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Slides developed by:

Pamela L. Hall, Western Washington University

Cash FlowEstimation

Chapter !

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Capital "#dgeting Pro$esses

Capital b#dgeting pro$ess $onsists o% the%ollowing steps: &etermine 'estimate( the e)pe$ted $ash %lows o%

available pro*e$ts +pply de$ision $riteria s#$h as P- and //

People tend to ta0e %ore$asted $ash %lows %orgranted b#t they are s#b*e$t to error Estimating pro*e$t $ash %lows is the most di%%i$#lt and

error1prone part o% $apital b#dgeting

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2he 3eneral +pproa$h to CashFlow Estimation

Con$ept#ally 4#ite simple Every event in whi$h a pro*e$t is e)pe$ted to

impa$t a %irm5s $ash %lows is $onsidered6 Cash estimates are done on spreadsheets

6 En#merate the iss#es that impa$t $ash and %ore$astingea$h over time

Fore$asts %or new vent#res tend to be themost $omple)

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2he 3eneral +pproa$h to CashFlow Estimation 3eneral o#tline %or estimating new vent#re $ash %lows

Pre1start1#p, the initial o#tlay7everything that has to be spentbe%ore the pro*e$t is tr#ly started

Sales %ore$ast, #nits and reven#es

Cost o% sales and e)penses +ssets7new assets to be a$4#ired, don5t %orget wor0ing $apital &epre$iation 2a)es and earnings S#mmari8e and $ombine7ad*#st earnings %or depre$iation and

$ombine it with the balan$e sheet items to arrive at a $ash %lowestimate

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2he 3eneral +pproa$h to CashFlow Estimation

E)pansion pro*e$ts tend to re4#ire thesame elements as new vent#res 3enerally re4#ire less new e4#ipment and

%a$ilities /epla$ement pro*e$ts generally e)pe$ted

to save $osts witho#t generating new

reven#e Estimating pro$ess tends to be somewhatless elaborate

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+ Few Spe$i%i$ ss#es

S#n0 Costs Costs that have already o$$#rred and $annot be re$overed7

sho#ld not be in$l#ded in pro*e$t5s $ash %lows

pport#nity Costs What is given #p to #nderta0e the new pro*e$t

2he opport#nity $ost o% a reso#r$e is its val#e in its bestalternative #se

For instan$e, i% %irm needs a new wareho#se, it $o#ld either:

6 Lease wareho#se spa$e6 "#y wareho#se

6 "#ild wareho#se on land they $#rrently own 'b#t $o#ld sell %or;,!!!,!!!(7the ;,!!!,!!! represents an opport#nity $ost

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mpa$ts on ther Parts o% Company Sales erosion '$annibali8ation(7when a %irm sells a prod#$t that

$ompetes with other prod#$ts within the same %irm '&iet Pepsi vs. Pepsine(

2a)es

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gnore Finan$ing Costs Even tho#gh a pro*e$t may be %inan$ed with debt 'or

a $ombination o% debt>e4#ity( we do not in$l#de the

interest e)pense 'or dividends( as a $ash o#t%low 2his iss#e is addressed via the dis$o#nt rate when

determining P- or eval#ating //

ld E4#ipment

% this is a repla$ement pro*e$t, old e4#ipment $an besold 'thereby generating a $ash in%low(

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Estimating ew -ent#re CashFlows

ew vent#re pro*e$ts tend to be largerand more elaborate than e)pansions orrepla$ements However, in$remental $ash %lows $an be

easier to isolate6 "e$a#se whole pro*e$t is easily seen as distin$t

and separate %rom the rest o% the $ompany

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?: 2he Wilmont "i$y$le Company man#%a$t#rers a line o% traditional m#lti1speed road bi$y$les.

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?: Last year, anti$ipating an interest in o%%1road bi$y$les, the $ompanybo#ght the rights to a new gearshi%t design %or ;B!,!!!.

Wilmont5s prod#$tion %a$ilities are $#rrently being #tili8ed to$apa$ity, so a new shop has to be a$4#ired %or in$rementalprod#$tion. 2he $ompany owns a lot near the present %a$ility onwhi$h a new b#ilding $an be $onstr#$ted %or ;D!,!!!. 2he land wasp#r$hased ! years ago %or ;!,!!, and now has an estimatedmar0et val#e o% ;B!,!!!.

