10/18/2024

Corporate Finance
Miscellaneous Issues in Estimating Cash Flows

Objectives

• What are some issues that you need to take care of while
estimating cash flows?

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Miscellaneous Issues in Estimating

Cash Flows
Cash Flows Versus Accounting Income

Cash Flows Versus Accounting Income

• Do not confuse cash flows with the accounting income. Accounting

income shows profits as they are earned, rather than when the
company and its customers pay.

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Cash Flows Versus Accounting Income

• Accountants also categorize cash outflows into current expenses

and capital expenses. They deduct current expenses when
calculating income, but do not deduct capital expenses. This
categorization is not relevant for cash flows of the project.

Cash Flows Versus Accounting Income

Divergence…

• Generally, current expenses are everyday costs of keeping your

business going, such as the rent and electricity bills.
• Rules for deducting current expenses are fairly straight forward.
You subtract the amounts spent from your business’s gross income
in the year the expenses are incurred.

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Cash Flows Versus Accounting Income

Divergence…

• Capital expenses are expenditures that create future benefits. A

capital expense is incurred when a business spends money either
to buy fixed assets or to add to the value of an existing fixed asset
with a useful life extending beyond the taxable year.

Miscellaneous Issues in Estimating

Cash Flows
Indirect/Synergistic Effects

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Indirect/Synergistic Effects

• All the indirect or synergistic effects of a project should be

included in the cash flow calculation. Synergistic effects can be
negative or positive.

Indirect/Synergistic Effects
Example 1

• Consider that OF Corporation is considering introducing a new

model (MAKO), which is a close substitute for an existing model
(RAPTOR). Therefore, it is expected that the introduction of MAKO
will reduce the sales of RAPTOR.
• Also assume that the RAPTOR sales are expected to decrease by
$25 million over the project’s life from this effect. What impact
should it have on the cash flows of MAKO?

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Indirect/Synergistic Effects
Example 1

• This negative effect would have to be counted as an incremental

cost of the proposed MAKO project.
• The rationale is that ‘without’ the MAKO project, the firm’s future
cash flows would have been higher by $25 million.

Indirect/Synergistic Effects
Example 1

• In other words, ‘with’ the MAKO project, the firm’s RAPTOR cash
flow would be reduced by $25 million. The $25 million reduction
is calculated into the MAKO project by reducing its future net cash
flows by this amount.

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Indirect/Synergistic Effects
Example 2

• Assume that a proposed project (establishing a pharmacy)

introduces a new product or service which is complementary to an
existing product or service of the firm (surgery hospital).
Therefore, this project will enhance the sales of the existing
product. Patient numbers may increase at the surgery because of
the convenience of a pharmacy next door. What impact should it
have on the cash flows of new project?

Indirect/Synergistic Effects
Example 2

• This positive effect should be included in the proposed pharmacy

project’s cash flows.

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Miscellaneous Issues in Estimating

Cash Flows
Allocated Costs

Allocated Costs

• Generally, we should ignore the allocated costs in cash flow

calculations. These costs are not incremental. They do not change
if the project is undertaken. Thus, they should not be considered in
estimating the project’s incremental cash flows.

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Allocated Costs

• One example of allocated costs are the overhead costs. These costs
include the following:
• Utilities (Electricity, Gas and Water)
• Executive Salaries
• In the project evaluation, the issue is not the allocation of
overheads to production units, but the identification of
incremental overhead costs.

Allocated Costs

• Very often, overhead expenses would occur ‘with’ or ‘without’ the

proposed project – they occur whether or not a given project is
accepted or rejected.
• There is often not a single specific project to which the overhead
costs can be allocated.
• Therefore, the question is not whether or not the proposed project
would benefit from the overhead facilities, but whether or not the
overhead expenses are incremental cash flows associated with the
proposed project.

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Allocated Costs

• In project appraisal, the decision as to what overheads should be

allocated to a proposed project’s cash flows can be guided by the
fact that only the incremental cash flows resulting from changes in
overhead expenses should be included in evaluating a project
proposal.
• If the expenses are already being incurred, a proportion should not
be allocated to the new project.

