Analyzing Project Cash Flows
Chapter 12
1
Principles Applied in This Chapter
Principle 3: Cash Flows Are the Source of Value.
Principle 5: Individuals Respond to Incentives.
2
Learning Objectives
1. Identify incremental cash flows that are relevant to
project valuation.
2. Calculate and forecast project cash flows for expansion-
type investments.
3. Evaluate the effect of inflation on project cash flows.
4. Calculate the incremental cash flows for replacement-
type investments.
3
Project Cash Flows
Project cash flows for a capital investment typically fall into
one of three categories of cash flows:
• The cash flows associated with the launching of the
investment
• The operating period cash flows
• The terminal cash flows
4
Project Cash Flows
5
Identifying Incremental Cash Flows
Incremental cash flow refers to the additional cash
flow a firm receives by taking on a new project.
6
Guidelines for Forecasting Incremental
Cash Flows
Sunk Costs (such as market research) and overhead
costs (such as utilities expenses) are not incremental
cash flows.
Account for positive and negative synergistic effects
and opportunity costs.
7
Guidelines for Forecasting Incremental
Cash Flows
Work in Working Capital Requirement
Need for additional working capital arises as cash inflows and
outflows are often mismatched.
Ignore Financing Costs
They are accounted for in the discount rate used to discount
cash flows.
8
Forecasting Project Cash Flows
Pro forma financial statements are forecasts of
future financial statements.
We can calculate free cash flow using the following
equation:
9
Forecasting Project Cash Flows
Four Step Procedure for calculating cash flows
1. Depreciation expense
2. Change in working capital required
3. Change in capital expenditures
4. Calculate Free Cash Flows for project
10
Depreciation Expense, Taxes and Cash Flow
Depreciation expenses is subtracted while calculating the
firm’s taxable income.
However, depreciation is a not a cash expense.
Therefore, depreciation must be added back into net
operating income when calculating cash flows.
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Depreciation Expense, Taxes and Cash Flow
Annual Depreciation expense (using straight line method)
= (Cost of equipment
+ Shipping & Installation Expense
– Expected salvage value) ÷ (Life of the equipment)
12
Depreciation Expense, Taxes and Cash Flow
Example Consider a firm that purchased an equipment for
$500,000 and incurred an additional $50,000 for shipping
and installation.
The equipment is expected to last 10 years and have a
salvage value of $25,000?
What is the annual depreciation expense?
13
Depreciation Expense, Taxes and Cash
Flow
Annual Depreciation expense
= (Cost of equipment + Shipping & Installation Expense –
Expected salvage value) ÷ (Life of the equipment)
= ($500,000 + $50,000 - $25,000) ÷ (10)
= $52,500
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Working Capital
Step 2: Calculating a Project’s Working Capital
Requirements
When sales increase, firm’s account receivable balance will
tend to grow.
In addition, new projects may lead to an increase in the
firm’s investment in inventories.
Both lead to cash outflow.
15
Working Capital
If the firm is able to finance some or all of its inventories
using trade credits, this will offset the cash outflow. Thus
the net increase is given by:
16
Working Capital
Increase working capital is a cash outflow
Will working capital requirements drop when the project
ends?
If “Yes,” we have a cash inflow at the end of the project
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Capital Expenditures
Step 3: Calculating a Project’s Capital Expenditure
Requirement
When the project is over, we add the salvage value of asset to
the final year’s free cash flow along with recovery of any
operating working capital.
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Free Cash Flow
Step 4: Calculating a Project’s Free Cash Flow
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The Problem
Crockett Clothing Company is considering investing in a
new sewing machine.
The firm’s management wants to know the impact of tis
investment if expected revenues are $240,000 per year.
What would be the project’s operating cash flow under
the revised revenue estimate?
What is the project’s NPV? IRR? PI? Payback period?
20
Step 1: Picture the Problem
Years 0 1 2 3 4 5
Cash flow OCF1 OCF2 OCF3 OCF4 OCF5
OCF1-5 = Sum of additional revenues less operating
expenses (cash and depreciation) less taxes plus
depreciation expense
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Step 1: Picture the Problem
This is the information given to us:
Equipment $2,00,000
Project life 5 years
Salvage Value -
Depreciation expense $40,000 per year
Cash Operating Expenses -$5,000 per year
Revenues $240,000 per year
Growth rate for revenues 0%
Cost of goods sold/Revenues 60%
Investment in Net operating working -$78,000
capital
Required rate of return 20%
Tax rate 30%
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Step 2: Decide on a Solution Strategy
We need to calculate the operating cash flows
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Step 3: Solve
Since there is no change in revenues or other sources of
cash flows from year to year, the total operating cash flows
will be the same every year.
