Financial Management:: Analyzing Project Cash Flows

Financial Management:
Principles & Applications

Thirteenth Edition
Chapter 12
Analyzing Project
Cash Flows
Copyright © 2018, 2014, 2011 Pearson

CopyrightEducation, Inc. All
© 2018, 2014, 2011 Pearson Rights
Education, Inc. All Reserved
Rights Reserved
Learning Objectives
1. Identify incremental cash flows that are relevant
to project valuation.
2. Calculate and forecast project cash flows for
expansion-type investments.
3. Evaluate the effect of inflation on project cash
flows.
4. Calculate the incremental cash flows for
replacement-type investments.
Copyright © 2018, 2014, 2011 Pearson Education, Inc. All Rights Reserved
Principles Applied in This Chapter
• Principle 3: Cash Flows Are the Source of Value.
• Principle 5: Individuals Respond to Incentives.
12.1 PROJECT CASH FLOWS
The Anatomy of Project Cash Flows
Figure 12.1 characterizes the typical project cash
flows for a capital investment into one of three
categories of cash flows:
• The cash flows associated with the launching of
the investment
• The operating period cash flows
• The terminal cash flows
Figure 12.1 The Anatomy of Project Cash Flows for the
Typical Investment
Project Life Initial Investment Period Interim Operating Period Terminal Period
Cycle
Relevant • Costs of purchasing plant • Incremental revenues • Proceeds from the

cash and equipment disposal of plant and
flows • Incremental expenses equipment (net of taxes)
• Costs of installing
equipment and training • Incremental taxes • Cleanup or
employees • Increase in working- decommissioning costs
• Investment in working- capital requirements • Recapture of working-
capital requirements (e.g., • Incremental capital capital investment
investments in accounts expenditures for plant
receivable and inventories and equipment
less those in accounts
payable)
Incremental Cash Flows are what Matters
• Incremental cash flow refers to the additional
cash flow a firm receives from taking on a new
project.
Incremental Project  Firm Cash Flows   Firm Cash Flows 

