CHAPTER 11 CASH FLOW ESTIMATION FOCUS Cash flow estimation focuses on the numerical methodology used in putting together an estimate of a capital project. We keep the question of accuracy and risk in mind throughout, and continue in the next chapter with a discussion of the methods available to incorporate risk into the process. PEDAGOGY This chapter contains an important pedagogical point with respect to practicality. Most texts present capital budgeting as more accurate and reliable than it is, and students can get the incorrect impression finance has the precision of engineering. In real companies, the cash flow estimates associated with capital projects are generally very fluid. If an analysis results in an unfavorable IRR, the people behind the project often change the input numbers until they get the result they want. This reality creates a problem and a challenge at the same time. The problem is bias and inaccuracy. The challenge lies in the role created for finance in ensuring that estimated cash flows are reasonable and likely to come true. This chapter provides a thorough discussion of the sources of error and vagueness in estimated figures. TEACHING OBJECTIVES At the end of this chapter students will be able to make estimates of cash flows in the context of capital budgeting in fairly complex situations. They should also be fully aware of the difficulties and uncertainties associated with estimation as well as the biases that people bring to the process. OUTLINE I. CASH FLOW ESTIMATION A. Capital Budgeting Processes Conceptually divides capital budgeting into the calculation process and the more difficult estimation process. II. PROJECT CASH FLOWS - AN OVERVIEW AND SOME SPECIFICS A. The General Approach to Cash Flow Estimation A general outline. Consider the initial investment first, then periodic revenues, costs and expenses, or savings. Include tax effects and plan to acquire the required assets. B. A Few Specific Issues The typical cash flow pattern, the incremental concept, sunk costs, opportunity costs, impacts on the rest of the company, overheads, taxes, working capital, financing costs, and old equipment. III. ESTIMATING NEW VENTURE CASH FLOWS A comprehensive example in a manufacturing context. A Terminal Values Treating cash flows that may go on indefinitely. B. Accuracy and Estimates NPV and IRR give answers to several decimal places, but the accuracy isn't real. That’s because the results are no better than the inputs, which are inherently inaccurate estimates of the future. This section contains an important discussion of the practical sources of error in capital budgeting including well-meaning biases. IV. ESTIMATING CASH FLOW FOR REPLACEMENT PROJECTS Replacements are usually simpler projects, but the cash flows can be trickier to properly identify and quantify. A comprehensive example. QUESTION 1. The typical cash flow pattern for business projects involves cash outflows first, then inflows. However, it's possible to imagine a project in which the pattern is reversed. For example, we might receive inflows now in return for guarantying to make payments later. Would the Payback, NPV, and IRR methods work for such a project? What would the NPV profile look like? Would the NPV and IRR methods give conflicting results? Answer: Payback wouldn't make sense for such a product, because there would be no initial outlay to recover. The NPV and IRR methods would work because they're based on the present value of future cash flows regardless of their pattern. The NPV profile would slope upward, because higher rates would reduce the present values of the negative flows in the distant future more than those of the positive short-term flows. This would result in a more positive NPV as the interest rate rose. NPV and IRR could give conflicting results if the up-sloping profiles crossed in the first quadrant just as in the case of the traditional patterns. BUSINESS ANALYSIS 1. You are a new financial analyst at Belvedere Corp, a large manufacturing firm that is currently looking into diversification opportunities. The vice president of marketing is particularly interested in a venture that is only marginally connected with what the firm does now. Other managers have suggested enterprises in more closely related fields. The proponents of the various ideas have all provided you with business forecasts from which you have developed financial projections including project cash flows. You have also calculated each project's IRR with the following results: You are now in a meeting with senior managers that was called to discuss the options. You have just presented your analysis ending your talk with the preceding information. After your presentation, the vice president of marketing stands, congratulates you on a fine job, and states that the figures clearly show that Project A is the best option. He also says that your financial analysis shows that project A has the full backing of the finance department. All eyes, including the CFO's, turn to you. How do you respond? Answer: Although A's IRR is highest it isn't likely to be the best project because of its risk. Projects of significantly different risk aren't directly comparable without risk adjustments. In this case Projects A and B are likely to be much riskier than C, because they're in unfamiliar fields. They should therefore be measured against a substantially higher hurdle rate than Project C. Further, the difference shown between A and B is finer than makes sense for capital budgeting techniques. Remember that a calculated IRR can be no more accurate than the estimated cash flows input to the model. Those are certainly not good to four significant figures as shown. This analysis essentially says that the three projects are about equal in terms of IRR without adjusting for risk. Part of the problem is in the presentation. The analyst should not have displayed results to a hundredth of a percent. Doing so gives the wrong impression to people unfamiliar with financial analysis techniques. 