cash flow estimation session 30
TRANSCRIPT
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Session 30
Capital Budgeting
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Who estimate?
Capital outlays-----engineering and product outlaydept.
Revenue projectionmarketing group Operating cost----- production dept. cost
accountants, purchase manager, personnel exe, taxexpert
Finance manager coordinate the efforts Minimizes the biases inherent in cash flow
forecasting
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Investment Project Proposals
New Product
Expansion of Existing Product Replacement
Research and Development
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Basic principles Separation Principle
Incremental Principle
Post tax Principle
Consistency Priciple
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Separation Principle
Profit after tax + interest(1- tax rate)
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Incremental Principle
Guidelines:
Consider all incidental effects
Ignore sunk cost
Include opportunity cost
Question of allocation of overhead cost
Estimate working capital properly Includeproject-driven changes in working capitalchanges in working capital net of
spontaneous changes in current liabilities
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Post tax principle
Since taxes are cash
flows, we must include taxes in our cash
flow estimates. All estimated cash flows should be after-taxcash flow estimates!
Effect of non cash charges
DepreciationDepreciation represents the systematic allocation of thecost of a capital asset over a period of time for financialreporting purposes, tax purposes, or both.
Everything else equal, the greater the depreciation charges, thelower the taxes paid by the firm.
Depreciation is a non-cash expense.
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Consistency Principle Cash flows and discount rate must be
consistent with respect to inflation
Cash flow discount rate
Nominal Cash flow nominal discount rate
Real Cash flow real discount rate
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Elements of Cash
Flow Stream Initial investment
Operating cash flow
Terminal cash
flow Net salvage value of fixed asset + net recovery
of working capital margin
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Biases in cash
flow estimation Overstatement of profitability
Intentional overstatement
Lack of experience
Understatement of profitability
Salvage values are under estimated
Intangible benefits are ignored
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Initial Cash OutflowInitial Cash Outflowa) Cost of new assetsCost of new assets
b) + Capitalized expenditures
c) + (-) Increased (decreased) NWCd) - Net proceeds from sale of
old asset(s) if replacement
e) + (-) Taxes (savings) due to the sale
of old asset(s) if replacementf) == Initial cashInitial cashoutflowoutflow
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Incremental Cash FlowsIncremental Cash Flowsa) Net incr. (decr.) in operating revenue
less (plus) any net incr. (decr.) in
operating expenses, excluding depr.
b) - (+) Net incr. (decr.) in tax depreciationc) = Net change in income before taxes
d) - (+) Net incr. (decr.) in taxes
e) = Net change in income after taxes
f) + (-) Net incr. (decr.) in tax depr. Charges
g) == Incremental net cash flow for periodIncremental net cash flow for period
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TerminalTerminal--YearYear
Incremental Cash FlowsIncremental Cash Flowsa) Calculate the incremental net cashincremental net cash
flowflow for the terminal periodterminal period
b) + (-) Salvage value (disposal costs) of any sold or disposed
assetsc) - (+) Taxes (tax savings) due to asset sale or disposal of
new assets
d) + (-) Decreased (increased) level of net
working capitale) == Terminal year incremental net cash flowTerminal year incremental net cash flow
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Example of an AssetExample of an Asset
Expansion ProjectExpansion ProjectX Ltd is considering the purchase of a new basket weaving machine.
The machine will cost Rs.50,000 plus Rs.20,000 for shipping and
installation and falls under the 3-year MACRS class. NWC will rise
by Rs.5,000. Mr. Sengupta forecasts that revenues will increase byRs.110,000 for each of the next 4 years and will then be sold
(scrapped) for Rs.10,000 at the end of the fourth year, when the
project ends. Operating costs will rise by Rs.70,000 for each of the
next four years. X Ltd. is in the 40% tax bracket.
