Cash Flow Lecture - UNO CBA

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Project Cash Flow Analysis
•Relevant cash flows
•Working capital treatment
•Inflation
•Abandonment value
•Equity Residual Model
•Replacement Project
Incremental Cash Flow
= Corporate cash flow
with project
minus
Corporate cash flow
without project
Incremental cash flows- any and all cash
flows that are a direct consequence of taking
a project.
Relevant Cashflows are:
• those that come into or out of being
because a project is undertaken.
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Allied Foods I Cash Flow Estimation
Initial Investment:
Price $200,000
Freight $10,000
Installation $5,000
Change in NWC $10,000
Operating Flows and Inflation Rates:
Sales volume 1,450,000
Year 0 sales price $0.90
Operating costs 80.0%
Salvage Value, Tax Rate, and Cost of capital:
Salvage value $50,000
Tax rate 40%
Cost of capital 15%
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Three steps to estimating a project’s
cash flows are:
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Three steps to estimating a project’s
cash flows are:
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0 1 2 3 4
0 1 2 3 4
Initial
Outlay
OCF 1 OCF 2 OCF 3 OCF 4
+ Terminal
CF
Initial
Outlay
OCF 1 OCF 2 OCF 3 OCF 4
+ Terminal
CF
NCF 0 NCF 1 NCF 2 NCF 3 NCF 4
NCF 0 NCF 1 NCF 2 NCF 3 NCF 4
1. estimate initial cash outlay.
2. estimate incremental operating cash flows.
3. estimate nonoperating cash flows.
1. estimate initial cash outlay.
2. estimate incremental operating cash flows.
3. estimate nonoperating cash flows.

Allied Foods I
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Net Investment Outlay:
Price $200,000
Freight 10,000
Installation 5,000
Change in NWC 10,000
-------------
$225,000
========
Three steps to estimating a project’s
cash flows are:
0 1 2 3 4
Initial
Outlay
OCF 1 OCF 2 OCF 3 OCF 4
+ Terminal
CF
NCF 0 NCF 1 NCF 2 NCF 3 NCF 4
1. estimate initial cash outlay.
2. estimate incremental operating cash flows.
3. estimate nonoperating cash flows.
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Allied Foods I
Year Year
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OCF t = (Revenue t - Cost t - Depr t )(1-T) + Depr t Operating costs
1,044,000 1,044,000
1 2
Unit price
$0.90 $0.90
Operating cashflow (OCF t )
Unit sales
1,450,000 1,450,000
-------- --------
Revenues
$1,305,000 $1,305,000
Depreciation
Before tax income
Taxes
Net income
Plus depreciation
Net op cash flow
Allied Foods I Allied Foods I
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Year Year
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1 2
Unit price
Unit sales
Depreciable basis = $215,000
EOY
MACRS Dep. Book
Year Factor Expense Value
------ ------ -------- --------
1 33%
2 45%
3 15%
4 7%
------
100%
$70,950 $144,050
96,750 47,300
32,250 15,050
15,050 (0)
--------
$215,000
Revenues
Operating costs
Depreciation
Before tax income
Taxes
Net income
Plus depreciation
Net op cash flow
$0.90 $0.90
1,450,000 1,450,000
-------- --------
$1,305,000 $1,305,000
1,044,000 1,044,000
70,950 96,750
-------- --------
$190,050 $164,250
76,020 65,700
-------- --------
$114,030 $98,550
70,950 96,750
-------- --------
$184,980 $195,300

Allied Foods I
Year Year
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Allied Foods I
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3 4
Unit price
Unit sales
Revenues
Operating costs
Depreciation
Before tax income
Taxes
Net income
Plus depreciation
Net op cash flow
$0.90 $0.90
1,450,000 1,450,000
-------- --------
$1,305,000 $1,305,000
1,044,000 1,044,000
32,250 15,050
-------- -------
$228,750 $245,950
91,500 98,380
-------- --------
$137,250 $147,570
32,250 15,050
-------- --------
$169,500 $162,620
Year Year Year Year Year
0 1 2 3 4
Net op cash flow $184,980 $195,300 $169,500 $162,620
Three steps to estimating a project’s
cash flows are:
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Allied Foods I
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0 1 2 3 4
Initial
Outlay
OCF 1 OCF 2 OCF 3 OCF 4
+ Terminal
CF
NCF 0 NCF 1 NCF 2 NCF 3 NCF 4
1. estimate initial cash outlay.