=     
Cash Flows  with the Project   without the Pr oject 
Guidelines for Forecasting Incremental
Cash Flows
This section provides a set of basic guidelines for
proper identification of following cash flow items:
• Sunk Costs
• Overhead costs
• Synergistic effects
• Opportunity costs
• Working capital requirements
• Interest payments and other financing costs
Sunk Costs Are Not Incremental Cash
Flows
Sunk Costs (such as market research) are those
costs that have already been incurred, regardless of
whether or not the investment is undertaken. These
costs are not incremental cash flows resulting from
acceptance of the investment because they will be
incurred in any case.
Overhead Costs Are Generally Not
Incremental Cash Flows
Overhead costs such as the cost of heat, light, and
rent often occur whether we accept or reject a
particular project. In these instances, overhead
expenses are not a relevant consideration when
evaluating project cash flows.
Look for Synergistic Effects
Oftentimes the acceptance of a new project will
have an effect on the cash flows of the firm’s other
projects or investments. These effects can be either
positive or negative, and if these synergistic effects
can be anticipated, their costs and benefits are
relevant to the project analysis.
Account for Opportunity Costs
Opportunity cost is the cost of passing up the next
best choice when making a decision. For example,
rent foregone on a building space in order to
accommodate expansion plan for the existing line of
business will be a relevant incremental expense
because it represents an opportunity cost.
Work in Working—Capital Requirements
New projects often involve an additional investment
in working capital. The need for additional working
capital arises out of the fact that cash inflows and
outflows from the operations of an investment are
often mismatched.
Ignore Interest Payments and Other
Financing Costs
interest payments and other financing costs are not
included in the computation of project cash flows as
they are accounted for in the cost of capital used to
discount cash flows. Including interest expense in
both the computation of the project’s cash flows and
the discount rate would amount to counting interest
twice.
12.2 FORECASTING PROJECT CASH FLOWS
Forecasting Project Cash Flows
Free cash flow is the total amount of cash flow available for
distribution to the creditors who have loaned money to
finance the project and to the owners who have invested in
the equity of the project. In practice, this cash flow
information is compiled from pro forma financial statements.
Pro forma financial statements are forecasts of future
financial statements. We can calculate free cash flow using
the following equation:
Operating Cash Flow
                           Increase in Capital Increase in Net
Free Cash Net Operating Depreciation
=  Taxes   Expenditur es  Operating W orking
Flow Income (Profit) Expense
           (CAPEX ) Capital (NOWC )
Net Operating Profit after Taxes or NOPAT
Dealing with Depreciation Expense, Taxes
and Cash Flow (1 of 4)
Depreciation expenses is subtracted while
calculating the firm’s taxable income. However,
depreciation is a non-cash flow expense. Therefore,
depreciation must be added back into net operating
income when calculating cash flows.
Annual Depreciation expense (using straight line
method)
= (Cost of equipment
+ Shipping & Installation Expense
– Expected salvage value)
÷ (Life of the equipment)
Example Consider a firm that purchased an
equipment for $500,000 and incurred an additional
$50,000 for shipping and installation. What will be
the annual depreciation expense if the equipment is
expected to last 10 years and have a salvage value
of $25,000?
Annual Depreciation expense
= (Cost of equipment + Shipping & Installation
Expense – Expected salvage value) ÷ (Life of the
equipment)
= ($500,000 + $50,000 − $25,000) ÷ (10)
= $52,500
Four Step Procedure for Calculating
Project Cash Flows
In order to estimate project cash flows for future
periods, we use the following four step procedure:
1. Estimate the project’s operating cash flows
2. Calculate the project’s working-capital
requirements
3. Calculate the project’s capital expenditure
requirements
4. Calculate the project’s free cash flow
Step 1: Estimate the Project’s Operating
Cash Flows
Operating cash flows is simply the sum of the first
three terms found in Equation (12-2). Specifically,
operating cash flow for year t is defined in Equation
(12-3)
Operating Cash Net Operating Depreciation

  Taxest 
Flow t Income (or Profit)t Expense t
            
NOPATt
Step 2: Calculate the Project’s Working—
Capital Requirements (1 of 2)
When a firm invests in a new project, it often
experiences an increase in sales that requires it to
extend credit, which means that the firm’s account
receivable balance will grow. In addition, new
projects often lead to a need to increase in the
firm’s investment in inventories. Both lead to cash
outflow. However, the firm may be able to finance
some or all of its inventories using trade credit
(accounts payable), this offsets the effects of the
increased investment in receivables and
inventories.
Step 2: Calculate the Project’s Working—
Capital Requirements (2 of 2)
Investment in
 Increase in   Increase in   Increase in 
Net Operating   
  
  
Accounts Receivable Inventories Accounts P ayable
W orking Capital      
 $60,000  36,000  18,000  $78,000
Step 3: Calculate the Project’s Capital
Expenditure Requirements
Capital expenditure is the term we use to refer to the cash
the firm spends to purchase fixed assets. The cost of a firm’s
purchase of fixed assets is not recognized immediately but is
allocated or expensed over the life of the asset by
depreciating the investment. We incorporate depreciation
into our computation of project cash flow by deducting it from
taxable income and then adding it back after taxes have
been computed. In this way, the effect of depreciation is
simply to reduce the tax liability created by the investment.
When the project is over, we add the salvage value of asset
to the final year’s free cash flow along with recovery of any
net operating working capital.
Step 4: Calculating the Project’s Free
Cash Flow
Operating Cash Flow

