Estimating Earnings and

Cash F$ws on Projects

N CHAPTER 8, we established a process for estimating hurdle rates for prqects

from the perspective of both equiry investors and the firm. Thus, we argued that
Boeing, in deciding on rvhether to invest in the Super Jumbo Jet, should examine
whether the expected return on this investment would be greater than 10.77Yo to
its equiqv investors elr,d9.32% to the firm. To complete the analysis, however,we
have to estimate how much Boeing wi-1l make as a return on this investment.
In this chapter, rve take our first steps toward measuring proJect returns. We
begin with an assessment of holv to forecast project revenues and expenses, and the
tools that are available to firms for this endeavor. We follow up by converting these
forecasts into expected accounting earnings on the project; this allows us to see how
the project r'vill contribute to the firmt earnings over time. We then explore the
reasons for the differences berween accounting earnings and cash flows, and present a

our arguments for using cash flows rather than earnings in assessing project returns. I

.We
next introduce the notion of incremental cash flows, t'hich measure how much
an investment or pr:oject creates in cash flows to the firm or entiry considering it. :

Fina1ly, we present the arguments for considering the timing of cash flows in returns
measurement; cash flows that occur sooner should be weighted more than cuh : I
flows that occur later in a project's liG. I
In addition to laying ouc these steps, we also present investment analysis from
rwo perspectives. In the first, we consider the returns oniy to equiiy investors, both
in accounting earnings and in cash flows, as a prelude to comparing these returns to
the cost of equiry In the second, we consider the returns to the entire firm, again
in terms of earnings and cash flows, as preparation for the comparison to the cost
of capital.

Estimating trroject Revenues and Expenses

How do we estimate a projecti expected revenues and expenses? The key word in
this question is "estimate." No one, no matter what his or her skill at forecasring and
degree of preparation, can forecast with certainry how a prqect will rurn out. All of
the risks described in the previous chapter, ranging from estimation errors specific to
the project, to competitive reaction, to technological advances, and to unanricipated
increases.in interest rates, can cause actual results to deviate from expectarions. In this
section, wr consider three ways in u'hich firms try to deai rvith this unc<irtainry. Some

256
ESTIMATING PRO.JECT REVENUES AND EXPENSES 257

firms use the experience they have acquired from investing in similar prqects in the past,
others employ market testing to gauge the potential demand and revenues, and still orh-
and ers consider what they will make under di{ferent economic scenarios.

CtS Experience and History

The process of estimating prqect revenues and expenses is simplest for firms that con-
sider the same kind of projects repeatedly. These firms can use their experience from
similar projects that are already in operation to estimate expected values for new proj-
ects. The Home Depot, lor instance, analyzes dozens of new home improvement
It also has hundreds ofstores in operationl at different stages in their
stores every year.
life cycles; some of these stores have been in operation for several years, and others
have been around for only a couple ofyears. Thus, when forecasting revenues for a
new store, The Home Depot can draw on this rich database to make its estimates
e rates for projects more precise. The firm has a reasonable idea of how iong it takes a new store to
.us, we argued that become established and how store revenues change as the store ages and new stores
et, should examine open close by.
ler than 10.77% to In other cases, experience can prove useful for estimating revenues and expenses
alysis, howeveq ws on a new investment. An oil companu in assessing whether to put up an oil ng, comes
.s investment. to the decision with a clear sense of whar the costs are of putting up a rig and how
,roject returns. We long it r.vill take for the rig ro be productive. Similarly, a pharmaceutical firm, when
I expenses, and the introducing a new drug, can bring to its analysis its experience with other drugs in
ry converting these the past, how quickly such drugs are accepted and prescribed by docrors, and how
lows us to see how responsive revenues are to pricing polic,v.
: then e4plore the 'we are not sr-rBgesting
that rhe experience rhese firms have had in analyzing sim-
. flows, and present ilar prgects in the past removes uncertainfy about rhe project from the analysis. The
ng project returns. Home Depot is still exposed to considerable risk on each new srore that it analyzes
leasure how much toda,v,but the experience does make the estimation process easier and the esrimation
riry considering it. error smaller than it r,vould be for a firm that is assessing a unique project.
sh flows in rerurns
d more than

