Chapter 10

Cash Flow
Estimation

Slides developed by:

Pamela L. Hall, Western Washington University

Capital Budgeting Processes

Capital budgeting process consists of the

following steps:

Determine (estimate) the expected cash flows of

available projects
Apply decision criteria such as NPV and IRR

People tend to take forecasted cash flows for

granted but they are subject to error

Estimating project cash flows is the most difficult and

error-prone part of capital budgeting

The General Approach to Cash

Flow Estimation

Conceptually quite simple

Every event in which a project is expected to

impact a firms cash flows is considered
Cash estimates are done on spreadsheets
Enumerate the issues that impact cash and forecasting
each over time

Forecasts for new ventures tend to be the

most complex

The General Approach to Cash

Flow Estimation

General outline for estimating new venture cash flows

Pre-start-up, the initial outlayeverything that has to be spent

before the project is truly started
Sales forecast, units and revenues
Cost of sales and expenses
Assetsnew assets to be acquired, dont forget working capital
Depreciation
Taxes and earnings
Summarize and combineadjust earnings for depreciation and
combine it with the balance sheet items to arrive at a cash flow
estimate

The General Approach to Cash

Flow Estimation

Expansion projects tend to require the

same elements as new ventures

Generally require less new equipment and

facilities

Replacement projects generally expected

to save costs without generating new
revenue

Estimating process tends to be somewhat

less elaborate
5

A Few Specific Issues

Regardless of the type of project, the basic

process is the same

The Typical Pattern

At the beginning of the project, some amount must be spent
to invest in the project (Initial outlay)
Subsequent cash flows tend to be positive

Project Cash Flows Are Incremental

What cash flows will occur if we undertake this project that
wouldnt occur if we left it undone and continued business as
before?

A Few Specific Issues

Sunk Costs

Costs that have already occurred and cannot be recovered

should not be included in projects cash flows

Opportunity Costs

What is given up to undertake the new project

The opportunity cost of a resource is its value in its best
alternative use
For instance, if firm needs a new warehouse, it could either:
Lease warehouse space
Buy warehouse
Build warehouse on land they currently own (but could sell for
$1,000,000)the $1,000,000 represents an opportunity cost

A Few Specific Issues

Impacts on Other Parts of Company

Taxes

Must net all cash flows of taxes (because taxes paid represent a cash
outflow)

Cash Versus Accounting Results

Sales erosion (cannibalization)when a firm sells a product that

competes with other products within the same firm (Diet Pepsi vs. Pepsi
One)

Capital budgeting deals only with cash flows; however business

managers want to know a projects net income

Working Capital

A new project many times requires investment in working capital

inventory, for instance
Increasing net working capital means a cash outflow

A Few Specific Issues

Ignore Financing Costs

Even though a project may be financed with debt (or

a combination of debt/equity) we do not include the
interest expense (or dividends) as a cash outflow
This issue is addressed via the discount rate when
determining NPV or evaluating IRR

Old Equipment

If this is a replacement project, old equipment can be

sold (thereby generating a cash inflow)

Estimating New Venture Cash

Flows

New venture projects tend to be larger

and more elaborate than expansions or
replacements

However, incremental cash flows can be

easier to isolate
Because whole project is easily seen as distinct
and separate from the rest of the company

10

Example

Estimating New Venture Cash

Flows
Q: The Wilmont Bicycle Company manufacturers a line of traditional multi-speed road bicycles.
Management is considering a new business proposal to produce a line of off-road
mountain bikes. The proposal has been studied carefully and the following information is
forecast:
Cost of new production equipment and machinery including
freight and setup $200,000
Expense of hiring and training new employees.. $125,000
Pre-start-up advertising and other miscellaneous
expenses..
$20,000
Additional selling and administrative expense per year
after start-up $120,000
Unit sales forecast
Year 1.
Year 2.
Year 3.
Year 4 and beyond

200
600
1,200
1,500

Unit price.
Unit cost to manufacture (60% of revenue)

$600
$360

11

Estimating New Venture Cash

Flows

Example

Q: Last year, anticipating an interest in off-road bicycles, the company

bought the rights to a new gearshift design for $50,000.
Wilmonts production facilities are currently being utilized to
capacity, so a new shop has to be acquired for incremental
production. The company owns a lot near the present facility on
which a new building can be constructed for $60,000. The land was
purchased 10 years ago for $30,700, and now has an estimated
market value of $150,000.
If Wilmont produces off-road bicycles, it expects to lose some of its
current sales to the new product. Three percent of the new unit
forecast is expected to come out of sales that would have been
made in the old line. Prices and direct costs are about the same in
the old line as in the new.

12

Estimating New Venture Cash

Flows
Q: Wilmonts general overhead includes personnel, finance, and

Example

executive functions, and runs about 5% of revenue. Small one-time

increments in business dont affect overhead spending, but a major
continuing increase in volume would require additional support.
Management estimates that additional spending in overhead areas
will amount to about 2% of the new projects revenues.
New revenues are expected to be collected in 30 days. Incremental
inventories are estimated at $12,000 at startup and for the first year.
After than an inventory turnover of 12 times based on cost of sales is
expected. Incremental payables are estimated to be 25% of
inventories.
Wilmonts current business is profitable, so losses in the new line will
result in tax credits. The companys marginal tax rate is 34%.

