STEPS IN ESTIMATING CASH FLOWS

First of all, we dont want to includeinterest/financing expenses in our Project Cash Flows.
Projects must make sense regardless of how financed, Debt or Equity. Financing expenses
would be taken care of in the project discount rate (that we will learn later)!!!

Step 1. Determine initial investment

- Forget about sunk costs (paid or incurred the liability to pay prior to making the
decision)
- Include opportunity costs (take next best alternative useof the existing resources)
- Include side effects: can be positive (in case of synergies) or negative ( in case of
cannibalization)
- Include overhead costs

Step 2. Determine operating cash flow (OCF)

- Use cash flows, not accounting profit

- Depreciation: non-cash expense but has an effect on our cash flows since it has a tax
shield Incorporate the tax effect of depreciation, not the depreciation itself
- Four different ways to calcuate OCF (all approaches yield the same answer)
o OCF = EBIT + Depreciation Taxes
o OCF = NI + Depreciation
o OCF = Sales Costs Taxes
o OCF = (Sales Costs) *(1-Tax rate) + Depreciation* Tax rate

Step 3. Determine working capital (WC) needs

- Working capital considered a loan to the project and fullyrecovered in the last
year of project life
- Consider the change in WC:
o Increase in Working Capital negative cash flows (outflows)
o Decrease in Working Capital Positive cash flows (inflows)

Step 4. Incorporate after-tax salvage value (of fixed assets)

- If salvage value > Book value over-depreciation in previous periods excessive

tax shield in previous periods tax paid to government
- If salvage value < Book value under-depreciation in previous periods
insufficient tax shield in previous periods tax rebate (government pays back)
 Taxes on the sale of asset = (Book value Salvage value) * tax rate

Note 1: Please note that salvage value used in this formula is the MARKET VALUE that we can
actually sell the assets for at the end of the project life. The reason I have to state this explicitly
is because for some problems it is easy to confuse between salvage value and remaining
book value

Using this formula, (from the perspective of the company itself)

If taxes on sale of asset < 0: we pay governement

If taxes on sale of asset >0: government pays us

Note 2: Somewhere you may see that in calculating depreciation expense (in accounting), they
employ this formula

Annual Depreciation expense = (Original cost of fixed asset salvage value)/ # of useful life (years)

Thats the word salvage that makes you confused!!!

The salvage value employed in this formula refers to the remaining BOOK VALUE of the fixed
assets at the end of its useful life.

Example: (not Mr. Thanh case) if one question says " the fixed asset costs 300,000, is
depreciated straight line to zero" and "by the end of the project, the fixed asset would be sold
for 15,000" and if project life is 5 years then we understand that :

- By the end of the project, Book value is 0

- By the end of the project, Market value is 15,000
- Then depreciation expense = (300,000 - 0)/5 years = 60,000 each year
-There is tax effect from selling that fixed asset, because there is a difference between the book
value and market value, that effect would be incorporated in calculating CFs when selling fixed
asset

Step 5. Find annual, net project cash flows by incorporating these above elements:
Initial investment, Operating Cash Flows (OCF), Working capital, and sale price of fixed
asset +/- tax on asset sale

Step 6. Apply decision criteria (NPV, PI, IRR) to come up with the decision about the
project concerned (accept/reject)
COMPREHENSIVE ILLUSTRATION EXAMPLE:

Mr. Thanhs (Tan Hiep Phats CEO) Superior Herbal Tea project has the following features:

- Feasibility study/market research cost: $500,000

- The company has an existing piece of land that could be used for this project, with
current market value of $150,000. Assume that after 5 years of usage, by the end of
the project, the market value of that land still remains the same
- The machinery used to produce the tea could be bought for $100,000. This machine
is depreciated according to a 5-year property MACRS schedule
- The project requires an initial investment in working capital of $10,000; The working
capital changes each year in response to changes in sale volume (10% of sales)
- This project is intended to last for 5 years, the projected sales volume for each year
is 5,000; 10,000; 8,000; 6,000; and 2,000 bottles respectively
- Price per bottle: $30 (first year). This sale price will increase by 1% per year
- Production cost for the tea: $10 per bottle. This cost will increase by 5% per year
- At the end of project life, the machinery could be sold as scrap for $30,000
- Discount rate 15% and tax rate 34%

SOLUTION

Step 1. Determine initial investment

Investment Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Machinery (100,000)
Land (150,000)
Total (250,000)

- Include feasibility/market research cost or not? No, thats sunk. It happens prior
to making the decision to accept/reject the project
- While other fixed assets are depreciable, land isnot depreciable (Note: only land has
this characteristic so be careful why why why???!!!)
- Thus land can be sold for $150,000 at project end since we assume that the market
value of this land doesnt change across time (well take care of that in Step 4 later)

Step 2. Determine operating cash flow (OCF)

 Operating Cash Flow (OCF) for year 1:

OCF Calculation Year 1

Sales revenue = units x price = 5,000 x 30 $150,000

Less: cost = units x cost per unit= 5,000 x 10 ($50,000)

Equals: EBDIT = sales costs $100,000
Less: Depreciation =cost of machine x MACRS rate = ($20,000)
$100,000 x 20%
Equals: EBIT = EBDIT - Depreciation $80,000
Less: Taxes = EBIT x tax rate 34% ($27,200)
Equals: Net Income =EBIT - Taxes $52,800
Add: Depreciation Add Depreciation $20,000
Equals: OCF = Net income + Depreciation $72,800

Changes starting from year 2:

- Starting from year 2, selling price per unit increases by 1% while cost increases by
5%
- Depreciation according to MACRS schedule
Doing similarly, we get OCF for year 2-year 5 (refer to the table)

Step 3. Determine working capital (WC) needs

Initial working capital requirement = $10,000

Change in Working Capital = -(New WC Requirement Old WC Requirement)

Year 1 = - (15,000 10,000) = -5,000 (cash outflow)

Year 2 = - (30,300 15,000) = -15,300 (cash outflow)

Year 3 = - (24,482 30,300) = + 5,818 (cash inflow)

Year 4 = - (18,545 24,482) = + 5,937 (cash inflow)

Year 5 = - (0 18,545) = + 18,545 (WC is fully recovered in the final year)

Step 4. Incorporate after-tax salvage value (of fixed assets)

 Land is not depreciated (Book value remains the same)and market value doesnt change
across time (given by the question)
Book value of land, end of project: $150,000
Market value of land, end of project (can be sold for): $150,000
The sale of Land by the end of project has no tax effect since no difference between
Book value and Market value.

Machinery:
o End of year 5, book value of machinery = 5.76% x 100,000 = $5,760
o Salvage value (market value) = $30,000
Tax on the sale of machinery = (5,760 30,000) x 34% = -8,242
Since tax < 0 the company has to pay to the government
Net Cash flows from the sale of machinery = $30,000 + (-8,242) = $21,758
Total after-tax cash flows from land and machinery = $150,000 + 21,758 = $171,758

Step 5. Find annual, net project cash flows

Refer to the table

Step 6. Apply decision criteria (NPV, PI, IRR)

Refer to the table