nent analysis
cash

fum
H ln Prastiue $"?: llsin$ Eurnent Frsiects to Estimata Expeeted
rity investors, both firuenues on a l{sut Pnoiecl
19 these returns to fusume that The Home Depot is analyzing a new home improvement store that will fol-
entire frm, again low its traditional format.2 The firm needs to make several estimates when analyzing a
)arison to the cost new store. Perhaps the most important is the likely revenues at the store. Given that The
Home Depot's store sizes are similar across locations, the firm can get an idea of the
expected revenues by looking at revenues at their existing stores. Figure 9.1 summarizes
the distribution3 of annual revenues at existing stores in 1998. This distribution not only
yields an expected revenue per store of about $44 million. but also provides a measure of
the uncertainty associated with the estimate, in the form of a 'standard deviation in
The key word in
at forecasting and
r At the end of 1998, The Home
ill turn out. All of Depot had 7,13 Home Depot stores in operation,707 of which u'ere in lhe
Unired States.
1 errors specific to 2 A rypical Home Depot store has store space of about 100,000 square feer and carries a wide range of home
I to unanticipated improvement products, from hardware to flooring.
(pecadons. In this 3 This distribution is a hypothetical one, since The Home Depot does not provide this inlormadon ro oursiders.
uncdrtainty. Some It does hare the information internally
258 CHAPTER NINE,/ ESTIIV{ATING EARNINGS AND CASH FLOWS ON PROJECTS

Figure 9.1
RevenueYstore: Home 9.3 Operatir
Depot U.S. Stores in Asa
1998 of

revenues per store. The data can be broken down.ftrrther. For instance, we look at
the
average revenues per store, categorized by the
/ge of the stores. for all Home D"pot:
stores in 1998, in Figure 9.2. This infollallgDJdn be used to estimate the expected isy.:i
enues at a new stofe each year over its life and to make a judgment on how long the
life
of the store should be for analytical purposes. ln this case, it looks like the aniual rev-
enues at a store start slightly below average, peak when the store is about five to six
vears .:
old, and decline beyond that. :

, Based on the information that The Home Depot has collected on its other stores, we
will assume

Figure 9.2 Annual

RevenueYstore and
Store Age

45

40

35

4 ,5 6 7 8 9 >10
ESTIMATING PROJECT REVENUES AND EXPENSES 25g

Figwe 9.3 Operating

Expenses A5 a
180
Percentage of
Revenues '160

140
ao
o
o 120
(r,
o 100
o
..t
E 80
zt
60

40

20
88.5-89 89-89.5 89.5-90 90-00.5 90.5_91 91-91.5 91.5-92
Operating Expenses as percent of Revenues (dollars)

l, we look at the o That the new store being considered by The Home Depot
will have expected revenues
all Home Depot of $40 million in year 1 (which is approximately the average revenue per store at exist-
:he expected rev- ing stores after one year in operation).
how long the life o That these revenues will grow So/o alear.
l the annual rev- r That our analysis will cover 10 years (since revenues start dropping at existing stores
t five to six years after the tenth year).
ln addition to the revenues, we need to assess the expected operating expenses at the
other stores, we
store. Here again, we could look at operating expenses (not including depreciation) as a
percentage of revenues at existing stores. Figure 9.3, for instance, sumniarizes
this statis-
tic at existing stores in 1998. The operating expenses average 90% of revenues at existing
stores, and we will use that statistic to estimate expected operating expenses at the
new
store.

/ CC g,t:For what type of projects is historical experience likely to be most usefiil in

making predictions of expected revenues and income? For what types is it least
likely to be useful?