13

Estimating New Venture Cash

Flows

Example

A: First well consider the Initial Outlay, or those costs occurring prior to
start-up. The cost of hiring, training and advertising are tax deductible:
Hiring and training
Advertising and miscellaneous
Deductible expense
Tax credit @34%
Net after tax expenses

$125.0
20.0
$145.0
49.3
$95.7

Next well add the cash needed for physical assets:

Equipment
$200.0
New construction
$60.0
Initial inventory
12.0
Assets subtotal
$272.0

14

Estimating New Venture Cash

Flows

Example

A: Adding the operating items and physical assets gives us the total,
actual pre-start-up outlay:
Net after tax expenses
Assets subtotal
Actual pre-start-up outlay

$95.7
$272.0
$367.7

There is also the opportunity cost of the land of $150,000. However,

since the land initially cost only $30,700, selling the land today would
result in a capital gain of $119,300, which would result in taxes of
$40,600. Thus, the opportunity cost is $109,400, or $150,000 $40,600.
Thus, the initial outlay, or C0, is $367,700 + $109,400, or $477,100.

15

Estimating New Venture Cash

Flows
A: The operating cash flows are as follows:

Example

Sales are forecasted to grow for 4

years before leveling off. Well
estimate for 6 yearsfor a longer
forecast just repeat the last year as
many times as you want.

The building is
depreciated
over 39 years
while the
equipment is
depreciated
over 5 years.

16

Example

Estimating New Venture Cash

Flows
Assume
that the
$12,000 of
initial
inventory
was
acquired
prior to
start-up.

Profit Impact and Tax

EBT impact
Tax
EAT impact
Add depreciation
Subtotal

$ (117.4) $ (29.1) $ 103.4

$ (39.9) $ (9.9) $ 35.2
$ (77.5) $ (19.2) $ 68.3
$ 41.5 $ 41.5 $ 41.5
$ (35.9) $ 22.4 $ 109.8

$ 169.7 $ 169.7 $ 209.7

$ 57.7 $ 57.7 $ 71.3
$ 112.0 $ 112.0 $ 138.4
$ 41.5 $ 41.5 $
1.5
$ 153.5 $ 153.5 $ 139.9

Working Capital
Accounts receivable
Inventory
Payables
Working Capital
Change in working capital

$
$
$
$
$

$ 75.0 $ 75.0 $ 75.0

$ 45.0 $ 45.0 $ 45.0
$ 11.3 $ 11.3 $ 11.3
$ 108.8 $ 108.8 $ 108.8
$ 14.3 $
$
-

Net Cash Flow

Net cash

20.0
12.0
3.0
29.0
17.0

(52.9)

$
$
$
$
$

45.0
18.0
4.5
58.5
29.5

(7.1)

$
$
$
$
$

67.5
36.0
9.0
94.5
36.0

73.8

139.3

153.5

139.9

Represents the subtotal after adding

depreciation less the change in working capital.

17

Terminal Values

Its possible to assume that incremental cash

flows last forever

Especially common with new ventures

Cash flows forecast to continue forever are

compressed into finite terminal values using
perpetuity formulas

For instance, a repetitive cash flow starting at time 7

would be a perpetuity beginning at year 7
The present value at time 6 would be represented as C7
discount rate
Very sensitive to the discount rate

18

Accuracy and Estimates

NPV and IRR techniques give the impression of

great accuracy
However, capital budgeting results are no more
accurate than the projections of the future used
as inputs
Unintentional biases are probably the biggest
problem in capital budgeting

Projects are generally proposed by people who want

to see them approved which leads to favorable
biases
Tend to overestimate benefits and underestimate costs
19

MACRSA Note on
Depreciation

U.S. government allows companies the use of

accelerated depreciation for income tax purposes

Depreciation is shifted so that more is taken early in the

projects life and less later ontotal depreciation remains the
same
Advantageous because larger tax deductions happen earlier
Present value of tax savings is greater

Companies generally dont use accelerated methods for

earnings reported to the public because reported
earnings are lower

If accelerated methods are used for tax calculations,

accelerated methods should be used for cash flow projections

20

Modified Accelerated Cost

Recovery System

The tax code dictates exactly how accelerated

depreciation is to be done
MACRS classifies assets into different categories
and specifies a depreciation life for each

A table is provided showing the percentage of the

assets cost that can be taken in depreciation during
each year of life

Only applies to equipment

Buildings are depreciated using straight-line over 27.5

years (residential) and 39 years (otherwise)
Land isnt depreciated
21

Estimating Cash Flows for

Replacement Projects

Generally have fewer elements than new

ventures
Identifying what is incremental can be trickier
Can be difficult to determine what will happen if
you dont do the project

For example, if replacing an old production machine

do you compare the performance of the new machine
to the current performance of the old, or do you
compare it to flows the current machine are expected
to generate if it continues to deteriorate

22

Example

Estimating Cash Flows for

Replacement ProjectsExample
Q: Harrington Metals Inc. purchased a large stamping machine five
years ago for $80,000. To keep the example simple well assume
that the tax laws at the time permitted straight-line depreciation over
eight years and that machinery purchased today can be
depreciated straight line over five years. The machine has not
performed well, and management is considering replacing it with a
new one that will cost $150,000. If the new machine is purchased,
it is estimated that the old one can be sold for $45,000. The quoted
costs include all freight, installation and setup.
The old machine requires three operators, each of whom earns
$25,000 a year including all benefits and payroll costs. The new
machine is more efficiently designed and will require only two
operators, each earning the same amount.

