Forecast the Cash Flows

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M6: Forecast the Cash Flows Part B -

Last week, you forecasted the cash flows related to starting a business with a hot dog cart. (Please see M5 attachment for the forecasted analysis from the week prior). Use each of the methods learned this week to calculate the terminal cash flow and make a decision whether the hot dog cart venture should be a go or a no-go decision.

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FINC 560 Corporate Financial Decision Making Module 5a: Capital Budgeting Part 1 Capital Budgeting Capital Asset: an asset used in the production of goods or services. Capital Budget: a plan for expenditures on capital assets. Capital Budgeting: the process of determining how much to spend and which capital assets to buy. Capital Budgeting Process • As with all corporate financial decisions, the process is cash flow based • Steps: 1. Determine the change in cash flows from the investment. 2. Forecast the amounts and timing of the cash flows. 3. Analyze the cash flows to decide whether to invest in the asset. Forecasting the Relevant Cash Flows • There are three cash flows related to a capital asset: the cost of buying it, using it, and selling it • In more formal terms: • Net Cash Outlay: the cash outflow from buying and installing the new asset, and selling the old asset (covered in this module) Forecasting the Relevant Cash Flows • Operating Cash flows: the marginal*, after-tax cash inflows from the operation of the asset over its useful economic life (covered in this module) *Marginal = cash flownew – cash flowold • Terminal Cash flow: the cash inflow from the sale of the asset at the end of its useful economic life (covered in the next module) FINC 560 Corporate Financial Decision Making Module 5b: Net Cash Outlay The Net Cash Outlay + Cost of the new asset + Installation cost - Proceeds on sale of the old asset ± Taxes on proceeds of the old asset* ± Change in net working capital* = Net cash outlay *Issues Tax Effects Issue 1: + Taxes on proceeds on sale: tax effects of selling the old asset • VARIABLES: book value, purchase price, selling price, recaptured depreciation • Book value: The purchase price of the assets less depreciation to date • Purchase price: the purchase price of the asset being sold • Selling price: the proceeds on sale of the asset being sold • Recaptured depreciation: the firm may recover some depreciation expense when the asset is sold Tax Effects POSSIBLE TAX EFFECTS: • None: proceeds on sale = book value (exchanging one asset for another asset of the same value) • Capital loss: proceeds on sale are less than book value: results in a tax credit at the capital gains tax rate (15%) Tax Effects • Capital gain: proceeds on sale are greater than the purchase price; taxed at the capital gains tax rate (15%) • Recaptured depreciation: proceeds on sale are greater than book value but less than purchase price: company recaptures some of the depreciation cost; taxed at the ordinary income tax rate (30%) Tax Effects: the Cash Distribution Table To find the tax effects of selling the asset being replaced, we use the cash distribution table. + BV Distribution Calculation Tax effect given none none + CG POS > PP? POS – PP CG tax rate (15%) - CL POS < BV? POS – BV CG tax rate (15%) + RD what’s left POS – BV – CG + CL Income tax rate (30%) = POS POS Total taxes BV = book value POS = proceeds on sale CG = capital gain PP = purchase price CL = capital loss RD = recaptured depreciation The Cash Distribution Table 1. Put the proceeds on sale at the bottom of the distribution column, then distribute the proceeds, working from the top down. 2. Complete the calculations identified in the calculation column. 3. Multiply the values in the calculation column by the tax rates in the tax effect column. 