FIN 64 Cash Flow Forecasting Professor Robert B.H. Hauswald Kogod School of Business, AU Vitamin C Cash flows matter: focus on economics not earnings or other accounting measures Continue our focus on cash flows example of pro-forma statements and NPV revisit cash flows: forecasting taking uncertainty into account: scenarios example of scenario analysis 2/8/20 Cash Flow Forecasting Robert B.H. Hauswald 2
Incremental Cash Flows Stand-alone principle Project cash flows Pro forma analysis: how to generate CFs investment needs: assets required funds: financing Terminal value Corporate decision making 2/8/20 Cash Flow Forecasting Robert B.H. Hauswald 3 Decision Criteria Net Present Value - NPV: brute force pros/cons: Internal Rate of Return - IRR: beauty contest pros/cons: Payback period: take the money and run pros/cons: Adjusted PV - APV: divide and conquer separate out economics and financials of project Options approach: wait and see valuation of strategy, flexibility and managerial decisions 2/8/20 Cash Flow Forecasting Robert B.H. Hauswald 4
Project Estimates Garbage in, garbage out: the hard part is modeling project economics and cash flows translating scenarios and assumptions into cash 2/8/20 Cash Flow Forecasting Robert B.H. Hauswald 5 The Baldwin Company: An Example Costs of test marketing (already spent): $250,000. Current market value of proposed factory site (which we own): $50,000. Cost of bowling ball machine: $00,000 (depreciated according to ACRS 5-year life). Increase in net working capital: $0,000. Production (in units) by year during 5-year life of the machine: 5,000, 8,000, 2,000, 0,000, 6,000. Price during first year is $20; price increases 2% per year thereafter. Production costs during first year are $0 per unit and increase 0% per year thereafter. Required rate of return = corporate hurdle rate: 0% Working Capital: initially $0,000 changes with sales. 2/8/20 Cash Flow Forecasting Robert B.H. Hauswald 6
Baldwin Investment Cash Flows Year 0 Year Year 2 Year 3 Year 4 Year 5 Investments: () Bowling ball machine 00.00 2.76* (2) Accumulated 20.00 52.00 7.20 82.72 94.24 depreciation (3) Adjusted basis of 80.00 48.00 28.80 7.28 5.76 machine after depreciation (end of year) (4) Opportunity cost 50.00 50.00 (warehouse) (5) Net working capital 0.00 0.00 6.32 24.97 2.22 0 (end of year) (6) Change in net 0.00 6.32 8.65 3.75 2.22 working capital (7) Total cash flow of 260.00 6.32 8.65 3.75 92.98 investment [() + (4) + (6)] * We assume that the ending market value of the capital investment at year 5 is $30 (in thousands). Capital gain is the difference between ending market value and adjusted basis of the machine. The adjusted basis is the original purchase price of the machine less depreciation. The capital gain is $24.24 ($30 $5.76). We will assume the incremental corporate tax for Baldwin on this project is 34 percent. Capital gains are now taxed at the ordinary income rate, so the capital gains tax here is $8.24 [0.34 ($30 $5.76)]. The after-tax capital gain is $30 [0.34 ($30 $5.76)] = 2.76. 