Cash flow estimation ppt @ bec doms on finance


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Cash flow estimation ppt @ bec doms on finance

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  • Cash flow estimation ppt @ bec doms on finance

    1. 1. Cash Flow Estimation
    2. 2. Capital Budgeting Processes <ul><li>Capital budgeting process consists of: </li></ul><ul><ul><li>Estimating the cash flows associated with projects </li></ul></ul><ul><ul><li>Evaluating the estimates using NPV and IRR </li></ul></ul><ul><li>Forecasting cash flows is often taken for granted </li></ul><ul><ul><li>Estimating project cash flows is the most difficult and error-prone part of capital budgeting </li></ul></ul>2
    3. 3. The General Approach to Cash Flow Estimation <ul><li>Cash flow estimates are done in spreadsheet format by enumerating issues that impact cash and forecasting each over time </li></ul><ul><ul><li>A sales forecast leads to an estimate of cash inflows from customers </li></ul></ul><ul><ul><li>A cost/expense projection leads to a pattern of outflows to employees and vendors </li></ul></ul><ul><ul><li>An equipment plan leads to a series of outflows for capital assets </li></ul></ul>3
    4. 4. The General Approach to Cash Flow Estimation <ul><li>General outline for estimating new venture cash flows </li></ul><ul><ul><li>Pre-Start-Up, the Initial Outlay—spent before the project starts </li></ul></ul><ul><ul><li>Sales forecast, units and revenues </li></ul></ul><ul><ul><li>Cost of sales and expenses </li></ul></ul><ul><ul><li>Assets—new assets to be acquired, including working capital </li></ul></ul><ul><ul><li>Depreciation </li></ul></ul><ul><ul><li>Taxes and Earnings </li></ul></ul><ul><ul><li>Summarize and combine—adjust earnings for depreciation and combine it with the balance sheet items to arrive at a cash flow estimate </li></ul></ul>4
    5. 5. The General Approach to Cash Flow Estimation <ul><li>Expansion Projects </li></ul><ul><li>Require the same elements as new ventures </li></ul><ul><li>Usually need less new equipment and facilities </li></ul><ul><li>Replacement Projects </li></ul><ul><li>Generally saves on cost without generating new revenue </li></ul><ul><li>Estimating process may be less elaborate </li></ul>5
    6. 6. A Few Specific Issues <ul><li>Regardless of the project, the basic process is the same </li></ul><ul><ul><li>The Typical Pattern </li></ul></ul><ul><ul><ul><li>Requires an initial outlay </li></ul></ul></ul><ul><ul><ul><li>Subsequent cash flows tend to be positive </li></ul></ul></ul><ul><ul><li>Project Cash Flows Are Incremental </li></ul></ul><ul><ul><ul><li>Separable from the existing business </li></ul></ul></ul>6
    7. 7. A Few Specific Issues <ul><li>Sunk Costs </li></ul><ul><ul><li>Have already been spent and are ignored </li></ul></ul><ul><li>Opportunity Costs </li></ul><ul><ul><li>The value of a resource in its best alternative use </li></ul></ul><ul><ul><li>The cost of a resource is whatever is given up to use it </li></ul></ul><ul><ul><li>Example: A firm needing a new warehouse could: </li></ul></ul><ul><ul><ul><ul><li>Lease warehouse space </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Buy a warehouse </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Build warehouse on land it already owns which might be sold for $1,000,000 </li></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>the opportunity cost of the land is $1,000,000 </li></ul></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>It isn’t free even though there was no immediate need for it </li></ul></ul></ul></ul></ul>7
    8. 8. A Few Specific Issues <ul><li>Impacts on Other Parts of Company </li></ul><ul><li>Sales erosion: a new product may take some revenue from older lines </li></ul><ul><li>Raw materials may be cheaper when purchased in larger volumes </li></ul><ul><li>Taxes </li></ul><ul><li>Projects that improve profitability also result in paying more tax - a current cash outflow </li></ul><ul><li>Show cash flows in every period net of taxes </li></ul>8
    9. 9. A Few Specific Issues <ul><li>Cash Versus Accounting Results </li></ul><ul><li>Capital budgeting deals only with cash flows, but </li></ul><ul><li>Business managers always want an estimate of a project’s impact on net income </li></ul><ul><li>Working Capital </li></ul><ul><li>Projects generally require additional working capital , which requires cash </li></ul><ul><li>Increasing net working capital means a cash outflow </li></ul><ul><li>Cash flow is the change in working capital </li></ul>9
