Estimating Project Cash Flows

The cost of undertaking the project The cash inflows during the life of the project The terminal or ending value of the project

(most important, most difficult)

Incremental

cash flows: The additional revenue that will be generated or expenses that will be incurred by undertaking a particular action.
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Cannibalization: a new product taking sales away from the firms existing products. Cannibalization also occurs when a firm builds a plant overseas and winds up substituting foreign production for parent company exports. To the extent that sales of a new product or plant just replace other corporate sales, the new projects estimated profits must be reduced by the earnings on the lost sales.
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Sales Creation: An investment created or was

expected to create additional sales for other products. This is the opposite of cannibalization. In calculating the projects cash flows, the additional sales and associated incremental cash flows should be attributed to the project.

Opportunity Cost: The cash the asset could

generate for the firm should it be sold or put to some other productive use. Project costs must include the true economic cost of any resource required for the project, regardless of whether the firm already owns the resource or has to go out and acquire it.

Sunk Costs: a cost that has been incurred and

cannot be reversed.

expenditures on a project should influence the decision whether or not to continue or terminate the project. Instead, this decision should be based on future costs and benefits alone. Transfer Pricing: the prices at which goods and services are traded within a company. Prices used to evaluate projects should be at market prices.

Sunk Cost Fallacy: the idea that past

Allocated Overhead: Only charge the additional expenditures that can be attributed to the project. Getting the Base Case Right. Asking yourself, What will happen if we do not make this investment? Do not ignore the competitor behavior. The rule: If you must be the victim of a cannibal, make sure the cannibal is a member of your family.

Accounting for Intangible Benefits.

Better quality Faster time to market Quicker and less error prone order processing Higher customer satisfaction

All these can have a very tangible impact on corporate cash flows, even if you cant measure them precisely.

Replacing an existing piece of equipment with a new piece of equipment. Why?

Cost Reduction Quality Improvement Both

Estimating the Initial Investment, which is the projects net cash outlay.
1. The cost of acquiring and placing into service the necessary assets; purchase price, freight costs, installation expenses. 2. The necessary increase in working capital; A/P to suppliers, Inventory for production, A/R for increases sales to customers. 3. The net proceeds from sale of existing assets in the case of a replacement decision. (new product sale replaces old product sale) 4. The tax effects associated with the sale of existing assets and their replacement with new assets; tax write offs, capital gains taxes, taxes on depreciation recapture, investment tax credits.
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The net proceeds from sale of existing assets in the case of a replacement decision. The tax effects associated with the sale of existing assets and their replacement with new assets. Estimating this is difficult. 4 Possible situations can occur:
1. 2. 3. The asset is sold for its book value. The asset is sold for less than book value. The asset is sold for more than book value, but less than initial purchase price. The asset is sold for more than its original purchase price.

4.

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Investment Tax Credit (ITC): allows a company to reduce its taxes by an amount equal to a specified percentage of the cost of qualifying new property placed into service. Example: under ACRS, depreciation (Economic Recovery Act of 1981), firms received a 10% tax credit for qualifying property having ACRS recovery period of at least 5 years. ITC is no longer in effect, but political pressure is there is resurrect it.
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Multiyear Investments. Sometimes projects can take several years (like the building of a factory). Stretching out the investment reduces the present value of the initial cost, but it also delays the receipt of project cash inflows. The net result is typically a reduction in the project NPV.

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Estimating Operating Cash Flows: + Change in After tax income + Depreciation - Working Capital = Incremental operating cash flow

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Depreciation: because it is a noncash charge, its only significance lies in the fact that it reduces (or shields) taxable income, and thereby reduces taxes. Financing Costs: These are left out as they are incorporated into the rate of return or the cost of capital for the project. Subtracting interest charges or dividend payments from projected cash flows and then discounting these cash flows at the appropriate rate would be double counting the financing costs.

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Estimating the Terminal Value In general, the terminal value of any asset is equal to the present value of the future cash flows generated by the asset, whether it be the scrap value or the revenue produced by a product. Terminal Value: the value of an investment at the end of a period, taking into account a specified interest rate.

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Break-Even Analysis. One way to incorporate terminal value in a project analysis is to find the breakeven terminal value TERM that would yield a zero NPV project.

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Depending on whether the new product is a simple extension of an existing product or a true product innovation, estimates of cash flows are subject to high degrees of uncertainty. Starting point:
1. 2. 3. 4. sales forecast Capital investment needed to satisfy projected demand Operating costs The projects working capital needs

This accounting based financial forecast can then be used to identify relevant cash flows and calculate the projects NPV.
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Estimating Terminal Values for New Product Introductions:

Salvage value of the equipment Recovery of the projects working capital Some products have sales and cash flows beyond the initial evaluation period. Limiting the analysis to a set time period may seriously underestimate a projects NPV. Challenge: Capturing these post-evaluation period cash flows. Variation of the constant dividend growth model:

TVn

CFn + 1 Kg

TV=terminal value CF = CF 1 yr beyond initial eval period k = required return for the project g = projected growth rate
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Over optimism Lack of Consistency Natural biases (the more you work with a project analysis; always good to have a second set of eyes review the work).

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Post Investment Audit: compares actual results with budget figures. By reviewing the record of past investments, the firm can learn from its mistakes And its successes.

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