4. Add the values in the tax effect column to find the total taxes or tax credits from the sale. The Cash Distribution Table • Example 1: Proceeds on sale ($100,000) = book value ($100,000) Distribution Tax effect BV 100,000 0 CG 0 0 CL 0 0 RD 0 0 POS 100,000 0 The Cash Distribution Table • Example 2: Proceeds on sale ($80,000) < book value ($100,000) Distribution Tax effect BV 100,000 0 CG 0 0 CL (20,000) (20,000) * 0.15 = (3,000) RD 0 0 POS 80,000 (3,000) The Cash Distribution Table • Example 3: Proceeds on sale ($115,000) > Purchase price ($100,000) [assume bv is $60,000] Distribution Tax effect BV 60,000 0 CG 15,000 15,000 * 0.15 = 2,250 CL 0 0 RD 40,000 40,000 * 0.30 = 12,000 POS $115,000 $14,250 The Cash Distribution Table • Example 4: Proceeds on sale ($100,000) > book value ($60,000) but < purchase price ($120,000) Distribution Tax effect BV 60,000 0 CG 0 0 CL 0 0 RD 40,000 40,000 * 0.30 = 12,000 POS 100,000 12,000 Working Capital Issue 2: + Change in working capital • Working capital = short-term assets and liabilities • Replacing a capital asset – whether it's a machine, a factory, or another company - can have an impact on the firm's working capital. Working Capital The easiest way to understand the impact of the change in working capital on cash flows is to think of it as a change in inventory: • ↑ inventory: use cash to buy inventory = cash outflow • ↓ inventory: don't have to keep as much on hand = cash inflow Net Cash Outlay • Example 5: NJ Best, Inc. Cost of new asset Installation cost ↓ Working Capital $450,000 10,000 9,000 Old asset BV 0 POS 50,000 PP 200,000 Net Cash Outlay Solution Distrib. Tax Effects BV 0 CG 0 0 CL 0 0 RD 50,000 15,000 POS 50,000 15,000 Cost of New Asset Installation Costs Proceeds on Sale, Old Asset Taxes on Proceeds on Sale ↓ in Working Capital Net Cash Outlay 450,000 10,000 (50,000) 15,000 (9,000) 416,000 FINC 560 Corporate Financial Decision Making Module 5c: Marginal Operating Cash Flows Marginal Operating Cash Flows After we've calculated the net cash outlay, we forecast the cash flows from the operation of the new asset over its useful economic life • Marginal operating cash flows: cash flowsnew asset - cash flowsold asset Marginal Operating Cash Flows Cash flow: net income + expensesnoncash Depreciation: depreciation expense affects cash flows because it decreases the firm's taxes. However, since it is a non-cash expense, it is added back to find the operating cash flow. Depreciation • Example 6: No depreciation Depreciation 1,000 1,000 Sales 0 200 Depreciation 1,000 800 Operating income 300 240 Taxes (30%) 700 560 Net income Depreciation expense decreases taxes Depreciation • After subtracting it to find the tax effect, we add it back to net income to get cash flows • Example 7: Sales Depreciation Operating income Taxes (30%) Net income Depreciation Operating cash flow 1,000 200 800 240 560 200 760 Depreciation • We will be using straight-line depreciation: • Straight-line depreciation = Cost of new asset/years in asset’s life • Example 8: An asset costs $1,000,000, and has a useful life of 5 years. What is the annual depreciation expense for this asset? Depreciation expense = 1,000,000/5 = $200,000 Marginal Operating Cash Flows + Projected revenuenew asset - Projected operating expensesnew asset - Depreciation expensenew asset = Operating incomenew asset - Taxes = Net incomenew asset + Depreciation expensenew asset = Operating cash flownew asset - Operating cash flowold asset = Marginal operating cash flownew asset Forecasting Operating Cash Flows Relevant calculations: • Operating incomenew asset = sales – total operating expenses • Taxes = operating incomenew asset x income tax rate • Net income = operating incomenew asset – taxes • Operating cash flow = net incomenew asset + non-cash expensesnew asset • Marginal operating cash flownew asset = OCFnew asset - OCFold asset Forecasting the Relevant Cash Flows Example 9: Returning to NJ Best, Inc., recall that the new asset costs $450,000 and has a useful life of three years. Below is the information for its marginal cash flows Revenues Expenses Expense Inflation Rate Cost of new asset Operating Cash Flows, Old Asset 2018 2019 2020 299,000 389,000 429,000 128,570 10% 10% 450,000 100,000 100,000 100,000 Marginal Operating Cash Flows: NJ Best, Inc. • Solution (Depreciation = $450,000/3) Revenues Operating Expenses Depreciation Expense Earnings Before Taxes Taxes Net Income Depreciation Expense Operating Cash Flow Operating Cash Flow, Old Asset Net Operating Cash Flows 2018 299,000 128,570 150,000 20,430 6,129 14,301 150,000 164,301 100,000 64,301 2019 389,000 141,427 150,000 97,573 29,272 68,301 150,000 218,301 100,000 118,301 2020 429,000 155,570 150,000 123,430 37,029 86,401 150,000 236,401 100,000 136,401 FINC 560 Corporate Financial Decision