of the equipment. So C0 = ($60,000). The remaining cash flows are calculated as follows ($000). Year Cash flow before interest And depreciation Depreciation EBT Tax (@ 25%) EAT Add back Depreciation

1

2

3

4

5

6

$23 15 8 2 6 15

$23 15 8 2 6 15

$23 15 8 2 6 15

$23 15 8 2 6 15

$23

$23

23 6 17

23 6 17

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Chapter 11 Cash Flow 21 21 21 21 17 17 2. 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. SOLUTION: Years 0 Cost 90 Savings Depreciation EBT impact Tax EAT impact Add back deprec. Sale in year 5 Tax on sale Cash Flow (90)

1

2

3

4

5

40 30 10 3 7 30

40 30 10 3 7 30

40 30 10 3 7 30

40

40

40 12 28

40 12 28

28

20 ( 6) 42

37

37

37

Replacement Projects – Sale of an Old Asset: Example 11-3 (page 509) 3. 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. SOLUTION: Sale of old equip Book value Accounting profit Tax on profit Cash flow from sale

$75,000 35,000 $40,000 14,000

Cost of new equipment Less: cash from sale Initial outlay, C0

$75,000 14,000 $61,000 $150,000 (61,000) $ 89,000

Replacement Projects – Initial Outlay: Example 11-3 (page 509) 4. Tomatoes Inc. is planning a project that involves machinery purchases of $100,000. The new equipment will be depreciated over five years, straight line. It will replace old machinery that will be sold for an estimated $36,000 and has a book value of $22,000. The project will also require hiring and training ten new people at a cost of about $12,000 each. All of this must happen before the project is actually started. The firm’s marginal tax rate is 40%. Calculate, C0, the project’s initial cash outlay. SOLUTION: First notice that the hiring and training costs are tax deductible: Hiring and training cost $120,000 Tax saving at 40% $ 48,000 Net cash flow after tax $ 72,000

Cash Flow Estimation

Next calculate the proceeds of the sale of the old equipment: Sale of old equip $36,000 Book value 22,000 Accounting profit $14,000 Tax on profit 5,600 Cash flow from sale Then calculate the Initial Outlay: Cost of new equipment After tax cost of hiring and training Less: cash from sale Initial outlay, C0 5.

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$36,000 5,600 $30,400 $100,000 72,000 ( 30,400) $141,600

The Olson Company plans to replace an old machine with a new one costing $85,000. The old machine originally cost $55,000, and has six years of its expected 11-year life remaining. It has been depreciated straight line assuming zero salvage value, and has a current market value of $24,000. Olson’s effective tax rate is 36%. Calculate the initial outlay associated with selling the old machine and acquiring the new one.

SOLUTION: Purchase price – old machine Accumulated depreciation Book value

$55,000 25,000 30,000

Salvage value – old machine Book value Loss on sale Tax rate Tax savings

$24,000 30,000 (6,000) .36 $ 2,160

Purchase new machine Sell old machine Tax savings on sale of old machine Net after-tax outlay

($85,000) 24,000 2,160 $ 58,840

6. A four-year project has cash flows before taxes and depreciation of $12,000 per year. The project requires the purchase of a $50,000 asset that will be depreciated over five years, straight line. At the end of the fourth year the asset will be sold for $18,000. The firm's marginal tax rate is 35%. Calculate the cash flows associated with the project. (For convenience assume the gain on the sale of the asset is taxed at 35%.) SOLUTION: Disposal:

Sale Price $18,000 NBV of asset $10,000 Gain $ 8,000 Tax (2,800) Net from sale

$18,000 (2,800) $15,200

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Chapter 11

0 Asset ($50,000) Income Depreciation EBT Contribution Tax EAT Contribution Add Back Depreciation Annual CF Sale of Asset Net Cash Flow: NCF ($50,000) 7.

1

CASH FLOWS 2

3

4

$12,000 $10,000 $ 2,000 (700) $ 1,300 $10,000 $11,300

$12,000 $10,000 $ 2,000 (700) $ 1,300 $10,000 $11,300

$12,000 $10,000 $ 2,000 (700) $ 1,300 $10,000 $11,300

$12,000 $10,000 $ 2,000 (700) $ 1,300 $10,000 $11,300 $15,200

$11,300

$11,300

$11,300

$26,500

Voxland Industries purchased a computer for $10,000, which it will depreciate straight line over five years to a $1,000 salvage value. The computer will then be sold at that price. The company’s marginal tax rate is 40%. Calculate the cash flows associated with the computer from its purchase to its eventual sale including the years in between. (Hint: Depreciate the difference between the cost of the computer and the salvage value. At the end of the depreciation life there’s a net book value remaining equal to the salvage value.)

