CHAPTER 12

Cash Flow Estimation and Risk Analysis

Proposed Project

Total depreciable cost

Equipment: $200,000
Shipping: $10,000
Installation: $30,000

Changes in working capital

Inventories will rise by $25,000
Accounts payable will rise by $5,000

Effect on operations
New sales: 100,000 units/year @ $2/unit
Variable cost: 60% of sales

Proposed Project

Life of the project

Economic life: 4 years
Depreciable life: MACRS 3-year class
Salvage value: $25,000

Tax rate: 40%

WACC: 10%

Determining project value

Estimate relevant cash flows

Calculating annual operating cash flows.

Revenues
- Op. Costs (60%)
- Depr Expense
Oper. Income (BT)
- Tax (40%)
Net Oper Profit After Tax (NOPAT)
+ Depr Expense
Operating Cash Flow

Should financing effects be included in cash flows?

1
No, dividends and interest expense should not be included in the
analysis.
Financing effects have already been taken into account by discounting
cash flows at the WACC of 10%.
Deducting interest expense and dividends would be “double counting”
financing costs.

Identifying changes in working capital.

Calculating terminal cash flows.

Initial year net cash flow

Find Δ NOWC.
⇧ in inventories of $25,000
Funded partly by an ⇧ in A/P of $5,000
Δ NOWC = $25,000 - $5,000 = $20,000

Combine Δ NOWC with initial costs.

Equipment -$200,000
Installation -40,000
Δ NOWC -20,000
Net CF0 -$260,000

Determining annual depreciation expense (MACRS p. 5)

Year Rate x Basis Depr
1 0.33 x $240 = $ 79
2 0.45 x 240 = 108
3 0.15 x 240 = 36
4 0.07 x 240 = 17
1.00 $240

Due to the MACRS ½-year convention, a

3-year asset is depreciated over 4 years.
Annual operating cash flows
0 1 2 3 4
Equip - 200 Revenues 200 200 200 200
Ship - 10 - Op. Costs (60%) -120 -120 -120 -120
Install - 30 - Depr Expense -79 -108 -36 -17
Dep Bas - 240 Oper. Income (BT) 1 -28 44 63
- Tax (40%) 0 -11 18 25
ΔNOWC - 20 NOPAT 1 -17 26 38
Io = -260 + Dep Expense 79 108 36 17
OCF 80 91 62 55

Terminal net cash flow

2
 Recovery of NOWC $20
Salvage value 25
Tax on SV (40%) -10
Terminal CF $35
Total CF Year 4 $90

Should a $50,000 improvement cost from the previous year be

included in the analysis?

No, the building improvement cost is a sunk cost and should not be
considered.
This analysis should only include incremental investment.
If the facility could be leased out for $25,000 per year, would this
affect the analysis?
Yes, by accepting the project, the firm foregoes a possible annual cash
flow of $25,000, which is an opportunity cost to be charged to the
project.
The relevant cash flow is the annual after-tax opportunity cost.
A-T opportunity cost = $25,000 (1 – T)
= $25,000(0.6)
= $15,000

If the new product line were to decrease the sales of the firm’s other
lines, would this affect the analysis?

Yes. The effect on other projects’ CFs is an “externality.”

Net CF loss per year on other lines would be a cost to this project.
Externalities can be positive (in the case of complements) or negative
(substitutes).

Proposed project’s cash flow time line

What is the project’s Payback, NPV, IRR, MIRR?

Year 0 1 2 3 4
Cash Flows -260 80 91 62 90

12-1 Truman Industries is considering an expansion project. The necessary equipment could
be purchased for $9 million, and the project would also require an initial $3 million

3
 investment in net operating working capital. The company's tax rate is 40 percent. What
is the project's initial investment outlay?

12-2 Eisenhower Communications is trying to estimate the first-year operating cash flow (at t
= I) for a proposed project. The financial staff has collected me following information:

Projected sales $10 million

Operating costs (excluding depreciation) 7 million
Depreciation 2 million
Interest expense 2 million

The company faces a 40 percent tax rate. What is the project's operating cash flow for the first year
(t = 1)?

If this were a replacement rather than a new project, would the

analysis change?

Yes, the old equipment would be sold, and new equipment purchased.
The incremental CFs would be the changes from the old to the new
situation.
The relevant depreciation expense would be the change with the new
equipment.
If the old machine was sold, the firm would not receive the SV at the
end of the machine’s life. This is the opportunity cost for the
replacement project.

4
Project
Equip Purchase Price = $10,000
$2,000 in modifications
3 yr MACRS Life
Change in NOWC = $1,000
Salvage Value = $2,000
Tax Rate = 40%
Project lasts 4 years Cost of Capital = 10%

Revenues $9,000 per year Operating Cost=$4,000 per year

(excluding depreciation)
Find NPV, IRR, Payback

NET SALVAGE VALUE

Net Salvage Value = Salvage Value (SV) - Taxes
Taxes = (SV - Book Value) * Tax Rate
Book Value (BV) = Depreciable Basis – Accumulated Depreciation

MACRS Recovery Allowances

Class of Investment
Ownership
Year 3-Year 5-Year 7-Year 10-Year
1 33% 20% 14% 10%
2 45 32 25 18
3 15 19 17 14
4 7 12 13 12
5 11 9 9
6 6 9 7
7 9 7
8 4 7
9 7
10 6
11 3

100% 100% 100% 100%

The formulas used to develop the table are prescribed by Congress and
provided by the IRS