2. Most top executives are graded primarily on their results in terms of net income rather than net cash flow. Why then, is capital budgeting done with incremental cash flows rather than with incremental net income? Answer: Net income is an accounting construction designed to indicate the long-term health of a business rather than its immediate cash performance. Presumably, executives are graded on long term results of the business as a going concern that will last over a long period, so net income is an appropriate measure. Capital budgeting is aimed at allocating resources among competing uses as objectively as possible. It is not concerned with painting a picture of the business the way accounting results do. The best basis for resource allocation among uses is the contribution those uses make to wealth. That contribution is best measured by the present value of expected cash flows which is therefore the basis for capital budgeting. The Accounting Rate of Return provides a convenient way to show operating managers the impact projects will have on financial statements, but it should not be used as the basis for decisions. 3. Creighton Inc. is preparing a bid to sell a large telephone communications system to a major business customer. It is characteristic of the telephone business that the vendor selling a system gets substantial follow-on business in later years by making changes and alterations to that system. The marketing department wants to take an incremental approach to the bid, basically treating it as a capital budgeting project. They propose selling the system at or below its direct cost in labor and materials (the incremental cost) to ensure getting the follow-on business. They've projected the value of that business by treating future sales less direct costs as cash inflows. They maintain that the initial outlay is the direct cost to install the system, which is almost immediately paid back by the price. Future cash flows are then the net inflows from the follow-on sales. These calculations have led to an enormous NPV and IRR for the sale viewed as a project. Both support and criticize this approach. (Hint: what would happen if Creighton did most of its business this way?) Answer: The approach makes sense if the follow-on business is in total large relative to the initial sale. If not, the idea creates several problems. The fact that the installation is paid for immediately makes it seem as if the initial outlay for the project is zero, and the subsequent inflows are free. This results in an NPV that is just the present value of expected profits with no initial cost offset and an IRR that's virtually infinite. However, it masks the fact that the project's risk is related to the level of resource committed to the initial installation. Hence the risk may be out of proportion to the expected dollar return. For example, if the job is underbid by 10%, the loss on the installation could be impossible to make up through follow-on business. It's also important to compare the project with alternate uses of the labor and material to be spent on the installation. If they could be used on traditional sales with normal profit margins, the project isn't likely to look good regardless of its IRR. If the project takes up a large portion of the company's resources, incremental thinking may not be appropriate. This is because a firm made up of too much incrementally acceptable business may find itself without the income to support necessary overhead. 4. Webley Motors, a manufacturer of small gas engines, has been working on a new design for several years. It's now considering going into the market with the new product, and has projected future sales and cash flows. The marketing and finance departments are putting together a joint presentation for the board of directors that they hope will gain approval for the new venture. Part of the presentation is a capital budgeting analysis of the project that includes only estimated future costs and revenues. Dan Eyeshade, the head of investor relations, insists that calculations shown to the board include the money spent on research in the past several years. He says that to ignore or omit those costs would be deceiving the board about the true cost of the project, which would be both unethical and legally dangerous. Comment on Dan's position. If you disagree, prepare an argument that will convince him to change his mind, and suggest an alternative presentation that will satisfy you both. Answer: Dan is confusing decision making with honest and open reporting. Only future revenues and costs matter to the decision, because only the future can be changed by it. Past costs are "sunk", and cannot be changed by anything. In theory that means only future costs have to be shown to the decision makers. On the other hand, Dan is right that it would be less than honest and ethical to lead the board to believe that the future costs were the only ones that went into the project. The solution is fairly obvious. Present the decision in terms of the future cash flows but make a side point about the effort that's gone on to date, being sure to point out that those costs are gone regardless of the outcome of the project. 