CHAPTER 11

CASH FLOW ESTIMATION

OBJECTIVE Subjective FOCUS Cash flow estimation focuses on the numerical methodology used in putting together an estimate of a capital project. We keep the question of accuracy and risk in mind throughout, and continue in the next chapter with a discussion of the methods available to incorporate risk into the process. PEDAGOG This chapter contains an important pedagogical point with respect to practicality. ost texts present capital budgeting as more accurate and reliable than it is, and students can get the incorrect impression finance has the precision of engineering. !n real companies, the cash flow estimates associated with capital projects are generally very fluid. !f an analysis results in an unfavorable !"", the people behind the project often change the input numbers until they get the result they want. This reality creates a problem and a challenge at the same time. The problem is bias and inaccuracy. The challenge lies in the role created for finance in ensuring that estimated cash flows are reasonable and likely to come true. This chapter provides a thorough discussion of the sources of error and vagueness in estimated figures. TEACHING OBJECTIVES #t the end of this chapter students should be fully aware of the difficulties and uncertainties associated with making cash flow estimates in a capital budgeting context. They should also be able to make estimates in fairly complex situations. OUTLINE !. C#$% &'(W )$T! #T!(* #. Capital +udgeting ,rocesses Conceptually divides capital budgeting into the calculation process and the more arbitrary and difficult estimation process.

!!. ,"(-)CT C#$% &'(W$ . #* (/)"/!)W #*0 $( ) $,)C!&!C$ #. The 1eneral #pproach to Cash &low )stimation # general outline. Consider the initial investment first, then periodic revenues, costs and expenses, or savings. !nclude tax effects and plan to acquire the required assets. +. # &ew $pecific !ssues The typical cash flow pattern, the incremental concept, sunk costs, opportunity costs, impacts on the rest of the company, overheads, taxes, working capital, financing costs, and old equipment. C. )stimating *ew /enture Cash &lows # comprehensive example in a manufacturing context. 0. Terminal /alues Treating cash flows that can be expected to continue indefinitely. ). #ccuracy and )stimates

Chapter 33 *,/ and !"" give answers to several decimal places, but the accuracy isn4t real, because the results are no better than input estimates of the future. This section contains an important discussion of the practical sources of error in capital budgeting including well. meaning biases. &. )stimating Cash &low for "eplacement ,rojects "eplacements are usually simpler projects, but the cash flows can be trickier to properly identify and quantify. # comprehensive example.

!UESTION 3. The typical cash flow pattern for business projects involves cash outflows first, then inflows. %owever, it4s possible to imagine a project in which the pattern is reversed. &or example, we might receive inflows now in return for guarantying to make payments later. Would the ,ayback, *,/, and !"" methods work for such a project5 What would the *,/ profile look like5 Would the *,/ and !"" methods give conflicting results5 ANSWER" ,ayback wouldn4t make sense for such a product, because there would be no initial outlay to recover. The *,/ and !"" methods would work because they4re based on the present value of future cash flows regardless of their pattern. The *,/ profile would slope upward, because higher rates would reduce the present values of the negative flows in the distant future more than those of the positive short.term flows. This would result in a more positive *,/ as the interest rate rose. *,/ and !"" could give conflicting results if the up.sloping profiles crossed in the first quadrant just as in the case of the traditional patterns. BUSINESS ANAL SIS 3. 6ou are a new financial analyst at +elvedere Corp, a large manufacturing firm that is currently looking into diversification opportunities. The vice president of marketing is particularly interested in a venture that is only marginally connected with what the firm does now. (ther managers have suggested enterprises in more closely related fields. The proponents of the various ideas have all provided you with business forecasts from which you have developed financial projections including project cash flows. 6ou have also calculated each project4s !"" with the following results7 ,roject !"" # 38.9:; + C 38.<=; 3>.?=; Comments arketing4s project, an almost totally new field ,roposed by manufacturing, also a very different field. ,roposed by engineering, a familiar field.

6ou are now in a meeting with senior managers that was called to discuss the options. 6ou have just presented your analysis ending your talk with the preceding information. #fter your presentation, the vice president of marketing stands, congratulates you on a fine job, and states that the figures clearly show that ,roject # is the best option. %e also says that your financial analysis shows that project # has the full backing of the finance department. #ll eyes, including the C&(4s, turn to you. %ow do you respond5 ANSWER" #lthough #4s !"" is highest it isn4t likely to be the best project because of its risk. ,rojects of significantly different risk aren4t directly comparable without risk adjustments. !n this

Cash &low )stimation

case ,rojects # and + are likely to be much riskier than C, because they4re in unfamiliar fields. They should therefore be measured against a substantially higher hurdle rate than ,roject C. &urther, the difference shown between # and + is finer than makes sense for capital budgeting techniques. "emember that a calculated !"" can be no more accurate than the estimated cash flows input to the model. Those are certainly not good to four significant figures as shown. This analysis essentially says that the three projects are about equal in terms of !"" without adjusting for risk. ,art of the problem is in the presentation. The analyst should not have displayed results to a hundredth of a percent. 0oing so gives the wrong impression to people unfamiliar with financial analysis techniques. <. ost top executives are graded primarily on their results in terms of net income rather than net cash flow. Why then, is capital budgeting done with incremental cash flows rather than with incremental net income5 ANSWER" *et income is an accounting construction designed to indicate the long.term health of a business rather than its immediate cash performance. ,resumably, executives are graded on long term results of the business as a going concern that will last over a long period, so net income is an appropriate measure. Capital budgeting is aimed at allocating resources among competing uses as objectively as possible. !t is not concerned with painting a picture of the business the way accounting results do. The best basis for resource allocation among uses is the contribution those uses make to wealth. That contribution is best measured by the present value of expected cash flows which is therefore the basis for capital budgeting. 2. Creighton !nc. is preparing a bid to sell a large telephone communications system to a major business customer. !t is characteristic of the telephone business that the vendor selling a system gets substantial follow.on business in later years by making changes and alterations to that system. The marketing department wants to take an incremental approach to the bid, basically treating it as a capital budgeting project. They propose selling the system at or below its direct cost in labor and materials Athe incremental costB to ensure getting the follow.on business. They4ve projected the value of that business by treating future sales less direct costs as cash inflows. They maintain that the initial outlay is the direct cost to install the system, which is almost immediately paid back by the price. &uture cash flows are then the net inflows from the follow.on sales. These calculations have led to an enormous *,/ and !"" for the sale viewed as a project. +oth support and criticiCe this approach. AHint7 what would happen if Creighton did most of its business this way5B ANSWER" The approach makes sense if the follow.on business is in total large relative to the initial sale. !f not, the idea creates several problems. The fact that the installation is paid for immediately makes it seem as if the initial outlay for the project is Cero, and the subsequent inflows are free. This results in an *,/ that is just the present value of expected profits with no initial cost offset and an !"" that4s virtually infinite. %owever, it masks the fact that the project4s risk is related to the level of resource committed to the initial installation. %ence the risk may be out of proportion to the expected dollar return. &or example, if the job is underbid by 3?;, the loss on the installation could be impossible to make up through follow.on business. !t4s also important to compare the project with alternate uses of the labor and material to be spent on the installation. !f they could be used on traditional sales with normal profit margins, the project isn4t likely to look good regardless of its !"". !f the project takes up a large portion of the company4s resources, incremental thinking may not be appropriate. This is because a firm made up of too much incrementally acceptable business may find itself without the income to support necessary overhead.

