13 Chapter Cash Flow Estimation Slides Developed by: Terry Fegarty Seneca College.

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Slides Developed by:

Terry FegartySeneca College

© 2006 by Nelson, a division of Thomson Canada Limited 2

Chapter 13 – Outline

• Cash Flow Estimation Capital Budgeting Process

• Project Cash Flows—An Overview and Some specifics The General Approach to Cash Flow Estimation A Few Specific Issues Terminal Values Accuracy and Estimates CCA—A Note on Amortization for Tax Purposes Capital Cost Allowance System CCA Tax Shield Estimating Cash Flows for Replacement Projects


Capital Budgeting Process

• Consists of the following steps:1. Determine (estimate) expected cash flows of

available projects2. Evaluate estimates using decision criteria such as

NPV and IRR

• People tend to take forecasted cash flows for granted, but they are subject to error

Estimating project cash flows is the most difficult and error-prone part of capital budgeting


The General Approach to Cash Flow Estimation• Consider each expected impact of project

on firm’s cash flows • Cash estimates are done on spreadsheets

• Enumerate the issues that impact cash and forecast each over time

• Forecasts for new ventures tend to be the most complex


The General Approach to Cash Flow Estimation• General outline for estimating new venture cash flows

Pre-start-up, the initial outlay—everything that has to be spent before the project is started

Sales forecast—units and revenues Cost of sales and expenses Assets—new assets to be acquired, including changes in

working capital Amortization—non-cash expense but affects income taxes Taxes and earnings Summarize and combine—adjust earnings for amortization and

combine result with balance sheet items to arrive at a cash flow estimate


The General Approach to Cash Flow Estimation• Expansion projects—tend to require the

same elements as new ventures But less new equipment and facilities

• Replacement projects—generally expected to save costs without generating new revenue Estimating process tends to be somewhat

less elaborate


A Few Specific Issues

• The Typical Pattern• At beginning of the project, some amount must be spent to

invest in the project (Initial outlay)• Subsequent cash flows tend to be positive

• Project Cash Flows Are Incremental• What cash flows will occur if we undertake this project that

wouldn’t occur if we left it undone and continued business as before?



• Sunk Costs Costs that have already occurred and cannot be recovered—

should not be included in project’s cash flows• Only future costs are relevant

• Opportunity Costs What is given up to undertake the new project The opportunity cost of a resource is its value in its best

alternative use For instance, if firm needs a new warehouse, it could either:

• Lease warehouse space• Buy warehouse• Build warehouse on land they currently own (but could

sell for $1,000,000)—the $1,000,000 represents an opportunity cost



• Impacts on Other Parts of Company Sales erosion (cannibalization)—when firm sells a product that

competes with other products within the same firm (Diet Coke vs. Coke Classic)

Margin lost in other line—negative cash flow for project

• Taxes Cash outflow Use after-tax cash flows

• Cash Versus Accounting Results Capital budgeting deals only with cash flows; however

business managers want to know project’s net income



• Working Capital New project often requires investment in working capital—

inventory, for instance Increasing net working capital means cash outflow

• Ignore Financing Costs Do not include interest expense on debt (or dividends on

shares) as cash outflow Addressed via discount rate when determining NPV or

evaluating IRR

• Old Equipment If this is replacement project, old equipment can be sold

(thereby generating a cash inflow)




Table 13.1: Cash Flow Estimation:

Revenue and Gross MarginUnits 200 600 1,200 1,500 1,500 1,500 Revenue 120.0$ 360.0$ 720.0$ 900.0$ 900.0$ 900.0$ Cost of sales 72.0$ 216.0$ 432.0$ 540.0$ 540.0$ 540.0$ Gross margin 48.0$ 144.0$ 288.0$ 360.0$ 360.0$ 360.0$

Tax Deductible ExpensesSG&A expense 120.0$ 120.0$ 120.0$ 120.0$ 120.0$ 120.0$ Amortization 41.5$ 41.5$ 41.5$ 41.5$ 41.5$ 1.5$ General overhead 2.4$ 7.2$ 14.4$ 18.0$ 18.0$ 18.0$ Loss old line 1.4$ 4.3$ 8.6$ 10.8$ 10.8$ 10.8$ Total 165.4$ 173.1$ 184.6$ 190.3$ 190.3$ 150.3$

Profit Impact and TaxEBT impact (117.4)$ (29.1)$ 103.4$ 169.7$ 169.7$ 209.7$ Tax (39.9)$ (9.9)$ 35.2$ 57.7$ 57.7$ 71.3$ NI impact (77.5)$ (19.2)$ 68.3$ 112.0$ 112.0$ 138.4$ Add Amortization 41.5$ 41.5$ 41.5$ 41.5$ 41.5$ 1.5$ Subtotal (35.9)$ 22.4$ 109.8$ 153.5$ 153.5$ 139.9$