5. The Capricorn Company is launching a new venture in a field related to, but separate from, its present business. Management is proposing that financing for the new enterprise be supplied by a local bank that it has approached for a loan. Capricorn's finance department has done a capital budgeting analysis of the venture projecting reasonable cash flows and calculating an NPV and an IRR that both look very favorable . The bank's loan officer, however, isn't satisfied with the analysis. She insists on seeing a financial projection that made which calculates interest on cumulative cash flows, incorporates that interest as a cost of the project, and shows the buildup and decline of the debt necessary to accomplish the proposal. She essentially wants a business plan complete with projected financial statements. Reconcile the bank officer's position with capital budgeting theory. Answer: Capital budgeting considers financing costs through the time value calculations inherent in the techniques. Conceptually, capital budgeting draws money out of and pays it into a general pool of funds maintained by the company, but isn't explicit about the size of the pool at any point in time. It also charges interest at a conceptual weighted average rate, the cost of capital, rather than a particular rate tied to a specific source of funds. This is the correct approach when evaluating projects as part of the ongoing operation of a company. The bank on the other hand is concerned about getting its money back on a specific loan at a specific rate of interest. In this case, the loan is tied to a particular project, so the bank wants to make sure the project will generate the cash flows required to pay the loan off. It also needs to know when the money will be drawn and repaid so it can calculate the outstanding balance at any time. This helps the bank forecast its own funding requirements. Both approaches are correct from the perspectives of the respective decision making parties. 6. Wilson Petroleum is a local distributor of home heating oil. The firm also installs and services furnaces and heating systems in homes and small commercial buildings. The customer service department maintains sales and service records on current customers who number about 400. Detailed customer records are kept manually in file cabinets, and a small computer system holds all customer names and addresses for mailing and billing purposes. One full-time clerk maintains all the records and handles all billing and customer inquiries. Customers occasionally complain if delivery or service is late, but only one or two mild complaints are received each month. Delays are primarily a result of problems in the field rather than problems in assigning calls in the service department. A consultant has proposed a new computer system that will completely automate the customer service function. It will provide on-line billing and immediate access to all customer records. The cost of the proposed system is $100,000 initially plus about $15,000 a year for maintenance and support. It will still take a person to run it. The consultant says the new system will provide faster service and superior insight into the needs of the customer base, which will result in better customer relations and more sales in the long run. Discuss the pros and cons of the consultant's proposal. What further justification should management demand before buying? Could the consultant have made the proposal for reasons that aren't in Wilson's best interest? Could the consultant be well meaning yet biased? Explain. Answer: The new system can be viewed as a capital budgeting project in which the costs are well known, but the benefits are hard to predict or measure. Estimating the actual increased cash flows that will come from an improved administrative system is a difficult and very subjective matter. In this case it seems that the system is unlikely to be a worthwhile project, because it doesn't save any labor and the administrative problems it would fix are minor. Such situations are very subject to overestimation of benefits. Before accepting the consultant's idea, management should demand a detailed, well-supported estimate of the expected benefits. He or she will probably be unable to provide this. If the consultant also sells the proposed system, it's likely that a conflict of interest exists. He or she could be motivated by the money to be made on the sale rather than by improving Wilson's business. It's not at all unusual for technical salespeople to propose systems that do more than their customers need in order to generate big commissions. It's also possible that the consultant honestly believes that computers are the answer to virtually all problems. People in high technology businesses are often biased toward computer solutions even when doing things by hand is cheaper. PROBLEMS New Venture Cash Flows – Depreciation: Concept Connection Example 11-1 (page 488) 1. A project that is expected to last six years will generate a profit and cash flow contribution before taxes and depreciation of $23,000 per year. It requires the initial purchase of equipment costing $60,000, which will be depreciated straight line over four years. The relevant tax rate is 25%. 