                             Increase in Capital Increase in Net
Free Cash Net Operating Depreciation
  Taxes   Expenditur es  Operating W orking
Flow Income (Profit) Expense
           (CAPEX ) Capital (NOWC )
Net Operating Profit after Taxes or NOPAT
CHECKPOINT 12.1: CHECK YOURSELF
Forecasting a Project’s Operating Cash Flow
The Problem
Crockett Clothing Company is reconsidering its
sewing machine investment in light of a change in
its expectations regarding project revenues. The
firm’s management wants to know the impact of a
decrease in expected revenues from $360,000 to
$240,000 per year. What would be the project’s
operating cash flow under the revised revenue
estimate?
Step 1: Picture the Problem (1 of 2)
Years 0 1 2 3 4 5
Cash flow OCF1 OCF2 OCF3 OCF4 OCF5
• OCF1-5 = Sum of additional revenues less

operating expenses (cash and depreciation) less
taxes plus depreciation expense
This is the information given to us:
Equipment $2,00,000
Project life 5 years
Salvage Value −
Depreciation expense $40,000 per year

Cash Operating Expenses −$5,000 per year
Revenues $240,000 per year
Growth rate for revenues 0%
Cost of goods sold/Revenues 60%
Investment in Net operating working capital −$78,000
Required rate of return 20%
Tax rate 30%
Step 2: Decide on a Solution Strategy
We can calculate the operating cash flows using
equation 12-3.
Operating Cash Net Operating Depreciation

  Taxest 
Flow t Income (Profit)t Expense t
           
NOPATt
Step 3: Solve (1 of 2)
Since there is no change in revenues or other
sources of cash flows from year to year, the total
operating cash flows will be the same every year.
Blank Year 1-5
Project Revenues (growth rate = 0%) $240,000
− Cost of goods sold (60% of revenues) −144,000
= Gross Profit $96,000
− Cash operating expense −$5,000
− Depreciation −$40,000
= Net operating income $51,000
− Taxes (30%) −$15,300
= Net Operating Profit after Taxes (NOPAT) $35,700
+ Depreciation $40,000
= Operating Cash Flows $75,700
Step 4: Analyze (1 of 3)
• This project contributes $35,700 to the firm’s net
operating income (after taxes) based on annual
revenues of $240,000.This represents a
significant drop from $69,300 when the revenues
were $360,000.
• Since depreciation is a non-cash expense, it is
added back to determine the annual operating
cash flows.
Blank Year 1-5
Project Revenues (growth rate =0%) $240,000
− Cost of goods sold (60% of revenues) −144,000
= Gross Profit $96,000
− Cash operating expense −$5,000
− Depreciation −$40,000
= Net operating income $51,000
− Taxes (30%) −$15,300
= Net Operating Profit after Taxes (NOPAT) $35,700
+ Depreciation $40,000
= Operating Cash Flows $75,700
• The project contributes $75,700 to the firm’s net
operating income (before taxes). It shows that if
the revenues drop from $360,000 to $240,000, the
operating cash flows will also drop.
Computing Project NPV (1 of 5)
Once we have estimated the operating cash flow,
we can compute the NPV using equation 11-1.
Cash Flow Cash Flow Cash Flow
Net Present Cash Flow for Year 1( CF1 ) for Year 2(CF2 ) for Year n (CFn )
    
Value ( NPV ) for Year 0( CF0 )  Discount 1  Discount   Discount 
n
1   1   1 
 Rate ( k )   Rate (k )   Rate ( k ) 
                          
Cost of making the investment =

Initial cash flow (this is typically a Present value of the investment’s cash inflows =
cash outflow, taking on a negative Present value of the project’s future cash inflows
value)
• Compute the NPV for Checkpoint 12.1: Check
Yourself based on the following additional
assumptions:
– Increase in net working capital = −$70,000 in Year 0
– Increase in net working capital = $70,000 in Year 5
– Discount Rate = 15%
• The next slide includes the original information
from Checkpoint 12.1: Check Yourself
Blank Year 0 Year 1-4 Year 5
Operating Cash flow − $75,700 $75,700
Less: Capital expenditure −$200,000 − −
Less: additional net working capital −$70,000 − $70,000
Free Cash Flow −$270,000 $75,700 $145,700
Using a Mathematical Equation
Cash Flow Cash Flow Cash Flow
Net Present Cash Flow for Year 1( CF1 ) for Year 2 (CF2 ) for Year n (CFn )
  1
 2
 n
Value or NPV for Year 0( CF0 )  Discount   Discount   Discount 
1  1   1 
 Rate ( k )    Rate (k )   Rate ( k ) 
                       
