Relevant cashflows

1
CHAPTER 7 Project Cash Flow Analysis

• Relevant cashflows
• Working capital treatment
• Unequal project lives
• Abandonment value

2
Proposed Project

• Cost 200,000 10,000 shipping 30,000
  installation.
• Depreciable cost 240,000.
• Inventories will rise by 25,000 and payables
  will rise by 5,000.
• Economic life 4 years.
• Salvage value 25,000.
• MACRS 3-year class.

3

• Incremental gross sales 250,000.
• Incremental cash operating costs 125,000.
• Tax rate 40.
• Cost of capital WACC 10

4
Set up without numbers a time line for the
project CFs.
0
1
2
3
4
Initial Outlay
OCF1
OCF2
OCF3
OCF4
Terminal CF
NCF0
NCF1
NCF2
NCF3
NCF4
5
What is the annual depreciation?
Year Rate x Basis Depreciation
1 0.33 240 79 2 0.45 240 108
3 0.15 240 36 4 0.07 240
17 1.00 240 Due to half-year convention, a
3-year asset is depreciated over 4 years.
6
Operating cash flows 1 2 3 4 Sales 250 25
0 250 250 Cash costs 125 125 125
125 Depreciation 79 108 36
17 EBT 46 17 89 108 Taxes (40)
18 7 36 43 Net Income 28
10 53 65 Add Depreciation 79 108
36 17 Operating Cash flow 107 118 89 82
7
Should CFs include interest expense? Dividends?

• NO. The costs of capital are already incorporated
  in the analysis since we use them in discounting.
  
• If we included them as cashflows, we would be
  double counting the cost of capital.

8
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 cash flows.

9
Suppose 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.
• A.T. opportunity cost 25,000 (1-T) 15,000
  annual cost.

10
If the new product line would decrease sales of
the firms other products by 50,000 per year,
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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Net Investment Outlay At t0
Equipment Freight Inst. Change in NWC Net CF0
(200,000) (40,000) (20,000) (260,000)
D NWC 25,000 - 5,000
12
Net Terminal Cash Flow At t 4
Salvage value Tax on SV Recovery on NWC Net
Termination CF
25,000 (10,000) 20,000 35,000
13
Project net CFs on a time line

• 0 1 2 3 4
• (260) 107 118 89 117

Enter CFs in CFLO register and I 10. NPV
81,573 IRR 23.8
14
What is the projects MIRR?

• 0 1 2 3 4
• (260) 107 118 89 117

97.9 142.8 142.4 500.1
(260)
MIRR ?
15
Calculator Solution 1. Enter positive CFs in
CFLO I 10 Solve for NPV 341.60
16
Use the FV TV of inputs to find MIRR.
MIRR 17.8. Since MIRR gt k 10, accept the
project.
17
What is the projects payback?

• 0 1 2 3 4
• (260) 107 118 89 117

Cumulative (260) (153) (35) 54
171 Payback 2 35/89 2.4 years
18
What is cash flow estimation bias?

• CFs are estimated for many future periods.
• If company has many projects and errors are
  random and unbiased, errors cancel out
  (aggregate NPV estimate will be OK).
• Studies show that forecasts are biased (overly
  optimistic revenues, underestimated costs).

19
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 projects CF
  estimates should be lowered or the cost of
  capital raised to offset the bias.

20
Is it likely that the project being considered
here might have strategic option value over and
above the indicated NPV?

• Strategic option value Investment in a project
  may lead to other valuable opportunities
• Because of this, managers might be willing to
  accept a negative NPV project if it might lead to
  one or more positive NPV projects in the
  future. (More...)

21

• In many instances, only a qualitative evaluation
  is possible.
• It is unlikely that this particular project has
  strategic option value because it involves adding
  only one machine to support a new product line.

22
If 5 inflation is expected over the next 5
years, are the firms cash flow estimates
accurate?

• No. Net revenues are assumed to be constant over
  the 4-year project life, so inflation effects
  have not been incorporated into the cash flows.

23
Real vs. Nominal Cash Flows

• In DCF analysis, k includes an estimate of
  inflation.
• If cash flow estimates are not adjusted for
  inflation (i.e., are in todays dollars), this
  will bias the NPV downward.
• This bias may offset the optimistic bias of
  management.

24
S and L are mutually exclusive and will be
repeated. k 10 Which is better?
0
1
2
3
4
(100K)
60K
60K
Project S
(100K)
33.5
33.5
33.5
33.5
Project L
25
S L CF0 -100,000 -100,000 CF1
60,000 33,500 Nj 2 4 I 10 10 NPV 4
,132 6,190
NPVL gt NPVS. But is L better? Cant say yet.
Need replacement chain analysis.
26

• Note that Project S could be repeated after 2
  years to generate additional profits.
• Use replacement chain to calculate extended NPVs
  to a common life.
• Since S has a 2 year life and L has a 4 year
  life, the common life is 4 years.

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Project L (100K) 33.5K 33.5K
33.5K 33.5K NPVL 6,190 (already to year
4)
(100K)
60K
60K
Project S
(100K)
60K
60K
NPVS 7,547 (to year 4)
28
Alternative to replacement chain Equivalent
annual annuity EAA constant PMT whose PV
equals project NPV.
0
1
2
EAAL
EAAS
PV1 PV2 4,132
Previously determined NPVS.
29
Project S (EAA)
Project L (EAA)
Higher EAA is better.
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• The project, in effect, provides an annuity of
  EAA.
• EAAS gt EAAL so pick S.
• Replacement chains and EAA always lead to the
  same decision if cashflows are expected to stay
  the same.

31
If the cost to repeat S in two years rises to
105,000, which is best?
0
1
2
3
4
(100K)
60K
60K
Project S
(105K) (45k)
60K
60K
NPVS 3,415 lt NPVL 6,190. Now choose L.
32
Consider another project with a 3 yr life. If
abandoned prior to year 3, the machinery will
have positive abandonment value.
33
CFs Under Each Alternative
0
1
2
3
1. No abandonment
(5K)
2.1K
2.1K
1.75K
NPV -41
34
CFs Under Each Alternative
0
1
2
3
2. Abandon 2 years
(5K)
2.1K
2.1K 1.7K 3.8K

NPV 50
35
CFs Under Each Alternative
0
1
2
3
3. Abandon 1 year
(5K)
2.1K 3.1K 5.2K
NPV -273
36
Conclusions

• The project is acceptable only if operated for 2
  years.
• A projects engineering life does not always
  equal its economic life.
• The ability to abandon a project may make and
  otherwise unattractive project acceptable.
• Abandonment possibilities will be very important
  when we get to risk.