2. Calculate the project’s cash flows. Round all figures within your computations to the nearest thousand dollars. Solution: The initial outlay is just the cost of the equipment. So C0 = ($60,000). The remaining cash flows are calculated as follows ($000). 2. Auburn Concrete Inc. is considering the purchase of a new concrete mixer to replace an inefficient older model that is completely worn out. If purchased, the new machine will cost $90,000 and is expected to generate savings of $40,000 per year for five years at the end of which it will be sold for $20,000. The mixer will be depreciated to a zero salvage value over three years using the straight line method. Develop a five year cash flow estimate for the proposal. Auburn’s marginal tax rate is 30%. Work to the nearest thousand dollars. Solution: Replacement Projects – Sale of an Old Asset: Concept Connection Example 11-3 (page 497) 3. Flextech Inc. is considering a project that will require new equipment costing $150,000. It will replace old equipment with a book value of $35,000 that can be sold on the second hand market for $75,000. The company’s marginal tax rate is 35%. Calculate the project’s initial outlay. Solution: Replacement Projects – Initial Outlay: Concept Connection Example 11-3 (page 497) 4. Tomatoes Inc. is planning a project that involves machinery purchases of $100,000. The new equipment will be depreciated over five years, straight line. It will replace old machinery that will be sold for an estimated $36,000 and has a book value of $22,000. The project will also require hiring and training ten new people at a cost of about $12,000 each. All of this must happen before the project is actually started. The firm’s marginal tax rate is 40%. Calculate, C0, the project’s initial cash outlay. Solution: 5. The Olson Company plans to replace an old machine with a new one costing $85,000. The old machine originally cost $55,000, and has six years of its expected 11-year life remaining. It has been depreciated straight line assuming zero salvage value, and has a current market value of $24,000. Olson’s effective tax rate is 36%. Calculate the initial outlay associated with selling the old machine and acquiring the new one. Solution: 6. A four-year project has cash flows before taxes and depreciation of $12,000 per year. The project requires the purchase of a $50,000 asset that will be depreciated over five years, straight line. At the end of the fourth year the asset will be sold for $18,000. The firm's marginal tax rate is 35%. Calculate the cash flows associated with the project. (For convenience assume the gain on the sale of the asset is taxed at 35%.) Solution: 7. Voxland Industries purchased a computer for $10,000, which it will depreciate straight line over five years to a $1,000 salvage value. The computer will then be sold at that price. The company’s marginal tax rate is 40%. Calculate the cash flows associated with the computer from its purchase to its eventual sale including the years in between. (Hint: Depreciate the difference between the cost of the computer and the salvage value. At the end of the depreciation life there’s a net book value remaining equal to the salvage value.) Solution: ($000) 8. Resolve the previous problem assuming Voxland uses the 5-year Modified Accelerated Cost Recovery System (MACRS) with no salvage value to depreciate the computer. Continue to assume the machine is sold after five years for $1,000. (Hint: Apply the MACRS rules for computers in the chapter (page XXX) to the entire cost of the computer. Notice, however, that there will be a positive net book value after five years because MACRS takes five years of depreciation over six years due to the half-year convention.) Solution: 9. Shelton Pharmaceuticals Inc. is planning to introduce a new drug for pain relief. Management expects to sell 3 million units in the first year at $8.50 each, and anticipates 10% growth in sales per year thereafter. Operating costs are estimated at 70% of revenues. Shelton will invest $20 million in depreciable equipment to develop and produce this product. The equipment will be depreciated straight line over 15 years to a salvage value of $2.0 million. Shelton’s marginal tax rate is 40%. Calculate the project’s operating cash flows in its third year. Solution: ($000) New Venture Cash Flows: Example 11-1 (page 488) 10. Harry and Flo Simone are planning to start a restaurant. Stoves, refrigerators, other kitchen equipment, and furniture are expected to cost $50,000 all of which will be depreciated straight line over five years. Construction and other costs of getting started will be $30,000 The Simones expect the following revenue stream. ($000) Food costs are expected to be 35% of revenues while other variable expenses are forecast at 25% of revenues. Fixed overhead will be $40,000 per year. All operating expenses will be paid in cash, revenues will be collected immediately and inventory is negligible, so working capital need not be considered. Assume