Allocated Costs
Example 1

• Assume that OF Corporation currently incurs utility overheads of

$500000 from the operation of its main office complex. The
company allocates this cost to the production departments on the
basis of floor space.
• Suppose that OF Corporation is considering extending its factory
in order to manufacture a new product. In doing so, a new
production department will be created which will take up 20% of
the available floor space of the factory.

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Allocated Costs
Example 1

• The new project is not expected to affect main office utility

overheads.
• Should the firm’s management accountant allocate $100000 [=
0.20 * $500000] as an expense associated with the new project?

Allocated Costs
Example 1

• While it would be tempting to include this overhead expense in the

evaluation of the proposed project, it would be incorrect to do so.
• From a project evaluation perspective, this utilities overhead
would not be included in the project analysis, because this cost is
not an incremental cost to the project – ‘with’ or ‘without’ the
project, this utilities cost is incurred.

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Allocated Costs
Example 2

• Assume that OF Corporation allocates executive salaries to the

production department, based on the floor space. The Chief
Executive is paid $800000 as a salary.
• Should the firm’s management accountant allocate $160000 [=
0.20 * $800000] as an expense associated with the new project?

Allocated Costs
Example 2

• While it would be tempting to include this overhead expense in the

evaluation of the proposed project, it would be incorrect to do so,
because this cost is not an incremental cost to the project – ‘with’
or ‘without’ the project, this salary is paid.

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Allocated Costs
Example 2

• Will your answer change if 25% of the chief executive’s time is

spent on the project and this causes a decrease in the productivity
of the firm’s other activities?

Allocated Costs
Example 2

• This cost should be included in the analysis.

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Allocated Costs
Example 2

• Now assume that an additional staff (costing $200000) were

recruited to look after the firm’s existing business. The additional
staff was expected to prevent the possible adverse effects on the
productivity of the firm’s other activities. Will it affect the cash
flows of the project?

Allocated Costs
Example 2

• In this case, $200000 will be an increment to the project and

should be included in its evaluation.

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Miscellaneous Issues in Estimating

Cash Flows
Sunk Costs

Sunk Costs

• Another key concept used in identifying relevant cash flows is the

notion of sunk costs.
• A sunk cost is an amount spent in the past in relation to the
project, but which cannot now be recovered or offset by the
current decision.
• Sunk costs are past and irreversible. They are not contingent upon
the decision to accept (or reject) a proposed project. Therefore,
they should not be included in the cash flows.

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Sunk Costs

• Some of the examples of sunk cost are the following:

• Research and Development Expenses
• Consultant Fees

Sunk Costs
Example 1

• OF Corporation has spent $10000 in research and development

(R&D) on an automated machine. Mr. ABC and Mr. XYZ must now
decide whether to produce the new automated machine or stay
with the existing manual machine.
• Mr. ABC argues that OF Corporation should add the after-tax
equivalent of $10000 to the cost of investing in the new automated
machine. Mr. XYZ disagrees. He sees the $10000 R&D expenditure
as “water under the bridge,” irrelevant to the choice at hand. Who
is right?

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Sunk Costs
Example 1

• Mr. XYZ is right. The R&D expenditure was in the past and cannot
influence the choice between the automated and manual
machines. This decision must be based on a comparison of the
future cash flows associated with the two alternative choices.

Miscellaneous Issues in Estimating

Cash Flows
Opportunity Costs

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Opportunity Costs

• When a firm undertakes a project, various resources will be used

and not be available for other projects.
• The cost to the firm of not being able to use these resources for
other projects is referred to as an ‘opportunity cost’.

Opportunity Costs

• The value of these resources should be measured in terms of their

opportunity cost.
• The opportunity cost, in the context of capital budgeting, is the
value of the most valuable alternative that is given up if the
proposed investment project is undertaken. This opportunity cost
should be included in the project’s cash flows.

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Opportunity Costs
Divergence…

• An asset’s opportunity cost is the money that the firm can receive
if the asset is put to the next best use. The ‘next best’ use may be to
sell the asset.

