1.
<ul><li>Relevant cash flows </li></ul><ul><li>Working capital treatment </li></ul><ul><li>Unequal project lives </li></ul><ul><li>Abandonment value </li></ul><ul><li>Inflation </li></ul>CHAPTER 12 Project Cash Flow Analysis
2.
<ul><li>Cost: $200,000 + $10,000 shipping + $30,000 installation. </li></ul><ul><li>Depreciable cost $240,000. </li></ul><ul><li>Inventories will rise by $25,000 and payables will rise by $5,000. </li></ul><ul><li>Economic life = 4 years. </li></ul><ul><li>Salvage value = $25,000. </li></ul><ul><li>MACRS 3-year class. </li></ul>Proposed Project
4.
0 1 2 3 4 Initial Outlay OCF 1 OCF 2 OCF 3 OCF 4 + Terminal CF NCF 0 NCF 1 NCF 2 NCF 3 NCF 4 Set up without numbers a time line for the project CFs.
6.
<ul><li>NO. The costs of capital are already incorporated in the analysis since we use them in discounting. </li></ul><ul><li>If we included them as cash flows, we would be double counting capital costs. </li></ul>Should CFs include interest expense? Dividends?
7.
<ul><li>NO. This is a sunk cost . Focus on incremental investment and operating cash flows. </li></ul>Suppose $100,000 had been spent last year to improve the production line site. Should this cost be included in the analysis?
8.
<ul><li>Yes. Accepting the project means we will not receive the $25,000. This is an opportunity cost and it should be charged to the project. </li></ul><ul><li>A.T. opportunity cost = $25,000 (1 - T) = $15,000 annual cost. </li></ul>Suppose the plant space could be leased out for $25,000 a year. Would this affect the analysis?
9.
<ul><li>Yes. The effects on the other projects’ CFs are “externalities” . </li></ul><ul><li>Net CF loss per year on other lines would be a cost to this project. </li></ul><ul><li>Externalities will be positive if new projects are complements to existing assets, negative if substitutes. </li></ul>If the new product line would decrease sales of the firm’s other products by $50,000 per year, would this affect the analysis?
10.
Net Investment Outlay at t = 0 (000s) Equipment Freight + Inst. Change in NWC Net CF 0 ($200) (40) (20) ($260) NWC = $25,000 - $5,000 = $20,000.
13.
Net revenue Depreciation Before-tax income Taxes (40%) Net income Depreciation Net operating CF $125 (79 ) $ 46 (18 ) $ 28 79 $107 Year 1 Year 1 Operating Cash Flows (000s)
14.
Net revenue Depreciation Before-tax income Taxes (40%) Net income Depreciation Net operating CF $125 (79 ) $ 46 (18 ) $ 28 79 $107 $125 (17 ) $108 (43 ) $ 65 17 $ 82 Year 4 Year 1 Year 4 Operating Cash Flows (000s)
15.
Net Terminal Cash Flow at t = 4 (000s) Salvage value Tax on SV Recovery on NWC Net terminal CF $25 (10) 20 $35
16.
What if you terminate a project before the asset is fully depreciated? Cash flow from sale = Sale proceeds - taxes paid. Taxes are based on difference between sales price and tax basis, where: Basis = Original basis - Accum. deprec.
17.
<ul><li>Original basis = $240. </li></ul><ul><li>After 3 years = $17 remaining. </li></ul><ul><li>Sales price = $25. </li></ul><ul><li>Tax on sale = 0.4($25-$17) = $3.2. </li></ul><ul><li>Cash flow = $25-$3.2=$21.7. </li></ul>Example: If Sold After 3 Years (000s)
18.
Project Net CFs on a Time Line Enter CFs in CFLO register and I = 10. NPV = $81,573. IRR = 23.8%. *In thousands. 0 1 2 3 4 (260)* 107 118 89 117
19.
What is the project’s MIRR? (000s) ( 260 ) MIRR = ? 0 1 2 3 4 (260)* 107 118 89 117.0 97.9 142.8 142.4 500.1
20.
1. Enter positive CFs in CFLO: I = 10; Solve for NPV = $341.60. 2. Use TVM keys: PV = 341.60, N = 4 I = 10; PMT = 0; Solve for FV = 500.10. (TV of inflows) 3. Use TVM keys: N = 4; FV = 500.10; PV = -260; PMT= 0; Solve for I = 17.8. MIRR = 17.8%. Calculator Solution
21.
What is the project’s payback? (000s) Cumulative: Payback = 2 + 35/89 = 2.4 years. 0 1 2 3 4 (260)* (260) 107 (153) 118 (35) 89 54 117 171
22.
If this were a replacement rather than a new project, would the analysis change? Yes. The old equipment would be sold and the incremental CFs would be the changes from the old to the new situation.
23.
<ul><li>Revenues. </li></ul><ul><li>Costs. </li></ul><ul><li>The relevant depreciation would be the change with the new equipment. </li></ul><ul><li>Also, if the firm sold the old machine now, it would not receive the salvage value at the end of the machine’s life. </li></ul>
24.
