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Chapter 13

By Chris Harper,2014-06-27 22:59
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Chapter 13 ...

    Chapter 13

    Cash Flow Estimation

A. Cash flow estimation

     Estimating project cash flows is the most difficult and error-prone part of capital

    budgeting.

     Garbage in garbage out. Error and bias can creep into analysis. a. General approach to cash flow estimation

    a. Initial outlayeverything that has to be spent before the project is started

    b. Sales forecastunits and revenues

    c. Cost of sales and expenses

    d. Assetsnew assets to be acquired, including changes in working capital

    e. Amortizationnon-cash expense but affects income taxes

    f. Taxes and earnings (project net income)

    g. Summarize and combineadjust earnings for amortization and combine

    result with balance sheet items to arrive at a cash flow estimate

b. Projects types

     Expansion projectstend to require the same elements as new ventures

    ? But less new equipment and facilities

     Replacement projectsgenerally expected to save costs without generating

    new revenue

    ? Estimating process tends to be somewhat less elaborate

B. Specific issues

    a. Typical pattern

     At beginning of the project, some amount must be spent to invest in the

    project (Initial outlay)

     Subsequent cash flows tend to be positive

     Called conventional cash flow pattern

    b. Project cash flows are incremental

     What cash flows will occur if we undertake this project that wouldn’t occur if we

    left it undone and continued business as before?

c. Sunk costs

    : Costs that have already occurred and cannot be recoveredshould not be

    included in project’s cash flows

     Only future costs are relevant

     Ex: prior R&D expenditures

d. 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

    ? Ex: If firm needs a new warehouse, it could

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     Build warehouse on land they currently own (but could sell for

    $1,000,000)the $1,000,000 represents an opportunity cost

e. Impacts on other parts of company

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

    with other products within the same firm (Diet Coke vs. Coke Classic)

    ? Lost in other line becomes a negative cash flow for the project

f. Taxes Cash outflows to the project

g. Cash flows vs. accounting results

    ? Capital budgeting deals only with cash flows; however business managers

    want to know project’s net income

h. Working capital

    ? New project often requires investment in working capitalinventory, special

    tools, and spare parts, for instance

    ? Increasing net working capital means cash outflow to the project

i. Ignore financing costs

    ? Do not include interest expense on debt as cash outflow

    ? Avoid double-discounting

j. Old equipment

    ? If this is replacement project, old equipment can be sold; thereby generating

    a cash inflow residual value of the old asset

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C. Example

    Units200 600 1,200 1,500 1,500 1,500 Revenue120.0$ 360.0$ 720.0$ 900.0$ 900.0$ 900.0$ Cost of sales72.0$ 216.0$ 432.0$ 540.0$ 540.0$ 540.0$ Gross margin48.0$ 144.0$ 288.0$ 360.0$ 360.0$ 360.0$ SG&A expense120.0$ 120.0$ 120.0$ 120.0$ 120.0$ 120.0$ Amortization41.5$ 41.5$ 41.5$ 41.5$ 41.5$ 1.5$ General overhead2.4$ 7.2$ 14.4$ 18.0$ 18.0$ 18.0$ Loss old line1.4$ 4.3$ 8.6$ 10.8$ 10.8$ 10.8$ Total165.4$ 173.1$ 184.6$ 190.3$ 190.3$ 150.3$

    EBT impact(117.4)$ (29.1)$ 103.4$ 169.7$ 169.7$ 209.7$ Tax(39.9)$ (9.9)$ 35.2$ 57.7$ 57.7$ 71.3$ NI impact(77.5)$ (19.2)$ 68.3$ 112.0$ 112.0$ 138.4$ Add Amortization41.5$ 41.5$ 41.5$ 41.5$ 41.5$ 1.5$ Subtotal(35.9)$ 22.4$ 109.8$ 153.5$ 153.5$ 139.9$

     Unintentional bias is probably the biggest problem in capital budgeting

    ? Projects generally proposed by people who want to see them approved which

    leads to favorable biases

    ? Tend to overestimate benefits and underestimate costs

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D. Capital cost allowance (CCA)

     CRA requires that firms use capital cost allowance (CCA) to calculate

    amortization for income tax purposes

    ? Provides for accelerated amortization

    ? Amortization is shifted forward

     More is taken early in project’s life and less later on

     Total amortization remains the same

    ? Larger tax deductions happen earlier

     Present value of tax savings is greater

     Companies generally don’t use accelerated methods for earnings reported to the

    public

    ? Reported earnings are lower

    ? If accelerated methods are used for tax calculations, accelerated methods

    should be used for cash flow projections

     The Income Tax Act dictates exactly how tax amortization (CCA) to be done

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     CCA divides capital assets into different classes (categories) and assigns a

    CCA rate for each

    ? Most classes call for declining balance CCA (accelerated amortization)

     When asset is purchased, purchase price added to appropriate class

    ? Any increases in a class are usually eligible for only half of the normal CCA

    in year they are added (the half-year rule) ? Once capital asset has been added to a CCA class, capital cost allowance is

    calculated on the undepreciated capital cost (UCC) of the pool of assets,

    rather than on individual assets

     When asset is sold, the lower of the sale price or its original cost is deducted from

    the pool.

     If asset sold for more than its original cost, difference is capital gain for tax

    purposes.

    ? Only 50% of capital gain is added to taxable income for the year.

     If sale of asset leaves no assets in the class, resulting positive balance, if any,

    is terminal loss

    ? deductible for tax purposes.

     Any negative balance in the class at the end of the year is recapture

    ? taxed as income.

     CCA tax shieldtax savings from deducting CCA on capital assets

     For capital budgeting purposes, we need to calculate present value of tax

    shield

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