Opportunity Costs
Example 1

• A proposed project involves the establishment of a production

facility. This facility will be located within a factory the firm
already owns.
• The estimated rental value of the space that the production facility
will occupy is $29000 per year. The space has not been rented in
the past, but the firm expects to rent it in the future. What impact
should it have on the cash flows of the project?

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Opportunity Costs
Example 1

• The firm will lose $29000 ‘with’ the project because that space will
be used for the project.
• Therefore, the opportunity cost is $29000 per year in rent forgone
and it should be included as a cash outflow.

Opportunity Costs
Example 1

• Does this example contradict the principle that we should only

consider cash flows while evaluating the project?

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Opportunity Costs
Example 1

• This example illustrates that even when no cash changes hands,

there could be an opportunity cost. The reason is that opportunity
cost of the space measures an extra cash flow that would be
generated (for the firm) ‘without’ the project.

Opportunity Costs
Example 1

• Suppose that this space has not been rented in the past and there
is no intention to rent, sell or use for any other purpose in the
future. Will it effect the project’s cash flows?

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Opportunity Costs
Example 1

• In this case, there is no opportunity cost if the resource is used for

the proposed project. Therefore, in this situation, the $29000 will
not be included as a cash outflow.

Opportunity Costs
Example 2

• A project under consideration involves the use of an existing

building to set up a factory to produce shoes. The market value of
this building is $200000.
• If the project is undertaken, there will be no direct cash outflow
associated with purchasing the building since the firm already
owns it. In evaluating the proposed shoe manufacturing project,
should we then assume zero cost for the building?

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Opportunity Costs
Example 2

• No.
• The building is not a ‘free’ resource for the project because if the
building was not used for this project it could be used for some
other purpose; for example, it could be sold to generate cash.
• Using the existing building for the proposed shoe project has an
opportunity cost of $200000.

Opportunity Costs
Example 3

• ADA Corporation is considering a new heating system for its office.

This system will use the existing boiler, which is currently
operating at 60% capacity. The new heating system will utilize
30% of the boiler’s capacity. Should the heating system project be
“charged” something annually for the use of the boiler?

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Opportunity Costs
Example 3

• It depends.
• Any incremental costs (such as those for additional water or fuel)
should be charged to the new heating project.

Opportunity Costs
Example 3

• In addition, we should also take into considerations the charges

for the use of capacity.

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Opportunity Costs
Example 3

• For example, if ADA Corporation could “rent out” the previously

idle 40% capacity to other users outside the firm to generate
income, then that income will be lost if the capacity is used for the
new heating project. In this case, the lost rental income should be
considered a cost of the new heating system.
• Alternatively, if the 40% boiler capacity cannot be utilized
elsewhere, then there should be no charge to the heating project
for the cost of the boiler capacity.

• Another charge that should be included in the estimation of cash

flow for this project is due to wear and tear that excessive use of
existing boiler will cause. As a result of this, OF Corporation may
have to replace the boiler early.

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Opportunity Costs
Example 3

• For instance, suppose that using the new heating system will
reduce the boiler’s life from ten years to nine years. This means
that the boiler will have to be replaced one year sooner if the new
heating project is installed.
• This effect should also be taken into consideration while
estimating cash flows. More specifically, we should incorporate the
present value of spending money on a new boiler in nine years
rather than ten years as a cost of the new heating system.

Opportunity Costs
Example 3

• Suppose the boiler replacement cost is $9000, and assume a 10%

discount rate. The present value of the boiler replacement cost can
be computed as follows:
• If boiler is replaced in 10 years (no new heating system), present value of
replacement cost is $3470 [= 9000 / (1.10)10].
• If boiler is replaced in 9 years (new heating system installed), present
value of replacement cost is $3817 [= 9000 / (1.10)9].
• The difference of $347 [= 3817 – 3470] is the present value cost of
the new heating system.

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Miscellaneous Issues in Estimating

Cash Flows
Inflation

Inflation

• Treat inflation consistently.