Cost of making the investment Present value of the investment’s cash inflows =
= Initial cash flow, this is Present value of the project’s future cash inflows.
typically a cash outflow taking
on a negative value.
• NPV = −$270,000 + {$75,700/(1.15)} + {$75,700/(1.15)2} +

{$75,700/(1.15)3} + {$75,700/(1.15)4} + {$145,700/(1.15)5}
= $18,560
Using an Excel Spreadsheet
NPV = −$270,000
+ npv(.15,75700,75700,75700,75700,145700)
= $18,560.51
12.3 INFLATION AND CAPITAL BUDGETING
Inflation and Capital Budgeting
• Cash flows that account for future inflation are
referred to as nominal cash flows. Real cash
flows are cash flows that would occur in the
absence of inflation.
• Nominal cash flows must be discounted at
nominal rate of interest and real cash flows must
be discounted at real rate of interest.
12.4 REPLACEMENT PROJECT CASH FLOWS
Replacement Project Cash Flows (1 of 2)
A replacement investment represents an
acquisition of a new productive asset that replaces
an older, less productive asset. A distinctive feature
of many replacement investments is that the
principal source of investment cash flows is cost
savings, not new revenues, because the firm
already operates an existing asset to generate
revenue.
Replacement Project Cash Flows (2 of 2)
To facilitate the capital budgeting analysis for
replacement projects, we categorize the investment
cash flows into two categories:
– Initial Outlay (CF0), and
– Annual Cash Flows
Category 1: Initial Outlay, CF0 (1 of 2)
Initial outlay typically requires consideration of:
– Cost of fixed assets
– Shipping and installation expense
– Investment in net working capital
– Sale of old equipment
– Tax implications from sale of old equipment
Category 1: Initial Outlay, CF0 (2 of 2)
• There are three possible scenarios when an old asset is
sold:
Selling Price of old asset Tax Implications

At depreciated value No taxes
Higher than depreciated value (or book Difference between the selling price and depreciated
value) book value is a taxable gain and is taxed at the marginal
corporate tax rate.
Lower than depreciated value (or book Difference between the depreciated book value and
value) selling price is a taxable loss and may be used to offset
capital gains.
Category 2: Annual Cash Flows
Annual cash flows for a replacement decision differ
from a simple asset acquisition because we must
now consider the differential operating cash flow of
the new versus the old (replaced) asset.
Changes in Depreciation and Taxes
The depreciation expenses will increase by the
amount of depreciation on the new asset but
decrease by the amount of the depreciation of the
replaced asset. Because our concern is with
incremental savings, we take the new depreciation
less the lost depreciation, and that difference is our
incremental change in depreciation. This is used in
cash flow calculation to determine the change in
taxes.
Changes in Working Capital
Increase in working capital is necessitated by the
increase in accounts receivable and increased
investment in inventories. The increase is partially
offset if inventory is financed by accounts payable.
Changes in Capital Spending
The replacement asset will require an outlay at the
time of its acquisition but may also require
additional capital over its life. Finally, at the end of
the project’s life, there will be a cash inflow equal to
the after-tax salvage value of the new asset if it is
expected to have one.
CHECKPOINT 12.2: CHECK YOURSELF
Calculating Free Cash Flows for a Replacement Investment
The Problem (1 of 2)
Forecast the project cash flows for the replacement
press for Leggett where the new press results in net
operating income per year of $600,000 compared to
$580,000 for the old machine. This increase in
revenues also means that the firm will also have to
increase it’s investment in net working capital by
$20,000. Estimate the initial cash outlay required to
replace the old machine with the new one and
estimate the annual cash flow for years 1 through 5.
The Problem (2 of 2)
Blank New Machine Old Machine
Annual cost of defects $ 20,000 $ 70,000
Net operating income $580,000 $580,000
Book value of equipment $350,000 $100,000
Salvage value (today) NA $150,000
Salvage value (Year 5) $ 50,000 —
Shipping cost $ 20,000 NA
Installation cost $ 30,000 NA
Remaining project life (years) 5 5
Net operating working capital $ 60,000 $ 60,000
Salaries $100,000 $200,000
Fringe benefits $ 10,000 $ 20,000
Maintenance $ 60,000 $ 20,000
• The new machine will require an initial outlay,
which will be partially offset by the after-tax cash
flows from the old machine.
• The new machine will help improve efficiency and
reduce repairs, but it will also increase the annual
maintenance expense.
Years
0 1 2 3 4 5
Cash flows(New) CF(N)0 CF(N)1 CF(N)2 CF(N)3 CF(N)4 CF(N)5
MINUS
Cash Flows (Old) CF(O)0 CF(O)1 CF(O)2 CF(O)3 CF(O)4 CF(O)5
EQUALS
Difference (New – Old) ∆CF0 ∆ CF1 ∆ CF2 ∆ CF3 ∆CF4 ∆ CF5
The decision to replace will be based on the
replacement cash flows.
 Ca sh Flow fo r   Cash Flow for 

