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Cash Flow Estimation and Other Issues in Capital Budgeting (thru page 398 plus 406-7) plus Appendices 12-A and 12-B
Overview
Cash Flow Estimation
New or Expansion Project
Other Cash Flow Estimation Issues Replacement Project
4.
For a potential project: Forecast the project cash flows. Estimate the cost of capital Discount the future cash flows at the cost of capital. Find NPV of project = PV of future cash flows required investment, and accept if NPV > 0.
flows that the project is expected to generate. General form: Cash Flow = Incremental Net Income + Depreciation Other special cash flows
Initial costs Extra ending or terminal cash flows at the end of the
Secret Documents from Jelly Donut. The Sun Blocker Project: What was Mr. Burns thinking?
In planning construction of the Sun Blocker, my
engineers and I determined that the Sun Blocker would cost $50 million to build today (t=0). The estimated useful life for Sun Blocker is 3 years with no expected salvage value at the end of the projects useful life. My assistant, Smithers, thought Sun Blockers cost wouldnt qualify for annual depreciation write offs due to its nefarious nature. Pish-posh I said, ordering Smithers to look into this matter further. After further research, Smithers reports that Sun Blocker qualifies for the 3-year MACRS depreciation class. Smithers also reports that the marketing department spent $1 million commissioning a electricity demand sensitivity analysis for the project. I fire the entire department and replace them with that Simpson chap since he always seems deep in thought.
department now informs me that we will need an increase in working capital at the beginning of the project of $8 million. Before I have a chance to fire him, he quickly adds that this increased investment in working capital can be sold at the end of the projects life. I let him keep his job for now, and go back to the drawing board.
that Sun Blocker will increased need for electricity and will increase revenues and operating costs of $80 million and $15 million respectively for each of the next 3 years. Our companys despicable combined federal and state income tax rate is 40%, and our opportunity cost of capital is 11%. What are the expected cash flows for this project and should Mr. Burns go ahead with Sun Blocker?
Liabilities Most new projects require additional short-term (current) assets and often additional current liabilities, such as
Additional receivables from increased credit sales.
additional new products. Additional trade credit (accounts payables) and taxes and wages payable.
is an outflow of cash, but these outflows are recovered by the end of the project.
Year 1 2 3 4
Cost = 50 50 50 50
Todays Agenda
Other Cash Flow Estimation Issues
the project affects this cost. Financing costs, such as interest expense = EXCLUDE. Already included in WACC. Opportunity Costs = INCLUDE. Generally revenues forgone from using land or building for another purpose other than the project.
in other part of the firm. Can be positive or negative and should be INCLUDED as part of the projects incremental cash flows. Cannibalization = INCLUDE. A negative externality, occurs when the introduction of a new product diminishes the sales of existing products.
the new one. Receive inflow from the sale of old project today, but give up any future expected inflows (opportunity costs). General form: Increase in Net Income + (Depreciation on New - Depreciation on Old)
Imperial Defense Co. (IDC) built the original Death Star at a cost of $100 billion. This original project is being depreciated on a straight-line basis over a 10-year period to zero. IDC is considering building a new and improved Death Star at a cost of $200 billion. The old death star can be sold for scrap today for $20 billion.
useful life and falls into the 3-yr MACRS depreciation class. The new Death Star is expected to increase protection revenues by $60 billion in year 1and by $90 billion in years 2 thru 4. Rebel defense expenses are expected to increase by $10, $20, $30 and $40 billion in years 1 thru 4 respectively. The new Death Star has an estimated salvage value of $30 billion at the end of its 4-yr useful life and the original Death Star has a $6 billion salvage value at the end of its useful life.
project assuming a marginal tax rate of 40%. Should the old Death Star be replaced if Imperial Defense Co.s cost of capital is 10%.
Year 1 2 3 4
New Dep 10 10 10 10
56
80
20
=0 Old Salvage Value = $6, Old Book Value = 0 New Salvage Value -Taxes on New SV = .4(30-0) -Old Salvage Value +Taxes on Old SV = .4(6-0) Total Terminal CF (t = 4)
10.2%
wealth (stock price). Bond prices and interest rates have an inverse relationship. To enhance wealth select positive NPV investments.