Market Testing
Although some firms can use the experience from similar projects in the past to esti-
mate revenues and expenses on new projects, other firms have to assess projects that
are different from exiiting projects. In some cases, the products o. services being con-
sidered by the fir-m might cater to a new market, the magnirude of,which the firm
is
uncertain about. In other cases, the firm may consider offering a new product or serv-
ice to an existing market and may be unsure about the potentiil demand for the prod-
uct. The firm may need a preliminary asSessment of the market before actually invest-
ing in the project. This preliminary assessment can come either from a market survey
or from market testing.
In a market survey, potential customers are asked about the'product or service
being considered in order to gauge the interest they would have in acquiring it. The
260 CHAPTER NINE / ESTIMAIING EARNINGS AND CASH FLOWS ON PROJECTS

nst.o.rg
results usually are qual,itative and indicate whether the interest is or weak,
allowing the firm to decide whether to use optimistic forecasts for revenues (if the
interest is strong) or pessimistic forecasts (if the interest is weak). As an example, con-
sider InfoSoft, the private sofrware firm that we have been analyzing, and assume that
it is thinking about creating a web site to seil its sofrware on1ine rather than through
sofEware retailers. it might decide to conduct a market survey of potential custorners4
to see whether they would be interested in buying software online. Based on the
response to the survey, it can then decide rvhether the revenues at the online store will
be strong or weak.
A market survey may not provide enough inlbrmation for forecasting a project's
revenues for companies planning to invest large amounts on a new product or serv-
ice. These companies will often test market the concept on smaller markets before
introducing it on a larger scale. This approach had appeal, for instance, to The Home
Depot in analyzing its Home Depot Expo stores, which were designed to seil upscale
furnishings. Since these stores appeal to a different market than the one that its exist-
ing stores cater to, The Home Depot opened eight Expo stores in diiTerent parts of
.the country and used chese stores to test and refine the concept. In its 1999 annual
report, The Home Depot reported plans to considcr a new concept
-
smaller hard-
ware stores, called Villager stores, with a wider range of home enhancement productss
and test it by opening a Villager store in NewJersey. Test marketing not only allows
H
-firms to test out the product or serr,'ice directly, but aiso yields far more detailed intor-
niation about the potential size of the market. In addition to the expected market size,
firms can get a sense of how much variance there is iikely to be in expected revenues,
and the relarionship berween actions that a firm might take volume of advertising,
' foa inrtarraa and the revenues.
-
-
Scenario Analysis
In some cases a firm may be consrdering introducing a product to a market it knows
we1l, but there is considerable uncertaintv introduced by external factors that tl-e firm
cannot control. In such cases, a firm may decide to consider different scenarios, and
revenues and expenses on the project under each scenario. Ifprobabilities are atteched
to each scenario, they can be used to arrive at expected values for the prqect. This is
the process ofscenario analysis,
Although the concept is a simple one, it has four cricicai components. The first
involves determining the tlctors around which the scenarios will be built. These fac-
tors can range &om the state of the economy for an automobile firm considering a
new plant, to the response of competitors tbr a consumer products firm introducing
a new product, to the behavior of regulatory aurhorities and the governmcnt for a
phone company considering a new phone service. In general, firms should focus on
the rwo or three most critical factors that will determine the success of a project and
build scenarios around these factors.

