Projections of Cash Flows for Projects (LECTURE 5)

Question 1

What are the objectives of a financial manager and how do they achieve them?

Answer 1

By making investing and financing decisions the financial manager is attempting to achieve the objective of maximising the current value of shareholders’ wealth.

Question 2

What is capital budgeting?

Answer 2

The process of identifying and selecting investment projects whose returns (cash flows) are expected to extend beyond one year.

Question 3

THE CAPITAL BUDGETING PROCESS

Answer 3

• Generate investment proposals consistent with the firm’s strategic objectives.
• Estimate after-tax incremental operating cash flows for the investment projects.
• Estimate the cost of capital.
• Evaluate project incremental cash flows.
• Select projects based on a value maximising acceptance criterion.
• Re-evaluate implemented investment projects continually and perform post-audits for completed projects.

Question 4

How are investment project proposals classified?

Answer 4

1. New products or expansion of existing projects and facilities.
2. Replacement of existing equipment or buildings.
3. Research and developing.
4. Exploration.
5. Other (e.g. safety and or pollution related)

Question 5

What are profit adding projects?

Answer 5

1. Expansion project
2. Product improvement project
3. Cost improvement project

Question 6

What are profit maintaining projects?

Answer 6

1. Replacement project

2. Necessity project

Question 7

What is the importance of cash flow?

Answer 7

Cash flow measures the actual inflow and outflow of cash, while profits represent merely an accounting measure of periodic performance.

A firm can spend its operating cash flow but not its net income.

Some firms have net losses and yet can pay dividends from cash balances, while others show profits and may not have the cash available for even a small dividend to shareholders.

Question 8

What are relevant cash flows? (INCREMENTAL CASH FLOWS)

Answer 8

The cash flows that should be included in a capital budgeting analysis are those that will occur if the project is accepted.

These are called incremental cash flows.

Question 9

What does the stand alone principle allow us to do?

Answer 9

Allows us to analyse each project in isolation from the firm simply by focusing on incremental cash flows.

Question 10

How do you determine incremental cash flows?

Answer 10

Look for incremental costs and benefits.

Ask question: would this cash flow still exist if the project did not exist?

No?: Include the cash flow in the analysis.
Yes?: Do not include the cash flow in the analysis.

Question 11

How do you discount incremental cash flows?

Answer 11

Look for incremental benefits.
A project’s success depends on the extra cash flows it produces.
You should:

1. Calculate the firm’s cash flows if it goes ahead with the project.
2. Calculate the cash flows if the firm doesn’t go ahead with the project.
3. Take the difference, which gives you the extra, or incremental, cash flow of the project.

Incremental cash flow = Cash flow with the project - Cash flow without the project

Question 12

What must be considered for expansion, replacement or new project analysis?

Answer 12

Incremental effects on revenues and expenses.

Question 13

What are the 8 important issues to be considered and valued when estimating cash flow for projects?

Answer 13

• Sunk Costs
• Opportunity Costs
• Erosion
• Synergy Gains
• Working Capital
• Capital Expenditures
• Capital Allowance and cost recovery of assets
• Tax Implications

Question 14

SUNK COSTS

Answer 14

Expenses that have already been incurred, or that will be incurred, regardless of the decision to accept or reject a project.

These costs, although part of the income statement, should not be considered as part of the relevant cash flows when evaluating a capital budgeting proposal.

Question 15

OPPORTUNITY COSTS

Answer 15

Costs that may not be directly observable or obvious, but result from benefits being lost as a result of taking on a project.
Should be included.
Should be taxed.

Question 16

CANNIBALISATION OR EROSION

Answer 16

Costs that arise when a new product or service competes with revenue generated by current product or service offered by a firm.

Question 17

SYNERGY GAINS

Answer 17

The impulse purchases or sales increases for other existing products related to the introduction of a new product.

Complementary products.

Question 18

WORKING CAPITAL

Answer 18

Additional cash flows arising from changes in current assets such as inventory and receivables and current liabilities such as accounts payables that occur as a result of a new project.

Generally at the end of the project, these additional cash flows are recovered and must be accordingly shown as cash inflows.

Even thought the net cash outflows- due to increase in net working capital at the start- may equal the net cash inflow arising from the liquidation of the assets at the end, the time value of money effects make these costs relevant.