23

Estimating Cash Flows for

Replacement ProjectsExample
Q: The old machine has the following history of high maintenance cost
and significant downtime.
Year

Example

Hours down

Maintenance
expense ($000)

2`

40

60

100

130

128

In
warranty

$10

$35

$42

$45

Downtime on the machine is a major inconvenience, but it doesnt

usually stop production unless it lasts for an extended period. This
is because the company maintains an emergency inventory of
stamped pieces and has been able to temporarily reroute
production without much notice. Manufacturing managers estimate
that every hour of downtime costs the company $500, but have no
hard data backing up that figure.
24

Estimating Cash Flows for

Replacement ProjectsExample

Example

Q: The makers of the replacement machines have said that Harrington will
spend about $15,000 a year maintaining their product and that an average
of only 30 hours of downtime a year should be expected. However, they
are not willing to guarantee those estimates after the one-year warranty
runs out.
The new machine is expected to produce higher quality output than the old
one. The result is expected to be better customer satisfaction and possibly
more sales in the future. Management would like to include some benefit
for this effect in the analysis, but is unsure of how to quantify it.
Estimate the incremental cash flows over the next five years associated
with buying the new machine. Assume Harringtons marginal tax rate is
34%, and that the company is currently profitable so that changes in taxable
income result in tax changes at 34% whether positive or negative. Assume
any gain on the sale of the old machine is also taxed at 34% since
corporations dont receive favorable tax treatment on capital gains.

25

Estimating Cash Flows for

Replacement ProjectsExample
A: There are two kinds of cash flows in this problemthose that can be
estimated fairly objectively and those that require some degree of
subjective guesswork.

Example

Objective Cash Flows:

The initial outlay is relatively straightforward:
Cost of new machine

Less proceeds from sale of old

machine
Initial outlay

$150.0

39.9
$110.1

The old machine has a current

market value of $45,000 and a
book value of $30,000 (initial cost
of $80,000 les depreciation of
$50,000). Thus, a gain on the sale
of the old machine of $15,000
results in additional taxes of $5.1.
The net cash proceeds on the sale
of the old machine are $39.9 (or
$45.0 $5.1).

26

Estimating Cash Flows for

Replacement ProjectsExample
A: Depreciation and labor savings are straightforward as well:

Example

Year
1

New depreciation

$30.0

$30.0

$30.0

$30.0

$30.0

Old depreciation

10.0

10.0

10.0

Net increase in
depreciation

$20.0

$20.0

$20.0

$30.0

$30.0

$6.8

$6.8

$6.8

$10.2

$10.2

$25.0

$25.0

$25.0

$25.0

$25.0

Cash tax savings @

34%
Labor savings

Represent the cost savings from needing

only two employees rather than three.
27

Estimating Cash Flows for

Replacement ProjectsExample
A: The subjective benefits (which are based on opinions) are hard to quantify
and lead to biases when estimated by people who want project approval.
The financial analyst should ensure that only reasonable estimates of
unprovable benefits are used.

Example

Year

Old machine
maintenance
New machine
maintenance
Savings

$45.0

$45.0

$45.0

$45.0

$45.0

In
warranty

15.0

15.0

15.0

15.0

$45.0

$30.0

$30.0

$30.0

$30.0

The question is: Should we assume maintenance on the old

machine would have remained at $45.0 or increase as the
machine gets older? Also, will maintenance on the new
machine rise as the new machine ages?

28

Estimating Cash Flows for

Replacement ProjectsExample

Example

A: Another subjective estimate is that of downtime. The old machine has been

having about 130 hours of downtime while the new one promises 30 hoursa
savings of 100 hours. But, argument could be made for using different
assumptions for downtime hours. Another question is: How much is each hour
of downtime savings worth? Arguments range from no savings (as we are
unable to say exactly how much its worth) to $500 an hour. Most people favor a
middle-of-the-road approachwell use $200 an hour, which yields an estimated
cash flow savings of $20,000 per year.

Labor savings
Maintenance savings
Downtime savings
Total
Tax
Net after tax
Tax savings on depreciation
Cash flow

1
$25.0
$45.0
$20.0
$90.0
30.6
$59.4
6.8
$66.2

2
$25.0
$30.0
$20.0
$75.0
25.5
$49.5
6.8
$56.3

Year
3
$25.0
$30.0
$20.0
$75.0
25.5
$49.5
6.8
$56.3

4
$25.0
$30.0
$20.0
$75.0
25.5
$49.5
10.2
$59.7

5
$25.0
$30.0
$20.0
$75.0
25.5
$49.5
10.2
$59.7

29