• Discount nominal cash flows at the nominal rate.
• Discount real cash flows at the real rate.

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Inflation
Divergence…

• Real interest rate is calculated by the following relationship:

1  Nominal Interest Rate
1  Real Interest Rate 
1  Inflation Rate

• Approximate relationship between real interest rate, nominal

interest rate, and inflation is:
Real Interest Rate  Nominal Interest Rate - Inflation Rate

Inflation
Divergence…

• Following relationship is used to convert nominal cash flows to

real cash flows.

Real Cash Flow 

Nominal Cash Flow t
1  Inflation t
• In the above calculation, t is the time period when the nominal
cash flow occurs.

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Inflation
Example 1

• You own a lease that will cost you $8000 next year, increasing at
3% a year (the forecasted inflation rate) for 3 additional years (4
years total). If discount rates are 10% what is the present value
cost of the lease?

Inflation
Example 1

• Calculation using nominal values are as follows:

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Inflation
Example 1

• Calculation using real values are as follows:

Miscellaneous Issues in Estimating

Cash Flows
Interest Expenses

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Interest Expenses

• We should ignore interest expenses in cash flow calculations.

The discount rate (WACC) includes the effect of interest expenses.
• Not ignoring interest expenses will result in double counting of
interest expenses.

Miscellaneous Issues in Estimating

Cash Flows
Problems

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Problems
Question 2

• OF Corporation spent 3 years and $1000000 to develop its new

microprocessor to replace a microprocessor that is becoming
obsolete. To begin manufacturing them, the company will have to
invest $1800000 in new equipment. The new microprocessors are
expected to generate an increase in operating cash inflows of
$750000 per year for the next 10 years. The company has
determined that the existing equipment could be sold to a
competitor for $250000.

Problems
Question 2

• How should the $1000000 in development costs be classified?

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Problems
Answer 2

• The $1000000 development costs should not be considered part

of the decision to go ahead with the new production.
• This money has already been spent and cannot be retrieved so it is
a sunk cost.

Problems
Question 2

• How should the $250000 sale price for the existing line be
classified?

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Problems
Answer 2

• The $250000 sale price of the existing line is an opportunity cost.

If OF Corporation does not proceed with the new microprocessor,
it will not receive the $250000. Therefore, it must be included in
the calculation of initial investment cash flow.

Problems
Question 3

• OF Corporation is developing the relevant cash flows associated

with the proposed replacement of an existing machine tool with a
new, technologically advanced one.
• Given the following costs related to the proposed project, explain
whether each would be treated as a sunk cost or an opportunity
cost in developing the relevant cash flows associated with the
proposed replacement decision.

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Problems
Question 3

• OF Corporation would be able to use the same tools, which had a

book value of $40000, on the new machine as it had used on the
old one.

Problems
Answer 3

• Sunk Cost.
• The funds for the tools had already been expended and would not
change, no matter whether the new technology would be acquired
or not.

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Problems
Question 3

• OF Corporation would be able to use its existing computer system

to develop programs for operating the new machine. The old
machine did not require these programs. The excess capacity of
computer system was previously leased to another firm for an
annual fee of $17000.

Problems
Answer 3

• Opportunity Cost.
• The development of the computer programs can be done without
additional expenditures on the computers. However, the loss of
cash inflow from the leasing arrangement would be a lost
opportunity to the firm.

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Problems
Question 3

• OF Corporation would have to obtain additional floor space to

accommodate the larger new machine. The space that would be
used is currently being leased to another company for $10,000 per
year.

Problems
Answer 3

• Opportunity Cost.
• OF Corporation will not have to spend any funds for floor space
but the lost cash inflow from the rent would be a cost to the firm.

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Miscellaneous Issues in Estimating

Cash Flows
References

References

• Brealey, R.A., Myers, S.C., and Allen, F., (2020). Principles of

Corporate Finance (Chapter 6). 13th Edition, McGraw-Hill.
• Gitman, L.J. and Zutter, C.J., (2012). Principles of Managerial
Finance (Chapter 11). 13th Edition, Pearson Prentice Hall.

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