relevant cash flows working capital treatment unequal project lives project cash flow analysis

Relevant cash flowsWorking capital treatmentUnequal project lives

Project Cash Flow Analysis

Whenever the companies contemplate the development of a new product, they must conduct a capital budgeting analysis(including project cash flow). For example, Coke is deciding whether to produce and market a new lemonade product. Here are some of the factors that it would have to consider:

How many people would like the new product well enough to buy it, and how many units would each customer buy per year?

What share of the lemonade market could Coke expect to capture?

How important would price be; that is, would demand be greatly affected by a small change in price

If Coke did go into the lemonade market, and if it were highly profitable, how long would it take Pepsi and other competitors to follow, and how badly would Coke’s prices and sales be eroded?

How much would lemonade sales cut into the sales of Coke’s other products?

How large an investment would be required to set up a plant to produce lemonade and then launch a marketing campaign?

What would the production and distribution costs per unit be?

If the product were successful in the United States, might this lead to a worldwide expansion, hence to additional profits?

Cost: $200,000 + $10,000 shipping + $30,000 installation.

Depreciable cost $240,000.Inventories will rise by $25,000 and pay

ables will rise by $5,000.Economic life = 4 years.Salvage value = $25,000.Depreciation=MACRS 3-year class.

Proposed Project

Incremental gross sales = $250,000.Incremental cash operating costs = $125,

000.Tax rate = 40%.Overall cost of capital = 10%.

0 1 2 3 4

InitialOutlay

OCF1 OCF2 OCF3 OCF4

+ Terminal CF

NCF0 NCF1 NCF2 NCF3 NCF4

Set up without numbers a time line for the project CFs.

= Corporate cash flow with project

minus

Corporate cash flow without project

Incremental Cash Flow

Net Investment Outlay at t = 0 (000s)

EquipmentFreight + Inst.Change in NWC

Net CF0

EquipmentFreight + Inst.Change in NWC

Net CF0

($200)(40)(20)

($260)

($200)(40)(20)

($260)

NWC = $25,000 - $5,000= $20,000.

NWC = $25,000 - $5,000= $20,000.

Basis = Cost + Shipping + Installation $240,000

Depreciation Basics

Straight-Line Method

For stockholder report or “book” purpose

= Cost of Asset - Salvage Value

Economic Life of Asset

Class Type of Property

3 yrs Certain special manufacturing tools

5 yrs Automobiles, light-duty trucks,

computers, and certain special manufacturing equipment

7 yrs Most industrial equipment, office furniture, and fixtures

10 yrs Certain longer-lived types of

equipment

Modified Accelerated Cost Recovery System(MACRS)

Modified Accelerated Cost Recovery System(MACRS)

Ownership Year 3 Yrs 5 Yrs 7 Yrs 10 Yrs 1 33% 20% 14% 10%

2 45 32 25 18

3 15 19 17 14

4 7 12 13 12

5 11 9 9

6 6 9 7

7 9 7

8 4 7

9 7

10 6

11 3

100 100 100 100

Year1234

% 0.330.450.150.07

Depr.$ 79 108 36 17

x Basis =

Annual Depreciation Expense (000s)

$240

Net revenueDepreciationBefore-tax incomeTaxes (40%)Net incomeDepreciationNet operating CF

$125 (79)$ 46 (18)$ 28 79$107

Year 1

Year 1 Operating Cash Flows (000s)

Net revenueDepreciationBefore-tax incomeTaxes (40%)Net incomeDepreciationNet operating CF

Net revenueDepreciationBefore-tax incomeTaxes (40%)Net incomeDepreciationNet operating CF

$125 (79)$ 46 (18)$ 28 79$107

$125 (79)$ 46 (18)$ 28 79$107

$125 (17)$108 (43)$ 65 17$ 82

$125 (17)$108 (43)$ 65 17$ 82

Year 4Year 4Year 1Year 1

Year 4 Operating Cash Flows (000s)

Net Terminal Cash Flow at t = 4 (000s)

Salvage valueTax on SVRecovery on NWCNet terminal CF

Salvage valueTax on SVRecovery on NWCNet terminal CF

$25 (10) 20 $35

$25 (10) 20 $35

What if you terminate a project before the asset is fully depreciated?

Cash flow from sale = Sale proceeds- taxes paid.

Taxes are based on difference between sales price and tax basis, where:

Basis = Original basis - Accum. deprec.

Original basis = $240.After 3 years = $17 remaining.Sales price = $25.Tax on sale = 0.4($25-$17)

= $3.2.Cash flow = $25-$3.2=$21.7.

Example: If Sold After 3 Years (000s)

Project Net CFs on a Time Line

I = 10.NPV = $81,573.IRR = 23.8%.

*In thousands.

0 1 2 3 4

(260)* 107 118 89 117

What is the project’s payback? (000s)

Cumulative:

Payback = 2 + 35/89 = 2.4 years.

0 1 2 3 4

(260)*

(260)

107

(153)

118

(35)

89

54

117

171

S and L are mutually exclusive and will be repeated. k = 10%. Which is bette

r? (000s)

0 1 2 3 4

Project S:(100)

Project L:(100)

60

33.5

60

33.5 33.5 33.5

S LCF0 -100,000 -100,000CF1 60,000 33,500Nj 2 4I 10 10

NPV 4,132 6,190NPVL > NPVS. But is L better?Can’t say yet. Need to perform common life analysis.

Note that Project S could be repeated after 2 years to generate additional profits.

Can use either replacement chain or equivalent annual annuity analysis to make decision.

Project S with Replication: k=10%

NPV = $7,547.

Replacement Chain Approach (000s)

0 1 2 3 4

Project S:(100) (100)

60 60

60(100) (40)

6060

6060

Compare to Project L NPV = $6,190.Compare to Project L NPV = $6,190.

Or, use NPVs:

0 1 2 3 4

4,1323,4157,547

4,13210%

Equivalent Annual Annuity(EAA) Approach

Finds the constant annuity payment whose PV is equal to the project’s raw NPV over its original life.

EAA Calculator Solution

Project SPV = Raw NPV = $4,132.n = Original project life = 2.k = 10%.Solve for PMT = EAAS = $2,381.

Project LPV = $6,190; n = 4; k = 10%.Solve for PMT = EAAL = $1,953.

The project, in effect, provides an annuity of EAA.

EAAS > EAAL so pick S.Replacement chains and EAA always l

ead to the same decision if cash flows are expected to stay the same.

If the cost to repeat S in two years rises to $105,000, which is best? (000s)

NPVS = $3,415 < NPVL = $6,190.Now choose L.NPVS = $3,415 < NPVL = $6,190.Now choose L.

0 1 2 3 4

Project S:(100)

60 60(105) (45)

60 60

Types of Abandonment

Sale to another party who can obtain greater cash flows, e.g., IBM sold PC division.

Abandon because losing money, e.g., smokeless cigarette.