Making Module 6a: Capital Budgeting 2 Terminal Cash Flow Capital Budgeting 2 • In Module 5, you learned to forecast the net cash outlay and operating cash flows. In this module, we will cover calculating the terminal cash flow, as well as analyzing the cash flows. • Recall that a firm will buy an asset (net cash outlay), use it over its useful life (marginal operating cash flows), and then sell it (terminal cash flow) Forecasting the Terminal Cash Flow • Terminal Cash Flow: the cash inflow from the sale or disposal of the asset at the end of its useful economic life • Three cash flows: • The amount for which the asset can be sold • The taxes on the sale of the asset, if any* • Returning working capital to the state it was in before the asset was purchased** * Use the cash distribution table ** If working capital increased (decreased) in the net cash outlay, it must be decreased (increased) in the terminal cash flow Forecasting the Terminal Cash Flow Returning working capital to the state it was in before the asset was purchased in Year 0: Net Cash Outlay Terminal Cash Flow • Inflows are negative; outflows are positive • ↑ working capital: positive • ↓ working capital: negative • Inflows are positive; outflows are negative • ↓ working capital: positive • ↑ working capital: negative Forecasting the Terminal Cash Flow Example 1: Suppose we purchased an asset that produced our product faster. We had to keep an extra $10,000 in inventory on hand, which would increase our working capital: Net Cash Outlay • ↑ working capital: add $10,000 to the net cash outlay Terminal Cash Flow • ↓ working capital: add $10,000 to the terminal cash flow Forecasting the Terminal Cash Flow Example 2: Returning to NJ Best in Module 5, we had a $9,000 decrease in working capital; in the terminal cash flow, we must increase our working capital by $9,000: Net Cash Outlay Terminal Cash Flow • ↓ working capital: subtract $9,000 from the net cash outlay • ↑ working capital: subtract $9,000 from the terminal cash flow Forecasting the Terminal Cash Flow Terminal Cash Flow: + Proceeds on sale of asset purchased in Year 0 + Taxes on proceeds on sale + Change in working capital = Terminal cash flow Forecasting the Terminal Cash Flow Example 2 (continued): Returning to NJ Best, we can sell the asset purchased in Year 0 for $100,000. What are the tax effects of the sale? (Recall that we depreciated the asset down to zero) Book value 0 Capital gain 0 Capital loss 0 Recaptured depreciation 100,000 30,000 Proceeds on sale 100,000 Total taxes 30,000 Forecasting the Terminal Cash Flow Example 2 (continued): What is the terminal cash flow for the asset NJ Best is thinking about buying? Proceeds on sale of asset purchased in year 0 100,000 Taxes on proceeds on sale (30,000) Increase in working capital (9,000) Terminal cash flow $61,000 FINC 560 Corporate Financial Decision Making Module 6b: The Go-No Go Decision Putting It All Together: NJ Best, Inc. Net cash outlay Cost of new asset Installation costs POS, old asset Taxes on POS ↓ working capital Net cash outlay 2017 450,000 10,000 (50,000) 15,000 (9,000) 416,000 Operating cash flows Revenues Operating expenses Depreciation expense Earnings before taxes Taxes Net income Depreciation expense Oper. cash flow Oper. cash flow, old asset Net operating cash flows Terminal cash flow 2020 POSasset purchased in 2017 Taxes on POS ↑ working capital Terminal cash flow 100,000 (30,000) (9,000) 61,000 2018 299,000 128,570 150,000 20,430 6,129 14,301 150,000 164,301 100,000 64,301 2019 389,000 141,427 150,000 97,573 29,272 68,301 150,000 218,301 100,000 118,301 2020 429,000 155,570 150,000 123,430 37,029 86,401 150,000 236,401 100,000 136,401 CF 1 CF 2 CF 3 CF 4 Net cash outlay Operating cash flow Operating cash flow OCF + terminal cash flow (416,000) 64,301 118,301 197,401 Capital Budgeting: the Go – No Go Decision • Now we've forecasted the relevant cash flows for a capital asset, we must analyze them and use that analysis as the basis for a go-no go decision. • Three methods used in the go-no go decision • Payback period • Net present value • Internal rate of return The Payback Period • PAYBACK PERIOD = number of years or partial years it takes to recover the net cash outlay • Decision rule: choose asset with shortest payback period • Example 3: your company needs to buy a new