Capital Budgeting: Estimating Cash Flows and Project Valuation - Prof. Gordon M. Phillips, Study Guides, Projects, Research of Introduction to Business Management

Download Capital Budgeting: Estimating Cash Flows and Project Valuation - Prof. Gordon M. Phillips and more Study Guides, Projects, Research Introduction to Business Management in PDF only on Docsity! Professor G. Phillips - 1 Capital Budgeting Review - 1 PROJECT VALUATION REVIEW 1. ESTIMATING CASH FLOWS 2. FINANCING AND INVESTMENT DECISIONS & EXTERNAL FUNDS NEEDED 3. DETERMINING INCREMENTAL CASH FLOWS 4. THE 4 CENTRAL INPUTS TO CASH FLOW FORECASTS 5. SENSITIVITY ANALYSIS Varying the Key Parameters: Some Sensitivity Analysis 6. Some conclusions / generalizations Capital Budgeting Review - 2 BEYOND THE BASICS • The key to capital budgeting is not just the mechanics - but rather varying key parameters into cash flow forecasts- ALONG with different discount rates changes the PRESENT VALUE of the cash flows. • It is in how the assumptions are modeled that many mistakes can be made. This note thus does not focus on discount rates, but rather on the formulation of the cash flows. • Capital budgeting emphasizes the key role management has in value creation by taking projects and expanding the size of the firm if profitable. Professor G. Phillips - 2 Capital Budgeting Review - 3 1. PROJECT CASH FLOWS A. Relevant Cash Flows: WHAT ARE THESE? • Relevant cash flows are those that come into or out of being because a project is undertaken, thus we are interested in incremental cash flows. • Incremental cash flows - Any and all changes in the firm's future cash flows that are a direct consequence of taking the project. B. The Stand-Alone Principle Viewing projects as "mini-firms" with • their own assets, • revenues and • costs Allows us to evaluate the investments separate from the other activities of the firm. Capital Budgeting Review - 4 ESTIMATING CASH FLOWS PRO FORMA FINANCIAL STATEMENTS AND PROJECT CASH FLOWS A. Getting Started: Pro Forma Financial Statements Treat the project as a mini-firm: 1. PROFORMAS: Start with pro forma (forecasted) income statement and balance sheet (don't include interest). • The proforma income statement forecasts sales, costs and thus profit for the life of the project. • The proforma balance sheet answers 2 primary questions: 1. The amount of assets needed to generate forecasted sales. 2. The amount of external capital needed to finance the assets Professor G. Phillips - 5 Capital Budgeting Review - 9 B3. ESTIMATING TERMINAL VALUE 2 alternatives: 1. Salvage or shut down business 2. Sell business as a going concern to a new owner 1. SALVAGE VALUE / SHUT DOWN I. SALE AMOUNT ii. RECAPTURE WORKING CAPITAL iii. TAX EFFECTS - GAIN VS BOOK VALUE 2. SALE OF BUSINESS AS GOING CONCERN i. PV OF FUTURE BUSINESS (Perhaps a multiple of earnings at that date OR use an Annuity Formula using last periods cash flow.) Capital Budgeting Review - 10 An Example: Fairways Driving Range Two friends are considering opening a driving range for golfers. Because of the growing popularity of golf, they estimate such a range could generate: • rentals of 20,000 buckets at $3 a bucket the first year, and • rentals will grow at 750 buckets a year thereafter. Equipment requirements include: • ball dispensing machine $2,000, ball pick-up vehicle $8,000, tractor $8,000 • All the equipment is 5-year ACRS property, and is expected to have a salvage value of 10% of cost after 6 years. • Stocking a small shop selling tees, visors, gloves, towels, sun-block, etc., plus a checking account for the business make: Net working capital $3,000 to start, growth of 5% per year. • Annual fixed operating costs are expected as follows: • Expenditures for balls and baskets, initially $3,000, are expected to grow at 5% per year. Fixed Costs: Lease on the land + Upkeep = $53,000 per year. • The relevant tax rate is 20% and the required return is also 15%. Project is to be evaluated over a 6 year life: Should they proceed? Professor G. Phillips - 6 Capital Budgeting Review - 11 Pro forma income statement Year Revenues Variable costs Fixed costs Depreciation EBIT Taxes Net income 1 2 3 4 5 6 $60,000 $62,250 $64,500 $66,750 $69,000 $71,250 3,000 3,150 3,308 3,473 3,647 53,000 53,000 53,000 53,000 