12

Estimating Cash
Flows on Capital
Budgeting Projects
Finance 3rd Edition

Cornett, Adair, and Nofsinger

Copyright 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education

Introduction
Proforma analysis
Process of estimating expected cash flows of

project
Uses relevant parts of the balance sheet and

income statements

12-2

Sample Project Description

Outlines relevant data to consider

Identifies incremental cash flows directly

attributable to new project adoption

12-3

Cash Flow Estimation

Incremental cash flows
Cash flow changes that a new project causes

throughout the firm

12-4

Opportunity Costs
Allocation of firms resources represent lost

opportunities
Charge the project for assets used, wages and

benefits

12-5

Sunk Costs
An expense or obligation the firm is

compelled to pay regardless of whether a

project is undertaken
Never counted in project cash flows

12-6

Substitutionary and Complementary Effects

Reductions or increases necessary to

produce new products that are included in

project cash flows
Sales

Costs
Necessary assets

12-7

Total Project Cash Flow

Calculate
Depreciation
Operating Cash Flow
Changes in Gross Fixed Assets
Net Working Capital

12-8

Depreciation
Depreciable basis outlined in IRS

Publication 946
Cost
Amounts paid such as sales tax

Freight charges
Installation and testing fees

12-9

Depreciation
Straight-line method

12-10

Operating Cash Flow

Operating Cash Flow (OCF) = EBIT(1 - Tax rate)

+ Depreciation

12-11

Gross Fixed Asset Changes

Almost always change at beginning and

end of project
At beginning, equals assets depreciable basis
At end, must consider tax consequences of sale

12-12

Gross Fixed Asset Changes

After-tax cash flow (ATCF) from sale of an

asset

12-13

Net Working Capital Changes

Use if project has steady sales or changes

in NWC do not affect it

Add NWC at project beginning and reduce at

end

12-14

Net Working Capital Changes

Typical product unit sales follow bell-

shaped curve
Changes in levels of NWC throughout the

projects life are what need to be financed, not

the levels themselves

12-15

Accelerated Depreciation and Half-Year Convention

IRS requires depreciation calculation using

half-year convention
Property assumed to be placed in service at

midpoint of the period

12-16

Straight-Line Depreciation with Half-Year Convention

12-17

MACRS Depreciation
Accelerated depreciation
Firms receive more depreciation earlier in

assets life
Double-declining-balance method
Results in double the depreciation rate used in

straight-line

12-18

Section 179 Deductions

Assets can be expensed immediately
Up to $500,000 of property placed in service

each year
Targeted at helping small businesses

12-19

Special Cases Not Special

Incremental Free Cash Flow (FCF) can be

used to calculate total project costs for

many project types

12-20

Alternative Assets with Differing Lives (EAC)

Situations where two different assets can

be used for same purpose

Requires restructuring each of the incremental

cash flows associated with the assets for

comparison

12-21

Flotation Costs
Can adjust projects initial cash flow to

reflect flotation costs as well as investment

in assets

12-22

Flotation Cost Calculation

Compute weighted-average flotation

cost using target capital weights

Compute flotation-adjusted initial investment

12-23