the combined state and federal tax rate is 25%. Do not assume a tax credit in loss years and ignore tax loss carry forwards. (Taxes are simply zero when EBT is a loss.) Develop a cash flow forecast for the Simones’ restaurant. Solution: The initial outlay, C0, is the cost of the equipment, construction, and other getting started expenses. C0 = $50,000 + $30,000 = $80,000 The remaining cash flows are calculated as follows ($000). Terminal Values: Example 11.2 (page 493) 11. Oxbow Inc. is contemplating a new venture project and has done a detailed five year cash flow estimate with the following result ($000): The firm’s cost of capital is 12%. a. Use a financial calculator to compute the project’s NPV and IRR, and make the appropriate recommendation to management. (If you don’t have a financial calculator just calculate NPV.) b. Charles Dunn, Oxbow’s Marketing VP, has argued that it’s unreasonable to exclude cash flows past year five from the analysis. Calculate the project’s terminal value assuming year five’s cash flow goes on forever. Recalculate the project’s NPV and IRR under that Charles’ assumption. c. Charles further argues that the most appropriate assumption is that cash flows beyond the fifth year incorporate a three percent long run growth rate. Calculate the terminal value, NPV, and IRR implied by this assumption. d. Comment on the results implied by the use of aggressive terminal value assumptions. Solution: a. Using a financial calculator enter the following according to the instructions in the chapter: Press NPV, enter I = 12% for the cost of capital, press enter, down arrow, and compute. The resulting NPV is ($32,036). Next punch IRR and then compute. The resulting IRR is 8.8%. The project should clearly be rejected as the NPV<0 and IRR<k. b. The terminal value at the end of period five is the present value of a perpetuity of $170,000 per year at an interest rate of 12%. TV = $170 / .12 = $1,417 Then F05 becomes F05 = $1,417 + $170 = $1,587 Recalculate the project’s NPV and IRR using $1,587 as C05. The result is NPV = $772 and IRR = 48.0. The project is now clearly acceptable in terms of both NPV and IRR c. Follow the procedure in b. using TV = $170 / (.12 - .03) = $1,889 and F05 = $1,889 + $170 = $2,059 From which NPV = $1,040 and IRR = 54.8. The project now appears to be even better. d. Aggressive terminal value assumptions just about always overwhelm short run detailed cash flow estimates. Virtually any project can be made to look good if we’re willing to assume a long period of very positive cash flows after a short period of realism. This kind of technique is often used to support projects that don’t make financial sense but people at the top simply want to do. 12. Sam Dozier, a very bright computer scientist, has come up with an idea for a new product. He plans to form a corporation to develop the idea and market the resulting product. He has estimated that it will take him and one employee about a year to develop a prototype and another year to bring a working model to market. There will be no income during those years. After that he expects sales to grow rapidly, estimating revenues of $700,000, $1,500,000, and $5,000,000 in the third, fourth, and fifth years respectively. Starting the project will require research equipment costing about $500,000 which will be depreciated for federal tax purposes under the MACRS system (see page XXX). Beyond that it will take another $400,000 in tax deducible expenses to get going. Sam thinks he can fund the development work including supporting himself and paying an employee with about $200,000 per year. Once sales begin in the third year, direct costs will be 40% of revenues and indirect costs, including salaries for Sam and all employees, will be $300,000, $500,000, and $1,800,000 in the third, fourth and fifth years respectively. The nature of the business is such that working capital requirements are minimal. A net investment of $200,000 in the third is expected to provide for working capital needs. Sam has $1,500,000 saved which he thinks is enough to launch and operate the business until it begins to generate income. Sam plans to sell the business at the end of the fifth year. He thinks it will be worth $2,500,000 at that time. The business will be a C-type corporation subject to federal corporate income taxes. Sam will be the sole stockholder and will be subject to federal (personal) capital gains tax when he sells the company (assume the top capital gains rate discussed in chapter 2). Ignore state taxes. a. Develop a cash flow estimate for Sam’s business. Include the effect of tax loss carry forwards as well as any capital gains taxes he will pay on its sale. Does Sam have enough cash to fund this venture without contributions from outside investors? b. Calculate the project’s NPV and IRR (a financial calculator is recommended). Assume the cost of capital is 12%. Is the venture a good investment of Sam’s time and money? Solution: ($000) a. First develop the equipment depreciation schedule noticing that under MACRS, special tooling is depreciated over 3 years. Sam has $1,500,000 saved to start his business. That’s a little more than the maximum forecast cash required requirement of $1,426,000. However, overruns are common in this kind of projection, and it would be foolish to undertake the project without back up