% Wilmont prod#$es o%%1road bi$y$les, it e)pe$ts to lose some o% its$#rrent sales to the new prod#$t. 2hree per$ent o% the new #nit%ore$ast is e)pe$ted to $ome o#t o% sales that wo#ld have beenmade in the old line. Pri$es and dire$t $osts are abo#t the same inthe old line as in the new.

E)ample

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?: Wilmont5s general overhead in$l#des personnel, %inan$e, ande)e$#tive %#n$tions, and r#ns abo#t BG o% reven#e. Small one1timein$rements in b#siness don5t a%%e$t overhead spending, b#t a ma*or$ontin#ing in$rease in vol#me wo#ld re4#ire additional s#pport.

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+: First we5ll $onsider the nitial #tlay, or those $osts o$$#rring prior tostart1#p. 2he $ost o% hiring, training and advertising are ta) ded#$tible:

Hiring and training ;AB.!

+dvertising and mis$ellaneo#s A!.!

&ed#$tible e)pense ;B.!

2a) $redit IG J.

et a%ter ta) e)penses ;JB.

e)t we5ll add the $ash needed %or physi$al assets:

E4#ipment ;A!!.!ew $onstr#$tion ;D!.!

nitial inventory A.!

+ssets s#btotal ;AA.!

E)ample

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+: +dding the operating items and physi$al assets gives #s the total,a$t#al pre1start1#p o#tlay:

et a%ter ta) e)penses ;JB.

+ssets s#btotal ;AA.!

+$t#al pre1start1#p o#tlay ;D.

2here is also the opport#nity $ost o% the land o% ;B!,!!!. However,sin$e the land initially $ost only ;!,!!, selling the land today wo#ldres#lt in a $apital gain o% ;J,!!, whi$h wo#ld res#lt in ta)es o%

;!,D!!. 2h#s, the opport#nity $ost is ;!J,!!, or ;B!,!!! 1;!,D!!.

2h#s, the initial o#tlay, or C!, is ;D,!! K ;!J,!!, or ;,!!.

E)ample

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+: 2he operating $ash %lows are as %ollows:

E)ample

Sales are %ore$asted to grow %or years be%ore leveling o%%. We5ll

estimate %or D years7%or a longer%ore$ast *#st repeat the last year as

many times as yo# want.

2he b#ilding isdepre$iated

over J yearswhile thee4#ipment isdepre$iatedover B years.

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E)ample

Profit Impact and Tax

E"2 impa$t 'H.F(; 'AJ.(; !.F; DJ.H; DJ.H; A!J.H;

2a) 'J.J(; 'J.J(; B.A; BH.H; BH.H; H.;

E+2 impa$t 'HH.B(; 'J.A(; DL.; A.!; A.!; L.F;

+dd depre$iation F.B; F.B; F.B; F.B; F.B; .B;

S#btotal 'B.J(; AA.F; !J.L; B.B; B.B; J.J;

Working Capital

+$$o#nts re$eivable A!.!; FB.!; DH.B; HB.!; HB.!; HB.!;

nventory A.!; L.!; D.!; FB.!; FB.!; FB.!;

Payables .!; F.B; J.!; .; .; .;

Wor0ing Capital AJ.!; BL.B; JF.B; !L.L; !L.L; !L.L;

Change in wor0ing $apital H.!; AJ.B; D.!; F.; 1; 1;

!t Ca"# $lo%

,et $ash 'BA.J( 'H.( H.L J. B.B J.J

+ss#methat the

;A,!!! o%initial

inventory

wasa$4#iredprior to

start1#p.

/epresents the s#btotal a%ter addingdepre$iation less the $hange in wor0ing $apital.

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2erminal -al#es

t5s possible to ass#me that in$remental $ash%lows last %orever Espe$ially $ommon with new vent#res

Cash %lows %ore$ast to $ontin#e %orever are$ompressed into %inite terminal val#es #singperpet#ity %orm#las For instan$e, a repetitive $ash %low starting at time

wo#ld be a perpet#ity beginning at year 6 2he present val#e at time D wo#ld be represented as Cdis$o#nt rate

6 -ery sensitive to the dis$o#nt rate

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+$$#ra$y and Estimates

P- and // te$hni4#es give the impression o%great a$$#ra$y

However, $apital b#dgeting res#lts are no more

a$$#rate than the pro*e$tions o% the %#t#re #sedas inp#ts Unintentional biases are probably the biggest

problem in $apital b#dgeting

Pro*e$ts are generally proposed by people who wantto see them approved whi$h leads to %avorablebiases

