To illustrate several important aspects of cash flow analysis and see how they relate to one another, consider a capital budgeting decision that faces Silicon Valley Controls Corp. (SVCC), a California–based high-tech firm. SVCC’s research and development department has been applying its expertise in microprocessor technology to develop a small computer specifically designed to control home appliances. Once programmed, the computer system automatically controls the heating and air-conditioning systems, security system, hot water heater, and even small appliances such as a coffee maker. By increasing the energy efficiency of a home, the appliance control computer can save on energy costs and hence pay for itself. The project evaluation effort has reached the stage at which a decision about whether to go forward with production must be made.
SVCC’s marketing department plans to target sales of the appliance control computer to the owners of larger homes; the computer is cost-effective only for homes with 2,000 or more square feet of heated and air-conditioned space. The marketing vice president believes that annual sales would be 25,000 units if the appliance control computers were priced at $2,200 each. The engineering department has estimated that the firm would need a new manufacturing facility. Such a plant could be built and made ready for production in 2 years, once the “go ahead” decision is made. The plant would require a 25-acre site, and SVCC currently has an option to purchase a suitable tract of land for $1.2 million. If the decision is made to go ahead with the project, building construction could begin immediately and would continue for 2 years. Because the project has an estimated economic life of 6 years, the overall planning period is 8 years: 2 years for plant construction (years 1 and 2) plus 6 years for operation (years 3 through 8). The building would cost $8 million and have a 31.5-year life for tax purposes. A$4 million payment would be due the building contractor at the end of each year of construction. Manufacturing equipment, with a cost of $10 million and a 7-year life for tax purposes, is to be installed and paid for at the end of the second year of construction, just prior to the beginning of operations.
The project also requires a working capital investment equal to 12 percent of estimated sales during the coming year. The initial working capital investment is to be made at the end of year 2 and is increased at the end of each subsequent period by 12 percent of the expected increase in the following year’s sales. After completion of the project’s 6-year operating period, the land is expected to have a market value of $1.7 million; the building, a value of $1 million; and the equipment, a value of $2 million. The production department has estimated that variable manufacturing costs would total 65 percent of dollar sales and that fixed overhead costs, excluding depreciation, would be $8 million for the first year of operations. Sales prices and fixed over-head costs, other than depreciation, are projected to increase with inflation, which is expected to average 6 percent per year over the 6-year production period.
SVCC’s marginal federal-plus-state tax rate is 40 percent, and its weighted average cost of capital is 15 percent. For capital budgeting purposes, the company’s policy is to assume that cash flows occur at the end of each year. Because the plant would begin operations at the start of year 3, the first operating cash flows would be realized at the end of year 3. As one of the company’s financial analysts, you have been assigned the task of supervising the capital budgeting analysis. For now, you may assume that the project has the same risk as the firm’s current average project, and hence you may use the 15 percent corporate cost of capital for this project. The first step in the analysis is to summarize the investment outlays required for the project; this is done in Table. Note that the land cannot be depreciated, and hence its depreciable basis is $0. Because the project will require an increase in net working capital during year 2, this is shown as an investment outlay for that year.
Once capital requirements have been identified, operating cash flows that will occur once production begins must be estimated; these are set forth in Table. The operating cash flow estimates are based on information provided by SVCC’s various departments. Note that the sales price and fixed costs are projected to increase each year by the 6 percent inflation rate, and because variable costs are 65 percent of sales, they too will rise by 6 percent each year. The changes in net working capital (NWC) represent the additional investments required to support sales increases (12 percent of the next year’s sales increase, which in this case results only from inflation) during years 3 through 7, as well as the recovery of the cumulative net working capital investment in year 8. Amounts for depreciation were obtained by multiplying the depreciable basis by the Modified Accelerated Cost Recovery System (MACRS) depreciation allowance rates set forth in footnote c to Table.
The analysis also requires an estimation of the cash flows generated by salvage values. Table summarizes this analysis. First is a comparison between projected market and book values for salvageable assets. Land cannot be depreciated and has an estimated salvage value greater than the initial purchase price. Thus, SVCC would have to pay taxes on the profit. The building has an estimated salvage value less than the book value; it will be sold at a loss for tax purposes. This loss will reduce taxable income and thus will generate a tax savings; in effect, the company has been depreciating the building too slowly, so it will write off the loss against ordinary income. Equipment, however, will be sold for more than book value, so the company will have to pay ordinary taxes on the $2 million profit. In all cases, the book value is the depreciable basis minus accumulated depreciation, and the total cash flow from salvage is merely the sum of the land, building, and equipment components.
As illustrated by this SVCC example, cash flow estimation involves a detailed analysis of demand, cost, and tax considerations. Even for fairly simple projects, such as that described here, the analysis can become complicated. Innovative, powerful spreadsheet software makes possible the accurate estimation of cash flows under a variety of operating assumptions, for even the most complex projects. More than just allowing managers to enter and manipulate data in several useful ways, these spreadsheet programs also incorporate various effective techniques for project evaluation. Among these techniques are a number of valuable capital budgeting decision rules.
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