Cashflow Estimation

Sony Thomas
What to discount?
 Only cash flow is relevant
 Always estimate cash flows on an incremental
basis
 Be consistent in your treatment of inflation
Items included/excluded in cashflows

 Capital Investment to be considered

 Depreciation is not considered
 Do not forget working capital requirements
 Include opportunity costs
 Forget sunk costs
 Beware of allocated operating costs
 Remember salvage value
Treatment of Cash Flows

 Estimating cashflows from investments(1)

 Estmating cashflows from operations(2)

 Calculate total cashflows of the project[1+2]

 Calculate NPV/IRR
Estimating Cash Flows from Investments
 Capital investment is cash outflow when the
investment is made
 After tax salvage value is treated as cash inflow
after the completion of project
 Opportunity cost(market value) is treated as cash
outflow at the start and inflow at the end of the
project
 Increase in working capital is cash outflow and
decrease in working capital in inflow
 Remaining working capital after the completion of
project is treated as inflow
Estimating Cash Flows From Operations
 Cash Flow from Operations
– Recall that:
OCF = EBIT – Taxes + Depreciation
 Bottom-Up Approach
– Works only when there is no interest expense
– OCF = NI + depreciation
 Top-Down Approach
– OCF = Sales – Costs – Taxes
– Do not subtract non-cash deductions
 Tax Shield Approach
– OCF = (Sales – Costs)(1 – T) + Depreciation*T
Interest Expense
 Later chapters will deal with the impact that
the amount of debt that a firm has in its
capital structure has on firm value.

 For now, it is enough to assume that the firm’s

level of debt (and, hence, interest expense) is
independent of the project at hand.
The Baldwin Company
Baldwin company is considering investing in a machine to
produce bowling balls

 Costs of test marketing (already spent): $250,000

 Current market value of proposed factory site (which we
own): $150,000
 Cost of bowling ball machine: $100,000 (depreciated
according to MACRS 5-year)
 At year 0 net working Capital of $10000 is required.
Subsequently, net working capital at the end of each year
will be equal to 10% of sales for that year.
 Production (in units) by year during 5-year life of the
machine: 5,000, 8,000, 12,000, 10,000, 6,000
The Baldwin Company
 Price during first year is $20; price increases 2% per year
thereafter.
 Production costs during first year are $10 per unit and
increase 10% per year thereafter.
 Annual inflation rate: 5%
 At the end of 5 years machine will be sold at a price estimated
to be $ 30000
 Tax rate is 34%
The Baldwin Company

($ thousands) (All cash flows occur at the end of the year.)

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Investments:
(1) Bowling ball machine –100.00 21.76*
(2) Accumulated 20.00 52.00 71.20 82.72 94.24
depreciation
(3) Adjusted basis of 80.00 48.00 28.80 17.28 5.76
machine after
depreciation (end of year)
(4) Opportunity cost –150.00 150.00
(warehouse)
(5) Net working capital 10.00 10.00 16.32 24.97 21.22 0
(end of year)
(6) Change in net –10.00 –6.32 –8.65 3.75 21.22
working capital
(7) Total cash flow of –260.00 –6.32 –8.65 3.75 192.98
investment
[(1) + (4) + (6)]
The Baldwin Company

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Investments:
(1) Bowling ball machine –100.00 21.76
(2) Accumulated 20.00 52.00 71.20 82.72 94.24
depreciation
(3) Adjusted basis of 80.00 48.00 28.80 17.28 5.76
machine after
depreciation (end of year)
(4) Opportunity cost –150.00 150.00
(warehouse)
(5) Net working capital 10.00 10.00 16.32 24.97 21.22 0
(end of year)
(6) Change in net –10.00 –6.32 –8.65 3.75 21.22
working capital
(7) Total cash flow of –260.00 –6.32 –8.65 3.75 192.98
investment
[(1) + (4) + (6)]
At the end of the project, the warehouse is unencumbered, so we can sell it if we want to.
The Baldwin Company

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Income:
(8) Sales Revenues 100.00 163.20 249.70 212.24 129.89

Recall that production (in units) by year during the 5-year life of the machine is
given by:
(5,000, 8,000, 12,000, 10,000, 6,000).
Price during the first year is $20 and increases 2% per year thereafter.
Sales revenue in year 2 = 8,000×[$20×(1.02)1] = 8,000×$20.40 = $163,200.
The Baldwin Company

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Income:
(8) Sales Revenues 100.00 163.20 249.70 212.24 129.89
(9) Operating costs 50.00 88.00 145.20 133.10 87.85

