Intermediate Financial Management

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					Intermediate Financial Management                                            FIN 36054
Lecture Notes                                                          Dr. Ramana Sonti

CHAPTER 7: CASH FLOW ESTIMATION


   This chapter is basically an adjunct to the previous chapter. It digs a little deeper and
    examines some more issues.
   The easiest thing to do in Capital Budgeting is to evaluate the project using the decision rules
    we developed in Chapter 6. The tough part is coming up with the inputs for evaluating the
    project – i.e. the cash flows. Recall the six steps to capital budgeting from the last chapter:
    1) Estimate the cost of the project
    2) Estimate the expected cash flows from the project
    3) Estimate the risk of the project cash flows
    4) Estimate the cost of capital for the project
    5) Find the present value of the project’s expected cash flows
    6) Compare the present value of the project’s cash flows to the cost of the project
    Before we can evaluate a project (Steps 5 and 6), we need to learn a little more about Step 2,
    estimating the cash flows from the project.


   Only the cash flows relevant to a project must be used for capital budgeting. The relevant
    cash flow is the amount added to the free cash flow of a firm because of the project. This is
    so simple a rule, and so innocuous; yet it is often difficult to isolate the relevant cash flows
    pertaining to a project. There are two cardinal rules to finding the incremental cash flows:
    1. Capital budgeting must be based on cash flows, not accounting income.
    2. Only incremental cash flows should be considered.
       Incremental cash flows = Cash flow to firm with project – Cash flow to firm without
                                     project
       i.e. we want to isolate those cash flows that are added to (and subtracted from) a firm’s
       free cash flows because of the project.




                                                  1
   Rule 1: Cash Flow is not accounting income
    Cash flows differ from accounting income in four important ways
    1) Cost of fixed assets
    2) Non-cash charges
    3) Changes in net operating working capital
    4) Interest expenses


    Let me illustrate point 1) above with an example. Let’s say Firm X needs to put up a project
    at a cost of $1000. This project has a useful life of 5 years, and the firm depreciates its fixed
    assets by the Straight Line Method (SLM). The accounting impact would be:

                         Year                   0           1           2           3           4           5
    In
                         Depreciation                   (200)       (200)       (200)       (200)       (200)
    co
    ntrast, the cash flow from setting up this project should be recognized as:
                   Year                0            1           2           3           4           5
                   Cash flow      (1000)


    That is to say, the cost of a fixed asset should be reflected as a cost when it is expected to
    occur, not as a depreciated item.


    Point 2) above is a familiar rule to us from Chapter 4. When calculating cash flow, we have
    to add back depreciation to the accounting income, since depreciation is not paid out as a
    charge to anyone. It is a notional or non-cash charge, and does not represent cash going out
    of the firm.


    Point 3) simply says that in setting up a project, a firm will likely tie up some cash in
    operating working capital such as inventories and accounts receivable. Some of these will be
    offset by increased current liabilities such as accounts payable (short-term credit extended by
    suppliers), and accruals (short-term financing by employees and the government). However,
    in most projects these increases in current liabilities will not completely take care of the
    additional working capital needs. The difference between required increase in working




                                                    2
    capital and increases in current liabilities is cash that must be provided by investors as part of
    this project. Hence, this is a relevant cash flow.


    Point 4) above is a little subtle. It says that we should not subtract interest expenses from the
    project cash inflows. If we were making up an income statement, we would subtract interest
    expense. However, in the case of project cash flows, we should not subtract interest income.
    Why? Recall that we calculate the NPV of a project by plugging numbers into the following
    equation.
                                         CF1         CF2           CFn
                        NPV  CF0                          
                                       (1  k) 1
                                                   (1  k) 2
                                                                 (1  k) n
    The numerators are the cash flows that we are concerned with in this chapter. The
    denominators are discount factors at the project’s cost of capital. We calculate the cost of
    capital as a weighted average of the costs of equity and debt. That means that financing costs
    have already been reflected in the denominators. We should not double count by including
    them once again in the numerators. For this reason, we do not concern ourselves with
    financing costs such as interest expenses in calculating the numerators i.e. the cash flows of
    the project. This is called the interest exclusion principle of capital budgeting.