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Step 3: Solve (cont.)
Year 1-5
Project Revenues (growth rate $240,000
=0%)
- Cost of goods sold (60% of -144,000
revenues)
= Gross Profit $96,000
- Cash operating expense -$5,000
- Depreciation -$40,000
= Net operating income $51,000
- Taxes (30%) -$15,300
=Net Operating Profit after $35,700
Taxes (NOPAT)
+ Depreciation $40,000
= Operating Cash Flows $75,700
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Step 4: Analyze
This project contributes $35,700 to the firm’s net
operating income (after taxes) based on annual revenues
of $240,000.
Since depreciation is a non-cash expense, it is added back
to determine the annual operating cash flows.
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Step 4: Analyze
Year 1-5
Project Revenues (growth rate $240,000
=0%)
- Cost of goods sold (60% of -144,000
revenues)
= Gross Profit $96,000
- Cash operating expense -$5,000
- Depreciation -$40,000
= Net operating income $51,000
- Taxes (30%) -$15,300
=Net Operating Profit after $35,700
Taxes (NOPAT)
+ Depreciation $40,000
= Operating Cash Flows $75,700
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Step 4: Analyze
The project contributes $75,700 to the firm’s net
operating income (before taxes).
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Computing Project NPV
Once we have estimated the operating cash flow, we can
compute the NPV
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Computing Project NPV
Compute the NPV for based on the following additional
assumptions:
Increase in net working capital = $78,000 in Year 0
Decrease in net working capital = +$78,000 in Year 5
Discount Rate = 15%
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Computing Project NPV (cont.)
Year 0 Year 1-4 Year 5
Operating - $75,700 $75,700
Cash flow
Less: Capital -$200,000 - -
expenditure
Less: -$78,000 - $78,000
additional
net working
capital
Free Cash -$278,000 $75,700 $153,700
Flow
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Computing Project NPV
Using a Mathematical Equation
NPV =-$278,000 + {$75,700/(1.15)} + {$75,700/(1.15)2 }+
{$75,700/(1.15)3}+ {$75,700/(1.15)4}+ {$153,700/(1.15)5}
= $14,538
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IRR, PI, Payback
IRR = 16.96%
PI = 1.0523
Payback = 3.67 years
33
Inflation and Capital Budgeting
Cash flows that account for future inflation are referred
to as nominal cash flows. Real cash flows are cash
flows that would occur in the absence of inflation.
Nominal cash flows must be discounted at nominal rate
and real cash flows must be discounted at real rate of
interest.
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Replacement Project Cash Flows
An expansion project increases the scope of firm’s
operations, but does not replace any existing assets or
operations.
A replacement investment, an acquisition of a new
productive asset, replaces an older, less productive asset.
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Replacement Project Cash Flows
A distinctive feature of many replacement investment is that
principal source of cash flows comes from cost savings, not
new revenues.
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Replacement Project Cash Flows
To facilitate the capital budgeting analysis for replacement
projects, we categorize the investment cash flows into two
categories:
Initial Outlay (CF0), and
Annual Cash Flows (CF1-end).
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Category 1: Initial Outlay, CF0
Initial outlay typically includes:
Cost of fixed assets
Shipping and installation expense
Investment in net working capital
Sale of old equipment
Tax implications from sale of old equipment
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Category 1: Initial Outlay
There are three possible scenarios when an old asset is
sold:
Selling Price of old Tax Implications
asset
At depreciated value No taxes
Higher than Difference between the selling price
depreciated value (or and depreciated book value is a
book value) taxable gain and is taxed at the
marginal corporate tax rate.
Lower than Difference between the depreciated
depreciated value (or book value and selling price is a
book value) taxable loss and may be used to
offset capital gains.
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Category 2: Annual Cash Flows
Annual cash flows for a replacement decision differ from a
simple asset acquisition because we must now consider the
differential operating cash flow of the new versus the old
(replaced) asset.
