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Cash Flow Estimation and Capital Budgeting

Case Assignment

Estimating Project Cash Flows

ABC Golf Equipment Corporation is considering venturing into the golf club manufacturing business with a new driver golf club.  As the CFO, it is your job is to add the financial perspective to the decision. It is estimated that the current cost (t=0) of the machinery to create the golf club would cost $2,050,000 including all installation expenses. The company also expects to have to maintain $100,000 of inventories associated with the manufacturing of the golf clubs.  The machinery is expected to last ten years. The production equipment is expected to last ten years.  The project’s cash inflows are expected at begin during year 1 (t=1) and continue through all ten years (t=10).  The company expects to sell 500 golf clubs per year at an anticipated price of $500 per golf club.  Operating costs, excluding depreciation, are anticipated to be 75% of sales each year.  The project’s cost of capital is 12% and the firm’s tax rate is 35%.  Determine the project’s cash flows for years t=0 to t=10.

Note: Don’t forget to consider depreciation (use straight line) when doing the calculations.The equipment is expected to have a resale value of only $40,000 at the end of the tenth year, so this amount is the salvage for purposes of the analysis.

Before you start the analysis, you can work through the example below for guidance.

Acme Company is considering the purchase of new equipment that will be used to produce widgets.  As the CFO, you’ve been asked to complete a financial analysis of cash flows associated with this new purchase.  It is estimated that the cost (t=0) of the equipment will be $285,000, with shipping and installation costs of $25,000.  The machinery is expected to last 5 years, and is expected to sell for $30,000 at the end of the 5-year period (this remaining value is referred to as the “salvage value”). Assume that the salvage value of the equipment will be equal to the market value of the equipment (i.e., there will be no gain or loss on sale of the equipment at end of Year 5). The project’s cash inflows will begin during year 1 (t=1) and will continue through all five years (t=5).  The company expects to sell 600 widgets each year at a price of $500 per widget. Operating costs, excluding depreciation, are anticipated to be 70% of sales each year.  The firm’s tax rate is 35%.  Calculate:

1) The initial investment cash outlay, and assume that the equipment requires $20,000 of supplies (i.e., working capital) be kept on hand at all times.

2) Straight-line depreciation

3) Operating cash flows for the 5-year period

Answers:

1) Compute the initial investment cash outlay. This is the total cost of equipment purchase ($285,000), installation and shipping ($25,000), and change in net working capital ($20,000):

= $285,000 + $25,000 + $20,000

= $330,000

2) Calculate straight-line depreciation, where salvage value is $30,000 and useful life of the equipment is 5 years:

            = [($285,000 + $25,000) – $30,000] = $280,000

            = ($280,000 / 5 years) =$56,000

           

3) Calculate operating cash flows, where CFt = (revenues – costs)*(1 – tax rate)

CF1 = ($300,000 – $210,000)*(1 – 35%) = $58,500

CF2 = ($300,000 – $210,000)*(1 – 35%) = $58,500

CF3 = ($300,000 – $210,000)*(1 – 35%) = $58,500

CF4 = ($300,000 – $210,000)*(1 – 35%) = $58,500

CF5 = ($300,000 – $210,000)*(1 – 35%) = $58,500

= $58,500 x 5

= $292,500

Required:

Computations (use Excel).

Use Excel to estimate the project’s cash flows. Presentation always matter, but you want to make sure that Mr. Hillbrandt can easily follow your work. He is a busy man.

Memo (use Word).

Write a memo to Mr. Hillbrandt and comment on the three questions below.  Limit the memo to four or five paragraphs since CEOs want an initial succinct explanation to accompany the financial calculations. Start with an introduction and end with a recommendation. Each of the four or five paragraphs should have a heading.

  1. If the manufacturer plans on using debt to finance the project, should the estimated project cash flows be changed to reflect these interest charges?  Why or why not?
  2. If the manufacturer spent $200,000 studying golf clubs last year, should that cost be taken into account with this analysis?  Why or why not?
  3. If the manufacturer could rent out the factory that is storing the golf club machinery for $80,000 a year, should that be taken into account with this analysis?  Why or why not?

