WEB-APPENDIX G*
ESTIMATING CASH FLOWS OF CAPITAL BUDGETING PROJECTS
In Chapter 6 we discussed capital budgeting decisions. As we explained, the firm's managers should invest only to increase the value of the owners’ interests. When a firm invests in new assets, it expects the future cash flows to be greater than without this new investment. The difference between the cash flows of the company with the investment project, compared over the same period of time to the cash flows of the company without the investment project is referred to as the project's incremental cash flows.
The change in the value of the company resulting from an investment can be broken down two components:
- The cash flows from the project's operating activities (revenues and operating expenses), referred to as the project's operating cash flows (OCF).
- The investment cash flows; that is, the expenditures needed to acquire the project's assets and any cash flows from disposing the project's assets.
The effect on the value of the company can then be evaluated using the techniques described in Chapter 6 (in the certainty case) and Chapters 25 and 26 in the more realistic case where management is exposed to risk.
G.1 OPERATING CASH FLOWS
In the simplest form of investment, there will be a cash outflow when the asset is acquired and there may be either a cash inflow or an outflow at the end of its economic life. In most cases there are also changes in operating cash flows to take into account—the investment will result in changes in revenues, expenditures, taxes, and working capital.
An economic analysis of a project requires estimates of operating cash flows. Management cannot know for certain what these cash flows will be in the future, but attempts must be made to estimate them. What is the basis for these estimates? Management typically bases them on marketing research, engineering analyses, operations, analysis of competitors, and managerial experience. The operating cash flows associated with a project include the following components:
- Change in revenues
- Change in expenses
- Change in taxes
- Change in working capital
G.1.1 Change in Revenues
When a company undertakes a new project, the firm's manager want to know how it changes the company's total revenues, not merely what the new product's revenues are expected to be. Consider a food processor contemplating a new investment in a line of frozen dinner products. Suppose management introduces a new ready-to-eat dinner product that is not frozen. The firm's marketing research group will indicate how much the firm can be expected to sell. Where do the new product sales come from? Some may come from consumers who do not already buy frozen dinner products. But some of the new product's sales may come from consumers who choose to switch from a product they previously bought. Perhaps the consumers are switching from competitors’ products, but some of them may be switching from other products of the firm introducing the new line. That is, if the firm introduces a new product, management is really interested in how that affects the incremental revenues of the entire company rather than the sales of the new product alone.
Management also needs to consider any foregone revenues—opportunity costs—related to the new investment. Suppose the firm owns a building currently being rented to another company. If management is considering terminating that rental agreement so it can use the building for a new project, management then needs to consider the foregone rent. The net revenues from the new project are thus the gross revenues from the project minus the revenue previously earned from renting the building.
G.1.2 Change in Expenses
The costs associated with a new project will also change the firm's expenses. After estimating the likely change in unit sales, management can develop an estimate of the costs of producing the additional units. And, management will want an estimate of how the product's inventory may change when production and sales of the product change.
If the investment involves changes in the costs of production, we compare the costs without this investment with the costs with this investment. For example, if the investment is the replacement of an assembly-line machine with a more efficient machine, management needs to estimate the change in the firm's overall production costs such as electricity, labor, materials, and management costs. A new investment may change both production costs and such operating costs as rental payments and administration charges.
G.1.3 Change in Taxes
Taxes affect operating cash flows in two ways. First, if revenues and expenses change, income and consequently taxes change. That means we need to estimate the change in taxable income resulting from the changes in revenues and expenses resulting from a new project to determine the effect of taxes on the company. Second, the deduction for depreciation reduces taxes, shielding income from taxation. While depreciation itself is not a cash flow, the tax shield from depreciation reduces tax payments, and is therefore like a cash inflow.
G.1.4 Change in Working Capital
Working capital consists of short-term or current assets that support the operating activities of the business. Net working capital is the difference between current assets and current liabilities, and represents what would be left over if the firm were to pay off its current obligations using its current assets. Changes in net working capital can result either from changes in current asset positions because of transactions or precautionary needs or from such accounting adjustments as the use of accrual methods.