machine. Below are the cash flows for two possible replacements Which one should you purchase? Machine A Machine B Net cash outlay (2,000,000) (1,500,000) Cash inflow 1 700,000 500,000 Cash inflow 2 600,000 500,000 Cash inflow 3 500,000 500,000 Cash inflow 4 200,000 500,000 The Payback Period • Solution End of Year 1 End of Year 2 End of Year 3 End of Year 4 • Machine A Machine B NCO = $2,000,000 NCO = $1,500,000 700,000 500,000 600,000 500,000 1,300,000 1,000,000 500,000 500,000 1,800,000 1,500,000 200,000 2,000,000 Choose Machine B because its payback period is 3 years, while Machine A's is 4 years. Net Present Value • NET PRESENT VALUE = PVnet cash benefits – Net cash outlay = PVfuture cash flows – Net cash outlay • • Future cash flows = Marginal OCFsusing asset + Terminal CFdisposing asset Decision rules: • NPV < 0 don’t buy asset: cash outflows > cash inflows • NPV > 0 buy asset: cash outflows < cash inflows • NPV = 0 cash outflows = cash inflows: look at other issues Net Present Value Example 4: Should NJ Best invest in the asset for which we've calculated the relevant cash flows? (cost of capital = 0.05) CF 1 Net cash outlay CF 2 Operating cash flow CF 3 Operating cash flow CF 4 OCF + terminal cash flow (416,000) 64,301 118,301 197,401 Net Present Value Solution Calculator 2ND CE/C CF0 416000 +/- ENTER ↓ C01 64301 ENTER ↓ ↓ CF C02 118301 ENTER ↓ ↓ C03 197401 ENTER NPV ↓ I 5 ENTER ↓ CPT NPV -76,936.05 NJ Best should not buy the asset because the NPV < 0 Net Present Value /Users/ceciliaricci/Google Drive/560 Online/CAPITAL BUDGETING WORK.xlsx Excel: A Interest rate Year 0 Year 1 Year 2 Year 3 69 70 71 72 73 74 75 NPV B 5.00% 416,000 64,301 118,301 197,401 C (76,936) =NPV(B69,B71:B73)-B70 NJ Best should not buy the asset because the NPV < 0 Internal Rate of Return • INTERNAL RATE OF RETURN: actual return on an investment • COST OF CAPITAL = minimum required rate of return on any long-term investment • Decision rules: • IRR < COC don’t buy: doesn’t meet the minimum return required • IRR >= COC buy: meets the minimum return required Internal Rate of Return Example 5: A firm has a cost of capital of 5%. It is considering buying a machine that will require a net cash outflow of $150,000. It will generate cash flows of $62,000 in year 1, $53,000 in year 2, and $44,000 in year 3. Should it invest in this asset? Justify your answer. Internal Rate of Return • Calculator: Uneven cash flows CF 2ND CE/C CF0 150000 +/- ENTER ↓ C01 62000 ENTER ↓ ↓ C02 53000 ENTER ↓ ↓ C03 44000 ENTER IRR CPT IRR 3.154% No, the IRR < COC: 3.154% < 5.0% Internal Rate of Return • Excel: A 18 19 20 21 22 23 Outlay CF 1 CF 2 CF 3 IRR B C (150,000) 62,000 53,000 44,000 3.15% =IRR(B18:B21) No, the IRR < COC: 3.154% < 5.0% You are going to start a new business selling hot dogs from a hot dog cart. Forecast the cash flows for the year in which you buy it and the next three years. Include all of the expenses related to the cart and the hot dogs. Calculate the net cash outlay, the operating cash flows. Work with your group on this assignment and one of your group members should summarize the assumptions you made in creating your forecast and post on this group discussion board. Business License Fee - 1 year $100 Vendor Cart Location License Fee - 1 year $100 Health Department Cart Inspection Fee $25 Health Department Food Handler Training Course Cost $50 Hot Dog Cart Purchase Cost $3,500 Initial Food Inventory Purchase Cost - 1 month $300 Initial Cost of Other Cart Supplies $50 Commissary Storage Fee - 1 month $50 Vendor Cart Location Rental Fee - 1 month $300 Business Supplies $10 Business Insurance - 6 months $400 Other Business Costs (Telephone, Bank) $100 Net Cash Outlay $4,985 Year 1 Cash Flow Revenue (100 hot dogs / day @ $2 for 365 days) 73,000 COGS (100 hot dogs / day @ $1 each for 365 days) -36,500 Commissary Storage Fee - 11 months -550 Vendor Cart Location Rental Fee - 11 months -3,300 Business Insurance - 6 months -400 Depreciation Expense -350 Operating Income 31,900 Taxes (15%) -4,785 Net Income 27,115 Depreciation Expense 350 Year 1 Operating Cash Flow 27,465 Year 2 Cash Flow Revenue (110 hot dogs / day @ $2 for 365 days) 80,300 COGS (110 hot dogs / day @ $1 each for 365 days) -40,150 Commissary Storage Fee - 12 months -600 Vendor Cart Location Rental Fee - 12 months -3,600 Business Insurance - 12 