I For instance, the suryey can be mrilecl out to individuals who have boughr sofrware recdnrly, or it m included
rvith a computer mJgazlne.
s With home enhantement products.
The Honte Depot seems ro be iooking at more expensive, higher margin
products than those sold in irs h,ome imfrorcment stors.
,,,
I .,t
ESTIMATING PROJECT R-EVENUES
AND EXPENSES 261,
s*it o.rg or weak, The second component is determining
rr revenues (if the rhe number of scenarios,to analyze for
each factor' Although firore scenarios
r an example, con:
may be more realistic than fewer, it
more difiicult to collect information becomes
and iiffe.enriate between rhe scenarios
g, and assume that ofproject revenues' Thus, estimating revenues in rerms
Lther than through under each scenario will be easier if
firm lays out three scenarios the
rtential customers4 instance
-., bart case, an average, and a worst case scenario, for
than if it lays out 15 sc:narios.
ine. Based on the - The questron of how many scenarios
cr:nsider will rhen depend on how to
different rhe sc.na.ios are and how we,
re online store will can forecast a pro3ect,s revenues the firm
under each scenario.
The third component the estimation of proJect revenues and
is,
ecasting a project's expenses under
each scenario. It is to the esdmation ,t thi, ,t.p that we focrs
ease
v product or serv- three critical factors and build rerativery on only two or
few s.enrrios for each factor.
ler markets before The final component is the assignment
of probabilities to each scenario. For
nce, to The Home scenarios involving macroeconomic some
factors ,u.h ,, exchange rates, interest
gred to sell upscale overall economic growth, the firm rates, and
can draw on the expertise of services
) one that its exist= rhese variables..,For other scenarios that forecast
invorving either the sector or competitors,
a different parts of can draw on iti own knor,vledge the firm
about the lndustry.
In its 1999 annual
rt
- smaller hard-
ncement productss
ing not only allows
El gas p''am€frmm
$"a; $cemas,io &,,arysEs fsr Bneing $upar
rore detailed infor- Jumfis JeE 'Im
pected market size, The Boeing 747, the largest-capacit!
airpra6g6 that Boeing manufactures
expected revenues, mercial aerospace market. was intr.oduce for the com_
d in lgTi.Assume that Boeing is considering
ume of advertising, introduction of a new rarge-capacity the
airprane, capabre of carrying 450 passengers,
the super Jumbo, to reprace t^e soeing cailed
7az. i*,1"0,, u, tt,".i.rg-"ii.,iJiong"*_r"rring
firm in the commerciar aircraft ma*et]
t."iig "k"o*, the market better than any other
wllrd,syrrlevs and market *rtirg'"ii" primary
lilT':::i:
panres. are unlikely to be useful tools in this
customers, the airtine com_
iase, toitf,e toitowi;; ,;"*
Ia market it knows
r Even if the demand exists now it wit be
several years before Boeing wi,
able to produce and deliver tte ai..ratq actuary be
actors that tl.le firm if,e U"r."a can change by then.
c Technorogicaily, it is not
:rent scenarios, and feasibre to produce a few Super
Jumbo Jets for test marketing,
since the cost of retooting ptant
,bfities are attached *itt o" t,rg..
. There'aie relatively few customers (the "il "o*;;";;
the project. This is
contact'with them. Thus,-Boeing should
airlines) i" th" ;";;";
and Boeing is in constant
current preferences are, in terms of
n.r" a reasonable ideJof what their
types"rr..ay
of commercial aircraft.
nponents. The first
At the saine time' there is considerable
be built. These fac- uncertainty as to whether airlines
ested in a Super Jumbo Jet. The demand will be inter-
firm considering a
f", ,fli i"i will be greatest on long_haul,7 inter_
nationar frights, since smailer airpranes
tic frights' rn addition. the demind rr
.r" ,uit'irore profitabre for short_haur, domes-
:ts firm introducing ririt"rv r"'ruoool two iarge-capacity airpranes,
: government for a companies. ft'u'. soeinei-"rp"*"a
ms should focus on
ij|:fitjri} ij[Tr:l' revenues wiu depend on two

1. The growth in the long_haul, international

:ess of a project and marke! relative to the domestic market.
Arguably, a strong--Asian economy wi, pray
a significant rore in fuering this growth,
wirr h"ue to cJme;;;, .n increase
:ff._11ilTflr."",,i.:i;lft1- in rrqits rr.om Europe

6
ccendy, or it ca included The Boeing 7-{7 has the capaciw ro carry .,116 passerlgers.
7
Since these planes cost a great deal
mo'. to op.o,., ,h.f[end to *'" economical
be most
expensive, higher margin 8 "-':':" for
ror rugn*
flights over long ditances.
Flighs liom Europe ro Norrh .\mericr ,.o.,,.*-.,., .r- ,-- -- segment orthe
l.,rt lik.lv,o *,o*i.*,r.i";#:ffi market. it is atso the segrnent
l:: ilj,'jItlj[largest
262 CHAPTER NINE ,/ ESTIMATING EARNINGS AND CASH FLO\)US ON PROJECTS