financing. b. Enter the project’s cash flows into a financial calculator following the instructions in the chapter as follows: Then press NPV, enter I = 12% for the cost of capital, press enter, down arrow, and compute. The resulting NPV is $169,427. Next punch IRR and then compute. The resulting IRR is 15.1% Analysis: The project is acceptable in accordance with capital budgeting rules in that the NPV is positive and the IRR is greater than the cost of capital. However, it plainly isn’t a good idea for Sam. The reward in NPV terms is just a little more than 10% of his current net worth, and undertaking the plan will tie him up for five years. This isn’t much of a payoff for risking everything he has as well as five years of his professional life. There’s also a good chance that the whole idea won’t work and that he’ll end up five years older and broke. He’d be much better off to find a job with an established company or look for a more promising entrepreneurial opportunity. 13. The Leventhal Baking Company is thinking of expanding its operations into a new line of pastries. The firm expects to sell $350,000 of the new product in the first year and $500,000 each year thereafter. Direct costs including labor and materials will be 60% of sales. Indirect incremental costs are estimated at $40,000 a year. The project will require several new ovens that will cost a total of $500,000 and be depreciated straight line over five years. The current plant is underutilized, so space is available that cannot be otherwise sold or rented. The firm's marginal tax rate is 35%, and its cost of capital is 12%. Assume revenue is collected immediately and inventory is bought and paid for every day, so no additional working capital is required. a. Prepare a statement showing the incremental cash flows for this project over an 8-year period. (Structure as a new venture.) b. Calculate the Payback Period, NPV, and PI. c. Recommend either acceptance or rejection. d. If the space to be used could otherwise be rented out for $30,000 a year, how would you put that fact into the calculation. Would the project be acceptable in that case? That is, treat the $30,000 as a real cash outflow. Solution: New Venture Cash Flows – Working Capital: Example 11.1 (page 488) 14. Harrington Inc. is introducing a new product in its line of household appliances. Household products generally have ten-year life cycles and are viewed as capital budgeting projects over that period. Harrington’s working capital forecast for the project is as follows: - $1.0 million will be invested in inventory before the project begins. - Inventory will increase by $100,000 in each of the first six years. - Accounts receivable will increase by $150,000 in each of the first four years, and by $100,000 in each of the next two years. - Accounts payable will increase by $110,000 in each of the first six years. - During the last four years, the balance in each of these accounts will return to zero in four equal increments. - Accruals are negligible. Calculate the cash flows associated with working capital from the initial outlay to the end of the project’s life. Replacement Projects: : Concept Connection Example 11.3 (page 497) 15. Meade Metals Inc plans to start doing its own deliveries instead of using an outside service for which it has been paying $150,000 per year. To make the change Meade will purchase a $200,000 truck that it will depreciate straight line over ten years to a $40,000 salvage value. Annual operating expenses are estimated at $80,000 including insurance, fuel and maintenance on the truck as well as the cost of a driver. Management plans to sell the truck after five years for $100,000. Develop the project’s five-year cash flows. Mead’s tax rate is 40%. (Hint: Treat as a replacement project. Savings are the difference in the contractor’s cost and that of operating the truck with an old asset sale in the last year.) Solution: 16. Assume that Meade Metals Inc of the previous problem is replacing an old truck with a new one instead of replacing an outside delivery service. The old truck was purchased 8 years ago for $120,000. It has been depreciated straight line based on a ten-year life and a $20,000 salvage value. The old truck’s annual operating expenses are $110,000, and it has a market value of $40,000. Develop a five-year cash flow projection for this replacement project. Solution: 17. Olson-Jackson Corp. (OJC) is considering replacing a machine that was purchased only two years ago because of dramatic improvements in new models. The old machine has been depreciated straight line anticipating a ten years life based on a cost of $240,000 and an expected salvage value of $20,000. It currently has a market value of $180,000. If the old machine is kept five more years it would have a market value of $60,000 at the end of that time. A new machine would cost $350,000 and would be depreciated straight line over five years to a salvage value of $50,000, at which time it would be sold at that price. Develop a cash flow projection showing the difference between keeping the old machine and acquiring the new one. Assume OJC’s tax rate is 40%. Note: A complete cash flow projection for the project would include the financial benefits of the better performance of the new machine as well as a comparison of the operating costs of the two models. In this problem we’re just