2/8/20 Cash Flow Forecasting Robert B.H. Hauswald 7 Baldwin Investment Cash Flows Year 0 Year Year 2 Year 3 Year 4 Year 5 Investments: () Bowling ball machine 00.00 2.76* (2) Accumulated 20.00 52.00 7.20 82.72 94.24 depreciation (3) Adjusted basis of 80.00 48.00 28.80 7.28 5.76 machine after depreciation (end of year) (4) Opportunity cost 50.00 50.00 (warehouse) (5) Net working capital 0.00 0.00 6.32 24.97 2.22 0 (end of year) (6) Change in net 0.00 6.32 8.65 3.75 2.22 working capital (7) Total cash flow of 260.00 6.32 8.65 3.75 92.98 investment [() + (4) + (6)] At the end of the project, the warehouse is unencumbered, so we can sell it if we want to. corresponds to what principle of cash-flow analysis? 2/8/20 Cash Flow Forecasting Robert B.H. Hauswald 8
Baldwin Sales Year 0 Year Year 2 Year 3 Year 4 Year 5 Income: (8) Sales Revenues 00.00 63.00 249.72 22.20 29.90 Recall that production (in units) by year during 5-year life of the machine is given by: (5,000, 8,000, 2,000, 0,000, 6,000). Price during first year is $20 and increases 2% per year thereafter. Sales revenue in year 3 = 2,000 [$20 (.02) 2 ] = 2,000 $20.8 = $249,720. 2/8/20 Cash Flow Forecasting Robert B.H. Hauswald 9 Baldwin Operating Costs Year 0 Year Year 2 Year 3 Year 4 Year 5 Income: (8) Sales Revenues 00.00 63.00 249.72 22.20 29.90 (9) Operating costs 50.00 88.00 45.20 33.0 87.84 Again, production (in units) by year during 5-year life of the machine is given by: (5,000, 8,000, 2,000, 0,000, 6,000). Production costs during first year (per unit) are $0 and (increase 0% per year thereafter). Production costs in year 2 = 8,000 [$0 (.0) ] = $88,000 2/8/20 Cash Flow Forecasting Robert B.H. Hauswald 0
Baldwin Depreciation Year 0 Year Year 2 Year 3 Year 4 Year 5 Income: (8) Sales Revenues 00.00 63.00 249.72 22.20 29.90 (9) Operating costs 50.00 88.00 45.20 33.0 87.84 (0) Depreciation 20.00 32.00 9.20.52.52 Depreciation is calculated using the Accelerated Cost Recovery System (shown at right) Our cost basis is $00,000 Depreciation charge in year 4 = $00,000 (.52) = $,520. Year ACRS % 20.00% 2 32.00% 3 9.20% 4.52% 5.52% 6 5.76% Total 00.00% 2/8/20 Cash Flow Forecasting Robert B.H. Hauswald Baldwin Net Income Year 0 Year Year 2 Year 3 Year 4 Year 5 Income: (8) Sales Revenues 00.00 63.00 249.72 22.20 29.90 (9) Operating costs 50.00 88.00 45.20 33.0 87.84 (0) Depreciation 20.00 32.00 9.20.52.52 () Income before taxes 30.00 43.20 85.32 67.58 30.54 [(8) (9) - (0)] (2) Tax at 34 percent 0.20 4.69 29.0 22.98 0.38 (3) Net Income 9.80 28.5 56.3 44.60 20.6 Consolidate the NI computation: subtracting or/and adding in net revenue treatment depreciation treatment 2/8/20 Cash Flow Forecasting Robert B.H. Hauswald 2
Incremental Cash Flows: Baldwin Year 0 Year Year 2 Year 3 Year 4 Year 5 () Sales Revenues (s.a. 8) 00.00 63.00 249.72 22.20 29.90 (2) Operating costs (s.a. 2) -50.00-88.00-45.20-33.0-87.84 (3) Tax at 34 percent (s.a. 2) -0.20-4.69-29.0-22.98-0.38 (4) Cash flow from operations 39.80 60.5 75.5 56.2 3.68 [() - (2) - (3)] (5) Total cash flow of 260.00 6.32 8.65 3.75 92.98 investment (s.a. 7) (6) Total project cash flow 260.00 39.80 54.9 66.86 59.87 224.66 [(4) + (5)] $39.80 $54.9 $66.86 $59.87 $224.66 NPV = $ 260+ + + + + 2 3 4 (.0) (.0) (.0) (.0) (.0) 5 NPV = $5,588.05 Discount Rate 4% 0% 5% 20% NPV 23.64 5.588 5.472-3.35 2/8/20 Cash Flow Forecasting Robert B.H. Hauswald 3 NPV Baldwin Company: Calculator CF0 260 CF4 59.87 CF 39.80 F4 F CF5 224.66 CF2 F2 54.9 F5 CF3 66.86 I 0 F3 NPV 5,588.05 2/8/20 Cash Flow Forecasting Robert B.H. Hauswald 4