    10. 10. A Few Specific Issues <ul><li>Ignore Financing Costs </li></ul><ul><ul><li>Ignore interest expense when estimating incremental cash flows </li></ul></ul><ul><ul><li>NPV and IRR comprehend project financing costs </li></ul></ul><ul><ul><ul><li>do not include the interest as a cash outflow </li></ul></ul></ul><ul><ul><ul><ul><li>Unlike financial planning (chapter 4) </li></ul></ul></ul></ul><ul><li>Old Equipment </li></ul><ul><ul><li>Selling used equipment generates a cash inflow </li></ul></ul><ul><ul><li>Recognize tax on any accounting profit realized on the sale as a cash outflow </li></ul></ul>10
    11. 11. Estimating New Venture Cash Flows <ul><li>New venture projects tend to be larger and more elaborate than expansions or replacements </li></ul><ul><ul><li>Incremental cash flows can be easier to isolate since the whole project is viewed as distinct and separate from the rest of the company </li></ul></ul>11
    12. 12. Terminal Values <ul><li>Cash flows forecast to continue forever are compressed into finite terminal values using perpetuity formulas </li></ul><ul><ul><li>Most common with new ventures </li></ul></ul><ul><ul><li>A repetitive cash flow starting in year 7 is valued as a perpetuity </li></ul></ul><ul><ul><li>In Wilmont’s case if k = 10% </li></ul></ul><ul><ul><li>$140,000 / .10 = $1,400,000 </li></ul></ul><ul><ul><li>(Note that TVs can overwhelm other figures in the cash flow estimate) </li></ul></ul>12
    13. 13. Accuracy and Estimates <ul><li>NPV and IRR techniques give the impression of great accuracy </li></ul><ul><li>Capital budgeting results are no more accurate than the projections of the future used as inputs </li></ul><ul><li>Unintentional biases are a problem in capital budgeting </li></ul><ul><ul><li>Favorable biases - projects are usually proposed by people who want them approved </li></ul></ul><ul><ul><li>Who tend to overestimate benefits and underestimate costs </li></ul></ul>13
    14. 14. MACRS—A Note on Depreciation <ul><li>U.S. government allows accelerated depreciation for income tax purposes </li></ul><ul><ul><li>Depreciation is shifted so more is taken earlier in the project’s life, while total depreciation remains the same </li></ul></ul><ul><ul><ul><li>It is advantageous to take larger tax deductions earlier because of the time value of money </li></ul></ul></ul><ul><ul><ul><ul><li>Present value of tax savings is greater </li></ul></ul></ul></ul><ul><li>Companies generally don’t use accelerated methods for earnings reported to the public </li></ul><ul><ul><li>Reported earnings are lower in the near term if accelerated depreciation is used </li></ul></ul>14
    15. 15. Modified Accelerated Cost Recovery System <ul><li>The tax code dictates exactly how accelerated depreciation is to be done </li></ul><ul><li>MACRS classifies assets into different categories and specifies a depreciation life for each </li></ul><ul><ul><li>A table shows the percentage of the asset’s cost that can be taken in depreciation during each year of life </li></ul></ul><ul><ul><li>Applies only to equipment </li></ul></ul><ul><ul><ul><li>Buildings are depreciated using straight-line over 27.5 years (residential) and 39 years (otherwise) </li></ul></ul></ul><ul><ul><ul><li>Land isn’t depreciated </li></ul></ul></ul>15
    16. 16. Modified Accelerated Cost Recovery System 16
    17. 17. Estimating Cash Flows for Replacement Projects <ul><li>Fewer elements than new ventures </li></ul><ul><li>Identifying what is incremental can be tricky </li></ul><ul><li>Difficult to determine what will happen if you don’t do the project </li></ul><ul><ul><li>If replacing an old production machine, do you: </li></ul></ul><ul><ul><ul><li>compare the performance of the new machine to the current performance of the old, or </li></ul></ul></ul><ul><ul><ul><li>compare it to flows the current machine are expected to generate if it continues to deteriorate </li></ul></ul></ul>17
    18. 18. Estimating Cash Flows for Replacement Projects Example 11.2 18 Q: Harrington Metals Inc. purchased a large stamping machine five years ago for $80,000. To keep the example simple we’ll assume that the tax laws at the time permitted straight-line depreciation over eight years and that machinery purchased today can be depreciated straight line over five years. The machine has not performed well, and management is considering replacing it with a new one that will cost $150,000. If the new machine is purchased, it is estimated that the old one can be sold for $45,000. The quoted costs include all freight, installation and setup. The old machine requires three operators, each of whom earns $25,000 a year including all benefits and payroll costs. The new machine is more efficiently designed and will require only two operators, each earning the same amount. Example