focusing on the cost of the equipment. Solution: 18. The Catseye Marble Co. is thinking of replacing a manual production process with a machine. The manual process requires three relatively unskilled workers and a supervisor. Each worker makes $17,500 per year while the supervisor earns $24,500. The new machine can be run with only one skilled operator who will earn $41,000. Payroll taxes and fringe benefits are an additional one third of all wages and salaries. The machine costs $150,000 and has a tax depreciation life of five years. Catseye elects straight- line depreciation for tax purposes. A service contract covers all maintenance for $5,000 a year. The machine is expected to last six years, at which time it will have no salvage value. The machine's output will be virtually indistinguishable from that of the manual process in both quality and quantity. There are no other operating differences between the manual and the machine processes. CATs eye’s marginal tax rate is 35%, and its cost of capital is 10%. a. Calculate the incremental cash flows associated with the project to acquire the machine. b. Calculate the project's payback and NPV. Would you accept or reject the project? c. Suppose there is no alternative but to lay off the displaced employees, and the cost of severance is about three months’ wages. How would you factor this information into the analysis? Does it change the project's acceptability? d. How would you characterize this project's risk? Solution: Replacement Projects – Subjective Issues: Example 11.3 (page 497) 19. Blackstone Inc manufactures western boots and saddles. The company is considering replacing an outmoded leather-processing machine with a new, more efficient model. The old machine was purchased for $48,000 six years ago and was expected to have an eight-year life. It has been depreciated on a straight-line basis (ignore partial year conventions). The used machine has an estimated market value of $15,323. The new machine will cost $60,000 and will be depreciated straight line over five years. All depreciation assumes zero salvage. The new machine is expected to actually last for eight years (its economic life) and then will have to be replaced. Assume it has no actual salvage value at that time. Assume Blackstone's marginal tax rate is 35%. Operating cost savings are summarized as follows: The shop foreman feels the new machine will produce a higher quality output and thus affect customer satisfaction and repeat sales. He thinks that benefit should be worth at least $5,000 a year, but he doesn't have a way to document the figure. Losses generate tax credits. a. Calculate the relatively certain incremental cash flows associated with the new machine over its projected economic life of eight years, and the NPV at a cost of capital of 12% based on those cash flows. (Round to whole $.) b. Suppose the foreman’s $5,000 quality improvement estimate were to be included. How big an impact would it have in relation to the other numbers? Comment. Solution: This illustrates an important real world phenomenon. Subjective guesses added at the end of capital budgeting analyses can override computations based on objectively estimated cash flows. New Venture/Expansion – Terminal Values: Concept Connection Example Examples 11-1, 11-2 (pages 488 and 493) 20. The Ebitts Field Corp. manufactures baseball gloves. Charlie Botz, the company's top salesman, has recommended expanding into the baseball bat business. He has put together a project proposal including the following information in support of his idea. • New production equipment will cost $75,000, and will be depreciated straight line over five years. • Overheads and expenses associated with the project are estimated at $20,000 per year during the first two years and $40,000 per year thereafter. • There is enough unused space in the factory for the bat project. The space has no alternative use or value. • Setting up production and establishing distribution channels before getting started will cost $300,000 (tax deductible). • Aluminum and Wood bats will be produced and sold to sporting goods retailers. Wholesale prices and incremental costs per unit (direct labor and materials) are as follows: • The sixth year sales level is expected to hold indefinitely. • Receivables will be collected in 30 days, inventories will be the cost of one month's production, and payables are expected to be half of inventories. Assume no additional cash or accruals are necessary. (Use 1/12 of the current year's revenue and cost for receivables and inventory.) Ebitts Field's marginal tax rate is 35% and its cost of capital is 12%. a. Develop a six-year cash flow estimate for Charlie's proposal. Work to the nearest $1,000. b. Calculate the payback period for the project. c. Calculate the project’s NPV, assuming a six-year life. Is the project acceptable? d. Is the cost of capital an appropriate discount rate for the project considering its likely risk relative to that of the rest of the business? Why? e. What is the project's NPV if the planning horizon is extended to eight years? (Add the incremental PV from two more years at year 6's cash flow.) f. What is the NPV if management is willing to look at an indefinitely long time horizon? (Hint: Think of the cash flows in years 6 and beyond as a perpetuity.) g. Comment on the results of parts e. and f. Solution: 21. Segwick Corp manufactures men's shoes that it sells through its own chain of retail stores. The firm is considering adding a line of women's shoes. Management considers the project a new venture because there are substantial differences in marketing and manufacturing processes between men’s and women’s footwear. The project will involve setting up a manufacturing facility as well as expanding or modifying the retail stores to carry two products. The stores are leased, so modification will involve leasing larger spaces, installing new leasehold improvements, and writing off some old leasehold improvements.