Chapter 33

@. Webley otors, a manufacturer of small gas engines, has been working on a new design for several years. !t4s now considering going into the market with the new product, and has projected future sales and cash flows. The marketing and finance departments are putting together a joint presentation for the board of directors that they hope will gain approval for the new venture. ,art of the presentation is a capital budgeting analysis of the project that includes only estimated future costs and revenues. 0an )yeshade, the head of investor relations, insists that calculations shown to the board include the money spent on research in the past several years. %e says that to ignore or omit those costs would be deceiving the board about the true cost of the project, which would be both unethical and legally dangerous. Comment on 0an4s position. !f you disagree, prepare an argument that will convince him to change his mind, and suggest an alternative presentation that will satisfy you both. ANSWER" 0an is confusing decision making with honest and open reporting. (nly future revenues and costs matter to the decision, because only the future can be changed by it. ,ast costs are DsunkD, and cannot be changed by anything. !n theory that means only future costs have to be shown to the decision makers. (n the other hand, 0an is right that it would be less than honest and ethical to lead the board to believe that the future costs were the only ones that went into the project. The solution is fairly obvious. ,resent the decision in terms of the future cash flows but make a side point about the effort that4s gone on to date, being sure to point out that those costs are gone regardless of the outcome of the project. =. The Capricorn Company is launching a new venture in a field related to, but separate from, its present business. anagement is proposing that financing for the new enterprise be supplied by a local bank that it has approached for a loan. Capricorn4s finance department has done a capital budgeting analysis of the venture projecting reasonable cash flows and calculating an *,/ and an !"" that both look very favorable . The bank4s loan officer, however, isn4t satisfied with the analysis. $he insists on seeing a financial projection that made which calculates interest on cumulative cash flows, incorporates that interest as a cost of the project, and shows the buildup and decline of the debt necessary to accomplish the proposal. $he essentially wants a business plan complete with projected financial statements. "econcile the bank officer4s position with capital budgeting theory. ANSWER" Capital budgeting considers financing costs through the time value calculations inherent in the techniques. Conceptually, capital budgeting draws money out of and pays it into a general pool of funds maintained by the company, but isn4t explicit about the siCe of the pool at any point in time. !t also charges interest at a conceptual weighted average rate, the cost of capital, rather than a particular rate tied to a specific source of funds. This is the correct approach when evaluating projects as part of the ongoing operation of a company. The bank on the other hand is concerned about getting its money back on a specific loan at a specific rate of interest. !n this case, the loan is tied to a particular project, so the bank wants to make sure the project will generate the cash flows required to pay the loan off. !t also needs to know when the money will be drawn and repaid so it can calculate the outstanding balance at any time. This helps the bank forecast its own funding requirements. +oth approaches are correct from the perspectives of the respective decision making parties. 9. Wilson ,etroleum is a local distributor of home heating oil. The firm also installs and services furnaces and heating systems in homes and small commercial buildings. The customer service department maintains sales and service records on current customers who number about @??. 0etailed customer records are kept manually in file cabinets, and a small computer system holds all

Cash &low )stimation

customer names and addresses for mailing and billing purposes. (ne full.time clerk maintains all the records and handles all billing and customer inquiries. Customers occasionally complain if delivery or service is late, but only one or two mild complaints are received each month. 0elays are primarily a result of problems in the field rather than problems in assigning calls in the service department. # consultant has proposed a new computer system that will completely automate the customer service function. !t will provide on.line billing and immediate access to all customer records. The cost of the proposed system is E=?,??? initially plus about E:,??? a year for maintenance and support. !t will still take a person to run it. The consultant says the new system will provide faster service and superior insight into the needs of the customer base, which will result in better customer relations and more sales in the long run. 0iscuss the pros and cons of the consultant4s proposal. What further justification should management demand before buying5 Could the consultant have made the proposal for reasons that aren4t in Wilson4s best interest5 Could the consultant be well meaning yet biased5 )xplain. ANSWER" The new system can be viewed as a capital budgeting project in which the costs are well known, but the benefits are hard to predict or measure. )stimating the actual increased cash flows that will come from an improved administrative system is a difficult and very subjective matter. !n this case it seems that the system is unlikely to be a worthwhile project, because it doesn4t save any labor and the administrative problems it would fix are minor. $uch situations are very subject to overestimation of benefits. +efore accepting the consultant4s idea, management should demand a detailed, well.supported estimate of the expected benefits. %e or she will probably be unable to provide this. !f the consultant also sells the proposed system, it4s likely that a conflict of interest exists. %e or she could be motivated by the money to be made on the sale rather than by improving Wilson4s business. !t4s not at all unusual for technical salespeople to propose systems that do more than their customers need in order to generate big commissions. !t4s also possible that the consultant honestly believes that computers are the answer to virtually all problems. ,eople in high technology businesses are often biased toward computer solutions even when doing things by hand is cheaper. PROBLEMS

Ne# Ve$tu%e C&'( F)*#' + De,%eci&ti*$" E-&.,)e 11/1 0,&1e 2345

3. # project that is expected to last six years will generate a profit and cash flow contribution before taxes and depreciation of E<2,??? per year. !t requires the initial purchase of equipment costing E9?,???, which will be depreciated straight line over four years. The relevant tax rate is <=;. Calculate the projectFs cash flows. "ound all figures within your computations to the nearest thousand dollars. SOLUTION" The initial outlay is just the cost of the equipment. $o C? G AE9?,???B. The remaining cash flows are calculated as follows AE???B. 6ear Cash flow before interest #nd depreciation 0epreciation )+T Tax AH <=;B )#T #dd back 0epreciation 3 E<2 3= > < 9 3= < E<2 3= > < 9 3= 2 E<2 3= > < 9 3= @ E<2 3= > < 9 3= = E<2 <2 9 3: 9 E<2 <2 9 3:

>

Chapter 33 Cash &low <3 <3 <3 <3 3: 3: <. #uburn Concrete !nc. is considering the purchase of a new concrete mixer to replace an inefficient older model that is completely worn out. !f purchased, the new machine will cost E8?,??? and is expected to generate savings of E@?,??? per year for five years at the end of which it will be sold for E<?,???. The mixer will be depreciated to a Cero salvage value over three years using the straight line method. 0evelop a five year cash flow estimate for the proposal. #uburnFs marginal tax rate is 2?;. Work to the nearest thousand dollars. SOLUTION" 6ears ? Cost 8? $avings 0epreciation )+T impact Tax )#T impact #dd back deprec. $ale in year = Tax on sale Cash &low A8?B 3 @? 2? 3? 2 : 2? 2: < @? 2? 3? 2 : 2? 2: 2 @? 2? 3? 2 : 2? 2: @ @? @? 3< <> = @? @? 3< <> <? A 9B @<

<>

Re,)&ce.e$t P%*ject' + S&)e *6 &$ O)7 A''et" E-&.,)e 11/8 0,&1e 2395
2. &lextech !nc. is considering a project that will require new equipment costing E3=?,???. !t will replace old equipment with a book value of E2=,??? that can be sold on the second hand market for E:=,???. The companyFs marginal tax rate is 2=;. Calculate the projectFs initial outlay. SOLUTION" $ale of old equip +ook value #ccounting profit Tax on profit Cash flow from sale Cost of new equipment 'ess7 cash from sale !nitial outlay, C? E:=,??? 2=,??? E@?,??? 3@,??? E:=,??? 3@,??? E93,??? E3=?,??? A93,???B E >8,???

Re,)&ce.e$t P%*ject' + I$iti&) Out)&:" E-&.,)e 11/8 0,&1e 2395

@. Tomatoes !nc. is planning a project that involves machinery purchases of E3??,???. The new equipment will be depreciated over five years, straight line. !t will replace old machinery that will be sold for an estimated E29,??? and has a book value of E<<,???. The project will also require hiring and training ten new people at a cost of about E3<,??? each. #ll of this must happen before the project is actually started. The firmFs marginal tax rate is @?;. Calculate, C ?, the projectFs initial cash outlay. SOLUTION" &irst notice that the hiring and training costs are tax deductible7 %iring and training cost E3<?,??? Tax saving at @?; E @>,??? *et cash flow after tax E :<,???

