Chapter 9

The Art and Science of

Estimating Project Cash Flows

Shapiro and Balbirer: Modern Corporate Finance:

A Multidisciplinary Approach to Value Creation
Graphics by Peeradej Supmonchai

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 Learning Objectives

 Explain the importance of using incremental reasoning in

identifying a project’s cash flows.
 Identify a project’s initial investment, incremental
operating cash flows, and terminal value and use these
estimates to calculate the project’s NPV.
 Describe how the failure to deal with inflation and other
biases in capital budgeting can lead to inappropriate
investment decisions.
 Discuss the importance of properly assessing the effects
of product line cannibalization in a new product
introduction.
 Use the principle of purchasing power parity to properly
evaluate an overseas project.
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 Learning Objectives (Cont.)

 Describe how the failure to identify managerial

options can systematically undervalue an
investment project
 Explain the importance of creating barriers to entry
by potential competitors is important to the
generation of positive NPV projects.
 Indicate how an option valuation approach can be
used to evaluate R&D projects.
 Describe how techniques such as sensitivity
analysis, simulation, and decision trees can help
managers to understand the sources of project
risk.
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 Guidelines for Estimating Project Cash Flows

 Apply incremental reasoning

 Ignore fictional accounting flows
 Be careful about transfer prices
 Ignore sunk costs
 Don’t ignore opportunity costs
 Don’t forget working capital requirements
 Don’t forget abandonment costs or terminal
value

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 Incremental Cash Flows for a Project

 Initial investment

 Operating cash flows

 Terminal or salvage values

 Abandonment costs
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 Initial Investment

A project’s initial investment may consist of three

components:

Cost of acquiring and placing the asset in service

Net proceeds from the sale of the existing equipment

Tax consequences of selling an existing asset

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 Operating Cash Flows

The incremental operating cash flows (OCF), per period, can

be expressed as

OCF = ( REV - COST - DEP)(1 - TAX) + DEP - WC

Where:
REV = the change in revenues
COST = the change in operating costs
DEP = the change in depreciation
WC = the annual increase in working capital
TAX = the marginal tax rate faced by the firm
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 Terminal or Salvage Values

A project’s terminal, or salvage value may consist

of one or more of the following elements:

Salvage value of equipment

Recovery of working capital

Cash flows beyond some initial evaluation period

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 Abandonment Costs

Some projects require cash outflows when

the project is terminated. For instance, firms

in certain industries may have to incur high

costs to meet environmental standards.

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 The Replacement Problem

 A class of investments where a company

is looking to replace an existing piece of
equipment with a new “model.”

 The motivation for these projects is either

cost reduction or quality improvement or
both.

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 Spectrum Manufacturing Company

Existing Equipment

Cost = $120,000 Depreciation = $12,000/Year Book Value = $60,000

Salvage Value Today = 10,000 Salvage Value in 5 Years = $0

New Equipment

Cost = $100,000 Depreciation = $20,000/Year

Cash Savings = $24,000/Year Salvage Value in 5 Years = $0

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 Spectrum Manufacturing Company-
Initial Investment

Installed Cost of Computerized Lathe $100,000

Salvage Value of Old Lathe 10,000
Tax Effects from Selling Old Lathe 20,000
INITIAL INVESTMENT $70,000

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 Spectrum Manufacturing Company -
Operating Cash Flows
Year 1 Year 2 Year 3 Year 4 Year 5

Annual Cash Savings $24,000 $24,000 $24,000 $24,000 $24,000

 Depreciation (8,000) (8,000) (8,000) (8,000) (8,000)
Taxable Income $16,000 $16,000 $16,000 $16,000 $16,000
Taxes@40% (6,400) (6,400) (6,400) (6,400) (6,400)
After-Tax Income $ 9,600 $9,600 $ 9,600 $9,600 $9,600
Plus:  Depreciation 8,000 8,000 8,000 8,000 8,000

Annual OCF $17,600 $17,600 $17,600 $17,600 $17,600

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 Spectrum Manufacturing Company-
The Project’s NPV

NPV = $17,600 [PVIFA 5,10] -$70,000

= $17,600(3.7908) - 70,000
= -$3,282

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 Inflation Biases in Capital Budgeting

Required returns in the financial markets

embody inflationary expectations. Not
adjusting cash flows for inflation means that
firms will be discounting real cash flows by
nominal interest rates. This systematically
understates a project’s NPV.