    19. 19. Estimating Cash Flows for Replacement Projects Example 11.2 19 Q: The old machine has the following history of high maintenance cost and significant downtime. Downtime on the machine is a major inconvenience, but it doesn’t usually stop production unless it lasts for an extended period. This is because the company maintains an emergency inventory of stamped pieces and has been able to temporarily reroute production without much notice. Manufacturing managers estimate that every hour of downtime costs the company $500, but have no hard data backing up that figure. Example $45 $42 $35 $10 In warranty Maintenance expense ($000) 128 130 100 60 40 Hours down 5 4 3 2` 1 Year
    20. 20. Estimating Cash Flows for Replacement Projects Example 11.2 20 Q: The makers of the replacement machines have said that Harrington will spend about $15,000 a year maintaining their product and that an average of only 30 hours of downtime a year should be expected. However, they are not willing to guarantee those estimates after the one-year warranty runs out. The new machine is expected to produce higher quality output than the old one. The result is expected to be better customer satisfaction and possibly more sales in the future. Management would like to include some benefit for this effect in the analysis, but is unsure of how to quantify it. Estimate the incremental cash flows over the next five years associated with buying the new machine. Assume Harrington’s marginal tax rate is 34%, and that the company is currently profitable so that changes in taxable income result in tax changes at 34% whether positive or negative. Assume any gain on the sale of the old machine is also taxed at 34% since corporations don’t receive favorable tax treatment on capital gains. Example
    21. 21. Estimating Cash Flows for Replacement Projects Example 11.2 21 A: There are two kinds of cash flows in this problem—those that can be estimated fairly objectively and those that require some degree of subjective guesswork. Objective Cash Flows: The initial outlay is relatively straightforward: Example $110.1 Initial outlay 39.9 Less proceeds from sale of old machine $150.0 Cost of new machine The old machine has a current market value of $45,000 and a book value of $30,000 (initial cost of $80,000 les depreciation of $50,000). Thus, a gain on the sale of the old machine of $15,000 results in additional taxes of $5.1. The net cash proceeds on the sale of the old machine are $39.9 (or $45.0 – $5.1).
    22. 22. Estimating Cash Flows for Replacement Projects Example 11.2 22 A: Depreciation and labor savings are straightforward as well: Example $25.0 $25.0 $25.0 $25.0 $25.0 Labor savings $10.2 $10.2 $6.8 $6.8 $6.8 Cash tax savings @ 34% $30.0 $30.0 $20.0 $20.0 $20.0 Net increase in depreciation 10.0 10.0 10.0 Old depreciation $30.0 $30.0 $30.0 $30.0 $30.0 New depreciation 5 4 3 2 1 Year Represent the cost savings from needing only two employees rather than three.
    23. 23. Estimating Cash Flows for Replacement Projects Example 11.2 23 A: The subjective benefits (which are based on opinions) are hard to quantify and lead to biases when estimated by people who want project approval. The financial analyst should ensure that only reasonable estimates of unprovable benefits are used. Example $30.0 $30.0 $30.0 $30.0 $45.0 Savings 15.0 15.0 15.0 15.0 In warranty New machine maintenance $45.0 $45.0 $45.0 $45.0 $45.0 Old machine maintenance 5 4 3 2 1 Year The question is: Should we assume maintenance on the old machine would have remained at $45.0 or increase as the machine gets older? Also, will maintenance on the new machine rise as the new machine ages?
    24. 24. Estimating Cash Flows for Replacement Projects Example 11.2 24 A: Another subjective estimate is that of downtime. The old machine has been having about 130 hours of downtime while the new one promises 30 hours—a savings of 100 hours. But, argument could be made for using different assumptions for downtime hours. Another question is: How much is each hour of downtime savings worth? Arguments range from no savings (as we are unable to say exactly how much it’s worth) to $500 an hour. Most people favor a middle-of-the-road approach—we’ll use $200 an hour, which yields an estimated cash flow savings of $20,000 per year. Example $49.5 $49.5 $49.5 $49.5 $59.4 Net after tax $75.0 $75.0 $75.0 $75.0 $90.0 Total $20.0 $20.0 $20.0 $20.0 $20.0 Downtime savings $30.0 $30.0 $30.0 $30.0 $45.0 Maintenance savings $25.0 $25.0 $25.0 $25.0 $25.0 Labor savings $59.7 $59.7 $56.3 $56.3 $66.2 Cash flow 10.2 10.2 6.8 6.8 6.8 Tax savings on depreciation 25.5 25.5 25.5 25.5 30.6 Tax 5 4 3 2 1 Year