Cash Flow Estimation n Relevant cash flows 11

Cash Flow Estimation n Relevant cash flows 11 -1

Proposed Project n Total depreciable cost n n Changes in working capital n n n Equipment: $180, 000 Shipping: $10, 000 Installation: $30, 000 Inventories will rise by $25, 000 Accounts payable will rise by $5, 000 Effect on operations n n New sales: 100, 000 units/year @ $2/unit Variable cost: 60% of sales 11 -2

Proposed Project n Life of the project n n n Economic life: 4 years Depreciation: Straight line method/reducing balance method. Salvage value: $25, 000 Tax rate: 40% WACC: 10% 11 -3

Determining project value n Estimate relevant cash flows n n n 0 Calculating annual operating cash flows. Identifying changes in working capital. Calculating terminal cash flows. 1 2 3 4 Initial Costs OCF 1 OCF 2 OCF 3 NCF 0 NCF 1 NCF 2 NCF 3 OCF 4 + Terminal CFs NCF 4 11 -4

Initial year net cash flow n Find Δ NOWC. n ⇧ in inventories of $25, 000 n Funded partly by an ⇧ in A/P of $5, 000 n n Δ NOWC = $25, 000 - $5, 000 = $20, 000 Combine Δ NOWC with initial costs. Equipment Installation Δ NOWC Net CF 0 -$180, 000 -40, 000 -20, 000 -$240, 000 11 -5

Determining annual depreciation expense 60 60 60 Year Rate x Basis Depr 1 0. 25 x $240 $ 2 0. 25 x 240 3 0. 25 x 240 4 0. 25 x 1. 00 240 60 $240 11 -6

Annual operating cash flows Revenues - Op. Costs (60%) - Deprn Expense Oper. Income (BT) - Tax (40%) Oper. Income (AT) + Deprn Expense Operating CF 1 2 3 4 200 200 -120 -60 -60 20 20 -8 -8 12 12 20 20 32 32 11 -7

Terminal net cash flow Recovery of NOWC Salvage value Tax on SV (40%) Terminal CF $20, 000 25, 000 -10, 000 $35, 000 Q. How is NOWC recovered? Q. Is there always a tax on SV? 11 -8

Should financing effects be included in cash flows? n n n No, dividends and interest expense should not be included in the analysis. Financing effects have already been taken into account by discounting cash flows at the WACC of 10%. Deducting interest expense and dividends would be “double counting” financing costs. 11 -9

Should a $50, 000 improvement cost from the previous year be included in the analysis? n n No, the building improvement cost is a sunk cost and should not be considered. This analysis should only include incremental investment. 11 -10

If the facility could be leased out for $25, 000 per year, would this affect the analysis? n n Yes, by accepting the project, the firm foregoes a possible annual cash flow of $25, 000, which is an opportunity cost to be charged to the project. The relevant cash flow is the annual aftertax opportunity cost. n A-T opportunity cost = $25, 000 (1 – T) = $25, 000(0. 6) = $15, 000 11 -11

Proposed project’s cash flow time line 0 1 2 -260 79. 7 91. 2 n 3 62. 4 Terminal CF → 4 54. 7 35. 0 89. 7 K= 10%. n n NPV = -$4. 03 million IRR = 9. 3% 11 -12

What is the project’s MIRR? 0 -260. 0 10% 1 2 3 79. 7 91. 2 62. 4 -260. 0 PV outflows $260 = $374. 8 (1 + MIRR)4 4 89. 7 68. 6 110. 4 106. 1 374. 8 TV inflows MIRR = 9. 6% < k = 10%, reject the project 11 -13

Evaluating the project: Payback period 0 1 2 3 4 -260 79. 7 91. 2 62. 4 89. 7 -89. 1 -26. 7 63. 0 Cumulative: -260 -180. 3 Payback = 3 + 26. 7 / 89. 7 = 3. 3 years. 11 -14