   Rule 2: Only incremental cash flows are relevant
    This is, as I said before, very important, but very slippery. There are three special issues with
    incremental costs that we need to watch out for.
    1) Sunk Costs: These are costs that have already been incurred, and will not be affected by
       the decision regarding the project under consideration. These costs have to be ignored
       when evaluating the project as they are not relevant. This is easy to say and apply.
       However, managers (and the rest of us) tend to hang on to the past and find it difficult to
       use this concept.




                                                   3
   Here’s a simple example: My computer broke down last week, and I took it in for repairs.
   The repairman said that it would cost me $400 to salvage some of the parts, buy some
   others, and put together a new system. Now, in evaluating whether $400 is a sensible
   price, I should not be thinking, “Hey I paid $1800 for this computer two years ago. It’s
   not worth it!”. The $1800 I spent 2 years ago is a sunk cost. It has been incurred and is
   history now. I have to evaluate the repair price of $400 in relation to the benefits I can get
   from my new system in the future. That is the sensible approach.


2) Opportunity costs: Opportunity costs are the amounts foregone by using an asset in a
   firm’s possession for the project under consideration. The question to ask is: By using
   this asset for this project, I am not doing something else with it. What is the cost of this
   opportunity that I’m passing up? Such costs have to be taken into account in capital
   budgeting as they are relevant costs.


   Continuing my earlier example, by giving the repairman my old system, and accepting
   his terms, I am foregoing some opportunities. One of them is the following: I could have
   just bought a new computer, and used my old one as a tool for learning PC repair, which I
   am interested in. There is a cost to foregoing this opportunity to learn something I like. If
   I think long and hard, I can even put a $$$ number to it. That’s my opportunity cost.
3) Externalities: Projects rarely are set up and exist in isolation. They have effects on other
   parts of the firm. These effects have to be estimated and taken into consideration, as they
   are very relevant. Let’s say Honda is thinking about introducing a new product, the
   Honda Discord. In evaluating this project, Honda’s financial managers have to consider
   the (very real!) possibility that a proportion of the estimated customers of the proposed
   Discord will be those who would have bought an Accord or a Civic. That means, to the
   extent that these customers switched to the Discord from an existing Honda product, the
   cash flows generated by them amounts are not incremental cash flows.




                                             4
   Depreciation and Taxes
    -   Firms sometimes calculate depreciation in different ways for reporting purposes and tax
        purposes. How they do this can significantly affect the cash flows of the project. Why?
    -   Depreciation, like interest is a tax-deductible expense, which means firms get to subtract
        it before paying taxes. Thus, the more depreciation a firm can charge in a particular year
        for tax purposes, the lesser its taxable income, and the lesser the taxes it pays, and the
        greater the cash flow after taxes from the project.
    -   Calculating tax depreciation
        Assets are typically depreciated for tax purposes using the Modified Accelerated Cost
        Recovery System (MACRS). See Tables 7-1 and 7-2 of your text for a description of this
        system and the applicable rates of depreciation. Let’s do an example, and see the
        difference between the MACRS method and the Straight Line Method.


        Example: Assume that Blockbuster Entertainment buys a $150,000 machine and places it
        into service on March 15, 1999. They must pay an additional $30,000 for delivery and
        installation, bringing the total cost of the machine to $180,000. Assume that Blockbuster
        estimates their EBITDA from this machine as $70,000 for the next 6 years. Also, to keep
        things simple, assume that there is no effect on the net working capital due to this project.
        Assume a tax rate of 40%. Let’s compare the difference in operating cash flow between
        the Straight Line Method and the MACRS method.


        MACRS method                         1         2           3        4         5          6
        EBITDA                          70,000    70,000      70,000   70,000    70,000     70,000
        Depreciation                    36,000    57,600      34,200   21,600    19,800     10,800
        Depreciation % (MACRS)            20%       32%         19%      12%       11%         6%
        EBIT                            34,000    12,400      35,800   48,400    50,200     59,200
        Interest                             0         0           0        0         0          0
        EBT                             34,000    12,400      35,800   48,400    50,200     59,200
        Taxes (@40%)                    13,600     4,960      14,320   19,360    20,080     23,680
        Net Income                      20,400     7,440      21,480   29,040    30,120     35,520
        Operating Cash Flow             56,400    65,040      55,680   50,640    49,920     46,320
        (Net Income + depreciation)