Again, production (in units) by year during 5-year life of the machine is given
by:
(5,000, 8,000, 12,000, 10,000, 6,000).
Production costs during the first year (per unit) are $10, and they increase
10% per year thereafter.
Production costs in year 2 = 8,000×[$10×(1.10)1] = $88,000
The Baldwin Company

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Income:
(8) Sales Revenues 100.00 163.20 249.70 212.24 129.89
(9) Operating costs 50.00 88.00 145.20 133.10 87.85
(10) Depreciation 20.00 32.00 19.20 11.52 11.52

Depreciation is calculated using the Modified Year MACRS %

Accelerated Cost Recovery System (shown at
right). 1 20.00%
Our cost basis is $100,000. 2 32.00%
Depreciation charge in year 4 3 19.20%
4 11.52%
= $100,000×(.1152) = $11,520.
5 11.52%
6 5.76%
Total 100.00%
Depreciation under MACRS
The Baldwin Company

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Income:
(8) Sales Revenues 100.00 163.20 249.70 212.24 129.89
(9) Operating costs 50.00 88.00 145.20 133.10 87.85
(10) Depreciation 20.00 32.00 19.20 11.52 11.52
(11) Income before taxes 30.00 43.20 85.30 67.62 30.53
[(8) – (9) - (10)]
(12) Tax at 34 percent 10.20 14.69 29.00 22.99 10.38
(13) Net Income 19.80 28.51 56.30 44.63 20.15
Incremental Cash flows for Baldwin Company
Inflation
Be consistent in how you handle
inflation!!
Use nominal interest rates to discount
nominal cash flows.
Use real interest rates to discount real
cash flows.
You will get the same results, whether
you use nominal or real figures
 Inflation
Example
You invest in a project that will produce real cash
flows of –Rs.100 in year zero and then Rs.35, Rs.50,
and Rs.30 in the three respective years. If the
nominal discount rate is 15% and the inflation rate is
10%, what is the NPV of the project?

real discount rate =

1+nominal discount rate
1+ inflation rate 1
 Inflation
Example
You invest in a project that will produce real cash
flows of –Rs.100 in year zero and then Rs.35, Rs.50,
and Rs.30 in the three respective years. If the
nominal discount rate is 15% and the inflation rate is
10%, what is the NPV of the project?

real discount rate =

1+ nominal discount rate
1+inflation rate 1
1.15
  1  .045
1.10
Inflation
Example - nominal figures

Year Cash Flow PV @ 15%

0 - 100  100
1 35 1.10 = 38.5 138.15.5  33.48
2 50 1.102 = 60.5 160.15.52  45.75
3 30 1.103 = 39.9 139.15.93  26.23
Rs.5.5
Inflation
Example - real figures

Year Cash Flow PV@4.50%

0 - 100  100
35
1 35 1.045
= -33.49
50
2 50 1.045 2
= 45.79
30
3 30 1.045 3
= 26.29
= Rs.5.5
Investment Timing
Sometimes you have the ability to defer an
investment and select a time that is more ideal at
which to make the investment decision. A common
example involves a tree farm. You may defer the
harvesting of trees. By doing so, you defer the
receipt of the cash flow, yet increase the cash flow.
 Investment Timing
Example
You own a large tract of inaccessible timber. To
harvest it, you have to invest a substantial amount in
access roads and other facilities. The longer you wait,
the higher the investment required. On the other
hand, lumber prices will rise as you wait, and the
trees will keep growing, although at a gradually
decreasing rate. Given the following data and a 10%
discount rate, when should you harvest?
 Investment Timing
Example
You own a large tract of inaccessible timber. To harvest it, you have to invest a
substantial amount in access roads and other facilities. The longer you wait, the
higher the investment required. On the other hand, lumber prices will rise as you
wait, and the trees will keep growing, although at a gradually decreasing rate.
Given the following data and a 10% discount rate, when should you harvest?
 Investment Timing
Example
You own a large tract of inaccessible timber. To harvest it, you have to invest a
substantial amount in access roads and other facilities. The longer you wait, the
higher the investment required. On the other hand, lumber prices will rise as you
wait, and the trees will keep growing, although at a gradually decreasing rate.
Given the following data and a 10% discount rate, when should you harvest?