Cash &low )stimation

*ext calculate the proceeds of the sale of the old equipment7 $ale of old equip E29,??? +ook value <<,??? #ccounting profit E3@,??? Tax on profit =,9?? Cash flow from sale Then calculate the !nitial (utlay7 Cost of new equipment #fter tax cost of hiring and training 'ess7 cash from sale !nitial outlay, C? =.

E29,??? =,9?? E2?,@?? E3??,??? :<,??? A 2?,@??B E3@3,9??

The (lson Company plans to replace an old machine with a new one costing E>=,???. The old machine originally cost E==,???, and has six years of its expected 33.year life remaining. !t has been depreciated straight line assuming Cero salvage value, and has a current market value of E<@,???. (lsonFs effective tax rate is 29;. Calculate the initial outlay associated with selling the old machine and acquiring the new one. E==,??? <=,??? 2?,??? E<@,??? 2?,??? A9,???B .29 E <,39? AE>=,???B <@,??? <,39? E =>,>@?

SOLUTION" ,urchase price I old machine #ccumulated depreciation +ook value $alvage value I old machine +ook value 'oss on sale Tax rate Tax savings ,urchase new machine $ell old machine Tax savings on sale of old machine *et after.tax outlay

9. # four.year project has cash flows before taxes and depreciation of E3<,??? per year. The project requires the purchase of a E=?,??? asset that will be depreciated over five years, straight line. #t the end of the fourth year the asset will be sold for E3>,???. The firm4s marginal tax rate is 2=;. Calculate the cash flows associated with the project. A&or convenience assume the gain on the sale of the asset is taxed at 2=;.B SOLUTION" 0isposal7 $ale ,rice E3>,??? *+/ of asset E3?,??? 1ain E >,??? Tax A<,>??B *et from sale E3>,??? A<,>??B E3=,<??

3?

Chapter 33

? #sset AE=?,???B !ncome 0epreciation )+T Contribution Tax )#T Contribution #dd +ack 0epreciation #nnual C& $ale of #sset *et Cash &low7 *C& AE=?,???B :.

C#$% &'(W$ < E3<,??? E3?,??? E <,??? A:??B E 3,2?? E3?,??? E33,2?? E33,2??

2 E3<,??? E3?,??? E <,??? A:??B E 3,2?? E3?,??? E33,2?? E33,2??

@ E3<,??? E3?,??? E <,??? A:??B E 3,2?? E3?,??? E33,2?? E3=,<?? E<9,=??

E3<,??? E3?,??? E <,??? A:??B E 3,2?? E3?,??? E33,2?? E33,2??

/oxland !ndustries purchased a computer for E3?,???, which it will depreciate straight line over five years to a E3,??? salvage value. The computer will then be sold at that price. The companyFs marginal tax rate is @?;. Calculate the cash flows associated with the computer from its purchase to its eventual sale including the years in between. A Hint: 0epreciate the difference between the cost of the computer and the salvage value. #t the end of the depreciation life thereFs a net book value remaining equal to the salvage value .B

SOLUTION" C&? C&3 C&< C&2 C&@ C&= A3?,???B :<? :<? :<? :<? 3,:<? A3>?? depreciation x @?;B

A0epreciation tax savings J E3,??? sale priceB

>. "esolve the previous problem assuming /oxland uses the =.year odified #ccelerated Cost "ecovery $ystem A #C"$B with no salvage value to depreciate the computer. Continue to assume the machine is sold after five years for E3,???. A Hint: #pply the #C"$ rules for computers in the chapter to the entire cost of the computer. *otice, however, that there will be a positive net book value after five years because #C"$ takes five years of depreciation over six years due to the half.year convention.B SOLUTION" Cash flow in years 3.@ is just the tax saved by depreciation. Cash flow in year = is the tax saved by depreciation plus the proceeds from selling the machine less taxes on that sale. The taxable profit on the sale is E3,??? less the book value at that time. C&? A3?,???B C&3 >?? A3?,??? x <?; x @?;B C&< 3,<>? A3?,??? x 2<; x @?;B C&2 :9> A3?,??? x 38.<; x @?;B C&@ @9? A3?,??? x 33.=; x @?;B C&= 3,<8< A3?,??? x 33.=; x @?;B J AE3,??? . K3,???I =>?L x .@B

Cash &low )stimation

33

8.

$helton ,harmaceuticals !nc. is introducing a new drug for pain relief. anagement expects to sell 2 million units in the first year at E>.=? each, and anticipates 3?; growth in sales per year thereafter. (perating costs are estimated at :?; of revenues. $helton invested E<? million in depreciable equipment to develop and produce this product. The equipment will be depreciated straight line over 3= years to a salvage value of E<.? million. $heltonFs marginal tax rate is @?;. Calculate the projectFs operating cash flows in its third year. E2?,>==.? <3,=8>.= 3,<??.? E >,?=9.= 2,<<<.9 E @,>22.8 3,<??.? E 9,?22.8 2,??? x A3.3B< x E>.=? "evenues x :?; AE<?,??? I E<,???BM3=

SOLUTION" AE???B "evenues )xpenses 0epreciation )+T Tax )#T #dd 0epreciation Cash &low

Ne# Ve$tu%e C&'( F)*#'" E-&.,)e 11/1 0,&1e ;9<5

3?. %arry and &lo $imone are planning to start a restaurant. $toves, refrigerators, other kitchen equipment, and furniture are expected to cost E=?,??? all of which will be depreciated straight line over five years. Construction and other costs of getting started will be E2?,???. The $imones expect the following revenue stream. AE???B 6ear $ales 3 E9? < E8? 2 E3@? @ E39? = E3>? 9 E<?? : E<??

&ood costs are expected to be 2=; of revenues while other variable expenses are forecast at <=; of revenues. &ixed overhead will be E@?,??? per year. #ll operating expenses will be paid in cash, revenues will be collected immediately and inventory is negligible, so working capital need not be considered. #ssume the combined state and federal tax rate is <=;. 0o not assume a tax credit in loss years and ignore tax loss carry forwards. ATaxes are simply Cero when )+T is a loss.B 0evelop a cash flow forecast for the $imonesF restaurant. SOLUTION" The initial outlay, C?, is simply the cost of the equipment, construction, and other getting started expenses. C? G E=?,??? J E2?,??? G E>?,??? The remaining cash flows are calculated as follows AE???B. 6ear $ales /ariable Costs H 9?; (verhead 0epreciation )+T Tax AH <=;B )#T #dd back 0epreciation Cash &low 3 E9? 29 @? 3? A <9B . A <9B 3? A 39B < E8? =@ @? 3? A 3@B . A 3@B 3? A @B 2 E3@? >@ @? 3? 9 < @ 3? 3@ @ E39? 89 @? 3? 3@ @ 3? 3? <? = E3>? 3?> @? 3? << 9 39 3? <9 9 E<?? 3<? @? . @? 3? 2? 2? : E<?? 3<? @? . @? 3? 2? N 2?

3<

Chapter 33

Te%.i$&) V&)ue'" E-&.,)e 11=4 0,&1e 23;5

33. (xbow !nc. is contemplating a new venture project and has done a detailed five year cash flow estimate with the following result AE???B7 C? A<=:B C3 A9=B C< =? C2 8? C@ 32? C= 3:?