* The expected costs are summarized as follows: Working Capital Sales are to retail customers who pay with checks or credit cards. It takes about 10 days to clear both of these and actually receive cash. Inventories are estimated to be approximately the cost of two months sales. Payables are estimated as one quarter of inventories. Assume incremental cash is required equal to 2% of revenues. Accruals are insignificant. Estimate the current accounts based on the current year's revenue and cost levels. Other Items Management expects a few of the company's current male customers to be lost, because they won't want to shop in a store that doesn't exclusively sell men's shoes. The gross margin impact of these lost sales is estimated to be $60,000 per year. The company has already purchased designs for certain styles of ladies' shoes for $60,000. Segwick's cost of capital is 10%. Its marginal tax rate is 35%. a. Develop a six-year forecast of after tax cash flows for Segwick. b. Calculate the project's payback period, NPV, IRR, and PI, and make a recommendation about acceptance. c. Assume you are told that the men's shoe industry is very stable being served by the same manufacturers year after year. However, firms enter and leave the ladies' shoe business regularly. Would this knowledge make you more or less comfortable with the analysis you've done of this project? Why? Solution: COMPUTER PROBLEM 22. The Paxton Homes Co. is a successful builder of moderate to high-priced houses. The firm is currently considering an expansion into light commercial construction in which it would build shopping centers and small office buildings. Management considers the idea a new venture because of the major differences between commercial and residential construction. Getting into the new line of business will require an investment of $12.5M in equipment and $3M in expenses. The equipment will be depreciated over five years. Part of the start-up money will come from the sale of some old trucks and cranes. These have a total market value of $1.8M and an NBV of $600K. Selling the equipment will result in a depreciation reduction of $200K per year for three years. Revenue from the commercial line is expected to be $6M in the first year and to grow by $2M in each succeeding year until it reaches $20M. After that growth is uncertain and may be anywhere from 0 to 6% per year. Costs and expenses, including incremental overhead, will be 110% of revenues in the first year, 85% in the next two years, and 70% thereafter. Economies of scale in materials purchasing are expected to save the residential business about $250K per year but not until the fourth year. Net working capital requirements are estimated at 10% of revenue. The combined federal and state tax rate on the incremental business will be 40%. Losses can be offset against other profits and can therefore be viewed as earning a tax credit at the same rate. Paxton's cost of capital is 12%. You are a financial analyst assigned to evaluate the commercial construction proposal. Use the CAPBUD program to analyze the project and prepare a presentation in which you will make a recommendation either favoring or opposing its undertaking. Here are some ideas for approaches to your presentation: a. Establish a base case using the information given. Forecast into the future until the numbers stop changing (eight years). Assume a terminal value based on a continuation of the eighth year's cash flows with no further growth. Is the project acceptable based on NPV and IRR given these assumptions? b. Test the sensitivity of the base case analysis to the terminal value assumption by varying the growth rate to 3% and 6%. 1) Comment on the difference the terminal growth rate assumption makes. 2) Construction is a cyclical industry in that it is very subject to the ups and downs of the economy. In good times growth is enormous, but in bad times the industry and the firms in it shrink rapidly. Given that fact, how do you feel about the terminal value assumption? 3) Evaluate the project's NPV and IRR assuming a ten-year planning horizon. That is, assuming zero cash flows after the tenth year. Does this approach make more or less sense to you than the terminal value assumptions used in part a.? c. Test the sensitivity of the analysis to changes in revenue growth. For example, suppose revenue grows by only $1M per year instead of two until the eighth year. Is the project a good idea then? What if cost/expense is a higher percentage of revenue than anticipated? Solution: Solutions are outputs of the CAPBUD program given the inputs stated in the problem. Solution Manual for Practical Financial Management William R. Lasher 9781305637542
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