2. estimate incremental operating cash flows.
Year Year Year Year Year
0 1 2 3 4
Net op cash flow $184,980 $195,300 $169,500 $162,620
Salvage value $50,000
SV tax=-(SV-BV)T (20,000)
Recovery of NWC 10,000
--------
Termination CF $40,000
-------- -------- -------- -------- --------
Project NCF ($225,000) $184,980 $195,300 $169,500 $202,620
3. estimate nonoperating cash flows.
Allied Foods I
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NPV
IRR
TV
MIRR
Payback
$310,825
74.0%
$937,161
42.9%
1.2
Suppose $100,000 had been spent last
year to improve the production line
site. Should this cost be included in
the analysis
•NO. This is a sunk cost. Focus on
incremental investment and
operating cash flows.

If the price of a can of fresh lemon
juice is expected to increase by 1.5%
per year while operating costs are
expected to increase by 8.0% per year,
would this affect the analysis
•Yes, because the discount rate is
quoted on a nominal basis the cash
flows and profitability analysis will
be biased if quoted on a real basis.
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If the plant space could be leased out
for $25,000 a year, would this affect
the analysis
•Yes. Accepting the project means we
will not receive the $25,000. This is
an opportunity cost and it should be
charged to the project.
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If the new product line would decrease
sales of the firm’s other products by
$15,000 per year, and decrease
operating costs of other porducts by
$20,000 would this affect the analysis
•Yes. The effects on the other projects’
CFs is an “externality”.
•Net CF loss per year on other lines
would be a cost to this project.
•Externalities will be positive if new
projects are complements to existing
assets, negative if substitutes.
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Allied Foods
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Allied Foods
(with inflation and externalities)
• Operating Flows and Inflation Rates:
Sales volume 1,450,000
Year 0 sales price $0.90
Operating costs 80.0%
Price inflation 1.5%
Cost inflation 8.0%
• Salvage Value, Tax Rate, and Cost of Capital:
Salvage value $50,000
Tax rate 40%
Cost of capital 15%
• Effects on Other Projects:
Revenue reduction $40,000
Cost reduction $20,000
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Allied Foods2
Unit price
Unit sales
Revenues
Operating costs
Depreciation
Other project effects
Before tax income
Taxes
Net income
Plus depreciation
Net op cash flow
Year Year Year
0 1 2
-------- -------- --------
$0.90 $0.91 $0.93
1,450,000 1,450,000
-------- --------
$1,324,575 $1,344,444
1,127,520 1,217,722
*Note that because 70,950 of differing 96,750 economic
pressures operating 20,000 costs will 20,000 not remain
at 80% of sales.
Yr1 operating costs $106,105 = (0.90 X 0.80)x(1.08) $9,972
42,442 x 1,450,000 = $1,127,520 3,989
-------- --------
$63,663 $5,983
Yr2 operating costs = $1,127,520 X 1.08 =
$1,217,721.60 70,950
--------
$134,613
96,750
--------
$102,733
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Allied Foods2
Unit price
Unit sales
Revenues
Operating costs
Depreciation
Other project effects
Before tax income
Taxes
Net income
Plus depreciation
Net op cash flow
Year Year
3 4
-------- --------
$0.94 $0.96
1,450,000 1,450,000
-------- --------
$1,364,610 $1,385,079
1,315,139 1,420,350
32,250 15,050
20,000 20,000
-------- --------
($2,779) ($70,321)
(1,112) (28,128)
-------- --------
($1,667) ($42,193)
32,250 15,050
-------- --------
$30,583 ($27,143)
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Allied Foods2 Allied Foods2
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Year Year Year Year Year
0 1 2 3 4
Net op cash flow $134,613 $102,733 $30,583 ($27,143)
Salvage value $50,000
SV tax=-(SV-BV)T ( 20,000)
Recovery of NWC 10,000
--------
Termination CF $40,000
-------- -------- -------- -------- --------
Project NCF ($225,000) $134,613 $102,733 $30,583 $12,857
NPV
IRR
TV
MIRR
Payback
($2,804)
14.1%
$388,622
14.6%
1.9
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Allied Foods3
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If you terminate a project before the
asset is fully depreciated, will this
affect the profitability of the project
•Yes, the early termination of a project
may either decrease or increase the
profitability of a project.