The firmFs cost of capital is 3<;. a. Ose a financial calculator to compute the projectFs *,/ and !"", and make the appropriate recommendation to management. A!f you donFt have a financial calculator just calculate *,/.B b. Charles 0unn, (xbowFs arketing /,, has argued that itFs unreasonable to exclude cash flows past year five from the analysis. Calculate the projectFs terminal value assuming year fiveFs cash flow goes on forever. "ecalculate the projectFs *,/ and !"" under that CharlesF assumption. c. Charles further argues that the most appropriate assumption is that cash flows beyond the fifth year incorporate a three percent long run growth rate. Calculate the terminal value, *,/, and !"" implied by this assumption. d. Comment on the results implied by the use of aggressive terminal value assumptions. S*)uti*$" &= Osing a financial calculator enter the following according to the instructions in the chapter7 C&o A<=:B C?3 A9=B &?3 3.? C?< =? &?< 3.? C?2 8? &?2 3.? C?@ 39= &?@ 3.? C?= 3:? &?= 3.? ,ress *,/, enter ! G 3<; for the cost of capital, press enter, down arrow, and compute. The resulting *,/ is AE2<,?29B. *ext punch !"" and then compute. The resulting !"" is >.>;. The project should clearly be rejected as the *,/P? and !""Pk. b= The terminal value at the end of period five is the present value of a perpetuity of E3:?,??? per year at an interest rate of 3<;. T/ G E3:? M .3< G E3,@3: Then &?= becomes &?= G E3,@3: J E3:? G E3,=>: "ecalculate the projectFs *,/ and !"" using E3,=>: as C?=. The result is *,/ G E::< and !"" G @>.?. The project is now clearly acceptable in terms of both *,/ and !"" c= &ollow the procedure in b. using T/ G E3:? M A.3< . .?2B G E3,>>8 and &?= G E3,>>8 J E3:? G E<,?=8

Cash &low )stimation

32

&rom which *,/ G E3,?@? and !"" G =@.>. The project now appears to be even better. d. #ggressive terminal value assumptions just about always overwhelm short run detailed cash flow estimates. /irtually any project can be made to look good if weFre willing to assume a long period of very positive cash flows after a short period of realism. This kind of technique is often used to support projects that donFt make financial sense but people at the top simply want to do. 3<. $am 0oCier, a very bright computer scientist, has come up with an idea for a new product. %e plans to form a corporation to develop the idea and market the resulting product. %e has estimated that it will take him and one employee about a year to develop a prototype and another year to bring a working model to market. There will be no income during those years. #fter that he expects sales to grow rapidly, estimating revenues of E:??,???, E3,=??,???, and E=,???,??? in the third, fourth, and fifth years respectively. $tarting the project will require research equipment costing about E=??,??? which will be depreciated for federal tax purposes under the #C"$ system Asee page xxxB. +eyond that it will take another E@??,??? in tax deducible expenses to get going. $am thinks he can fund the development work including supporting himself and paying an employee with about E<??,??? per year. (nce sales begin in the third year, direct costs will be @?; of revenues and indirect costs, including salaries for $am and all employees, will be E2??,???, E=??,???, and E3,>??,??? in the third, fourth and fifth years respectively. The nature of the business is such that working capital requirements are minimal. # net investment of E<??,??? in the third is expected to provide for working capital needs. $am has E3,=??,??? saved which he thinks is enough to launch and operate the business until it begins to generate income. $am plans to sell the business at the end of the fifth year. %e thinks it will be worth E<,=??,??? at that time. The business will be a C.type corporation subject to federal corporate income taxes. $am will be the sole stockholder and will be subject to federal ApersonalB capital gains tax when he sells the company Aassume the top capital gains rate discussed in chapter <B. !gnore state taxes. a. 0evelop a cash flow estimate for $amFs business. !nclude the effect of tax loss carry forwards as well as any capital gains taxes he will pay on its sale. 0oes $am have enough cash to fund this venture without contributions from outside investors5 b. Calculate the projectFs *,/ and !"" Aa financial calculator is recommendedB. #ssume the cost of capital is 3<;. !s the venture a good investment of $amFs time and money5 SOLUTION" AE???B &= &irst develop the equipment depreciation schedule noticing that under equipment is depreciated over 2 years. 6ear 3 < 2 @ #C"$ ; 22.2 @@.@ 3@.> :.= #C"$ > research

; x E=?? E39: Arounded upB <<< :@ 2: Arounded downB E=??

3@

Chapter 33

# Cash &low estimate for the project is then AE???B e&% 3 1 4 8 )quipment =?? "evenue 0irect Cost )xpense 0epreciation Total costMexp )+T 'oss Carry fwd #djusted )+T Tax H 2@; )#T #dd back depreciation ,reliminary CM& Working Capital $ale of business Capital gains tax on sale Total Cash &low Cumulative CM& A8??B A<??B A<??B A8??B @?? @?? A@??B ? A@??B <?? 39: 29: A29:B ? A29:B 39: A<??B <?? <<< @<< A@<<B ? A@<<B <<< A<??B :?? <>? 2?? :@ 9=@ @9 A@9B ? ? ? :@ :@ A<??B

; 3=?? 9?? =?? 2: 332: 292 A292B ? ? ? 2: 2:

2 =??? <??? 3>?? 2>?? 3<?? A:>?B @<? A3@2B <:: ? <:: <=?? A3>?B

A3<9B

2:

<=8: 3<?>

A8??B A33??B A32??B

A3@<9B A32>8B

$am has E3,=??,??? saved to start his business. ThatFs a little more than the maximum forecast cash required requirement of E3,@<9,???. %owever, overruns are common in this kind of projection, and it would be foolish to undertake the project without back up financing. b= )nter the projectFs cash flows into a financial calculator following the instructions in the chapter as follows7 C&o C?3 &?3 C?< &?< C?2 &?2 C?@ &?@ A8??B A<??B <.? A3<9B 3.? 2: 3.? <=8: 3.?

Then press *,/, enter ! G 3<; for the cost of capital, press enter, down arrow, and compute. The resulting *,/ is E398,@<:. *ext punch !"" and then compute. The resulting !"" is 3=.3;

Cash &low )stimation

3=

#nalysis7 The project is acceptable in accordance with capital budgeting rules in that the *,/ is positive and the !"" is greater than the cost of capital. %owever, it plainly isnFt a good idea for $am. The reward in *,/ terms is just a little more than 3?; of his current net worth, and undertaking the plan will tie him up for five years. This isnFt much of a payoff for risking everything he has as well as five years of his professional life. ThereFs also a good chance that the whole idea wonFt work and that heFll end up five years older and broke. %eFd be much better off to find a job with an established company or look for a more promising entrepreneurial opportunity. 32. The 'eventhal +aking Company is thinking of expanding its operations into a new line of pastries. The firm expects to sell E2=?,??? of the new product in the first year and E=??,??? each year thereafter. 0irect costs including labor and materials will be 9?; of sales. !ndirect incremental costs are estimated at E@?,??? a year. The project will require several new ovens that will cost a total of E=??,??? and be depreciated straight line over five years. The current plant is underutiliCed, so space is available that cannot be otherwise sold or rented. The firm4s marginal tax rate is 2=;, and its cost of capital is 3<;. #ssume revenue is collected immediately and inventory is bought and paid for every day, so no additional working capital is required. a. ,repare a statement showing the incremental cash flows for this project over an >.year period. A$tructure as a new venture.B b. Calculate the ,ayback ,eriod, *,/, and ,!. c. "ecommend either acceptance or rejection. d. !f the space to be used could otherwise be rented out for E2?,??? a year, how would you put that fact into the calculation. Would the project be acceptable in that case5 SOLUTION" a. C#$% &'(W$ AE???B (vens "evenue 0irect Cost !ndirect Cost 0epreciation )+T Contribution Tax )#T Contribution #dd +ack 0epreciation *C& b. 6ear ? 3 < 2 @ *C& AE=??B E3?? E328 E328 E328 Cum C& AE=??B AE@??B AE<93B AE3<<B E 3: ,M+ ,eriod G 2.8 yrs ? AE=??B 3 E2=? A <3?B A @?B A 3??B E ? E ? E3?? E3?? <.= E=?? A 2??B A @?B A 3??B E 9? AE <3B E 28 E3?? E328 9.> NNN E=?? A 2??B A @?B .NN E 39? AE =9B E 3?@ . E3?@

AE=??B

39 *,/

Chapter 33 G E=?? J E3??K,/&3<,3L J K,/&3<,3LQE328K,/&#3<,@LR J K,/&3<,=LQE3?@K,/&#3<,2LR G E=?? J E3??A.>8<8B J A.>8<8BAE328BA2.?2:2B J A.=9:@BAE3?@BA<.@?3>B G E=?? J E9?> G E3?> ,! G E9?> M E=?? G 3.<<

c. d.