                                                  5
Straight Line Method                 1          2            3         4         5         6
EBITDA                          70,000     70,000       70,000    70,000    70,000    70,000
Depreciation                    18,000     36,000       36,000    36,000    36,000    18,000
Depreciation % (SLM)              10%        20%          20%       20%       20%       10%
EBIT                            52,000     34,000       34,000    34,000    34,000    52,000
Interest                             0          0            0         0         0         0
EBT                             52,000     34,000       34,000    34,000    34,000    52,000
Taxes (@40%)                    20,800     13,600       13,600    13,600    13,600    20,800
Net Income                      31,200     20,400       20,400    20,400    20,400    31,200
Operating Cash Flow             49,200     56,400       56,400    56,400    56,400    49,200
(Net Income + depreciation)


Note some points from these calculations:
1) There is a half-year convention applied in depreciation i.e. the asset is assumed to be
   placed in service in the middle of the first year until the middle of the sixth year,
   which is five years in useful life.
2) I purposely put in a row for the interest and filled it with zeros to drive home the point
   that interest expenses are not to be deducted from cash flows in capital budgeting.
   This is the interest exclusion principle we talked about earlier.
3) In the MACRS method, we write off more of the asset as depreciation in the first two
   years compared to the SLM. This gives us a higher operating cash flow in the first
   two years. This is why the system is called an accelerated depreciation system.


Let’s calculate the difference in operating cash flow under the two methods.
Comparison                             1            2         3         4         5         6
Operating Cash Flow (MACRS)       56,400       65,040    55,680   50,640    49,920    46,320
Operating Cash Flow (SLM)         49,200       56,400    56,400   56,400    56,400    49,200
Difference                         7,200        8,640     (720)   (5,760)   (6,480)   (2,880)
NPV of difference (@10%)          $3,562


Note that the differences add up to zero i.e.
               7200+8640=720+5760+6480+2880, which means that using MACRS
allows a firm to merely redistribute the cash flows from the project from later to earlier,
and accelerate the project’s cash flows. What you gain in cash flows in the first two
years, you lose in years 3 through 6. However, because dollars in years 1 and 2 are more
valuable than dollars later, this results in some additional NPV for our project.


                                           6
        For instance, at a cost of capital of 10%, the extra NPV due to MACRS over SLM
        method is $3,562. This is value added to the firm by simply allowing accelerated
        depreciation. Hence, for capital budgeting purposes, we should include depreciation
        calculated for tax purposes, not the depreciation for reporting purposes.


   Comprehensive text example: Regency Integrated Chips
    To tie together all our concepts so far, we shall now work out the comprehensive example in
    your text. Download the accompanying spreadsheet that I put up on the course website, and
    take a good look at it.
    Regency Integrated Chips Expansion Project
    -   This is a microprocessor and sensor system specifically designed to control commercial
        watering systems.
    -   The project will be set up from 1999 through 2001, and will start producing revenues in
        2002. The project’s estimated economic life is 6 years, which means the last year for our
        analysis will be 2007.
    -   Project investment outlays, or fixed costs are as follows:


                                                 Set up period                    Total
           Project Set up Costs                 1999        2000       2001      Costs
           Land                            1,200,000           0          0 1,200,000
           Building                                0 4,000,000 4,000,000 8,000,000
           Equipment                               0           0 10,000,000 10,000,000
           Total Fixed Assets              1,200,000 4,000,000 14,000,000 19,200,000
           Net Working Capital                     0           0 6,600,000 6,600,000
           Total Investment                1,200,000 4,000,000 20,600,000 25,800,000


        The important thing to note is that the firm has to provide not only for land, building and
        equipment as part of its set-up costs, but also for Net Working Capital in the year before
        the project begins to earn revenues. This means RIC is planning to stock up some
        inventories and start preparation for credit sales a year ahead of revenues, which is a
        necessary and prudent thing to do.
        In fact, the assumption used here is that Net Working Capital of 12% of one-year ahead
        sales needs to be maintained. We will see that the first year’s (2002) revenues are
        projected at $55,000,000. Thus, we have 12%($55,000,000) = $6,600,000.