Cash Flows from Assets For any period estimate:. sales, (based on growth/ market share) 2. costs and thus the profit margin (as a % of sales typically) 3. capital spending (i.e. factory expansion) and also 4. net working capital requirements: Cash flow from assets = + operating cash flow - incremental capital spending / economic depreciation - change in net working capital where (net) operating cash flow (EBITDA) = + earnings before interest and taxes (EBIT) - taxes + depreciation 2/8/20 Cash Flow Forecasting Robert B.H. Hauswald 5 A Simple Income Statement SALES - Cost of Goods Sold (CGS) - Selling, General and Admin. Expense - Depreciation ----------------------------------------- = EBIT - Taxes + Depreciation ----------------------------------------- = Operating Cash Flow (Net Income) Pro forma income statement: forecast of the income statement not adding back depreciation, subtracting interest into the future for the relevant number of years 2/8/20 Cash Flow Forecasting Robert B.H. Hauswald 6
Estimating Investment Costs. Cost of acquiring investment and/or installing it 2. Additions to Net Working Capital: + Cash + AR + Inventory - A/P - Taxes Payable 3. Net Proceeds from Sales of existing assets. 4. Tax Effects associated with Sales and Purchases. Tax write-offs or capital gains tax on depreciation recapture Investment Tax Credit 2/8/20 Cash Flow Forecasting Robert B.H. Hauswald 7 Fairways Driving Range: Revenues and Capital Costs Because of the growing popularity of golf, two friends estimate a driving 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 equipment is 5-year ACRS property, and is expected to have a salvage value of 0% of cost after 6 years. Stocking a small shop selling tees, visors, gloves, towels, sun-block, etc., plus a checking account : Net working capital $3,000 to start, growth of 5% per year. 2/8/20 Cash Flow Forecasting Robert B.H. Hauswald 8
Operating Costs 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 5%. Project is to be evaluated over a 6 year life: Should they proceed? 2/8/20 Cash Flow Forecasting Robert B.H. Hauswald 9 Revenue Projections Get XLS to confess 2/8/20 Cash Flow Forecasting Robert B.H. Hauswald 20
Projected Revenues Year Number of buckets Revenues @$3.00 per bucket Costs of balls and buckets 2 3 4 5 6 2/8/20 Cash Flow Forecasting Robert B.H. Hauswald 2 Depreciation on $8,000 of equipment Year ACRS % Depreciation Book Value 20.00% $3,600 $4,400 2 32.00% 5,760 8,640 3 9.20% 3,456 5,84 4.52% 2,074 3,0 5.52% 2,074,036 6 5.76%,036 0 2/8/20 Cash Flow Forecasting Robert B.H. Hauswald 22
Pro Forma Income Statement Year 2 3 4 5 6 Revenues - Variable costs - Fixed costs - Depreciation = EBIT - Taxes = Net income 2/8/20 Cash Flow Forecasting Robert B.H. Hauswald 23 Net Working Capital Projection Year Net WC Increase in WC 0 2 3 4 5 6 2/8/20 Cash Flow Forecasting Robert B.H. Hauswald 24
Projected Cash Flows Year EBIT - Taxes + Depr. = Operating CF 2 3 4 5 6 2/8/20 Cash Flow Forecasting Robert B.H. Hauswald 25 Total Cash Flows Year + Operating CF - Increase in WC - Capital spending = Total CF 0 2 3 4 5 6 And the final NPV =? ; The IRR =?; 2/8/20 Cash Flow Forecasting Robert B.H. Hauswald 26