#ccept, since *,/ S ? and ,! S 3.?. !t would add a E2?,??? per year pre.tax opportunity cost to the analysis. The after.tax effect is E2?,??? .9= G E38,=??

The impact on the analysis would be to reduce the *,/ by the present value of an >.year annuity of this amount. $tated in thousands AE???B7 ,/# G E38.= K,/&#3<,>L G E38.= A@.89:9B G E8: Then, "evised *,/ G (ld *,/ E8: G E3?> E8: G E33 %ence the project would be marginally acceptable under this added condition.

Ne# Ve$tu%e C&'( F)*#' + W*%?i$1 C&,it&)" E-&.,)e 11=1 0,&1e 2345
3@. %arrington !nc. is introducing a new product in its line of household appliances. %ousehold products generally have ten.year life cycles and are viewed as capital budgeting projects over that period. %arringtonFs working capital forecast for the project is as follows7 . E3.? million will be invested in inventory before the project begins. . !nventory will increase by E3??,??? in each of the first six years. . #ccounts receivable will increase by E3=?,??? in each of the first four years, and by E3??,??? in each of the next two years. . #ccounts payable will increase by E33?,??? in each of the first six years. . 0uring the last four years, the balance in each of these accounts will return to Cero in four equal increments. . #ccruals are negligible. Calculate the cash flows associated with working capital from the initial outlay to the end of the projectFs life. > >?? @?? A22?B >:? @2= 8 @?? <?? A39=B @2= @2= 3? ? ? ? ? @2=

SOLUTION" 6ear ? 3 < 2 @ = 9 : !nv 3??? 33?? 3<?? 32?? 3@?? 3=?? 39?? 3<?? #M" 3=? 2?? @=? 9?? :?? >?? 9?? #M, A33?B A<<?B A22?B A@@?B A==?B A99?B A@8=B Total 3??? 33@? 3<>? 3@<? 3=9? 39=? 3:@? 32?= Cash flow G Change !n WMC A3???B A3@?B A3@?B A3@?B A3@?B A8?B A8?B @2=

Cash &low )stimation

3:

Re,)&ce.e$t P%*ject'" E-&.,)e 11=8 0,&1e 23<5

3=. eade etals !nc plans to start doing its own deliveries instead of using an outside service for which it has been paying E3=?,??? per year. To make the change eade will purchase a E<??,??? truck that it will depreciate straight line over ten years to a E@?,??? salvage value. #nnual operating expenses are estimated at E>?,??? including insurance, fuel and maintenance on the truck as well as the cost of a driver. anagement plans to sell the truck after five years for E3??,???. 0evelop the projectFs five.year cash flows. eadFs tax rate is @?;. AHint: Treat as a replacement project. $avings are the difference in the contractorFs cost and that of operating the truck with an old asset sale in the last year.B

SOLUTION" !nitial outlay G E<??,??? (perating cash flows I years 3 through = E3=?,??? $avings related to contractor A>?,???B #nnual truck expenses A39,???B 0epreciation A<??,??? I @?,???BM3? E =@,??? (perating income before tax <3,9?? Tax E 2<,@?? (perating income after tax 39,??? #dd back depreciation E @>,@?? (perating cash flow #dditional Cash flow I year = Tax on truck sale $ale value +ook value 'oss on sale Tax rate Tax savings Total 6ear = Cash &low G E@>,@?? J E3?>,??? G E3=9,@?? $ale of truck Tax savings cash flow E3??,??? >,??? E3?>,??? 39. E3??,??? 3<?,??? <?,??? x .@ E >,???

#ssume that eade etals !nc of the previous problem is replacing an old truck with a new one instead of replacing an outside delivery service. The old truck was purchased > years ago for E3<?,???. !t has been depreciated straight line based on a ten.year life and a E<?,??? salvage value. The old truckFs annual operating expenses are E33?,???, and it has a market value of E@?,???. 0evelop a five.year cash flow projection for this replacement project.

SOLUTION" !nitial (utlay ,urchase of new truck $ale of old truck *o tax Aold truck sold at book valueB !nitial Cash &low (perating Cash &lows )xpenses of old truck saved *ew truck expenses 0epreciation of old truck saved *ew truck depreciation )+T !mpact

AE<??,???B @?,??? ? AE39?,???B 6ears 3 and < 33?,??? A>?,???B 3?,??? A39,???B <@,??? 2 through = 33?,??? A>?,???B ? A39,???B 3@,???

3>

Chapter 33 Tax H @?; 8,9?? =,9?? )#T !mpact 3@,@?? >,@?? #dd back net depreciation 9,??? 39,??? Cash &low <?,@?? <@,@?? #dditional year = Cash &low G E3?>,??? . $ee previous problem Total 6ear = Cash &low G E<@,@?? J E3?>,??? G E32<,@??

3:.

(lson.-ackson Corp. A(-CB is considering replacing a machine that was purchased only two years ago because of dramatic improvements in new models. The old machine has been depreciated straight line anticipating a ten years life based on a cost of E<@?,??? and an expected salvage value of E<?,???. !t currently has a market value of E3>?,???. !f the old machine is kept five more years it would have a market value of E9?,??? at the end of that time. # new machine would cost E2=?,??? and would be depreciated straight line over five years to a salvage value of E=?,???, at which time it would be sold at that price. 0evelop a cash flow projection showing the difference between keeping the old machine and acquiring the new one. #ssume (-CFs tax rate is @?;. ANote: A complete cash flow projection for the project would include the financial benefits of the better performance of the new machine as well as a comparison of the operating costs of the two models. In this problem were just focusing on the cost of the equipment.)

SOLUTION" !nitial (utlay ,urchase of new machine $ale of old machine Tax savingsT !nitial cash flow

AE2=?,???B 3>?,??? 9,@?? AE392,9??B

T$ale of old machine E3>?,??? *+/ of old machine 389,??? 'oss on sale E 39,??? Tax rate x .@ Tax savings E 9,@??

(perating Cash &lows I 6ears 3.= (ld depreciation *ew depreciation )+T !mpact Tax $avings )#T !mpact #dd depreciation (perating C& Total Cash &low in 6ear = $ale of new machine Tax on sale (pportunity cost of sale of old machine Tax saving on opp. costT #dd7 (perating Cash &low Total Cash &low E=?,??? ?

E <<,??? A9?,???B A2>,???B 3=,<?? A<<,>??B 2>,??? E 3=,<??

A9?,???B 3?,@?? 3=,<?? E3=,9??

T$alvage value +ook value 'oss Tax rate Tax saving on opp. cost

E9?,??? >9,??? E<9,??? x .@ E3?,@??