SOLUTION: CF0 CF1 CF2 CF3 CF4 CF5

(10,000) 720 720 720 720 1,720

(1800 depreciation x 40%)

(Depreciation tax savings + $1,000 sale price)

8. Resolve the previous problem assuming Voxland uses the 5-year Modified Accelerated Cost Recovery System (MACRS) with no salvage value to depreciate the computer. Continue to assume the machine is sold after five years for $1,000. (Hint: Apply the MACRS rules for computers in the chapter to the entire cost of the computer. Notice, however, that there will be a positive net book value after five years because MACRS takes five years of depreciation over six years due to the half-year convention.) SOLUTION: Cash flow in years 1-4 is just the tax saved by depreciation. Cash flow in year 5 is the tax saved by depreciation plus the proceeds from selling the machine less taxes on that sale. The taxable profit on the sale is $1,000 less the book value at that time. CF0 (10,000) CF1 800 (10,000 x 20% x 40%) CF2 1,280 (10,000 x 32% x 40%) CF3 768 (10,000 x 19.2% x 40%) CF4 460 (10,000 x 11.5% x 40%) CF5 1,292 (10,000 x 11.5% x 40%) + ($1,000 - [1,000– 580] x .4)

Cash Flow Estimation

9.

11

Shelton Pharmaceuticals Inc. is introducing a new drug for pain relief. Management expects to sell 3 million units in the first year at $8.50 each, and anticipates 10% growth in sales per year thereafter. Operating costs are estimated at 70% of revenues. Shelton invested $20 million in depreciable equipment to develop and produce this product. The equipment will be depreciated straight line over 15 years to a salvage value of $2.0 million. Shelton’s marginal tax rate is 40%. Calculate the project’s operating cash flows in its third year.

SOLUTION: ($000) Revenues Expenses Depreciation EBT Tax EAT Add Depreciation Cash Flow

$30,855.0 21,598.5 1,200.0 $ 8,056.5 3,222.6 $ 4,833.9 1,200.0 $ 6,033.9

3,000 x (1.1)2 x $8.50 Revenues x 70% ($20,000 – $2,000)/15

New Venture Cash Flows: Example 11-1 (page 498) 10. Harry and Flo Simone are planning to start a restaurant. Stoves, refrigerators, other kitchen equipment, and furniture are expected to cost $50,000 all of which will be depreciated straight line over five years. Construction and other costs of getting started will be $30,000. The Simones expect the following revenue stream. ($000) Year Sales

1 $60

2 $90

3 $140

4 $160

5 $180

6 $200

7 $200

Food costs are expected to be 35% of revenues while other variable expenses are forecast at 25% of revenues. Fixed overhead will be $40,000 per year. All operating expenses will be paid in cash, revenues will be collected immediately and inventory is negligible, so working capital need not be considered. Assume the combined state and federal tax rate is 25%. Do not assume a tax credit in loss years and ignore tax loss carry forwards. (Taxes are simply zero when EBT is a loss.) Develop a cash flow forecast for the Simones’ restaurant. SOLUTION: The initial outlay, C0, is simply the cost of the equipment, construction, and other getting started expenses. C0 = $50,000 + $30,000 = $80,000 The remaining cash flows are calculated as follows ($000). Year Sales Variable Costs @ 60% Overhead Depreciation EBT Tax (@ 25%) EAT Add back Depreciation Cash Flow

1 $60 36 40 10 ( 26) ( 26) 10 ( 16)

2 $90 54 40 10 ( 14) ( 14) 10 ( 4)

3 $140 84 40 10 6 2 4 10 14

4 $160 96 40 10 14 4 10 10 20

5 $180 108 40 10 22 6 16 10 26

6 $200 120 40 40 10 30 30

7 $200 120 40 40 10 30 _ 30

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Chapter 11

Terminal Values: Example 11.2 (page 504) 11. Oxbow Inc. is contemplating a new venture project and has done a detailed five year cash flow estimate with the following result ($000): C0 (257)

C1 (65)

C2 50

C3 90

C4 130

C5 170

The firm’s cost of capital is 12%. a. Use a financial calculator to compute the project’s NPV and IRR, and make the appropriate recommendation to management. (If you don’t have a financial calculator just calculate NPV.) b. Charles Dunn, Oxbow’s Marketing VP, has argued that it’s unreasonable to exclude cash flows past year five from the analysis. Calculate the project’s terminal value assuming year five’s cash flow goes on forever. Recalculate the project’s NPV and IRR under that Charles’ assumption. c. Charles further argues that the most appropriate assumption is that cash flows beyond the fifth year incorporate a three percent long run growth rate. Calculate the terminal value, NPV, and IRR implied by this assumption. d. Comment on the results implied by the use of aggressive terminal value assumptions. Solution: a. Using a financial calculator enter the following according to the instructions in the chapter: CFo (257) C01 (65) F01 1.0 C02 50 F02 1.0 C03 90 F03 1.0 C04 165 F04 1.0 C05 170 F05 1.0 Press NPV, enter I = 12% for the cost of capital, press enter, down arrow, and compute. The resulting NPV is ($32,036). Next punch IRR and then compute. The resulting IRR is 8.8%. The project should clearly be rejected as the NPV