                                                  7
-     Let’s next work on the depreciation schedule.
                                 Production period
    Depreciation Schedule             2002       2003          2004      2005         2006      2007
    Land - No Depreciation
    Building
    MACRS Class: special
    MACRS Depreciation %             1.50%           3%          3%        3%           3%        3%
    Depreciation charge             120,000      240,000     240,000   240,000      240,000   240,000
    Equipment
    MACRS Class: 5-year
    MACRS Depreciation %               20%       32%       19%       12%       11%                6%
    Depreciation charge           2,000,000 3,200,000 1,900,000 1,200,000 1,100,000           600,000
    Total Depreciation            2,120,000 3,440,000 2,140,000 1,440,000 1,340,000           840,000


-     The land building and equipment are projected to have some market value at the end of
      the project. In other words, we can salvage some value out of the project’s equipment etc.
      at the end of its economic life. Hence, these values are known as salvage values. It is
      given that the land is expected to have a market value of $1.7 million in 2007, the
      building has a market value of $1.0 million, and the equipment a value of $2 million.
      How do these numbers translate into cash flows? Let us see:
                                              End of the project, 2007
              Salvage Value Calculation       Land       Building     Equipment
              Salvage Value                    1,700,000 1,000,000 2,000,000
              Initial book value:2001          1,200,000 8,000,000 10,000,000
              Depreciation: 2002                       0    (120,000) (2,000,000)
              Depreciation: 2003                       0    (240,000) (3,200,000)
              Depreciation: 2004                       0    (240,000) (1,900,000)
              Depreciation: 2005                       0    (240,000) (1,200,000)
              Depreciation: 2006                       0    (240,000) (1,100,000)
              Depreciation: 2007                       0    (240,000)   (600,000)
              Final book value: 2007           1,200,000 6,680,000              0
              Gain/Loss (Salvage-book)           500,000 (5,680,000) 2,000,000
              Taxes (@40%)                       200,000 (2,272,000)      800,000
              Net Salvage value                1,500,000 3,272,000 1,200,000
              (Salvage value-Taxes)


-     This means that the after its useful life, the project contributes a total of
      $ (1.50+3.272+1.20) = $ 5.972 mn which is not a small amount compared to the total
      initial cost of the project, which is $25.8 million.




                                                   8
-   Now, we can analyze the project’s cash flows during the production period, i.e. between 2002-2007.
              Assumptions
              RIC's Marginal Tax Rate                40%
              NWC % of next years sales              12%
              Unit sales per year                25,000
              Unit price (2002)                   2,200
              Unit price growth                       6%
              Variable costs % of sales              65%
              Fixed costs (2002)               8,000,000
              Fixed costs (overheads) growth          6%


                                               Production period
              Net Cash Flows                         2002        2003       2004       2005        2006         2007
              Revenues
              Unit sales                            25,000     25,000     25,000     25,000       25,000     25,000
              Unit price                             2,200      2,332      2,472      2,620        2,777      2,944
              Net Sales (Revenues)              55,000,000 58,300,000 61,798,000 65,505,880   69,436,233 73,602,407
              Expenses
              Variable costs                    35,750,000 37,895,000 40,168,700 42,578,822   45,133,551   47,841,564
              Fixed costs                        8,000,000 8,480,000 8,988,800 9,528,128      10,099,816   10,705,805
              Depreciation (from schedule)       2,120,000 3,440,000 2,140,000 1,440,000       1,340,000      840,000
              Total Expenses                    45,870,000 49,815,000 51,297,500 53,546,950   56,573,367   59,387,369
              Earnings before Taxes (EBT)        9,130,000 8,485,000 10,500,500 11,958,930    12,862,866   14,215,038
              Taxes                              3,652,000 3,394,000 4,200,200 4,783,572       5,145,146    5,686,015
              Projected net operating income     5,478,000 5,091,000 6,300,300 7,175,358       7,717,719    8,529,023
              Add back: Depreciation             2,120,000 3,440,000 2,140,000 1,440,000       1,340,000      840,000
              Net cash flow from operations      7,598,000 8,531,000 8,440,300 8,615,358       9,057,719    9,369,023
              Net working capital                6,996,000 7,415,760 7,860,706 8,332,348       8,832,289            0
              Investment in NWC                  (396,000) (419,760) (444,946) (471,642)       (499,941)    8,832,289
              Net salvage value (from schedule)          0          0          0          0            0    5,972,000
              Total projected cash flow          7,202,000 8,111,240 7,995,354 8,143,716       8,557,779   24,173,311




                                                              9
Now, we should put together project costs and benefits on the same scale, and prepare to apply some of our decision making
criteria to evaluate this project.


