Introduction to Finance

553
Year
Project 
Hitek
Project 
Lotek
0 $–453,000 
$–276,000
1 
132,000 
74,000
2 
169,500 
83,400
3 
193,000 
121,000
4 
150,700 
54,900
5 
102,000 
101,000
6 
0 
29,500
7
0 
18,000
a. 
Determine the PV of the cash infl ows for each project and 
then calculate their NPVs by subtracting the appropriate dollar 
amount of capital investment. Which, if either, of the projects is 
acceptable?
b. 
Calculate the IRRs for project HiTek and project LoTek. Which 
project would be preferred?
c. 
Assume that BioTek uses RADRs to adjust for diff erences in 
risk among diff erent investment opportunities. BioTek projects 
are discounted at the fi rm’s cost of capital of 15 percent. A risk 
premium of three percentage points is assigned to LoTek-type 
projects, while a 6 percentage point risk premium is used for pro-
jects similar to HiTek. Determine the risk-adjusted PV of the cash 
infl ows for LoTek and HiTek and calculate their risk-adjusted 
net present values. Should BioTek invest in either, both, or neither 
project?

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554
Estimating Project Cash Flows
LO 17.12
(Learning Extension) Apply cash fl ow estimation and capital budgeting methods to 
diff erent types of projects.
LO 17.13
(Learning Extension) Apply cash fl ow estimation and NPV analysis to a revenue 
expanding project, a cost-saving project, and to a need to determine a minimum bid price.
How are cash fl ow estimates developed? In this section, we give you a practical overview of 
how an analyst develops the data to estimate cash fl ows.
17.12
Project Stages and Cash 
Flow Estimation
A typical project encompasses three stages. First is the initial outlay or investment. Second 
is the operating life of the project, be it market expansion, a building, or technology. The 
fi nal stage is at the end of the project’s useful life. For projects involving fi xed assets or 
business lines, this can involve selling assets and reclaiming working capital. But for pro-
jects that have an indefi nite life, such as business expansion, a few years of careful cash fl ow 
estimations may give way in the third stage to an estimate of terminal value—that is, what 
the present value of project cash fl ows might be far into the future. We’ll examine each of 
the three stages below.
Initial Outlay
The fi rst cash fl ow estimate is the initial investment in the project. Engineering estimates may 
be available for projects that require designing or modifying equipment and buildings. Engin-
eers will examine preliminary designs or architectural sketches and estimate the quantities of 
materials needed. Estimates of purchases, transportation costs, and construction expenses can 
be developed based on current market prices.
Another way to estimate a project’s acquisition or construction cost is to solicit bids from 
construction or equipment manufacturers based upon preliminary design specifi cations. An 
approximate cost can be determined through discussions with bidding fi rms. If the fi rm is 
large enough that it has an in-house engineering or real estate acquisition staff , this expertise 
can be tapped to estimate relevant costs.
The expense of developing cost estimates is a sunk cost. That money is spent and gone 
whether or not the proposed project is accepted; it should be excluded from the project’s cash 
fl ow estimates. However, the initial outlay estimate must consider opportunity costs if the 
project will use property or equipment presently owned by the fi rm.
The investment cost estimate may have to be adjusted if the project involves replacing 
an asset with another, presumably newer and more cost-effi
cient model. If the old asset is 
going to be sold, the investment outlay must be reduced by the after-tax proceeds from the 
sale of the old asset. We will shortly discuss some of the specifi cs of adjusting for salvage 
value.
Finally, even though a project’s initial outlay may involve property and equipment (invest-
ing cash fl ows), it may have implications for net working capital (operating cash fl ows). For 
example, if a project aff ects the fi rm’s production process, inventory levels may change. New 
raw materials needs may aff ect accounts payable. These kinds of expected changes in net 
working capital must be included as part of the initial outlay.
Learning Extension