2. The likelihood that Airbus. Boeing's primary competitor, will come out with a larger
version of its largest capacity airplane, the A-300, over the period of the analysis'

We will consider three scenarios in regard to the first factor:

. A high-growth scenario, where real growth in the Asian economies exceeds |Vo aylear.
. An average-growth scenario, where real growth in Asia falls between 4o/o and 7o/o 7
year.
o A low-growth scenario, where real growth in Asia falls below 4% a year.
For the Airbus response. we will again consjder three scenariosi ,

. Airbus produces an airplane that has th€ same capacity as the Super Jumbo Jet, capa'
ble of carrying more than 450 passengers,
o Airbus produces an i'mproved version of its existing A-r300 jet that is capable of of car'
rying more than 300 Passengers'
o Airbuidecides to concentrate on producing smaller airplanes and abandons the large-
capacity airPlane market.
ln Table 9.1, we estimate the number of Super Jumbo Jets that Boeing expects
to sell each
year under each of these scenarios. These estimates are based on both Boeing's knowl-
eage of this market and responses from potential customers (willingness to
place large
advance orders).
Converting C
Table 9,1 Planes Sold under Scenarios
Accounting F
Airbus abandons
Airbus Airbus A-300 Airplane
120 150 200
High growth in Asia
100 135 160
Average growth in Asia
75 110 120
Low growth in Asia

Next we estimate the probabilities that each of these scenarios will occur, and we
report them in Table 9.2. These probabilities represent joint probabilities; the
probability
of Airbus going ahead with a large jet that will directly compete with the Boeing Super
sum to
Jumbo in ; high-growth Asian economy is 12.5%. Note also that the probabilities
1; summing up the probabilities. by column, yields the overall probabilities
of different
actions by Airbus; and summing up the probabilities by row yields probabilities of
differ-
ent growth scenarios in Asia.

Table 9.2 Probabilities of Scenarios

Airbus abandons
Large-Capacity
Airbus Jet Airbus 4-300 Sum

0.125 0.00 0.25

High growth in Asia 0.1 25
0.25 0.10 0.50
Average growth in Asia 0.15
Low growth in Asia 0.05 0.10 0.10 _ 0.25
0.325 0.475 0.20 1.00
5um

Bringing together the prolabilities of each scenario and the number of planes that
will be sold under each scenario, we arrive at an expected value:
tf',
ExPected Value = *, =
j-1 "'
where
ni = probability of scenario /
Ni = Number of planes tfrat will be sold in scenario 7"

we will aisumethat Boeing will be abie to sell, on an expected basis, I25 super Jumbo
j"tr . y".r, onie--iibuilds thi man'ufacturing facilities' We will assume, too, that it will take
CON\,GRTING OPERATING FORXCASTS INTO ACCOUNTING
FORECASTS 263
e out with a larger five years to retool existing plants and that Boeing wilr be able
to sustain this sales pace
of the analysis. ' (125 planes) for 15 years (through year 20). nfter-year
20, we will assume that sales will
decline to 100 planes a year, based on Boeing's experience
with the 747, Finary,we wiil
assume that Boeing wirr terminate operationJ on the super
Jumbo at the end of year 25.
; exceeds 7o/o alear.
ueen 4Vo and 7o/o a Estimation Error and Risk
AJthough we have laid our three ways of estimating revenues and
l year. expenses fo. prg-
ects, none of these apprdaches yields perfect esrimares.
,
while some p-.1.., risk may
.i come &om estimation error, a large portion of risk comes from real uncertainty
)er Jumbo Jet, capa- about
the future. Improving estimation techniques, using more
4narket testing, and doing
scenario analysis may reduce estimarion eiror but .rrnot eliminate real
is capable of of car- uncertainty,
This is why we incorporate a risk premium into the discount rate.