Assumed cost of capital            11.50%

                                         Set up period       Production period
Project Cash Flows ($ mn)             1999     2000    2001      2002    2003             2004      2005      2006      2007
Projected cash flow                  (1.20)   (4.00) (20.60)      7.20    8.11             8.00      8.14      8.56     24.17

Net Present Value                $ 12.08 million
Internal rate of return             25.1%
Modified internal rate of return    17.9%


Here, the project cost of capital is given to us as 11.5%.
                     4.00         20.60           7.20         8.11             8.00         8.14             8.56             24 .17
NPV  - 1.20 -                                                                                                                      12 .08
                 (1  0.115 ) (1  0.115)
                             1            2
                                              (1  0.115 ) (1  0.115 )
                                                          3             4
                                                                            (1  0.115 ) (1  0.115 )
                                                                                        5             6
                                                                                                          (1  0.115 ) 7
                                                                                                                           (1  0.115 ) 8
We can use the =NPV(), =IRR() and =MIRR() excel functions to do these calculations for us.




                                                                        10
   A Replacement Project
    Sometimes, new machinery or projects might be considered as replacements for existing
    projects. In such cases, the cash flows from both the new and the old machines have to be
    considered. Let us do the textbook example on pages 255-258.


    In this example, RIC wants to replace a 10-year old lathe.
    Details of the old lathe: It cost $7,500 when it was bought 10 years ago. The lathe had an
    estimated life of 15 years when it was bought. This means that the (straight line)
    depreciation per year is 7,500/15=$500. In ten years, the accumulated depreciation is
    $5,000. The remaining book value now is $7,500-$5,000 =$2,500. Finally, the market
    value of this old lathe is $1,000, which is $1,500 below the $2,500 book value.
    Details of the new lathe: The new machine can be purchased for $12,000 and has an
    estimated life of five years. This machine can be sold for a market value (salvage value)
    of $2,000 at the end of its useful life of 5 years. For depreciation purposes, the new lathe
    falls into the 3-year class.
    Other details:
    a) The new machine will cut operating costs by $3,000 from $7,000 to $4,000 per year.
    b) Net Working Capital will increase by $1,000 at the time of replacement and stay
        constant for the life of the new machine.
    c) Marginal tax rate = 40%
    d) Cost of capital of RIC = 11.5%
    Let us now do the replacement analysis step by step. First, the net investment needed for
    replacement.
        Costs of replacement                Year 0
        Sale of old machine                     1,000
        Book value of old machine               2,500
        Gain/(Loss) on old machine            (1,500)
        Tax (outflow)/inflow on gain/(loss)       600
        Net inflow from sale of old machine     1,600
        Purchase of new machine              (12,000)
        Net working capital                   (1,000)
        Net investment required              (11,400)




                                             11
   Note that the new machine results in cost savings of $3,000 per year. What is this on an
   after-tax basis? Let the revenues be R. Let the costs with the old machine be C. Then the
   taxable income with the old machine is (R-C). At a tax rate of 40%, the after-tax income
   from the old machine is (R-C)(1-0.40) = (R-C)0.60. With the new machine this
   becomes (R-C-3000)0.60. The difference in after-tax cash flows is:
            (R-C)0.60-(R-C-3000)0.60 = 30000.60=$1,800


   Now, we can analyze the inflows from the project.
Operating inflows                                  1         2         3       4       5
After-tax decrease in costs                     1800      1800      1800    1800    1800
Depreciation on new machine                   (3960)    (5400)    (1800)   (840)       0
MACRS depreciation %                            33%       45%       15%      7%      0%
Depreciation on old machine                    (500)     (500)     (500)   (500)   (500)
Net change in depreciation                   (3,460)   (4,900)   (1,300)   (340)     500
Tax savings due to depreciation                1,384     1,960       520     136   (200)
Net operating cash flows                       3,184     3,760     2,320   1,936   1,600