3>. The Catseye arble Co. is thinking of replacing a manual production process with a machine. The manual process requires three relatively unskilled workers and a supervisor. )ach worker makes E3:,=?? per year while the supervisor earns E<@,=??. The new machine can be run

Cash &low )stimation

38

with only one skilled operator who will earn E@3,???. ,ayroll taxes and fringe benefits are an additional one third of all wages and salaries. The machine costs E3=?,??? and has a tax depreciation life of five years. Catseye elects straight. line depreciation for tax purposes. # service contract covers all maintenance for E=,??? a year. The machine is expected to last six years, at which time it will have no salvage value. The machine4s output will be virtually indistinguishable from that of the manual process in both quality and quantity. There are no other operating differences between the manual and the machine processes. Catseye4s marginal tax rate is 2=;, and its cost of capital is 3?;. a. Calculate the incremental cash flows associated with the project to acquire the machine. b. Calculate the project4s payback and *,/. Would you accept or reject the project5 c. $uppose there is no alternative but to lay off the displaced employees, and the cost of severance is about three monthsF wages. %ow would you factor this information into the analysis5 0oes it change the project4s acceptability5 d. %ow would you characteriCe this project4s risk5 SOLUTION" a. #nnual labor savings7 (ld labor7 E3:,=?? 2 J E<@,=?? G *ew labor7 $avings &ringe +enefits H 3M2 #nnual 'abor $avings

E::,??? E@3,??? E29,??? E3<,??? E@>,??? C#$% &'(W$ AE???B

#sset 'abor $avings aintenance cost 0epreciation )+T Contribution Tax #dd +ack 0epreciation #nnual C& b.

? AE3=?,???B

3.= E@>,??? AE =,???B AE2?,???B E32,??? AE @,==?B E2?,??? E2>,@=?

9N E@>,??? AE =,???B .NNN E@2,??? AE3=,?=?B .NNN E<:,8=?

AE3=?,???B

,ayback ,eriod G E3=?,??? M E2>,@=? G 2.8 years *,/ G IE3=?,??? J E2>,@=? K,/&#3?,=L J E<:,8=? K,/&3?,9L G IE3=?,??? J E2>,@=? A2.:8?>BJ E<:,8=? A.=9@=B G E33,=2@ # positive *,/ indicates an acceptable project. Three months severance, after tax, on old wages would increase initial cost by7 E::,??? A2M3<B 3.222 .9= G E39,9:8 This would decrease the *,/ to *,/ G E33,=2@ E39,9:8 G E=,3@=, and make the project unacceptable.

c.

d. This project would probably be somewhat riskier than the usual replacement, because the machine is a new and unfamiliar way of doing the job.

<?

Chapter 33

Re,)&ce.e$t P%*ject' + Subjective I''ue'" E-&.,)e 11=8 0,&1e 2135

38. +lackstone !nc manufactures western boots and saddles. The company is considering replacing an outmoded leather.processing machine with a new, more efficient model. The old machine was purchased for E@>,??? six years ago and was expected to have an eight.year life. !t has been depreciated on a straight.line basis Aignore partial year conventionsB. The used machine has an estimated market value of E3=,2<2. The new machine will cost E9?,??? and will be depreciated straight line over five years. #ll depreciation assumes Cero salvage. The new machine is expected to actually last for eight years Aits economic lifeB and then will have to be replaced. #ssume it has no actual salvage value at that time. #ssume +lackstone4s marginal tax rate is 2=;. (perating cost savings are summariCed as follows7 #nnual maintenance cost Cost of fixing production defects (perators

(ld E<,??? increasing by E<?? in each future year E2,??? < H E<?,???

*ew *one for two years, E3,=?? thereafter E3,??? 3.= H <@,???

The shop foreman feels the new machine will produce a higher quality output and thus affect customer satisfaction and repeat sales. %e thinks that benefit should be worth at least E=,??? a year, but he doesn4t have a way to document the figure. 'osses generate tax credits. a. Calculate the relatively certain incremental cash flows associated with the new machine over its projected economic life of eight years, and the *,/ at a cost of capital of 3<; based on those cash flows. A"ound to whole E.B b. $uppose the foremanFs E=,??? quality improvement estimate were to be included. %ow big an impact would it have in relation to the other numbers5 Comment. SOLUTION" a. !nitial outlay7 $ell old machine $ales price *+/ of asset Taxable 1ain Tax H 2=; +uy new machine *et !nitial (utlay

E3=,2<2 E3<,??? E 2,2<2 AE3,392B

E3=,2<2 AE 3,392B AE9?,???B AE@=,>@?B

C#$% &'(W$ #&T)" (OT'#6 AE and commas omittedB 6)#"$ 3 aintenance7 (ld *ew $avings <??? <??? < <<?? . <<?? 2 <@?? 3=?? 8?? @ <9?? 3=?? 33?? = <>?? 3=?? 32?? 9 2??? 3=?? 3=?? : 2<?? 3=?? 3:?? > 2@?? 3=?? 38??

Cash &low )stimation 0epreciation7 (ld *ew !ncr

<3

9??? 9??? 3<??? 3<??? 3<??? 3<??? 3<??? 9??? 9??? 3<??? 3<??? 3<??? <??? @??? 9??? <<?? A ::?B 3@2? 9??? :@2? .:8:< =8<2 <??? @??? 9??? A=3??B 3:>= A223=B 3<??? >9>= .:33> 93>< <??? @??? 9??? A@8??B 3:3= A23>=B 3<??? >>3= .92== =9?< <??? @??? 9??? A@:??B 39@= A2?==B 3<??? >8@= .=9:@ =?:= <??? @??? 9??? <??? @??? 9??? <??? @??? 9???

$avings on defects and labor7 0efects <??? 'abor @??? Total 9??? !mpact on )arnings and taxes7 )+T <??? Tax A :??B )#T 32?? J 0epr 9??? *C& :2?? ,/&3<,! .>8<8 *,/s 9=3>

:=?? ::?? :8?? A<9<=B A<98=B A<:9=B @>:= =??= =32= @>:= .=?99 <@:? =??= .@=<2 <<9@ =32= .@?28 <?:@

,roject *,/ G E@=,>@? J E29,3?> G E8,:2< unacceptable ,ayback G approximately 9 years7 Cum *C& G E@=,>@? J E@9,?=? G E<3? b. #dding income of E=,??? per year has a significant effect. The after.tax addition to inflows each year is E=,??? .9= G E2,<=?. The impact on *,/ is the present value of an annuity of this amount for eight years at 3<;. ,/ G E2,<=? K,/&#3<,>L G E2,<=? A@.89:9B G E39,3@= This makes the *,/ acceptable7 *,/ G E8,:2< J E39,3@= G E9,@32 This illustrates an important real world phenomenon. $ubjective guesses added at the end of capital budgeting analyses can completely override the computations based on more objectively estimated cash flows.

Ne# Ve$tu%e@E-,&$'i*$ + Te%.i$&) V&)ue'" E-&.,)e' 11=1> 11=4 0,&1e' ;9< &$7 23;5
<?. The )bitts &ield Corp. manufactures baseball gloves. Charlie +otC, the company4s top salesman, has recommended expanding into the baseball bat business. %e has put together a project proposal including the following information in support of his idea. *ew production equipment will cost E:=,???, and will be depreciated straight line over five years. (verheads and expenses associated with the project are estimated at E<?,??? per year during the first two years and E@?,??? per year thereafter. There is enough unused space in the factory for the bat project. The space has no alternative use or value. $etting up production and establishing distribution channels before getting started will cost E2??,??? Atax deductibleB. #luminum and Wood bats will be produced and sold to sporting goods retailers. Wholesale prices and incremental costs per unit Adirect labor and materialsB are as follows7

<< #luminum E3> 33 E : Wood E3< 8 E2

Chapter 33

,rice Cost 1ross

argin

Charlie provides the following unit sales forecast is A???B7 6ear #luminum Wood

3 9 >

< 8 3<

2 3= 3@

@ 3> <?