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 Inflation Biases- An Example
Year 1 Year 2 Year 3 Year 4 Year 5

Annual Cash Savings $24,000 $24,960 $25,958 $26,997 $28,077

 Depreciation (8,000) (8,000) (8,000) (8,000) (8,000)

Taxable Income $16,000 $16,960 $17,958 $18,997 $20,077

Taxes@40% (6,400) (6,784) (7,183) (7,599) (8,031)

After-Tax Income $ 9,600 $10,176 $11,775 $11,398 $12,046

Plus:  Depreciation 8,000 8,000 8,000 8,000 8,000

Annual OCF $17,600 $18,176 $18,775 $19,398 $20,046

Present Value $16,000 $15,021 $14,106 $13,249 $12,447

NPV = $70,824  $70,000 = $824

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 Biases in Capital Budgeting

 Inflation

 Projects with overestimated cash flows are

more likely to be chosen

 Manager overoptimism

 Manager pessimism

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 New Product Introduction

Investments related to (1) product or service

extensions, or (2) product innovations. The
estimates of cash flows from new product
introductions are subject to a far greater
degree of uncertainty than are replacement
projects

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 New Product Introduction -
Smith Corporation
NEW PRODUCT FINANCIAL FORECASTS
( ALL FIGURES IN $1,000)
Period 0 1 2 3 4 5 6

Sales 500 5,500 8,000 14,000 7,000 4,000

Operating Expenses 800 3,410 4,960 8,680 4,340 2,480

Product Promotion 3,000 1,000

Depreciation 1,000 1,000 1,000 1,000 1,000 1,000
Profit Before Taxes  3,000  2,300 1,090 2,040 4,320 1.660 520
Taxes @ 34%  1,020  782 371 694 1,469 564 177
Profit After Taxes  1,980 1,518 719 1,346 2,851 1,096 343

Level of Working Capital 250 660 960 1,680 840 480

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 New Product Introduction -
Smith Corporation
CAPITAL PROFIT AFTER TAX WORKING TOTAL PRESENT

YEAR EQUIPMENT DEPRECIATION CAPITAL CASH FLOW VALUE @20%

0  $6,000  $1,980   $7,980  $1,980

1   518  250  768  640

2  1,719  410 1,309 909

3  2,346  300 2,046 1,184
4  3,851  720 3,131 1,510
5  2,096 840 2,936 1,180
6  1,343 360 1,703 570
7 $ 660  480 1,140 318
NPV =  $2,948

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 Post-Evaluation Period Cash Flow Estimation

The following equation can be used to

estimate the cash flows beyond some initial
evaluation period:

CFn+1
TVn = ———
(k-g)

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 Smith and Company
NEW PRODUCT #2 FINANCIAL FORECASTS
( ALL FIGURES IN $1,000)

Period 0 1 2 3 4 5 6

Sales 2,500 10,000 16,500 21,000 23,000 25,000

Operating Expenses 1,625 6,500 10,725 13,650 14,950 16,250

S&A Expenses 3,000 3,000 3,000 3,000 3,000 3,000 3,000

Depreciation 750 750 750 750 -0- -0-
Profit Before Taxes  3,000  2,875 250 2,025 3,600 5,050 5,750
Taxes @ 34%  1,020  978 -85 688 1,224 1,717 1,955
Profit After Taxes  1,980 1,898 -165 1,337 2,376 3,333 3,795

Level of Working Capital 750 3,000 4,950 6,300 6,900 7,500

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 Smith and Company

CAPITAL PROFIT AFTER TAX WORKING TOTAL PRESENT

YEAR EQUIPMENT DEPRECIATION CAPITAL CASH FLOW VALUE @20%

0 $3,000  $1,980   $4,980  $4,980

1   1,148  750  1,898  1,531

2  585  2,250  1,665  1,083

3  2,087  1,950 137 72
4  3,126  1,350 1,776 751
5  3,333  600 2,733 932
6  3,795  600 3,195 879