Finally, the terminal cash flows of the project.
Terminal year cash flows                           1        2         3        4       5
Estimated salvage value of new machine                                              2000
Book value in year 5 of new machine                                                    0
Gain/(Loss) on salvage value transaction                                            2000
Tax on salvage value                                                               (800)
Net salvage value                                                                  1,200
Recovery of net working capital                                                    1,000
Total termination cash flow                                                        2,200


The overall picture is:
Composite Cash Flows                     0         1        2         3       4       5
Net investment required           (11,400)
Net operating cash flows                      3,184     3,760     2,320    1,936   1,600
Termination cash flow                                                              2,200
Total project cash flows          (11,400)    3,184     3,760     2,320    1,936   3,800



Decision Criteria
Net Present Value                 (388.77)
Internal Rate of Return            10.09%
Modified IRR                       10.73%




                                             12
   Comparing projects with unequal lives
    -   Comparing mutually exclusive projects with significantly different lives using the
        NPV projects may be flawed sometimes as the two projects represent investments of
        fundamentally different lengths. We deal with this problem using two approaches, the
        replacement chain approach and the equivalent annual annuity approach.
    -   Consider the following projects:
        Project C
                 0        1          2          3          4         5        6
          -40,000     8,000     14,000     13,000     12,000    11,000   10,000

        Project F
                 0        1          2          3
          -20,000     7,000     13,000     12,000


           NPVC @ 11.5% = 7,165                      NPVF @ 11.5% = 5,391
           IRRC = 17.5%                              IRRF = 25.2%
           So far, it looks like C is the better project.


    -   However, we can see that within the time it takes to implement Project C, we could
        do a project F followed by another Project F. This is the replacement chain approach.
        This approach can be seen below:


        Project C
                 0        1          2          3          4         5        6
          -40,000     8,000     14,000     13,000     12,000    11,000   10,000

        NPV- C         7,165
        IRR- C        17.5%

        Project F
                 0        1          2           3          4       5        6
          -20,000     7,000     13,000      12,000
                                           -20,000     7,000    13,000   12,000
          -20,000     7,000     13,000      -8,000     7,000    13,000   12,000

        NPV- F         9,281
        IRR- F        25.2%




                                              13
-   The point is that we bring both projects under comparison to a common life, after
    replacements of both. This can get cumbersome very quickly. For example, comparing a
    4-year and a 7-year project require 4 repetitions of the 7-year project and 7 repetitions of
    the 4-year project. In general, you need to repeat both projects until you reach the Least
    Common Multiple of the two numbers.
-   The alternative method called the Equivalent Annual Annuity (EAA) method tries to
    resolve this by a clever way to get at an annual measure. You can find the EAA of any
    cash flow stream in a simple way.
-   Step 1: Find the NPV of the cash flow stream over say, n years
     Project C
              0          1         2          3         4         5         6
       -40,000       8,000    14,000     13,000    12,000    11,000    10,000

     NPV- C          7,165


-   Step 2: Find the annual payment every year for n years, that has a total present value
    equal to the NPV of the project.
     Project C
              0          1          2         3         4         5          6
                     1,718      1,718     1,718     1,718     1,718      1,718

     NPV- C          7,165


    How do we find the EAA? In Excel, we find EAA = PMT(0.115,6,7165). On a financial
    calculator, we would set PV= 7165, rate = 11.5%, N=6. We could also solve the EAA via
    an equation such as:
                       1      1 
                   EAA           n 
                                        NPV
                        r r(1  r) 
                                NPV
                    EAA 
                           1        1 
                                       n 
                            r r(1  r) 




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    Let us do this again for Project F.

          Project F
                   0            1        2             3
            -20,000         7,000   13,000        12,000

          NPV-F             5,391



           Project F
                        0           1         2         3
                                2,225     2,225     2,225

           NPV-F                5,391


   A final note: Inflation
    -   Let us look at the NPV equation. In general, this equation looks like:
                        CF1      CF2           CFn
        NPV  CF0                      
                       (1  k) (1  k) 2
                                             (1  k) n
    -   The denominators contain the cost of capital, which includes the effect of inflation.
    -   So, to be consistent the numerators or the cash flows have to also include the effect of
        inflation. In other words, cash flows must be stated in nominal terms, not in real
        terms.




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