An investment may increase the company's level of operations and hence the amount of net working capital needed. If the investment is intended to produce a new product, the company may have to increase inventories of raw materials, work-in-process, and finished goods. If increasing sales means extending more credit, then the firm's accounts receivable will also increase. If the investment requires maintaining a higher cash balance to handle the increased level of transactions, the firm will need more cash. On the other hand, if the investment makes the firm's production facilities more efficient, it may be able to reduce the level of inventory.
Given an increase sales, the firm may want to keep more cash and inventory on hand for precautionary purposes. As the level of operations increases, fluctuations in demand for goods and services may also increase, requiring the firm to keep additional cash and inventory “just in case.” If there is greater variability of cash and inventory, management may further increase working capital to provide a greater safety cushion. On the other hand, if a project enables the firm to be more efficient or lowers costs, it may lower its investment in cash, marketable securities, or inventory, releasing funds for investment elsewhere in the firm.
A change in net working capital can be thought of as the amount necessary to get the project going. Or it can be considered as part of operating activity—the day-today business of the company. So where in an economic analysis of a project should management classify the cash flow associated with net working capital? With the asset acquisition and disposition represented in the new project or with the operating cash flows? In many applications, management can arbitrarily classify the change in working capital as either investment cash flows or operating cash flows. Since it is only the net cash flows that matter, the classification of a change in working capital does not impact a project's attractiveness.
G.2 INVESTMENT CASH FLOWS
The economic analysis of a project must consider all the cash flows associated with acquiring and later disposing of project assets. The flows are usually referred to as investment cash flows. For any project, there are a number of different types of investment cash flows to consider, including the cost of acquisition (e.g., cost of the asset, setup expenditures, including shipping and installation, and any tax credit1).
At the end of the useful life of an asset, management may be able to sell the asset or may have to pay another party to haul it away or close it down. If management is making a decision that involves replacing an existing asset, the cash flow from disposing of the old asset must be considered because it is a cash flow relevant to the acquisition of the new asset.
If management disposes of an asset, whether at the end of its useful life or when it is replaced, two types of cash flows must be considered: (1) what the company expects to receive or expects to pay in disposing of the asset and (2) any tax consequences resulting from the disposal. The proceeds are what management projects it can sell the asset for if sold. If management must pay for the disposal of the asset, this cost is a cash outflow. Therefore,
Cash flow from disposing assets
= Proceeds or payment from disposing assets − Taxes from disposing assets
The tax consequences are a bit more complicated. Taxes depend on: (1) the expected sales price, (2) the carrying value of the asset for tax purposes (called the tax basis) at the time of disposition, and (3) the tax rate at the time of disposal. If management sells the asset for more than its tax basis but less than its original cost, the difference between the sales price and the tax basis is a gain, taxable at ordinary tax rates. If management sells the asset for more than its original cost, then the gain is broken into two parts: the capital gain (the difference between the sales price and the original cost) and recapture of depreciation (the difference between the original cost and the tax basis). The cash flow from asset disposition is the sum of the direct cash flow (someone pays the firm for the asset or the firm pays someone to dispose of it) and the tax consequences.
The capital gain is the benefit from appreciation in the value of the asset and may be taxed at preferential tax rates, depending on the tax law at the time of sale. The recapture of depreciation represents the amount by which the company has over-depreciated the asset during its life. This means that more depreciation has been deducted from income (hence, reducing taxes) than necessary to reflect the actual depreciation of the asset. The recapture portion is taxed at ordinary tax rates, because the excess depreciation taken over past years has reduced taxable income in those years.
If a company sells an asset for less than its tax basis (i.e., the asset value on the books of the company) the result is a capital loss. A capital loss offers an opportunity to reduce company income taxes, since the capital loss may be used to reduce earned income. The reduction in taxable income is referred to as a tax shield because the loss shields some income from taxation.
G.3 NET CASH FLOWS
To summarize: A project's cash flows consist of: (1) cash flows related to acquiring and disposing the assets represented in the investment and (2) how the investment affects cash flows related to operations. The sum of the cash flows from asset acquisition and disposition and from operations is referred to as net cash flows (NCF). This sum is calculated for each period. In each period, we add the cash flow from asset acquisition and disposition and the cash flow from operations. The analysis of the cash flows of investment projects can become quite complex. But by working through the problem systematically, management will be able to focus on those items that determine cash flows.