6 cash flow projection

Topic Cash flow projection Introduction to Financial Management course By Dr Nguyen Thu Hien Chapter Outline Project Cash Flows: A First Look Incremental Cash Flows Pro Forma Financial Statements and Project Cash Flows Alternative Definitions of Operating Cash Flow Some Special Cases of Cash Flow Analysis Clasical questions What should be the concern? Cash or Profit? What represents financial strength of project? Cash or Profit? How to know whether project is valuable? By looking at Project’s Cash flows – “relevant cash flows” Relevant Cash Flows The cash flows that should be included in a capital budgeting analysis are those that will only occur if the project is accepted These cash flows are called incremental cash flows The stand-alone principle: analyze each project as if it could exist independently or in isolation from the firm How to build relevant cash flows? Use this question: “Will this cash flow occur ONLY if we accept the project?” If the answer is “yes”, it should be included in the project’s CFs because it is incremental If the answer is “no”, it should not be included in the project’s CFs because it will occur anyway If the answer is “part of it”, then should include only the part that occurs if project is accepted Common Types of Cash Flows Sunk costs: costs that have accrued in the past before the project analysis and unrecovered unrelevant cash flow Opportunity costs: costs of lost options when an asset of firm is used for the project as if it was “free” relevant cash flow Side effects: indirect effects on other projects relevant cash flow Positive side effects: benefits to other projects Negative side effects: costs to other projects Common Types of Cash Flows (cond.) Changes in net working capital: Increase (decrease) in Cash, AR, Inventory, AP relevant cash flow Financing costs: cost of capitals already included in discount rate should not be double counted in CFs unrelevant cash flow Corporate Income Taxes relevant cash flow Depreciation: Non-cash expense unrelevant cash flow Example of Incremental cash flow Parker & Stone, Inc., is looking at setting up a new manufacturing plant in South Park to produce garden tools The company bought some land six years ago for $5 million in anticipation of using it as a warehouse and distribution site, but the company has since decided to rent these facilities from a competitor instead If the land were sold today, the company would get a net value of $5.4 million The company wants to build its new manufacturing plant on this land; the plant will cost $10.4 million to build, and the site requires $650,000 worth of upgrading before it is suitable for construction What is the proper cash flow amount to use as the initial investment in fixed assets when evaluating this project? Why? Example of Incremental cash flow Winnebagel Corp currently sells 30,000 motor homes (MH) per year at $45,000 each, and 12,000 luxury motor coaches (LMC) per year at $85,000 each The company wants to introduce a new portable camper (PC) to fill out its product line; it hopes to sel 21,000 of these campers per year at $12,000 each An independent consultant has determined that if Winnebagel introduces the new PC, it should boost the sales of its existing MH by 5,000 units per year, and reduce the sales of its LMC by 1,300 units per year What is the amount to use as the annual sales figure when evaluating this project? Why? 3-stage cash flow projection Stage 1: Investment CF0 = - Fixed Assets investments – Net working capital investments Stage 2: Operating CF1= CF2 =… =CFn = Net Income + Depreciation Stage 3: Salvage CFn+1 = After-tax Salvage value of Fixed Assets + Net working capital investments Example: Depreciation and After-tax Salvage You purchase equipment for $100,000 and it costs $10,000 to have it delivered and installed Based on past information, you believe that you can sell the equipment for $17,000 when you are done with it in years The company’s marginal tax rate is 40% What is the depreciation expense each year and the after-tax salvage in year for each of the following situations? 