53,000 53,000 3,600 5,760 3,456 2,074 2,074 1,036 13,38510,2798,2034,736 340 400 80 68 947 1,641 2,056 2,677 320 272 3,789 6,562 8,223 10,708 3,829 Capital Budgeting Review - 12 Depreciation on $18,000 of equipment Year ACRS % Depreciation Book Value 1 2 3 4 5 6 20.00% 32.00% 19.20% 11.52% 11.52% 5.76% $3,600 5,760 3,456 2,074 2,074 1,036 $14,400 8,640 3,110 1,036 0 5,184 Professor G. Phillips - 7 Capital Budgeting Review - 13 Projected increases in net working capital Year Net WC Increase in WC 0 1 2 3 4 5 3,150 3,308 3,473 3,647 3,829 $3,000 150 158 165 174 182 $3,000 6 4,020 -4,020 Capital Budgeting Review - 14 Projected cash flows Year EBIT + Depreciation - Taxes = Operating CF 1 2 3 4 5 6 $400 4,736 8,203 10,279 13,385 340 $3,600 5,760 3,456 2,074 2,074 1,036 $80 68 947 1,641 2,056 2,677 $3,920 6,032 8,636 10,297 11,744 7,245 Professor G. Phillips - 10 Capital Budgeting Review - 19 • Next go to Income Statement - Get Retained Earnings Year 1 Year 2 SALES 100,000 200,000 - Cost of Goods Sold (CGS) 50,000 100,000 - Selling, General and Admin. Expense 10,000 20,000 - Depreciation 20,000 40,000 ----------------------------------------- ----------- --------- = EBIT 20,000 40,000 - Interest 5,000 ? - Taxes (33.33% or 1/3rd) 5,000 ----------------------------------------- ----------- --------- = Net Income 10,000 - Dividend Payments 5,000 = Retained Earnings 5,000 • Note the difference between cash flows and profit Capital Budgeting Review - 20 Update retained earnings, debt, equity Yr. 2 • REPEAT STEPS, iterating between income statement and balance sheet until CONSISTENT. Assets Yr 1 Yr 2 Liabilities Yr 1 Yr 2 Cash ?? ?? Bank Loan: initial 50,000 ?? ?? Equip. Gross 100,000 200,000 - Acc. Depreciation -20,000 -60,000 Equity Equipment Net 80,000 140,000 Equity Invest. 70,000 ?? Retained Earnings 5,000 initial 10,000 Total Assets ?? ?? Total L+E ?? ?? Professor G. Phillips - 11 Capital Budgeting Review - 21 3. ADVANCED CASH FLOWS: INCREMENTAL IS KEY • KEY QUESTION: What’ the result if the firm doesn’t take the project? • Specific Items to Consider: A. Sunk Costs • Sunk cost - A cash flow already paid or already promised to be paid. Obviously, these costs should not be included in the incremental flows of a project. example: Allocated Overhead: • Conclusion: Ignore sunk costs unless adding new overhead in proportion to expenditure. Capital Budgeting Review - 22 B. Transfer Pricing: need market prices. C. Opportunity Costs • Opportunity cost - Any cash flows lost or foregone by taking one course rather than another. • These apply to any asset or resource that has value if sold rather than used. D. Side Effects: CANNIBALIZATION / SALES CREATION • With multi-line firms, projects often affect one another - sometimes helping, sometimes hurting. • Erosion - Revenues gained by a new project at the expense of the firm's other existing products or services. • Example: Every time Kellogg's brings out a new oat cereal it probably causes some erosion of existing product sales. • Qualification: If another firm would (or could) produce this product any sales erosion should be ignored - "water over the dam." Professor G. Phillips - 12 Capital Budgeting Review - 23 E. Net Working Capital • New projects often require incremental investments in cash, inventories, and receivables that need to be included in cash flows (if they are not offset by changes in payables, such as taxes or accounts payable.) • Later, as projects end, this investment is often recovered. F. Financing Costs • Do not include any interest or principal on debt or any dividends or other financing costs in computing cash flows. • The discount rate will take care of that. • Financing costs represent the division of cash flows to providers of capital as a result of the financing decision. • This is the BIGGEST DIFFERENCE between financial forecasting and project/firm valuation. G. After-Tax vs. Before-Tax Cash Flows • Use after-tax cash flow - not accounting earnings. Capital Budgeting Review - 24 4. The 4 Central Inputs to Cash Flow Forecasts 1. Initial Sales, S. 2. Rate of Growth in Sales, g (KEY: Consult with marketing gurus. 3. The After-Tax Profit Margin, p = 4. Capital Intensity, a = • Capacity Utilization and Fixed vs. Variable Cost important. EBIAT SALES FA NWC SALES +