Introduction to Finance

17

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17.12 Project Stages and Cash Flow Estimation
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Cash Flows During the Project’s Operating Life
Operating cash fl ows can be estimated using equation 17-4. The diffi
culty is determining the 
amounts for sales, costs, depreciation, taxes, and net working capital changes in order to enter 
these into the calculations.
A project with the main purpose of reducing costs should have a presumed impact on 
sales of zero. Expected cost savings can be derived from engineering estimates or production 
management techniques. Suppliers can often estimate the potential cost savings from new 
machines or processes, but these sales claims may be untrustworthy; the careful manager 
runs independent tests and trial runs, preferably at the plant that will house the new project, 
to verify any claims.
One asset often replaces another in cost-saving projects. This can involve a diff erence in 
depreciation schedules between the old and new asset (not to mention salvage value diff er-
ences), which the analyst must incorporate into the analysis. More will be said about this point 
later in the chapter when we review an example.
Revenue enhancing or revenue sustaining projects build or protect a fi rm’s competit-
ive advantage or extend its market penetration. Market researchers can provide detailed data 
about new products or features and the costs to develop them in order to help the fi nancial 
analyst construct cash fl ow estimates. Such research may include sales forecasts or informa-
tion on price, quantity, and quality trends in the market segment. If the project concerns one 
of the fi rm’s current products, the production staff can often provide data to estimate the cost 
implications of greater sales. If the project involves a new product off ering, engineers or the 
production staff should be able to provide production cost estimates. Depreciation expense 
can be estimated from the estimated initial investment outlay for the property or equipment 
needed for the project.
Net working capital may change over the course of the project’s life. Operating cash fl ow 
estimates must refl ect these changes in net working capital.
Salvage Value and NWC Recovery at Project Termination
If the project is expected to have a defi nite life span, the analysis must consider the salvage 
value of the project’s assets. Any increases in net working capital in the course of a project 
are generally assumed to be recovered by the fi rm and converted to cash at the project’s 
end.
Any property or equipment that is expected to be sold, either for use by someone else or 
for scrap, will generate infl ows. The cash fl ow for the sale will have to be adjusted to account 
for tax implications if the asset’s selling price diff ers from its book value. Book value (BV) 
represents an asset’s original cost less accumulated depreciation. At the end of a project, if 
the selling price of an asset equals its book value there is no need for tax adjustments; the 
after-tax cash fl ow equals the selling price. If the asset’s selling price exceeds its book value, 
then the asset was depreciated too quickly on the fi rm’s books. The amount of the recovered 
depreciation (Price − BV) is taxed at the fi rm’s marginal tax rate for ordinary income. Thus, 
the tax owed the government is 
T
(Price − BV). The total after-tax proceeds will be Price − 
T
(Price − BV); that is, the selling price less the tax obligation. If the selling price is less than 
the asset’s book value, the fi rm suff ers a loss. This loss refl ects failure to depreciate the asset’s 
book value quickly enough. The fi rm’s taxable income is reduced by the amount of the loss, 
and taxes will be reduced by 
T
(Price − BV).
If 
T
(Price − BV) is positive, the fi rm owes taxes, reducing the after-tax proceeds of the 
asset sale; if 
T
(Price − BV) is negative, the fi rm reduces its tax bill, increasing the after-tax 
sale proceeds. When 
T
(Price − BV) is zero, the transaction causes is no tax adjustment to be 
made. Thus, a general relationship for the after-tax salvage value is the following:
After-tax salvage value = Price − 
T
(Price − BV) 
(LE17-1)
Let’s look at an example. Assume an asset originally cost $100, had an expected life of ten 
years, and was depreciated on a straight-line basis. Seven years later, the fi rm must determine 
the after-tax cash fl ow from selling the asset if the selling price is (a) $50, (b) $30, or (c) $15. 
Assume the marginal tax rate for ordinary income is 34 percent.

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C H A PT E R 1 7 Capital Budgeting Analysis
First, we must determine the asset’s book value, and then equation LE17-1 can be used 
to compute cash fl ows for three situations. With an original cost of $100 and straight-line 
depreciation over ten years, its yearly depreciation expense is $100∕10 = $10. As seven years 
have passed, accumulated depreciation is now $70 (7 × $10∕year), so the asset’s book value is 
$100 minus $70, or $30.
If the asset’s sale price is $50, the fi rm has recovered some past depreciation and it must 
reduce the salvage value cash fl ow by the resulting tax liability. The after-tax salvage value is 
the following:
Price − 
T
(Price − BV) = $50 − 0.34($50 − $30) = $43.20
If the asset’s sale price is $30, this price equals the book value. According to equation LE17-1, 
the after-tax salvage value is $30: Price − 
T
(Price − BV) = $30 − 0.34($30 − $30) = $30.
If the asset’s sale price is $15, the fi rm suff ers a loss, as the price is below book value. 
This means the salvage value cash fl ow will rise above $15 by the amount of the subsequent 
tax savings. The after-tax cash fl ow equals the following:
Price − 
T
(Price − BV) = $15 − 0.34($15 − $30) = $20.10.
By their nature, after-tax salvage values are diffi
cult to estimate since the salvage value and 
expected future tax rate are uncertain. As a practical matter, if the project termination is many 
years in the future, the present value of the salvage proceeds will be small and inconsequential 
to the analysis. If necessary, however, the analyst can develop a salvage value forecast in two 
ways. First, one could tap the expertise of those involved in secondary market uses of the asset. 
Second, one could forecast future scrap material prices for the asset. Typically, the after-tax 
salvage cash fl ow is calculated using the fi rm’s current tax rate as an estimate for the future 
tax rate.
The problems of estimating values in the distant future are diffi
cult when the project 
involves a major strategic investment that the fi rm expects to maintain over a long period of 
time. In such a situation, the fi rm may estimate annual cash fl ows for a number of years (say, 
ten years) and attempt to estimate the project’s value as a going concern at the end of this time 
horizon. One method the fi rm can use to estimate the project’s going-concern value is the 
constant dividend growth model discussed in Chapter 10:
Price
horizon
=
Dividend
horizon + 1
r
−
g
(LE17-2)
The “salvage value” of the project is its going-concern value at the end of the time hori-
zon; the dividend is its expected operating cash fl ow one year past the horizon. The required 
rate of return, 
r
, is the project’s required return. The expected growth rate, 
g
, is the analyst’s 
estimate of the constant growth rate for operating cash fl ows after the horizon.