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Initial Cash OutflowInitial Cash Outflowa) Rs.50,000
b) + 20,000
c) + 5,000d) - 0 (not a replacement)
e) + (-) 0 (not a replacement)
f) == Rs.75,000Rs.75,000
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Incremental Cash FlowsIncremental Cash FlowsYear 1 Year 2 Year 3 Year 4
a) Rs.40,000 Rs.40,000 Rs.40,000 Rs.40,000
b) - 23,331 31,115 10,367 5,187
c) = Rs.16,669 Rs. 8,885 Rs.29,633 Rs.34,813
d) - 6,668 3,554 11,853 13,925
e) = Rs.10,001 Rs. 5,331 Rs.17,780 Rs.20,888
f) + 23,331 31,115 10,367 5,187
g) == Rs.33,332 Rs.36,446 Rs.28,147 Rs.26,075Rs.33,332 Rs.36,446 Rs.28,147 Rs.26,075
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TerminalTerminal--YearYear
Incremental Cash FlowsIncremental Cash Flowsa) Rs.26,075Rs.26,075 The incremental cash flowincremental cash flow
from the previous slide in
Year 4.
b) + 10,000 Salvage Value.c) - 4,000 .40*(Rs.10,000 - 0) Note, the
asset is fully depreciated at
the end ofYear 4
d) + 5,000 NW
C - Project ends.
e) == Rs.37,075Rs.37,075 TerminalTerminal--year incrementalyear incremental
cash flowcash flow..
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Summary of ProjectSummary of Project
Net Cash FlowsNet Cash FlowsAsset Expansion
Year 0 Year 1 Year 2 Year 3 Year 4
--Rs.75,000Rs.75,000 Rs.33,332Rs.33,332 Rs.36,446 Rs.28,147 Rs.37,075Rs.36,446 Rs.28,147 Rs.37,075
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Example of an AssetExample of an Asset
Replacement ProjectReplacement ProjectLet us assume that previous asset expansion project is actually an asset
replacement project. The original basis of the machine was Rs.30,000
and depreciated using straight-line over five years (Rs.6,000 per year).
The machine has two years of depreciation and four years of useful liferemain-ing.X Ltd. can sell the current machine for Rs.6,000. The new
machine will not increase revenues (remain at Rs.110,000) but it
decreases operating expenses by Rs.10,000 per year (old = Rs.80,000).
NWC will rise to Rs.10,000 from Rs.5,000 (old).
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Calculation of theCalculation of the
Change in DepreciationChange in DepreciationYear 1 Year 2 Year 3 Year 4
a) Rs.23,331 Rs.31,115 Rs.10,367 Rs. 5,187
b) - 6,000 6,000 0 0
c) = Rs.17,331 Rs.25,115 Rs.10,367 Rs. 5,187Rs.17,331 Rs.25,115 Rs.10,367 Rs. 5,187
a) Represent the depreciation on the new project.
b) Represent the remaining depreciation on the old project.
c) Net changechange in tax depreciation charges.
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Incremental Cash FlowsIncremental Cash FlowsYear 1 Year 2 Year 3 Year 4
a) Rs.10,000 Rs.10,000 Rs.10,000 Rs.10,000
b) - 17,331 25,115 10,367 5,18717,331 25,115 10,367 5,187
c) = Rs. -7,331 -Rs.15,115 Rs. -367 Rs. 4,813
d) - -2,932 -6,046 -147 1,925
e) = Rs. -4,399 Rs. -9,069 Rs. -220 Rs. 2,888
f) + 17,33117,331 25,11525,115 10,367 5,18710,367 5,187
g) == Rs.12,932 Rs.16,046 Rs.10,147 Rs. 8,075Rs.12,932 Rs.16,046 Rs.10,147 Rs. 8,075
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TerminalTerminal--YearYear
Incremental Cash FlowsIncremental Cash Flowsa) Rs. 8,075Rs. 8,075 The incremental cash flowincremental cash flow
from the previous slide in
Year 4.
b) + 10,000 Salvage Value.c) - 4,000 (.40)*(Rs.10,000 - 0). Note, the
asset is fully depreciated at
the end ofYear 4.
d) + 5,000 Return of added NW
C.e) == Rs.19,075Rs.19,075 TerminalTerminal--year incrementalyear incremental
cash flow.cash flow.