= <? <<

9 << <@

The sixth year sales level is expected to hold indefinitely. "eceivables will be collected in 2? days, inventories will be the cost of one month4s production, and payables are expected to be half of inventories. #ssume no additional cash or accruals are necessary. AOse 3M3< of the current year4s revenue and cost for receivables and inventory.B )bitts &ield4s marginal tax rate is 2=; and its cost of capital is 3<;. a. 0evelop a six.year cash flow estimate for Charlie4s proposal. Work to the nearest E3,???. b. Calculate the payback period for the project. c. Calculate the projectFs *,/, assuming a six.year life. !s the project acceptable5 d. !s the cost of capital an appropriate discount rate for the project considering its likely risk relative to that of the rest of the business5 Why5 e. What is the project4s *,/ if the planning horiCon is extended to eight years5 A#dd the incremental ,/ from two more years at year 94s cash flow.B f. What is the *,/ if management is willing to look at an indefinitely long time horiCon5 A Hint7 Think of the cash flows in years 9 and beyond as a perpetuity.B g. Comment on the results of parts e. and f. SOLUTION" &= G%*'' M&%1i$ &$7 W@C ? #luminum Onits A???B "ev H E3> Cost H E33 Wood Onits A???B "ev H E3< Cost H E 8

3 9 E3?> 99 > E 89 :<

< 8 E39< 88 3< E3@@ 3?>

2 3= E<:? 39= 3@ E39> 3<9

@ 3> E2<@ 38> <? E<@? 3>?

= <? E29? <<? << E<9@ 38>

9NN << E289 <@< <@ E<>> <39

Total "evenue Cost 1ross argin Working Capital #ccounts "eceivable !nventory #ccounts ,ayable Working Capital

E<?@ 32> E 99 E 3: E 3< AE 9B E <2

E2?9 <?: E 88 E <9 E 3: AE >B E 2=

E@2> <83 E3@: E 2: E <@ AE3<B E @8

E=9@ 2:> E3>9 E @: E 2< AE39B E 92

E9<@ @3> E<?9 E =< E 2= AE3:B E :?

E9>@ @=> E<<9 E =: E 2> AE38B E :9

Cash &low )stimation !ncrease in WMC E <2 E 3< E 3@ E 3@ E : E 9

<2

!nitial (utlay7 )xpenses after tax AE2?? .9=B E38= )quipment E := E<:? ? AE<:?B 3 E 99 AE 3=B AE <?B E 23 AE 33B E <? E 3= AE <2B E 3< CASH FLOWS < 2 @ E 88 AE 3=B AE <?B E 9@ AE <<B E @< E 3= AE 3<B E @= E3@: AE 3=B AE @?B E 8< AE 2<B E 9? E 3= AE 3@B E 93 E3>9 AE 3=B AE @?B E323 AE @9B E >= E 3= AE 3@B E >9 = E<?9 AE 3=B AE @?B E3=3 AE =2B E 8> E 3= AE :B E3?9 E3?9 E @? 9NN E<<9 AE ?B AE @?B E3:3 AE 9?B E333 E ? AE 9B E3<? E3<? E3==

!nitial (utlay 1ross argin 0epreciation (verhead U )xpenses )+T !mpact Tax )#T !mpact #dd back 0epr !ncr in WMC *C& AE<:?B b= P&:b&c? Pe%i*77 *C& Cum C&

AE<:?B E 3< E @= E 93 E >9 AE<:?B AE<=>B AE<32B AE3=<B AE 99B ,ayback ,eriod G @.9 years

c= NPV" *C& ,/&3<,i ,/s

AE<:?B E 3< E @= NNNNN .>8<8 .:8:< AE<:?B E 33 E 29

E 93 E >9 E3?9 E3<? .:33> .92== .=9:@ .=?99 E @2 E == E 9? E 93

*,/ G E<:? J E<99 G E@ ,roject is not acceptable since *,/ P ? d. 6es. The project is in the firm4s traditional business and can be expected to use the same distribution channels. anufacturing may be a little risky, because making bats is unlike making gloves, but that consideration seems minimal. e. *C& for periods beyond six is the same as period six. %ence7 2 E 3<? .@=<2 E =@ @N E 3<? .@?28 E @>

*C& ,/&3<,i ,/s

*,/> G *,/9 J E=@ J E@> G E@ J E3?< G E8>

<@ f. ,/p G E3<?M.3< G E3??? #dditional *,/ G E3??? K,/&3<,9L G E3??? A.=?99B G E=?: *,/inf G E@ J E=?: G E=?2

Chapter 33

g. Taking a longer view often makes projects look a lot better. %owever, the further into the future cash flows are forecast, the less certain they are. <3. $egwick Corp manufactures men4s shoes that it sells through its own chain of retail stores. The firm is considering adding a line of women4s shoes. anagement considers the project a new venture because there are substantial differences in marketing and manufacturing processes between menFs and womenFs footwear. The project will involve setting up a manufacturing facility as well as expanding or modifying the retail stores to carry two products. The stores are leased, so modification will involve leasing larger spaces, installing new leasehold improvements, and writing off some old leasehold improvements.T The expected costs are summariCed as follows7 #sset !tems *ew manufacturing equipment, straight line depreciation, five years .............. E:=?,??? #cquisition of a new facility for design and manufacturing 'and Ano deprec.B....................VE@>?,??? +uilding A233.= yr. deprec.B ..............V.. E92?,??? E3,33?,??? 'eased retail space *et new lease expense, per year VVVVVVVVVVVVVVV......E @?,??? *ew leasehold improvements straight line depreciation, five years ....V... E<??,??? Write.off of old improvements ....VVVVVVVVVVVVVVV... E 8?,??? 0epreciation reduction due to written off improvements per year for 2 more years .VVVVVVVVVVV..... E 2?,??? )xpense !tems Cost of hiring and training new people VVVVVVVVVVVVVVV... E3=?,??? !nitial advertising and promotion .......VVVVVVVVVVVVVVVV. E<??,??? 6early advertising and promotion .........VVVVVVVVVVVVVVV.. E =?,??? 6early sales salaries ..................VVVVVVVVVVVVVVVVVV...E8??,??? #dditional corporate overhead AE???Myr.B .....VVVVV...E<?, E@<, E9?, E>?, E>?, E>? "evenue and Cost The unit sales forecast is as follows in thousands 6ear Onits #verage ,rice 3 2? E9= < @? E9> 2 =? E:? @ and on 9? E:= 0irect cost excluding depreciation is @?; of sales
3T

'easehold improvements are assets added to leased premises by the tenant. They are generally depreciated over the remaining life of the lease.

Cash &low )stimation

<=

Working Capital $ales are to retail customers who pay with checks or credit cards. !t takes about 3? days to clear both of these and actually receive cash. !nventories are estimated to be approximately the cost of two months sales. ,ayables are estimated as one quarter of inventories. #ssume incremental cash is required equal to <; of revenues. #ccruals are insignificant. A)stimate the current accounts based on the current year4s revenue and cost levels.B (ther !tems anagement expects a few of the company4s current male customers to be lost, because they won4t want to shop in a store that doesn4t exclusively sell men4s shoes. The gross margin impact of these lost sales is estimated to be E9?,??? per year. The company has already purchased designs for certain styles of ladies4 shoes for E9?,???. $egwick4s cost of capital is 3?;. !ts marginal tax rate is 2=;. a. 0evelop a six.year forecast of after tax cash flows for $egwick. b. Calculate the project4s payback period, *,/, !"", and ,!, and make a recommendation about acceptance. c. #ssume you are told that the men4s shoe industry is very stable being served by the same manufacturers year after year. %owever, firms enter and leave the ladies4 shoe business regularly. Would this knowledge make you more or less comfortable with the analysis you4ve done of this project5 Why5 SOLUTION" a. &orecast of cash flows7 0epreciation7 )quipment AE:=?,??? M =B E3=?,??? +uilding AE92?,??? M23.=B E <?,??? *ew 'easehold !mprovements E @?,??? (ld 'easehold !mprovements AE 2?,???B ? )quipment +uilding *ew 'M% (ld 'M% !ncr. 0epreciation 3 E 3=? E <? E @? AE 2?B E 3>? AE???B < E 3=? E <? E @? AE 2?B E 3>? 2 E 3=? E <? E @? AE 2?B E 3>?