Short Essay (use Word).

If ABC Golf Equipment Corporation goes ahead with this new manufacturing venture, the company may no longer be allowed to represent a competing brand of golf clubs that currently accounts for 20% of its profits. Should this be considered in the analysis?  Why or why not? What other factors should be considered in making the decision?

Start with an introduction and end with a summary or conclusion. Use headings. Don’t forget to reference your sources. Maximum length of two pages.

Assignment Expectations

Each submission should include two files: (1) An Excel file; and (2) A Word document. The Word document shows the memo first and short essay last. Assume a knowledgeable business audience and use required format and length. Individuals in business are busy and want information presented in an organized and concise manner.

 

 

 

 

 

CASH FLOW ESTIMATION AND CAPITAL BUDGETING

Capital Budgeting Podcast (2014).  Pearson Learning Solutions, New York, NY.

Capital Budgeting Interactive Video. (2014).  Pearson Learning Solutions, New York,

As a financial manager, you are to focus on maximizing shareholder wealth.  You do that by accepting positive NPV projects and rejecting negative NPV projects.  In order to run a NPV calculation, you need cash flows which need to be estimated. 

There are several steps to estimate a project’s cash flows.

First, some assumptions need to be made regarding how many units of the goods are to be sold and at what price per unit.  The tax rate will also need to be determined. 

Second, depreciation needs to be calculated.  You need to decide which depreciation methodology you will use such as straight-line depreciation or MACRS. 

Third, you need to calculate the salvage value on the property and/or equipment that is disposed of at the end of the project’s life. 

Fourth, you can now proceed to put things together and estimate the project’s cash flows:

At Time 0 (today), you are likely to have the following cash outflows:

Building and/or equipment

Increase in net working capital

= total investment outlays (negative value) 

At Time 1 through Time N (the end of the project’s life), you are likely to have the following cash flows each year:

Sales revenue (units sold x sales price)

– Variable costs (usually some percentage of the sales revenue)

– Fixed operating costs

– Depreciation

= EBIT (earnings before interest and taxes)

-Taxes on the operating income

= NOPAT (net operating profit after taxes)

+ Depreciation add-back

= Operating cash flow 

Then at Time N (the end of the project’s life), you have terminal year cash flows likely consisting of the following:

+ Return of the net working capital

+ net salvage value

= Total terminal cash flows 

The project cash flows can finally be determined by adding together for the appropriate year the total investment outlays, the operating cash flows, and the total terminal cash flows. 

Now that you have the project cash flows, you can apply the various capital budgeting methodologies including net present value (NPV), internal rate of return (IRR), modified internal rate of return (MIRR), profitability index (PI), regular payback period, and the discounted payback period. 

Many of these can be calculated with Excel.

=NPV calculates a project’s NPV in Excel.

=IRR calculates a project’s IRR in Excel.

=MIRR calculates a project’s MIRR in Excel 

Review this video that focuses on NPV:

JohnFinance (2014). Net Present Value. Retrieved June 2014 from http://www.youtube.com/watch?v=GiNG9Va00fI

NPV is the best out of all the capital budgeting methodologies.  It takes into all of a project’s cash flows, it uses the time value of money, doesn’t have problems with non-normal cash flows like IRR can have when it can result in multiple IRRs, assumes reinvestment of the cash flows at the more conservative cost of capital instead of the higher less realistic IRR reinvestment rate assumption, gives consistent results with mutually exclusive and independent projects. 

Optional Resources

Bookboon.com. (2008). Corporate Finance. Retrieved from http://bookboon.com/en/economics-and-finance-ebooks 

Welch, Ivo. (2014). Corporate Finance (3rd Ed.). Chpts 4 and 12. Retrieved from http://book.ivo-welch.info/ed3/toc.html

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