Year Year Year Year
0 1 2 3
Net op cash flow $134,613 $102,733 $30,583
Salvage value $50,000
SV tax (13,980)
Recovery of NWC 10,000
--------
Termination CF $46,020
-------- -------- -------- --------
Project NCF ($225,000) $134,613 $102,733 $76,603
Allied Foods3
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Conclusions
NPV
IRR
TV
MIRR
Payback
$20,103
20.9%
$372,771
18.3%
1.9
•The project is acceptable only if
operated for 3 years.
•A project’s engineering life does not
always equal its economic life.
•The ability to abandon a project may
make an otherwise unattractive
project acceptable.
•Abandonment possibilities will be
very important when we get to risk.

Types of Abandonment
•Sale to another party who can obtain
greater cash flows, e.g., IBM sold
typewriter division.
•Abandon because the project is
losing money, e.g., smokeless
cigarette.
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Fairways Driving Range
• Initial Investment:
Dispensing Machine $2,000
Pick-up vehicle $7,000
Tractor and Accessories $9,000
Change in NWC $3,000
• Operating Flows and Inflation Rates:
Sales of buckets of balls 20,000
price per bucket $3.00
Fixed costs $53,000
Op costs 5.0%
Price inflation 4.0%
Cost inflation 5.0%
Growth in Unit Sales 10.0%
• Salvage Value, Tax Rate, and Cost of Capital:
Salvage value $1,800
Tax rate 30%
Market value of business $10,000
Cost of capital 14.3%
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Fairways 1 Fairways 1
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Net Investment Outlay:
Dispensing Machine $2,000
Pick-up vehicle $7,000
Tractor and Accessories $9,000
Change in NWC $3,000
--------
$21,000
Depreciable basis = $18,000
EOY
MACRS Dep. Book
Year Factor Expense Value
------ ------ -------- --------
1 33% $5,940 $12,060
2 45% 8,100 3,960
3 15% 2,700 1,260
4 7% 1,260 0
------ --------- -------
100% $18,000
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Year Year Year Year
0 1 2 3
-------- -------- -------- --------
Unit price $3.00 $3.12 $3.24 $3.37
Unit sales 20,000 22,000 24,200 26,620
Revenues $68,640 $78,524 $89,832
Fixed Costs ($53,000) ($53,000) ($53,000)
Operating costs per unit 0.1575 0.1654 0.1736
Total Operating costs (3,465) (4,002) (4,622)
Depreciation (5,940) (8,100) (2,700)
-------- -------- --------
Before tax income $6,235 $13,422 $29,509
Taxes 1,871 4,027 8,853
-------- -------- --------
Net income $4,365 $9,396 $20,657
Plus depreciation 5,940 8,100 2,700
-------- -------- --------
Net op cash flow $10,305 $17,496 $23,357
Net op cash flow $10,305 $17,496 $23,357
Salvage value
SV tax
Market Value of Business*
Tax on sale of business
Termination CF
$1,800
(162)
10,000
(3,000)
$8,638
-------- -------- -------- --------
Project NCF ($21,000) $10,305 $17,496 $31,995
*NWC is captured in the price when the business is sold.