NPV =  $4,960
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 Smith and Company- Sensitivity Analysis

(ALL FIGURES IN $1,000)

GROWTH TERMINAL PRESENT VALUE OF

RATE % VALUE TERMINAL VALUE PROJECT NPV

3 $15,671 $4,311 $ 648

4 16,614 $4,570  389
5 17,656 4,857  102
6 18,815 5,176 217
7 20,110 5,532 573

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 Product Line Cannibalization
A phenomenon where a new product takes sales
away from one or more of a firm’s existing products.
Evaluating cannibalization involves the following
considerations:

 What matters is the incremental effect of

cannibalization; the sales lost that can be
solely attributable to the new product
introduction

 Be sensitive to the competitive environment; it

is always better to lose volume to your own
entry than to one of your competitor’s

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 Evaluation of Foreign Projects - ACS Enterprises

ASSUMPTIONS:
Zero Inflation Environment
Exchange Rate : 1 puff/dollar
YEARS
0 1 2 3 4 5 6
Sales 200 200 200 200 200 0
Net Working Capital 30 30 30 30 30 0
Depreciation Expense 40 40 40 40 40 0
Profit After Taxes 20 20 20 20 20 0

Cash Flow Analysis

Investment in Equipment (200) 0 0 0 0 0 0
Investment in Working Capital 0 (30) 0 0 0 0 30
Cash Flow From Operations 0 60 60 60 60 60 0
Period Cash Flows (200) 30 60 60 60 60 30

Internal Rate of Return = 12.8%

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 Evaluation of Foreign Projects -
Purchasing Power Parity

e1 1 + ih
 = 
eo 1 + if

Where:
ih = price level increases (rates of inflation) for the home country
if = price level increases (rates of inflation) for the foreign country
eo = the current dollar value of one unit of the foreign currency

e1 = the end-of-period exchange rate.

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 Evaluation of Foreign Projects- ACS Enterprises
ASSUMPTIONS:
10 percent Annual Inflation
Exchange Rate : Puff Declines by 10% a Year Against Dollar

YEARS
0 1 2 3 4 5 6
Sales 200 220 242 266 292 0
Net Working Capital 30 33 36 40 44 0
Depreciation Expense 40 40 40 40 40 0
Profit After Taxes 20 24 28 33 39 0

Cash Flow Analysis

Investment in Equipment (200) 0 0 0 0 0 0
Investment in Working Capital 0 (30) (3) (3) (4) (4) 44
Cash Flow From Operations 0 60 64 68 73 79 0
Period Cash Flows ( in puffs) (200) 30 61 65 69 75 44
Period Cash Flows ( in dollars) (200) 27 50 49 47 47 25

Internal Rate of Return ( in puffs) = 16.9%

Internal Rate of Return ( in dollars ) = 6.2%

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 Managerial Options and Capital Budgeting

DCF techniques assume that a project’s

cash flows cannot be changed once the
decision to go ahead is made. This is
unrealistic for many projects since
management actions can alter the initial
cash flow estimates after implementation.
Such managerial discretions are options.
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 Strategic Options- Bubbly Beverage
SUMMARY OF CASH FLOWS FOR DELIGHTFULLY DELICIOUS LINE
(ALL FIGURES IN $MILLION)
YEAR 1998 1999 2000 2001 2002
After-Tax Operating Cash Flow 140 120 50 100 100
Capital Investment  80 - - - -
Working Capital Changes  20  30  30  20 -

Terminal Value - - - - 500

Net Cash Flow 240 150 20 80 600

NPV @ 20 percent = $15.5 Million

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 Strategic Options- Bubbly Beverage

Traditional capital budgeting analysis

ignores the potential for:

Add-on products

Vertical integration

Related diversification

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 Value of Projects With Strategic Options

VPROJ = VDCF + VSTRAT

Where:
VDCF = the project’s value using traditional DCF techniques
VSTRAT = the value of the strategic options

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 Sources of Positive NPV Projects

 Projects that create economies of scale

or scope
 Projects that create cost advantage
 Projects that allow firms to differentiate
products or services
 Projects that build or enhance channels
of distribution
 Government policy
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