abandons the large-

cr 9'1: what are some of the factors you wourd consider in deciding whether
to
use historical data, market testing, or scenario analysis in making
ievenue and
I expects to sell each expense forecasts for a project?
,oth Boeingt knowl-
gness to place large
Converting Operating Forecasts into
Accounting Forecasts
Airbus abandons once we forecast rhe revenues and expenses on a project, we can convert these
ge-Capacity Airplane for-e-
of operating pedormance into forecasts of accounting earnings. In this section,
casts
200
160
we examine r'vhv we do this and what changes we might need to make to arrive
at
120 accounting earnings.

rs will occur, and we

lities; the probability
\$[rhy Forecast Accounting Earnings?
ith the Boeing Super
In chapter 4, we looked at the process of estimating accounting earnings and sug-
rprobabilities sum to
gested several shortcomings, at least from the perspective of financial
rabilities of different analvsis, in this
,robabilities of differ- process' Given our skeptical vier,v of accounting rleasures of
earnings, ir mav seem sur-
prising rhrt rvc e'en consider Forecaqting accourrring earnings on an invesrmenr
or
project. There are at least rhree reasons for doing so:

ndons l ' A firm\ overall results are stjll reported as accounting earnings to financial mar-
acity kets, and markers reacr to rhis in{brmation. -when anaryzing i p.o.iect, it would
)e Sum
therefore be useliri to see its effect c,n accounting.rr.ri.rgr"rri pr.p...
rnvesrors
0.25 fbr any unpleasant surprises. For insrance. a firmlhat is aiaryzing a project
0.50 with
negative accounting earnings in the next three years may have ti p..pr..
0.25 th.
1.00 market and equiry research anarysts, who foliow the companv, fo, 1oor., earnrngs
in these years.
umber of planes that 2. The taxes paid by a firrn are based on its taxable income, which is estimated
using accounting statements. Thus, r.r,-e have to estimate the acccundng earnlngs
to neasure rhe tax liabilirv.
3. Accounting measures of ,.t.,.rr, such as return on equirv and capital, though
flawed, are r'videly used ar least as secondarv mef,sures rn investmenr analvsis.
To
compute these measures, we need to estimate accounting earnings.

rsis. 125 Super Jumbo

From Forecasts to Operatirag Incorne
e, too, that it will take To get from forecasts !o accounting earnings,we need to make a series
of adjustments:
264 CHAPTER NINE / ESTIMAIING EARNINGS AND CASH FLOWS ON PROJECTS

Separate projected expenses into operating and capital expenses. Operating

accountlng, are expenses designed to generate benefim only in the cument
while capital expenses generare benefits over multiple periods. The
expenses on an investment have to be categorized into operating an;
capiql,
expenses, based on this distinction.
Depreciate or amortize the capital expenses ouer time. once expehses have been
rizedas capital expenses, rhey have to be depreciated or amortized over
time.
In
process, firms have to make nvo judgments. The first reiates ro the period
(
r,vhich the expenses v,'iil be amorrized, and the second is the depreciation
that the flrm uses to e-stimare deprecration in each period. As we noted in
'1, depreciation can be spread equally over rime (straight-line depreciation), or ls.a
be higher in the earlier years ofan assett liG (accelerated depreciation).
Allocate,fixed expenses that cannot be trued to spedJic projects. Some expenses
by the firm are not directly ffaceable to a project. These expenses will often ger
a[;
cated to prqects, based on a measure such as revenues generated by the project; pm;-
ects that are expected to make more revenues will have proporrionately more
of
expense allocated to them. A simple example of such an expense is general
administrarive expenses (G&A); Boerng's cost of maintaining its headquarters
1n
Seattle and paying managers and emplo,vees there will be borne by ai1 projects
taken
by the firm. Anorher example is advertising expenses; The Home Depot adverdsm
as a firm, but individual stores benefit lrom the advertising. Therefore, each
new
store will be assessed a portion of the firmt advertisrng expenses.
' Consider the tax efect. Since
the cost of capital is after corporate taxes, the earrung
should also be after taxes. Thus, we need to bonsider the tax liabiliry thit
assessed
would be created by the operating income we have estimared, rvith the above-men-
tioned adjustments.
Estimated Tax Liabilitv = Estimated Operating Income (1 - Marginal rax rare)
This is, in a sense, a hypothetical ta-x liabiliry since rhe operaring income is prior to
interest expenses and since the tax paid is based on the marginal rax rare of the firm.
Horvever, it is consistent lo estimate tax on this basis, since we have already considered
the tax benefit ofinterest in the cost of capital (by using the after-tax cost of debt) and
used the marginal rax rate in that caicularion.