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Decision Measures:
NPV
IRR
TV
MIRR
Payback
Should CFs include interest expense
Dividends
Fairways Driving Range
Equity Residual Model
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Fairways 1
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• Salvage Value, Tax Rate, and Cost of Capital:
Salvage value $1,800
Tax rate 30%
Market value of business $10,000
Percent of Debt Financing 50%
Cost of Debt 12%
Cost of Equity 25%
Net Investment Outlay:
Dispensing Machine $2,000
Pick-up vehicle $7,000
Tractor and Accessories $9,000
Change in NWC $3,000
--------
$21,000
========
Equity Investment $10,500
Debt Financing $10,500
Year Year Year Year
0 1 2 3
-------- -------- -------- --------
Unit price $3.00 $3.12 $3.24 $3.37
Unit sales 20,000 22,000 24,200 26,620
Revenues $68,640 $78,524 $89,832
Fixed Costs ($53,000) ($53,000) ($53,000)
Operating costs per unit 0.1575 0.1654 0.1736
Total Operating costs (3,465) (4,002) (4,622)
Interest Expense (1,260) (1,260) (1,260)
Depreciation
Before tax income
Taxes
Net income
Plus depreciation
(5,940) (8,100) (2,700)
-------- -------- --------
$4,975 $12,162 $28,249
(1,493) (3,649) (8,475)
-------- -------- --------
$3,483 $8,514 $19,775
5,940 8,100 2,700
-------- -------- --------
Net op cash flow $9,423 $16,614 $22,475
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Fairways 2
Year Year Year Year
0 1 2 3
Net op cash flow $9,422 $16,613 $22,474
Salvage value $1,800
SV tax (162)
Market value of business* 10,000
Tax on sale of business (3,000)
Principal Repayment (10,500)
-----------
Termination CF (1,862)
-------- -------- -------- --------
Project NCF ($10,500) $9,422 $16,613 $20,612
*NWC is captured in the price when the business is sold.
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With an equity residual model, the
cost of equity, K=25%, is used to find
the project’s NPV, MIRR, and IRR.
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Adjusted-present-value (APV)
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NPV
IRR
TV
MIRR
Payback
APV = NPV + NPVF
The value of a project to a levered firm (APV)
is equal to the value of the project to an
unlevered firm (NPV) plus the net present value
of the financing side effects (NPVF).
Adjusted Present Value (APV)
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Adjusted Present Value (APV)
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There are four side effects caused by the issuance of
debt:
1.The Tax Subsidy to Debt. (T C B)
2.The Costs of Issuing New Securities.
3.The Costs of Financial Distress.
4. Subsidies to Debt Financing.
Cash flows are the same as the typical NPV
estimation:
Year Year Year Year
0 1 2 3
($21,000) $10,305 $17,496 $31,995
However, like the equity residual model, the cost of
equity is used to find the NPV of the unlevered firm:
NPV =
(Unlevered K= 25%)
Note: We can not use the IRR or MIRR for comparison or decision
making.
Adjusted Present Value (APV)
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Adjusted Present Value (APV)
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Floatation Costs are paid immediately but are amortized
over the life of the loan.
Floatation Costs
(1% of debt)
Deduction
Tax shield = Deduction * t
Floatation Cash Flow
NPV of Floatation Costs:
(discounted at the risk free rate of 10%)
Year Year Year Year
0 1 2 3
Tax Subsidy
Year Year Year Year
0 1 2 3
Loan Amount $10,500
Interest Paid @ 12%
After tax cost of debt (Int*(1-t))
Balloon payment of debt
Cash Flow
NPV of Tax Subsidy:
(discounted at the risk free rate of 10%)

Adjusted Present Value (APV)
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If this were a replacement rather than
a new project, would the analysis
change
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APV = NPV(Equity) + NPV(Floatation Costs) + NPV (Tax Subsidy)
APV =
NPV =
NPV (FTE) =
•Yes. The old equipment would be
sold and the incremental CFs would
be the changes from the old to the
new situation.