20 Example: Straight-line Depreciation Suppose the appropriate depreciation schedule is straight-line to the salvage value D = (110,000 – 17,000) / = 15,500 every year for years BV in year = 110,000 – 6(15,500) = 17,000 After-tax salvage = 17,000 - 4(17,000 – 17,000) = 17,000 21 Example: Three-year MACRS Year MACRS percent D 3333 3333(110,000) = 36,663 4444 4444(110,000) = 48,884 1482 1482(110,000) = 16,302 0741 0741(110,000) = 8,151 BV in year = 110,000 – 36,663 – 48,884 – 16,302 – 8,151 = After-tax salvage = 17,000 4(17,000 – 0) = $10,200 22 Example: 7-Year MACRS Year MACRS Percent D 1429 1429(110,000) = 15,719 2449 2449(110,000) = 26,939 1749 1749(110,000) = 19,239 1249 1249(110,000) = 13,739 0893 0893(110,000) = 9,823 0893 0893(110,000) = 9,823 0893 0893(110,000) = 9,823 0445 0445(110,000) = 4,895 BV in year = 110,000 – 15,719 – 26,939 – 19,239 – 13,739 – 9,823 – 9,823 = 14,718 After-tax salvage = 17,000 4(17,000 – 14,718) = 16,087.20 23 Example: Cost Cutting Project Your company is considering a new computer system that will initially cost $1 million It will save $300,000 a year in inventory and receivables management costs The system is expected to last for five years and will be depreciated using 3-year MACRS The system is expected to have a salvage value of $50,000 at the end of year There is no impact on net working capital The marginal tax rate is 40% The required return is 8% Click on the Excel icon to work through the example 24 Example: Cost Cutting Project (cond.) Initial Cost 1,000,000 Savings 300,000 Tax Rate 40% Expected Salvage 50,000 Discount Rate 8% MACRS Depreciation Schedule Year Percentage Depreciation Expense 33.33% 333,300 44.44% 444,400 14.82% 148,200 7.41% 74,100 Year Operating Cash Flow Net Capital Spending Changes in NWC Cash Flow from Assets 313,320 357,760 239,280 209,640 -1,000,000 -1,000,000 313,320 357,760 239,280 209,640 Book Value yr 5 180,000 30,000 210,000 Net Present Value $83,794.96 Internal Rate of Return 11.45% 25 Example: Replacement Project Original Machine Initial cost = 100,000 Annual depreciation = 9000 Purchased years ago Book Value = 55,000 Salvage today = 65,000 Salvage in years = 10,000 New Machine Initial cost = 150,000 5-year life Salvage in years = Cost savings = 50,000 per year 3-year MACRS depreciation Required return = 10% Tax rate = 40% No change to NWC and sales from replacement of machines 26 Replacement Project – Computing Cash Flows Remember that we are interested in incremental cash flows If we buy the new machine, then we will sell the old machine What are the cash flow consequences of selling the old machine today instead of in years? 27 Replacement Project – Pro Forma Income Statements Year Cost Savings 50,000 50,000 50,000 50,000 50,000 New 49,500 67,500 22,500 10,500 Old 9,000 9,000 9,000 9,000 9,000 40,500 58,500 13,500 1,500 (9,000) EBIT 9,500 (8,500) 36,500 48,500 59,000 Taxes 3,800 (3,400) 14,600 19,400 23,600 NI 5,700 (5,100) 21,900 29,100 35,400 Depr Increm 28 Replacement Project – Incremental Net Capital Spending Year Cost of new machine = 150,000 (outflow) After-tax salvage on old machine = 65,000 4(65,000 – 55,000) = 61,000 (inflow) Incremental net capital spending = 150,000 – 61,000 = 89,000 (outflow) Year After-tax salvage on old machine = 10,000 4(10,000 – 10,000) = 10,000 (outflow because we no longer receive this) 29 Replacement Project – Cash Flow From Assets Year 46,200 53,400 OCF 35,400 30,600 26,400 ∆ in FA -89,000 -10,000 ∆ in NWC 0 CFAT -89,000 46,200 53,400 35,400 30,600 16,400 30 Replacement Project – Analyzing the Cash Flows Now that we have the cash flows, we can compute the NPV and IRR Enter the cash flows Compute NPV = 54,812.10 Compute IRR = 36.28% Should the company replace the equipment? 31 Example: Equivalent Annual Cost Analysis Burnout Batteries Initial Cost = $36 each 3-year life $100 per year to keep charged Expected salvage = $5 Straight-line depreciation to salvage value Long-lasting Batteries Initial Cost = $60 each 5-year life $88 per year to keep charged Expected salvage = $5 Straight-line depreciation to salvage value The machine chosen will be replaced indefinitely and neither machine will have a differential impact on revenue No change in NWC is required The required return is 15% and the tax rate is 34% 32 Burnout Batteries Year OCF -62.49 -62.49 -62.49 NCS -36.00 5.00 NWC 0.00 0.00 CFFA NPV -36.00 -62.49 -$175.38 -62.49 EAC -57.49 -$76.81 Long-lasting Batteries Year OCF -54.34 -54.34 -54.34 -54.34 -54.34 NCS -60.00 5.00 NWC 0.00 0.00 CFFA NPV -60.00 -54.34 -54.34 -$239.67 EAC -54.34 -$71.50 -54.34 -49.34 33 Basics of Chapter How we determine if cash flows are relevant to the capital budgeting decision? What are the different methods for computing operating cash flow and when are they important? How to build cash flow of replacement project? What is equivalent annual cost and when should it be used? 34 ... Project Cash Flows: A First Look Incremental Cash Flows Pro Forma Financial Statements and Project Cash Flows Alternative Definitions of Operating Cash Flow Some Special Cases of Cash Flow Analysis... double counted in CFs unrelevant cash flow Corporate Income Taxes relevant cash flow Depreciation: Non -cash expense unrelevant cash flow Example of Incremental cash flow Parker & Stone, Inc., is... 30 ,60 0 16, 400 30 Replacement Project – Analyzing the Cash Flows Now that we have the cash flows, we can compute the NPV and IRR Enter the cash flows Compute NPV = 54,812.10 Compute IRR = 36. 28%