6 2end to overestimate bene%its and #nderestimate $osts

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Estimating Cash Flows %or/epla$ement Pro*e$ts

3enerally have %ewer elements than newvent#res

denti%ying what is in$remental $an be tri$0ier

Can be di%%i$#lt to determine what will happen i%yo# don5t do the pro*e$t For e)ample, i% repla$ing an old prod#$tion ma$hine

do yo# $ompare the per%orman$e o% the new ma$hine

to the $#rrent per%orman$e o% the old, or do yo#$ompare it to %lows the $#rrent ma$hine are e)pe$tedto generate i% it $ontin#es to deteriorate

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Estimating Cash Flows %or/epla$ement Pro*e$ts7E)ample

?: Harrington

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?: 2he old ma$hine has the %ollowing history o% high maintenan$e $ostand signi%i$ant downtime.

&owntime on the ma$hine is a ma*or in$onvenien$e, b#t it doesn5t#s#ally stop prod#$tion #nless it lasts %or an e)tended period. 2hisis be$a#se the $ompany maintains an emergen$y inventory o%stamped pie$es and has been able to temporarily rero#teprod#$tion witho#t m#$h noti$e.

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?: 2he ma0ers o% the repla$ement ma$hines have said that Harrington willspend abo#t ;B,!!! a year maintaining their prod#$t and that an averageo% only ! ho#rs o% downtime a year sho#ld be e)pe$ted. However, theyare not willing to g#arantee those estimates a%ter the one1year warrantyr#ns o#t.

2he new ma$hine is e)pe$ted to prod#$e higher 4#ality o#tp#t than the oldone. 2he res#lt is e)pe$ted to be better $#stomer satis%a$tion and possiblymore sales in the %#t#re.

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+: 2here are two 0inds o% $ash %lows in this problem7those that $an beestimated %airly ob*e$tively and those that re4#ire some degree o%s#b*e$tive g#esswor0.

b*e$tive Cash Flows:

2he initial o#tlay is relatively straight%orward:

E)ample

;!.nitial o#tlay

J.JLess pro$eeds %rom sale o% oldma$hine

;B!.!Cost o% new ma$hine 2he old ma$hine has a $#rrentmar0et val#e o% ;B,!!! and a

boo0 val#e o% ;!,!!! 'initial $osto% ;!,!!! les depre$iation o%

;B!,!!!(. 2h#s, a gain on the saleo% the old ma$hine o% ;B,!!!

res#lts in additional ta)es o% ;B..2he net $ash pro$eeds on the sale

o% the old ma$hine are ;J.J 'or;B.! N ;B.(.

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+: &epre$iation and labor savings are straight%orward as well:

E)ample

;AB.!;AB.!;AB.!;AB.!;AB.!Labor savings

;!.A;!.A;D.;D.;D.Cash ta) savings IG

;!.!;!.!;A!.!;A!.!;A!.!et in$rease indepre$iation

!.!!.!!.!ld depre$iation

;!.!;!.!;!.!;!.!;!.!ew depre$iation

BA

ear

/epresent the $ost savings %rom needingonly two employees rather than three.

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+: 2he s#b*e$tive bene%its 'whi$h are based on opinions( are hard to 4#anti%yand lead to biases when estimated by people who want pro*e$t approval.2he %inan$ial analyst sho#ld ens#re that only reasonable estimates o%#nprovable bene%its are #sed.

E)ample

;!.!;!.!;!.!;!.!;B.!Savings

B.!B.!B.!B.!n

warrantyew ma$hinemaintenan$e

;B.!;B.!;B.!;B.!;B.!ld ma$hinemaintenan$e

BA

ear

2he 4#estion is: Sho#ld we ass#me maintenan$e on the oldma$hine wo#ld have remained at ;B.! or in$rease as thema$hine gets older9 +lso, will maintenan$e on the new

ma$hine rise as the new ma$hine ages9

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+: +nother s#b*e$tive estimate is that o% downtime. 2he old ma$hine has beenhaving abo#t ! ho#rs o% downtime while the new one promises ! ho#rs7asavings o% !! ho#rs. "#t, arg#ment $o#ld be made %or #sing di%%erentass#mptions %or downtime ho#rs. +nother 4#estion is: How m#$h is ea$h ho#ro% downtime savings worth9 +rg#ments range %rom no savings 'as we are#nable to say e)a$tly how m#$h it5s worth( to ;B!! an ho#r.

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