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Category 2: Annual Cash Flows
Change in Depreciation and Taxes:
The depreciation expenses will increase by the amount of
depreciation on the new asset
but will decrease by the amount of the depreciation of the
replaced asset.
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Category 2: Annual Cash Flows
Changes in Working Capital: Increase in working
capital is necessitated by the increase in
accounts receivable and increased investment in
inventories.
The increase is partially offset if inventory is
financed by accounts payable.
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Category 2: Annual Cash Flows
Changes in Capital Spending: The replacement asset
will require an outlay at the time of acquisition but may also
require additional capital over its life.
Finally, at the end of the project’s life, there will be a cash
inflow equal to the after-tax salvage value of the new asset.
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The Problem
Forecast the project cash flows for the replacement press
for Leggett where the new press results in net operating
income per year of $600,000 compared to $580,000 for
the old machine.
This increase in revenues also means that the firm will
also have to increase it’s investment in net working
capital by $20,000.
Estimate the initial cash outlay required to replace the old
machine with the new one
Estimate the annual cash flow for years 1 through 5.
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The Problem
45
Step 1: Picture the Problem
The new machine will require an initial outlay, which will
be partially offset by the after-tax cash flows from the old
machine.
The new machine will help improve efficiency and reduce
repairs, but it will also increase the annual maintenance
expense.
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Step 1: Picture the Problem
Years
0 1 2 3 4 5
Cash flows(New) CF(N)0 CF(N)1 CF(N)2 CF(N)3 CF(N)4 CF(N)5
MINUS
Cash Flows (Old) CF(O)0 CF(O)1 CF(O)2 CF(O)3 CF(O)4 CF(O)5
EQUALS
Difference (New – Old) ∆CF0 ∆ CF1 ∆ CF2 ∆ CF3 ∆CF4 ∆ CF5
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Step 1: Picture the Problem
The decision to replace will be based on the replacement
cash flows.
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Step 2: Decide on a Solution Strategy
The cash flows will be calculated using
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Step 2: Decide on a Solution Strategy
However, for replacement projects, the emphasis is on the
difference in costs and benefits of the new machine
versus the old.
Accordingly, we compute the initial cash outflow and the
annual cash flows (from Year 1 through Year 5).
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Step 3: Solve
Initial cash outflow (CF0)
= Cost of new equipment
+ Shipping cost
+ Installation cost
– Sale of old equipment
± tax effects from sale of old equipment.
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Step 3: Solve
Year 0 New Machine Old Machine
Purchase price -$350,000
Shipping cost -$20,000
Installation cost -$30,000
Working Capital -$20,000
Total cost of New -$420,000
Sale Price $150,000
Less: Tax on gain $50,000*.30 -$15,000
Net cash flow $135,000
Replacement Net -$285,000
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Cash Flow
Step 3: Solve
Thus, the total cost of new machine of $400,000 is
partially offset by the old machine resulting in a net cost
of $285,000.
Next we compute the annual cash from years 1-5. Cash
Flows for years 1-4 will be the same.
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Step 3: Solve
Analysis of Annual Years 1-4 Year 5
Cash Inflows
Increase in operating $20,000 $20,000
income
Reduced salaries $100,000 $100,000
Reduced defects $50,000 $50,000
Reduced fringe benefits $10,000 $10,000
Total cash inflows $180,000 $180,000
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Step 3: Solve (continued)
Analysis of Annual Years 1-4 Years 5
Cash Out Flows
Increased maintenance -$40,000 -$40,000
Increased depreciation -$50,000 -$50,000
Net operating income $90,000 $90,000
Less: Taxes -$27,000 -$27,000
Net operating profit after $63,000 $63,000
taxes
Plus: depreciation $50,000 $50,000
Operating cash flow $113,000 $113,000
Less: Change in operating $20,000
working capital
Less: CAPEX 50,0000
55 Free Cash Flows $113,000 $183,000
Step 4: Analyze
In this case, we observe that the new machine generated
cost savings and also increased the revenues by $20,000.
Based on the estimates of initial cash outflow and
subsequent annual free cash flows for years 1-5, we can
compute the NPV.
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Computing NPV
Compute the NPV for this replacement project based on
discount rate of 15%.
NPV = -$285,000 + $113,000/(1.15)1 + $113,000/(1.15)2 +
$113,000/(1.15)3 + $113,000/(1.15)4 + $183,000/(1.15)5
= $128,595.90
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