Question 19

Working capital example:
Delta's management plans to have sufficient raw material and other working capital throughout the four years of product life cycle. Management estimates the requirement as follows:
(In table for Years across top then working capital requirements below)
Year 1:
Working Capital Requirements: £20,000
Year 2:
WCR: £10,000
Year 3:
WCR: £30,000
Year 4:
WCR: 0

Answer 19

Effects on cash flows:

Year 1:
Opening Balance: 0
Closing Balance: £20,000
Effect on Cash Flow: £(20,000)
WCR: £20,000

Year 2:
O/ Balance: £20,000
C/ Balance: £10,000
Effect on CF: £10,000
WCR: £10,000

Year 3:
O/ Balance: £10,000
C/ Balance: £30,000
Effect on CF: £(20,000)
WCR: £30,000

Year 4:
O/ Balance: £30,000
C/ Balance: 0
Effect on CF: £30,000
WCR: 0

Question 20

DEPRECIATION

Answer 20

A method of allocating the cost of a tangible asset over its useful life.

Firms can choose any method of depreciation for a certain class of assets.

Question 21

CAPITAL ALLOWANCE

Answer 21

In the UK, for tax purposes, capital allowances can be claimed when you buy assets that you keep to use in your business, e.g. equipment, machinery, business vehicles (P&M).

You can deduct some or all of the value of the item from your profits before you pay tax.

Question 22

What are the two reasons we need to deal with Capital Allowance when doing capital budgeting problems?

Answer 22

1. The tax flow implications from the annual operating cash flow.
2. The gain or loss at disposal of a capital asset.

Question 23

CAPITAL ALLOWANCE EXAMPLE:

Delta purchased a new plant to manufacture its new machines as the existing plant was running out of capacity. New plants cost Delta £200,000 with installation and shipping cost £50,000. Useful life is estimated to be 4 years after which it would have a residual value of £20,000.

Answer 23

Total cost of plant = cost of plant + shipping and installation costs

= £200,000 + £50,000 = £250,000

Residual Value = £20,000

Capital Allowance for 4 years:
At 18% reducing balance method.
Year 0:
Remaining Value: £250,000
Year 1:
Capital Allowance: £250,000 x 0.18 = £45,000
Remaining Value: £250,000 - £45,000 = £205,000

Year 2:
Capital Allowance: £205,000 x 0.18 = £36,000
Remaining Value: £205,000 - £36,000 = £168,100

Year 3:
Capital Allowance: £168,100 x 0.18 = £30,258
Remaining Value: £168,100 - £30,258 = £137,842

Year 4:
Capital Allowance: £137,842 - £20,000 = £117, 842
Remaining Value: 0

Have full cost of P&M in investment cash flows- £(250,000)

In operating cash flows remove capital allowance for each year.

In investment cash flows add Residual Value below P&M - £20,000

Question 24

ALLOCATED O/H COSTS

Answer 24

Costs such as heat, rent, electricity.

When analysing a project for acceptance, include only the extra expenses which would result from the project.

Question 25

Project Cash Flow Sheet (in order)

Answer 25

OPERATING CASH FLOWS:
Sales
- Variable Costs
Contribution
- Fixed Cash Costs
- Advertisement
- Loss of Sales
\+ Contributions from sale of existing products
- Capital Allowance
Profit Before taxes
- Taxes (x%)
Profit After Taxes
\+ Capital Allowance
Total Operating Cash Flows

INVESTMENT CASH FLOWS:
- Plant, Machinery and Building (Time 0)
\+ Residual Value (Time n)
- Opportunity Cost (After Tax x%)
Working Capital
Total Investment Cash Flows
INCREMENTAL CASH FLOWS FOR THE PROJECT (OCF + ICF)

Question 26

Ten Commandments of Forecasting Cash Flows

Answer 26

1. Estimate cash flows only on an Incremental Basis.
2. Forget sunk costs: costs incurred in the past and are irreversible.
3. Include all externalities- the effects of the project on the rest of the firm- e.g. cannibalisation & include effects of Synergy.
4. Do not forget overhead costs; be careful some of the costs may be just allocations.
5. Capital Allowance is not a cash flow, but it affects taxation (include). Add back once taxes are calculated.
6. Do not ignore investment in fixed assets (Capital Expenditures).
7. Don’t forget the residual value.
8. Do not ignore investment in net working capital.
9. Opportunity costs cannot be ignored.
10. Do not add financing costs.