Answer: Year 4
Investment Timing
You may purchase a computer anytime within the
next five years. While the computer will save your
company money, the cost of computers continues to
decline. If your cost of capital is 10% and given the
data listed below, when should you purchase the
computer?
Year Cost PV/FV Savings
0 50 70
1 45 70
2 40 70
3 36 70
4 33 70
5 31 70
Investment Timing
You may purchase a computer anytime within the next five years. While
the computer will save your company money, the cost of computers
continues to decline. If your cost of capital is 10% and given the data
listed below, when should you purchase the computer?

Year Cost PV Savings NPV at Purchase NPV Today

0 50 70 20 20.0
1 45 70 25 22.7
2 40 70 30 24.8
3 36 70 34 Time to purchase 25.5
4 33 70 37 25.3
5 31 70 39 24.2
 Point to note
Can we transform investment today into
equivalent stream of future cash out flows?
 Investments with unequal lives
Equivalent Annual Cost - The cost per period with the same
present value as the actual cash flow as the project.

present value of cash outflows

Equivalent annual cost =
annuity factor
 Equivalent Annual Cost
A company invest 400 million to upgrade the
refinery. The new equipment lasts for 25
years, and does not change raw material and
operating costs. The real cost of capital is 7%.
How much additional revenue does it take to
cover the 400 million investment? Assume tax
rate as 35%. Calculate additional pre tax
revenue.
Different Economic Lives
Example
Two machines A and B are designed differently but have
identical capacity and do exactly the same job. The
actual cost and cost of running machines A and B are
given below. Cost of capital is 6%. Which of the two
machine would you select?

Year
Mach. 0 1 2 3
A +15 +5 +5 +5
B +10 +6 +6
Equivalent Annual Cost
Example
Two machines A and B are designed differently but have
identical capacity and do exactly the same job. The
actual cost and cost of running machines A and B are
given below. Cost of capital is 6%. Which of the two
machine would you select?

Year
Mach. 0 1 2 3 PV@6% E.A.C.
A +15 +5 +5 +5 28.37 10.61
B +10 +6 +6 21.00 11.45
Problem1
Raphael restaurant is considering the purchase of a $9000
souffle maker. The souffle maker has an economic life of five
Years and will be fully depreciated by the straight line method.
The machine will produce 1500 souffles per year, with each
costing $2.30 to make and priced at $4.75. Assume that the
discount rate is 14% and tax rate is 34%. Should Raphael make
The purchase?
Problem2
The best manufacturing company is considering a new investment.
The details are given below. The corporate tax rate is 34%. Assume all sales
revenue is received in cash, and all cash flows occur at the end of the year. All
net working capital is recovered at the end of the project.

Year 0 1 2 3 4
Investment 24000
Sales revenue 12500 13000 13500 10500
Operating costs 2700 2800 2900 2100
Depreciation 6000 6000 6000 6000
Net working capital spend 300 350 400 300

a. Compute incremental net income for each year

b. Compute the incremental cash flows of the investment for each year
c. Suppose the appropriate discount rate is 12%. What is the NPV of the project?
Problem 3
ABC Inc is considering a new three year
expansion project that requires an initial
investment of $1.4 million. The fixed assets will
be depreciated using straight line method. The
project is estimated to generate $11,20,000 in
annual sales, with costs of $4,80,000. The tax
rate is 35% and required rate of return is 12%.
What is projects NPV?
Problem 4
In the previous problem, suppose the project
requires an initial investment in net working capital
of $285000 and the fixed asset will have a market
value of $225000 at the end of the project. What is
the project’s year 0 net cash flow? Year 1? Year2?
Year3? What is the new NPV?
Problem5
In the previous problem, suppose the fixed
assets actually falls into the three year MACRS
class. All the other facts are the same. What is
the projects year 1 net cash flow now? Year1?
Year2? Year3? What is the new NPV?
Year MACRS dep
1 33.33%
2 44.45%
3 14.81%
4 7.41%
Problem 6
Consider the following cash flows on two mutually exclusive
projects
Year Project A Project B
0 -50000 -65000
1 30000 29000
2 25000 38000
3 20000 41000

The cash flows of project A are expressed in real terms, whereas

those of project B are expressed in nominal terms. The appropriate
nominal discount rate is 13% and the inflation is 4%.
Which product should you chose?
Problem 7
A Golf academy is evaluating different golf practicing equipment.
Equipment A costs $94,000, has a three year life, and costs
$8600 to operate. The relevant discount rate is 12%. Assume
straight line method of depreciation. Furthermore, the
equipment has a salvage value of $18000 at the end of the
project’s life. The relevant tax rate is 34%. All cash flows occur at
the end of the year. What is the Equivalent Annual Cost(EAC) of
the equipment?