= years 9 years = years 2 years @ E 3=? E <? E @? NNNNN E <3? = 9NN

E 3=? E <? E <? E @? NNNNN NNNNN E <3? E <?

!nitial (utlay7 )xpenses %iring and Training #dvertising U ,romotion Write.off 'M% !mprove )+T !mpact Tax $avings 'ess *on.cash Write.off Cash (utflow I )xpenses

E3=?,??? E<??,??? E 8?,??? E@@?,??? AE3=@,???B E 8?,??? E389,???

<9 Capital )quipment &acility *ew 'M% !mprove Cash (utflow . Capital Total (utlay ? "evenue and Cost Onits ,rice "evenue Cost H @?; 'ost 1 1 Contribution NNNNN 3

Chapter 33

E:=?,??? E3,33?,??? E<??,??? E<,?9?,??? E<,<=9,??? AE???B < 2 @ = 9N

2? @? =? 9? 9? 9? E9= E9> E:? E:= E:= E:= E3,8=? E<,:<? E2,=?? E@,=?? E@,=?? E@,=??

E :>? E3,?>> E3,@?? E3,>?? E3,>?? E3,>?? NNNNN E 9? E 9? E 9? E 9? E 9? E 9? E3,33? E3,=:< E<,?@? E<,9@? E<,9@? E<,9@?

)xpenses *ew leases E @? E @? E @? E @? E @? E @? #dvertising U ,romotion =? =? =? =? =? =? $alaries 8?? 8?? 8?? 8?? 8?? 8?? (verhead <? @< 9? >? >? >? !ncr. 0epreciation NNNNN 3>? 3>? 3>? <3? <3? <? Total )xpenses E3,38? E3,<3< E3,<2? E3,<>? E3,<>? E3,?8? Contribution to )arnings )+T AE >?B E 29? E Tax NNNNN <> A3<9B )#T AE =<B E <2@ E #dd !ncr. 0eprec. NNNNN 3>? 3>? (perating C& E 3<> E @3@ E Working Capital Cash A<; "evB #M" A.22"evM3<B !nv ACostM9B #M, A!nvM@B WMCap !ncr in WMC !nitial (utlay *C& b. P&:b&c? Pe%i*7 *C& Cum C& >3? E3,29? E3,29? E3,==? A<>@B A@:9B A@:9B A=@2B =<9 E >>@ E >>@ E3,??: 3>? <3? <3? <? :?9 E3,?8@ E3,?8@ E3,?<:

E 28 =@ 32? NNNNN A 22B E 38? AE38?B

E =@ :9 3>3 A @=B E <99 AE :9B

E :? 8: <22 A =>B E 2@< AE :9B

E 8? E 8? E 8? 3<= 3<= 3<= 2?? 2?? 2?? A :=B A :=B A :=B E @@? E @@? E @@? AE 8>B . .

AE<,<=9B NNNNN NNNNN NNNNN NNNNNN NNNNN NNNNN AE<,<=9BAE 9<B E 22> E 92? E 889 E3,?8@ E3,?<:

AE<,<=9BAE 9<B E 22> E 92? E 889 E3,?8@ E3,?<: AE<,<=9BAE<,23>BAE3,8>?BAE3,2=?B AE 2=@B E :@? E3,:9: ,ayback ,eriod G @.2 years

Cash &low )stimation

<:

NPV &$7 PI *C& ,/&3?,i ,/s

AE<,<=9B AE 9<B E22> .8?83 .><9@ AE<,<=9B AE =9B E <:8 *,/ ,!

E92? .:=32 E @:2

E889 E3,?8@ E3,?<: .9>2? .9<?8 .=9@= E 9>? E9>? E=>?

G E<,<=9 J E<,929 G E2>? G E<,929 M E<,<=9 G 3.3:

IRR *C& ,/&3@,i ,/s

AE<,<=9B AE 9<B E 22> E 92? E 889 E3,?8@ E3,?<: NNNNNN .>::< .:98= .9:=? .=8<3 .=38@ .@==9 AE<,<=9B AE =@B E <9? E @<= E =8? E =9> E @9> *,/ !"" G E<,<=9 J E<,<=: G E3 G 3@;

#ccept since7

*,/ ,! !""

G E2>?,??? S ? G 3.3: S 3.? G 3@; S k G 3?;

c. Worse. The venture is riskier than the existing business, which implies the analysis accepts it too easily. COMPUTER PROBLEMS <<. The ,axton %omes is a successful builder of moderate to high.priced houses. The firm is currently considering an expansion into light commercial construction in which it would build shopping centers and small office buildings. anagement considers the idea a new venture because of the major differences between commercial and residential construction. 1etting into the new line of business will require an investment of E3<.= in equipment and E2 in expenses. The equipment will be depreciated over five years. ,art of the start.up money will come from the sale of some old trucks and cranes. These have a total market value of E3.> and an *+/ of E9??W. $elling the equipment will result in a depreciation reduction of E<??W per year for three years. "evenue from the commercial line is expected to be E9 in the first year and to grow by E< in each succeeding year until it reaches E<? . #fter that growth is uncertain and may be anywhere from ? to 9; per year. Costs and expenses, including incremental overhead, will be 33?; of revenues in the first year, >=; in the next two years, and :?; thereafter. )conomies of scale in materials purchasing are expected to save the residential business about E<=?W per year but not until the fourth year. *et working capital requirements are estimated at 3?; of revenue. The combined federal and state tax rate on the incremental business will be @?;. 'osses can be offset against other profits and can therefore be viewed as earning a tax credit at the same rate. ,axton4s cost of capital is 3<;. 6ou are a financial analyst assigned to evaluate the commercial construction proposal. Ose the C#,+O0 program to analyCe the project and prepare a presentation in which you will make a recommendation either favoring or opposing its undertaking. %ere are some ideas for approaches to your presentation7 a. )stablish a base case using the information given. &orecast into the future until the numbers stop changing Aeight yearsB. #ssume a terminal value based on a continuation of the eighth year4s cash flows with no further growth. !s the project acceptable based on *,/ and !"" given these assumptions5

<>

Chapter 33

b. Test the sensitivity of the base case analysis to the terminal value assumption by varying the growth rate to 2; and 9;. 3B Comment on the difference the terminal growth rate assumption makes. <B Construction is a cyclical industry in that it is very subject to the ups and downs of the economy. !n good times growth is enormous, but in bad times the industry and the firms in it shrink rapidly. 1iven that fact, how do you feel about the terminal value assumption5 2B )valuate the project4s *,/ and !"" assuming a ten.year planning horiCon. That is, assuming Cero cash flows after the tenth year. 0oes this approach make more or less sense to you than the terminal value assumptions used in part a.5 c. Test the sensitivity of the analysis to changes in revenue growth. &or example, suppose revenue grows by only E3 per year instead of two until the eighth year. !s the project a good idea then5 What if costMexpense is a higher percentage of revenue than anticipated5 SOLUTION" $olutions are outputs of the C#,+O0 program given the inputs stated in the problem.