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Table 13.1: Cash Flow Estimation

Working CapitalAccounts receivable 10.0$ 30.0$ 60.0$ 75.0$ 75.0$ 75.0$ Inventory 12.0$ 18.0$ 36.0$ 45.0$ 45.0$ 45.0$ Payables 3.0$ 4.5$ 9.0$ 11.3$ 11.3$ 11.3$ Working Capital 19.0$ 43.5$ 87.0$ 108.8$ 108.8$ 108.8$ Change in working capital (7.0)$ (24.5)$ (43.5)$ (21.8)$ -$ -$

Net Cash FlowNet cash (42.9)$ (2.1)$ 66.3$ 131.8$ 153.5$ 139.9$

Net cash - Year 7 139.9$ Net cash - Year 8 139.9$ Net cash - Year9 139.9$ Net cash - Year 10 139.9$

Initial Outlay -$497.40Discount rate (k) 8%

NPV $95.14

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Terminal Values

• Possible to assume that incremental cash flows last forever Especially common with new ventures

• Compressed into terminal values using perpetuity formulas For instance, a repetitive cash flow starting at time 7

would be a perpetuity beginning at year 7 The present value at time 6 would be represented as

Very sensitive to discount rate

May be preferable to set a time limit, say 10 years

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Accuracy and Estimates

• NPV and IRR techniques give impression of great accuracy

• However, capital budgeting results no more accurate than projections of the future used as inputs

• Unintentional biases probably biggest problem in capital budgeting Projects generally proposed by people who want to

see them approved which leads to favourable biases• Tend to overestimate benefits and underestimate costs


CCA—A Note on Amortization for Tax Purposes• CRA requires that firms use capital cost

allowance (CCA) to calculate amortization for income tax purposes Provides for accelerated amortization Amortization is shifted forward

• More is taken early in project’s life and less later on

• Total amortization remains the same

Larger tax deductions happen earlier• Present value of tax savings is greater


CCA—A Note on Amortization for Tax Purposes• Companies generally don’t use

accelerated methods for earnings reported to the public Reported earnings are lower If accelerated methods are used for tax

calculations, accelerated methods should be used for cash flow projections


Capital Cost Allowance System

• The Income Tax Act dictates exactly how tax amortization (CCA) to be done

• CCA divides capital assets into different classes (categories) and assigns a CCA rate for each Most classes call for declining balance CCA

(accelerated amortization)


Table 13.2: Some Capital Cost Allowance Classes



• When asset is purchased, purchase price added to appropriate class Any increases in a class are usually eligible

for only half of the normal CCA in year they are added (the half-year rule)

Once capital asset has been added to a CCA class, capital cost allowance is calculated on the undepreciated capital cost (UCC) of the pool of assets, rather than on individual assets



• When asset is sold, lower of the sale price or its original cost is deducted from the pool.

• If asset sold for more than its original cost, difference is capital gain for tax purposes. Only 50% of capital gain is added to taxable income

for the year.• If sale of asset leaves no assets in the class,

resulting positive balance, if any, is terminal loss deductible for tax purposes.

• Any negative balance in the class at the end of the year is recapture taxed as income.


CCA Tax Shield

• CCA tax shield—tax savings from deducting CCA on capital assets

• For capital budgeting purposes, we need to calculate present value of tax shield


Example 13.2: Capital Cost Allowance and Tax Shield

A vehicle costing $30,000 is added to Class 10 (30%). It will be sold in 4 years for $4,000. The tax rate is 39%.

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CCA Tax Shield

• Formula: PV of CCA tax shield

Where: C= Cost of the new asset (less any proceeds on disposal of assets replaced)

d = CCA rate for the asset class T= Tax rate

k = Discount rate (cost of capital) Spv= Present value of the salvage value of the new asset

n is the number of years until we salvage

the asset

n = Number of years until we sell the asset.

k

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Example 13.2: Capital Cost Allowance and Tax Shield

•We purchase a truck for $30,000•We will trade it in four years for $4,000•The CCA rate is 30%•Our tax rate is 39%•Our cost of capital is 12%

The present value of the salvage is $4,000 × 0.6355 = $2,542The present value of the CCA tax shield:

k

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1 0.05 0.120.30 0.39$30,000 $2,542 $7,239

0.12 0.30 1.12

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Estimating Cash Flows for Replacement Projects• Generally have fewer elements than new

ventures• Identifying what is incremental can be trickier• Can be difficult to determine what will happen if

you don’t do the project For example, if replacing old production machine,

• Do you compare expected cash flows for the new machine to current cash flows for the old?

• Or do you compare cash flows for the new machine to expected cash flows for the old machine if it continues to deteriorate?

13 Chapter Cash Flow Estimation Slides Developed by: Terry Fegarty Seneca College.

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