Re placem e nt    
  the New A sset,    the O ld A sset, 
Cash Flow s, Δ CFYear t
 CF (New )   CF (O ld) 
 Year t   Year t 
Step 2: Decide on a Solution Strategy (1 of 2)
The cash flows will be calculated using equation 12-3.
 Net Operating  Increase in Capital   Increase in Net 

Free Cash   Depreciation    
  Profit After    
  Expenditures 
  Operating Working
Flow  Taxes (NOPAT)  Expense     
   (Capex)   Capital (NOWC) 
Step 2: Decide on a Solution Strategy (2 of 2)
• However, for replacement projects, the emphasis
is on the difference in costs and benefits of the
new machine versus the old.
• Accordingly, we compute the initial cash outflow
and the annual cash flows (from Year 1 through
Year 5).
Initial cash outflow (CF0)
= Cost of new equipment
+ Shipping cost
+ Installation cost
– Sale of old equipment
± tax effects from sale of old equipment.
Year 0 Blank New Machine Old Machine
Purchase price Blank −$350,000 Blank
Shipping cost Blank −$20,000 Blank
Installation cost Blank −$30,000 Blank
Working Capital Blank −$20,000 Blank
Total cost of New Blank −$420,000 Blank
Blank Blank Blank Blank
Sale Price Blank Blank $150,000
Less: Tax on gain $50,000*.30 Blank −$15,000
Net cash flow Blank Blank $135,000
Blank Blank Blank Blank
Replacement Net Blank −$285,000 Blank

Cash Flow
• Thus, the total cost of new machine of $400,000 is
partially offset by the old machine resulting in a
net cost of $285,000.
• Next we compute the annual cash from years 1-5.
Cash Flows for years 1-4 will be the same.
Analysis of Annual Years 1-4 Year 5

