Capital Budgeting: Cash Flow Estimation

Readings: Chapter 11

At the end of this unit students should be able to: 

1. Explain the concept of incremental cash flows

2. Determine relevant incremental cash flows and categorize them into three categories

3. Define the following terms: sunk cost, opportunity cost and externalities.

4. Analyze both an expansion project and a replacement project and make a decision whether the project should be accepted on the basis of standard capital budgeting techniques.

In our previous examples, the after-tax cash flows were already derived. Estimating the cash flows is the most important part of the capital budgeting process. This section now examines this estimation analysis.

Recall that there are two basic types of projects, Expansion and Replacement. In either of these two, we are concerned with the additional cash flows that will be provided. For the expansion project, this is straight forward. For the replacement type project, the additional cash flows are those that occur as a result of the new project, in other words, the incremental cash flows. From here onwards the term incremental will be used in both cases.

In both types of projects we will have three categories of incremental cash flows: (1) The Initial outlay/investment (2) The Annual after-tax operating cash flows and (3) The terminal cash flows.

Initial outlay

For expansion projects, this will consist of the cash flows resulting from acquiring the new asset and will consist of:

1. The Purchase price of the new asset

2. Installation costs of the new asset e.g. transportation, shipping, handling etc.

3. Increases in working capital requirements e.g. inventory i.e. raw materials, finished goods etc

4. After-tax non-capital expenditures e.g. costs to train employees to operate asset

5. Investment tax credit (ITC) given by government due to the nature of the company's business. (This ITC could be given at any time during the project's life).

Note - the sum of the cash flows at a. and b. above is equal to the recorded value of the new asset in the company's books. (i.e.  the value at which the asset will be depreciated).

For the replacement project, we would also have to incorporate:

6.  those after-tax cash flows resulting from the sale of the existing asset. This is determined as follows:

                                    OR

Annual after-tax operating cash flows  ( ^ = incremental and T = Tax rate)

These cash flows occur on a yearly basis throughout the life of the new project. In practice, the yearly cash flows will not be constant but will more likely increase due to inflation. However, for our purpose, unless otherwise stated, we are assuming that the yearly cash flows will be constant. 

                                        OR

Note - Interest expenses are not to be included as costs. In other words, they are not to be deducted from ^ Revenues when determining ^ Profit before tax (as normal accounting rules stipulate). To do this would be double counting as interest expense (cost of debt) is already accounted for in the cost of capital (which is used to discount the cash flows).  

Terminal cash flows

For both the expansion and replacement projects this will comprises of those cash flows that occur as a result of termination of the new project. These may include:

1. The after-tax cash flows resulting from the sale of the new asset (calculation is similar to above, see Initial outlay)

2. Recovery of working capital, i.e. the working capital cash outflows experienced in the initial outlay will be recovered

3. Any other after-tax clean up costs

Other types of cash flows:

1. Sunk costs

These are cash outflows that have already occurred and therefore do not affect the capital budgeting decision.

 

2. Opportunity costs

In Economics, this is referred to as benefits foregone. In other words, opportunity costs are benefits that are not going to be achieved due to a particular action/decision. These must be accounted for in the capital budgeting decision as cash outflows, on an after-tax basis. 

E.g. In a replacement project analysis, we assume that the existing asset will be sold and the new asset bought. However if that 'old' asset were kept in operation until the end of its useful life, the company may have been able to receive some cash by selling it afterwards. If such a salvage value existed, then the company would not be able to fetch this amount if they went ahead and replaced the old asset  with the new one. Therefore, the after-tax effects of this opportunity cost would have to be incorporated in the analysis. Using this example of the asset's foregone salvage value, the procedure for determining the after-tax effect would be identical to that mentioned earlier (see Initial outlay above), except that the result would be an after-tax cash outflow.   

3. Externalities

In Economics, this refers to the effects of a project on other parts of the firm/company. If the increased revenues or the cost savings derived by a new project result in decreased revenues for other existing projects/products in a company, this effect must be factored into the capital budgeting process. To account for this, the decreased revenues of the existing project/products must be applied to offset/reduce the increased revenues of the new project (or be treated as increased costs of the new project). 

Alternatively, the increased revenues or the cost savings derived by the new project could result increased revenues for other existing projects/products in a company. In this case, the increased revenues of the other existing projects/products would be treated as additional increased revenues for the new project.  

Examples:          

Expansion type project:

Kingston Broilers Ltd. (KBL) is considering the purchase of an industrial incubator for the production of day old chicks. The firm does not currently own such a machine. A consultant was paid $250,000 six months ago to estimate the relevant cash flows which are summarised as follows:

The  incubator would save $500,000 per year in costs and provide additional revenues of $400,000 annually. It would cost $1,400,000 and installation and shipping costs would amount to $300,000 and $100,00 respectively.  KBL would need to train its staff to operate the incubator at an after-tax cost of $200,000.  The firm would also need to increase its stock of eggs at the hatchery by $500,000.  The company plans to issue debt to fund the project and this will increase interest expenses by $465,000 per year.  

The machine will be depreciated towards a salvage value of $400,000 over its useful life of 5 years.  At the end of the machine’s useful life it is expected that it can be sold for $500,000.  The Government's Tax Department will also give the firm a tax credit of $74,993 at the end of the project as agreed with the firm for partial recovery of import duties.

KBL has a cost of capital of 20% and a tax rate of 33 ^1/3 %  

a)      Calculate the NPV.  

b)      Calculate the PI of the project? 

c)  Should the project be accepted? Why or why not?

Solution

Initial Outlay:

Annual after-tax cash flows:

Terminal cash flow:

(a) NPV:

(b) PI:

(c) The project should not be accepted as the NPV is negative and PI is less than 1 

Replacement type project: 

 A local juice making company with a cost of capital of 15% and a marginal tax rate of 34%,  is considering replacing the current hand-operated machine with an automated machine. The following information is available:.  

Required : Determine the Payback Period and the IRR. Should the automated machine be acquired? Why?  

Solution:

Initial Outlay:

Annual after-tax cash flows:

Terminal cash flow:

Payback Period:

IRR:

Conclusion: The automated machine should be acquired. This is because the Payback Period looks reasonably short and more importantly, the IRR, 44.52% > k, 15%.