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Summary of ProjectSummary of Project
Net Cash FlowsNet Cash FlowsAsset Expansion
Year 0 Year 1 Year 2 Year 3 Year 4
--Rs.75,000Rs.75,000 Rs.33,332Rs.33,332 Rs.36,446 Rs.28,147 Rs.37,075Rs.36,446 Rs.28,147 Rs.37,075
Asset Replacement
Year 0 Year 1 Year 2 Year 3 Year 4
--Rs.66,600Rs.66,600 Rs.12,933Rs.12,933 Rs.16,046 Rs.10,147 Rs.19,075Rs.16,046 Rs.10,147 Rs.19,075
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Recapitulation Basic characteristics of relevant project flows
Cash (non accounting flows)
Operating ( non financing Flows)
After tax flows
Incremental flows
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Equivalent Annual CostEquivalent Annual Cost - The cost per period
with the same present value as the cost of
buying and operating a machine.
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Equivalent Annual CostEquivalent Annual Cost - The cost per period
with the same present value as the cost of
buying and operating a machine.
Equivalent annual cost =present value of costs
annuity factor
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Example
Given the followingcosts of operatingtwo machines
anda 6% cost ofcapital, select thelowercostmachine
usingequivalent annualcostmethod.
Year
Machine 1 2 3 4 PV@6% EAC
A 15 5 5 5 28.37 10.61
B 10 6 6 21.00 11.45
Equivalent Annual Cost
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Timing Even projects with positive NPV may be
more valuable if deferred.
The actual NPV is then the current value of
some future value of the deferred project.
trt
)1(dateofasvaluefutureNetNPVCurrent
!
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TimingExample
You may harvest a set of trees at anytime over the
next 5 years. Given the FV of delaying theharvest, whichharvest date maximizes current
NPV?
0 1 2 3 4 5
Net FV (Rs.1000s) 50 64.4 77.5 89.4 100 109.4
% change in value 28.8 20.3 15.4 11.9 9.4
Harvest Y ear
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TimingExample - continued
You may harvest a set of trees at anytime over the next 5 years. Given
the FV of delaying the harvest, whichharvest date maximizes currentNPV?
5.581.10
64.41yearinharvestedif !!NPV
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TimingExample - continued
You may harvest a set of trees at anytime over the next 5 years. Given
the FV of delaying the harvest, whichharvest date maximizes currentNPV?
5.581.10
64.41yearinharvestedif !!NPV
0 1 2 3 4 5
NPV (Rs.1000s) 50 58.5 64.0 67.2 68.3 67.9
Harve st Y ear
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Fluctuating Load Factors
Two Old Machines
Annual output per machine 750 units
Operating cost per machine 2 750 .1,500
PV operating cost per pachine 1,500/.10 .15,000
PV operating cost of two mach
ines 2 15,000 .30,000
Rs
Rs
Rs
v !
!
v !
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Fluctuating Load FactorsTwo New Machines
Annual output per machine 750 units
Capital cost per machine .6,000Operating cost per machine 1 750 .750
PV operating cost per pachine 6,000 750/.10 .13,500
PV operating cost of two mac
RsRs
Rs
v !
!
hines 2 13,500 .27,000Rsv !
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Fluctuating Load Factors
One Old Machine One New Machine
Annual output per machine 500 units 1,000 units
Capital cost per machine 0 .6,000
Operating cost per machine 2 500 .1,000 1 1,000 .1,000
PV operating cost per machine 1,000/.
Rs
Rs Rsv ! v !
10 .10,000 6,000 1,000 / .10 .16,000
PV operating cost of two machines ................................ .26,000
Rs Rs
Rs
! !
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Recapitulation Basic principles that must be adhered to in
estimating after tax incremental cash flows
Ignore sunk cost
Include opportunity cost
Include project driven changes in NWC
Includes effects ofInflation
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