Cash Inflows
Blank Blank Blank
Increase in operating income $20,000 $20,000

Reduced salaries $100,000 $100,000
Reduced defects $50,000 $50,000
Reduced fringe benefits $10,000 $10,000
Total cash inflows $180,000 $180,000
Analysis of Annual Cash Out Flows Years 1-4 Years 5
Increased maintenance −$40,000 −$40,000
Increased depreciation −$50,000 −$50,000
Net operating income $90,000 $90,000
Less: Taxes −$27,000 −$27,000
Net operating profit after taxes $63,000 $63,000
Plus: depreciation $50,000 $50,000
Operating cash flow $113,000 $113,000
Less: Change in operating working capital Blank $20,000
Less: CAPEX Blank 50,0000
Free Cash Flows $113,000 $183,000
Step 4: Analyze
• In this case, we observe that the new machine
generated cost savings and also increased the
revenues by $20,000.
• Based on the estimates of initial cash outflow and
subsequent annual free cash flows for years 1-5,
we can compute the NPV.
Computing NPV (1 of 2)
Continue Checkpoint 12.2: Check Yourself
example.
• Compute the NPV for this replacement project
based on discount rate of 15%.
Computing NPV (2 of 2)
NPV can be easily computed using equation (11-1):
NPV = −$285,000 + $113,000/(1.15)1 +
$113,000/(1.15)2 + $113,000/(1.15)3 +
$113,000/(1.15)4 + $183,000/(1.15)5
= $128,595.90
Key Terms (1 of 2)
• Expansion project
• Incremental cash flow
• Nominal cash flows
• Nominal rate of interest
• Pro forma statements
Key Terms (2 of 2)
• Real cash flows
• Real rate of interest
• Replacement investment
• Sunk costs
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Financial Management:

Principles & Applications

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Relevant • Costs of purchasing plant • Incremental revenues • Proceeds from the

Incremental Project  Firm Cash Flows   Firm Cash Flows 

Operating Cash Net Operating Depreciation

 $60,000  36,000  18,000  $78,000

Operating Cash Flow

• OCF1-5 = Sum of additional revenues less

Project life 5 years

Depreciation expense $40,000 per year

Investment in Net operating working capital −$78,000

Required rate of return 20%

Tax rate 30%

Operating Cash Net Operating Depreciation

Project Revenues (growth rate = 0%) $240,000

− Cost of goods sold (60% of revenues) −144,000

= Gross Profit $96,000

− Cash operating expense −$5,000

= Net operating income $51,000

− Taxes (30%) −$15,300

= Net Operating Profit after Taxes (NOPAT) $35,700

= Operating Cash Flows $75,700

Project Revenues (growth rate =0%) $240,000

− Cost of goods sold (60% of revenues) −144,000

= Gross Profit $96,000

− Cash operating expense −$5,000

= Net operating income $51,000

− Taxes (30%) −$15,300

= Net Operating Profit after Taxes (NOPAT) $35,700

= Operating Cash Flows $75,700

Cost of making the investment =

Blank Year 0 Year 1-4 Year 5

Operating Cash flow − $75,700 $75,700

Less: Capital expenditure −$200,000 − −

Less: additional net working capital −$70,000 − $70,000

Free Cash Flow −$270,000 $75,700 $145,700

• NPV = −$270,000 + {$75,700/(1.15)} + {$75,700/(1.15)2} +

Selling Price of old asset Tax Implications

Cash flows(New) CF(N)0 CF(N)1 CF(N)2 CF(N)3 CF(N)4 CF(N)5

Cash Flows (Old) CF(O)0 CF(O)1 CF(O)2 CF(O)3 CF(O)4 CF(O)5

Difference (New – Old) ∆CF0 ∆ CF1 ∆ CF2 ∆ CF3 ∆CF4 ∆ CF5

 Ca sh Flow fo r   Cash Flow for 

 Net Operating  Increase in Capital   Increase in Net 

Purchase price Blank −$350,000 Blank

Shipping cost Blank −$20,000 Blank

Installation cost Blank −$30,000 Blank

Working Capital Blank −$20,000 Blank

Total cost of New Blank −$420,000 Blank

Blank Blank Blank Blank

Sale Price Blank Blank $150,000

Less: Tax on gain $50,000*.30 Blank −$15,000

Net cash flow Blank Blank $135,000

Blank Blank Blank Blank

Replacement Net Blank −$285,000 Blank

Analysis of Annual Years 1-4 Year 5

Increase in operating income $20,000 $20,000

Increased maintenance −$40,000 −$40,000

Increased depreciation −$50,000 −$50,000

Net operating income $90,000 $90,000

Less: Taxes −$27,000 −$27,000

Net operating profit after taxes $63,000 $63,000

Plus: depreciation $50,000 $50,000