<ul><li>Coordination with other departments </li></ul><ul><li>Maintaining consistency of assumptions </li></ul><ul><li>Elimination of biases in the forecasts </li></ul>What is the role of the financial staff in the cash flow estimation process?
25.
<ul><li>CF’s are estimated for many future periods. </li></ul><ul><li>If company has many projects and errors are random and unbiased, errors will cancel out (aggregate NPV estimate will be OK). </li></ul><ul><li>Studies show that forecasts often are biased (overly optimistic revenues, underestimated costs). </li></ul>What is cash flow estimation bias?
26.
<ul><li>Routinely compare CF estimates with those actually realized and reward managers who are forecasting well, penalize those who are not. </li></ul><ul><li>When evidence of bias exists, the project’s CF estimates should be lowered or the cost of capital raised to offset the bias. </li></ul>What steps can management take to eliminate the incentives for cash flow estimation bias?
27.
<ul><li>Investment in a project may lead to other valuable opportunities. </li></ul><ul><li>Investment now may extinguish opportunity to undertake same project in the future. </li></ul><ul><li>True project NPV = NPV + value of options. </li></ul>What is option value?
28.
<ul><li>No. Net revenues are assumed to be constant over the 4-year project life, so inflation effects have not been incorporated into the cash flows. </li></ul>If 5% inflation is expected over the next 5 years, are the firm’s cash flow estimates accurate?
29.
<ul><li>In DCF analysis, k includes an estimate of inflation. </li></ul><ul><li>If cash flow estimates are not adjusted for inflation (i.e., are in today’s dollars), this will bias the NPV downward. </li></ul><ul><li>This bias may offset the optimistic bias of management. </li></ul>Real vs. Nominal Cash flows
30.
S and L are mutually exclusive and will be repeated. k = 10%. Which is better? (000s) 0 1 2 3 4 Project S: (100) Project L: (100) 60 33.5 60 33.5 33.5 33.5
31.
S L CF 0 -100,000 -100,000 CF 1 60,000 33,500 N j 2 4 I 10 10 NPV 4,132 6,190 NPV L > NPV S . But is L better? Can’t say yet. Need to perform common life analysis.
32.
<ul><li>Note that Project S could be repeated after 2 years to generate additional profits. </li></ul><ul><li>Can use either replacement chain or equivalent annual annuity analysis to make decision. </li></ul>
34.
Compare to Project L NPV = $6,190. Or, use NPVs: 0 1 2 3 4 4,132 3,415 7,547 4,132 10%
35.
Equivalent Annual Annuity (EAA) Approach <ul><li>Finds the constant annuity payment whose PV is equal to the project’s raw NPV over its original life. </li></ul>
36.
EAA Calculator Solution <ul><li>Project S </li></ul><ul><ul><li>PV = Raw NPV = $4,132. </li></ul></ul><ul><ul><li>n = Original project life = 2. </li></ul></ul><ul><ul><li>k = 10%. </li></ul></ul><ul><ul><li>Solve for PMT = EAA S = $2,381. </li></ul></ul><ul><li>Project L </li></ul><ul><ul><li>PV = $6,190; n = 4; k = 10%. </li></ul></ul><ul><ul><li>Solve for PMT = EAA L = $1,953. </li></ul></ul>
37.
<ul><li>The project, in effect, provides an annuity of EAA . </li></ul><ul><li>EAA S > EAA L so pick S. </li></ul><ul><li>Replacement chains and EAA always lead to the same decision if cash flows are expected to stay the same. </li></ul>
38.
If the cost to repeat S in two years rises to $105,000, which is best? (000s) NPV S = $3,415 < NPV L = $6,190. Now choose L. 0 1 2 3 4 Project S: (100) 60 60 ( 105 ) (45 ) 60 60
39.
Types of Abandonment <ul><li>Sale to another party who can obtain greater cash flows, e.g., IBM sold typewriter division. </li></ul><ul><li>Abandon because losing money, e.g., smokeless cigarette. </li></ul>
40.
Year 0 1 2 3 CF ($5,000) 2,100 2,000 1,750 Abandonment Value $5,000 3,100 2,000 0 Consider another project with a 3-year life. If abandoned prior to Year 3, the machinery will have positive abandonment value.
41.
1.75 1. No abandonment 2. Abandon 2 years 3. Abandon 1 year (5) (5) (5) 2.1 2.1 5.2 2 4 0 1 2 3 CFs Under Each Alternative (000s)
42.
NPV (no) = -$123. NPV (2) = $215. NPV (1) = -$273. Assuming a 10% cost of capital, what is the project’s optimal life?
43.
<ul><li>The project is acceptable only if operated for 2 years . </li></ul><ul><li>A project’s engineering life does not always equal its economic life. </li></ul><ul><li>The ability to abandon a project may make an otherwise unattractive project acceptable. </li></ul><ul><li>Abandonment possibilities will be very important when we get to risk. </li></ul>Conclusions
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