months -800 Depreciation Expense -350 Operating Income 34,800 Taxes (15%) -5,220 Net Income 29,580 Depreciation Expense 350 Year 2 Operating Cash Flow 29,930 Year 3 Cash Flow Revenue (121 hot dogs / day @ $2 for 365 days) 88,330 COGS (121 hot dogs / day @ $1 each for 365 days) -44,165 Commissary Storage Fee - 12 months -600 Vendor Cart Location Rental Fee - 12 months -3,600 Business Insurance - 12 months -800 Depreciation Expense -350 Operating Income 38,815 Taxes (15%) -5,822 Net Income 32,993 Depreciation Expense 350 Year 3 Operating Cash Flow 33,343 Year 4 Cash Flow Revenue (133 hot dogs / day @ $2 for 365 days) 97,090 COGS (133 hot dogs / day @ $1 each for 365 days) -48,545 Commissary Storage Fee - 12 months -600 Vendor Cart Location Rental Fee - 12 months -3,600 Business Insurance - 12 months -800 Depreciation Expense -350 Operating Income 43,195 Taxes (15%) -6,479 Net Income 36,716 Depreciation Expense 350 Year 4 Operating Cash Flow 37,066 Notes for summary net outlay 4985 Year 1 cash flow $27,465 Year 2 $29,930 9% increase since year prior Year 3 $33,343 11% increase since year prior Year 4 $37,066 11% increase since year prior overall 35% increase since year 1 Some assumptions made during forecasting: Business insurance would stay at the same rate, location an environment would stay the same throughout the years at a consistent rate, Cost of hot dogs does not rise, Assuming no employees, just one person therefore no salaries are needed. Assuming its in an area, that a hotdog stand would be (city, near a store, at an event). Assuming the owner has some business experience. Net Cash Outlay Assumptions: In our scenario the sole proprietor is new to the hotdog business and does not need to dispose of any old assets. This results in all of the items within the net cash outlay calculation appearing as expenses. These expenses take the form of equipment, initial inventory, licences and other ancillary items. We are working under the assumption that all of these items will be purchased without financing and are inclusive of all initial business expenses. Summary of Assumptions: The cash flow for the hotdog business has a steady increase between 9%-11% throughout four years. This cash flow is based upon rising revenue, consistent operational expenses, resulting in an increasing net income. We can assume a few things within this business. For starters we assume that there will be no employees aside from the owner. This cuts cost of salaries and allows all profits to remain as the owners. Another assumption made is that the rates for insurance and expenses would stay consistent throughout the years the business is running. This consistency allows for the operational expenses to stay the same. As for the environment, we can assume that the hotdog cart would be in the same location and in an area which it will thrive. The cart would be based in a heavy populated area such as a city with very heavy foot traffic during and after daily work hours. We assume that the number of hotdogs will increase year over year due to the good reputation of the hot dog cart. In effect, the reputation increases demand bringing the Operating Cash Flow from $27,465 in year 1 to the Operating Cash Flow of $37,066 by year 4. Future Recommendations: The owner of this hot dog cart managed to maintain a positive cash flow year over year. However, positive cash flow does not necessarily guarantee future profit. With only a 9%-11% increase shown each year, if operational costs multiplied, then the business would not be profitable. Some future recommendations to address this issue would be for the hot dog cart owner to begin expanding his business to multiple carts. The additional carts can be strategically placed in other locations around the city with high foot traffic during the day and night. Additionally, the original cart can begin increasing its price of selling hot dogs by 25 cents to increase its revenue stream.
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Student’s name
Professor name
Course
Date
Forecasting Operating Cash Flows.
a) Calculating the terminal cash flow.
Terminal cash flow is calculated as follows:
Proceeds from the sale of asset purchased in year 0
+/- Taxes on the proceeds of sale
+/- Change in working capital
= ...


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