Operating Cash Flows for a
Replacement Project
(New Revenue - New Cost - New depr)(1-T) + New depr
- (Old Revenue - Old Cost - Old depr)(1-T) + Old depr
---------------------------------------------------------------------------------
(@Revenue - @ Cost - @ depr)(1-T) + @ depr
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McDwyer Corporation
• Initial Investment: (000)
Price $300,000
Freight $10,000
Change in NWC $0
Sale of old machine $80,000
• Operating Flows and Inflation Rates:
New: Old:
Sales volume 200,000 200,000
Year 0 sales price $3.25 $3.25
Op costs 70.0% 80.0%
Price inflation 4.0% 4.0%
Cost inflation 3.0% 3.0%
• Salvage Value, Tax Rate, and Cost of Capital:
Salvage value $40,000 $30,000
Tax rate 40%
Cost of capital 12%
Depreciation: 3 yr MACRS Straight Line
Current Book Value $100,000
Life 4 years 2 years left
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Net Investment Outlay:
Price ($300,000)
Freight (10,000)
Sell old machine 80,000
Tax on old machine
-(80,000-100,000)*.4= 8,000
--------
($222,000)
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McDwyer
Depreciable basis = $310,000
EOY
MACRS Dep. Book
Year Factor Expense Value
------ ------ -------- --------
1 33% $102,300 $207,700
2 45% 139,500 68,200
3 15% 46,500 21,700
4 7% 21,700 0
------ ------------- ----------
100% $310,000
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Year Year Year
0 1 2
New: -------- -------- --------
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Year Year
3 4
-------- --------
Unit price $3.25 $3.38 $3.52 $3.66 $3.80
Unit sales 200,000 200,000 200,000 200,000
Old: -------- -------- -------- --------
Unit price $3.25 $3.38 $3.52 $0.00 $0.00
Unit sales 200,000 200,000 0 0
Change in Revenues $0 $0 $731,162 $760,408
New Cost per Unit $2.34 $2.41 $2.49 $2.56
New Operating costs 468,650 482,710 497,191 512,107
Old Cost per Unit 2.68 2.76 0 0
Old Operating costs 535,600 551,668 0 0
Change Operating costs ($66,950) ($68,959) $497,191 $512,107
New Depreciation 102,300 139,500 46,500 21,700
Old Depreciation 50000 50000 0 0
Change in Depreciation 52300 89500 46500 21700
-------- -------- -------- --------
Before tax income $14,650 ($20,541) $187,471 $226,602
Taxes 5,860 (8,217) 74,988 90,641
-------- -------- -------- --------
Change in Net income $8,790 ($12,325) $112,482 $135,961
Plus change in depreciation 52,300 89,500 46,500 21,700
-------- -------- -------- --------
Net change in operating cash flow $61,090 $77,175 $158,982 $157,661
Net change in operating
cash flow
$61,090 $77,175 $158,982 $157,661
-------- -------- -------- --------
Salvage value ($30,000) $40,000
SV tax $12,000 (16,000)
-------- --------
Termination CF ($18,000) $24,000
-------- -------- -------- -------- --------
Project NCF ($222,000) $61,090 $59,175 $158,982 $181,661
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McDwyer 57
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How many piano tuners are there in
Omaha
NPV
IRR
TV
MIRR
Payback
Estimating the revenue, operating costs, and external effects
of a project or business plan is similar to the Fermi problem
just discussed.
• If we become bogged down in obtaining the exact estimate,
wasted time and effort may be spent on a superfluous
process, or worse, no estimate is made because of
concerns about being wrong.
• If we simply throw out a guess without breaking down the
estimating process, significant and biased errors may be
made.
• To estimate a project’s revenue, cost, or external effect, we
should break the estimation processes down into several
incremental steps. Because of the law of diversification, an
error made in one step may be corrected by an opposite
error in another step.
• In addition, risk analysis will aid us in identifying those
incremental estimates that significantly affect profitablility
and warrant more research.
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What is the role of the executive
manager in the cash flow estimation
process
•Coordination with other
departments
•Maintaining consistency of
assumptions
•Elimination of biases in the
forecasts
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What is cash flow estimation bias
•CF’s are estimated for many future
periods.
•If company has many projects and
errors are random and unbiased,
errors will cancel out (aggregate
NPV estimate will be OK).
•Studies show that forecasts often are
biased (overly optimistic revenues,
underestimated costs).
What steps can management take to
eliminate the incentives for cash flow
estimation bias
•Routinely compare CF estimates with
those actually realized and reward
managers who are forecasting well,
penalize those who are not.
•When evidence of bias exists, the
project’s CF estimates should be
adjusted to offset the bias.
63
What is option value
•Investment in a project may lead to
other valuable opportunities.
•Investment now may extinguish
opportunity to undertake same
project in the future.
•True project NPV = NPV + value of
options.