{ cc g.z: tor rnost firnns, the rnarEinal tax rate is higher than the effective tax rate.
why do we use the marginal tax rate to assess the after-tax income on projects?
,:l

EI Erc Pr*msafrms $,ffi: $seill$ $upen Jumfio Je[: fnom fsneuasts to

fiffies'-lax fllpenatifig lllcome
we have already estimated the number of super Jumbo Jets that Boeing expects to sell
over the next 25 years (ln Prictice 9.2). To move from sales forecasts to opeiating earn-
ings, we will make the following additional assumptions:
t. has already spent $2.5 billion in research expendftutei, developing the Super
fogins
Jumbo. These expenses are treated as capitar expenditures, iiir purposei of project
CON\.ERTING OPERAIING FORECASTS INTO ACCOUNTING FORECASTS 265
)erating expenses, i1
analysis, and will be amortized over the next 15 years.
L the current period,
2. lf Boeing decides to proceed with the commercial introduction of the new plane, the
iods. The projected firm will have to spend an additional gs.5 billion building a new plant and equipping
reraring .and capital it for production. This expenditure, which is a capital expenditure, will be spread ovei
the next four years as follows:
:s have been catego-
Year lnvestment Needed
Now $500 million
zed over rime. In the 1 .1,00O million
to the period over 2 1,500 million
lepreciation method 3 1,500 million
ve noted in Chapter 4 1,000 million
After year 4, there will be a capital maintenance expendituree required of $250 million
preciation), or it can
each year from years 5 through 15.
:ciation).
3. The sale and delivery of the planes is expected to begin in the fifth year; when 50
e expenses incurred planes will be sold. For the next 15 years (years 6-20), Boeing expects to sell ,l25
rswiii often get allo_ planes a year. ln the last five years of the project (years 21-25), the sales are expected
by the project; prq- to decline to 100 planes a year. Although the planes delivered in year 5 will be priced
Lonarely more of lhe
at $200 million each, this price is expected to grow at the same rate as inflation
(which is assumed to be 3%) each year after that.
rense is general and
4. Based on past experience. Boeing anticipates that its cost of production, not includ- -
its headquarters in
ing depreciation or general, sales, and administrative (GS&A) expenses, will be 90%
by all projects taken ofthe revenue each year.
ne Depot advertises
5. Boeing allocates GS&A expenses to projects based on projected revenues, and this
'herefore, each new project will be assessed a charge equal to 4% of revenues. Boeing's internal assess-
ment of these expenses suggests that one-third of these expenses will be a direct
result of this project and can be treated as variable. The remalning two-thirds are
) taxes, the earnings
fixed expenses that would be generated even if this project were not accepted.
;he tax liabiiiry that
'ith the above-men- 6. The project is expected to have a useful life of 25 years.
7. The corporate tax rate is 35%.
ln order to estimate the operating earnings on this project, we first need to esti-
:ginal tax rate)
mate the depreciation on both the initial capital expenditures and the subsequent cap-
income is prior to ital maintenance expenditures. Boeing uses a variant of double-declining ibalance
-ax rate
of the firm_ depreciationt0 to estimate the depreciation each year. Based on a typical deprecia.ble
life of 20 years, the depreciation is computed to be I 0% of the book value of the assets
: already considered
(other than working capital) at the end of the previous year. Note that we begin depre-
ax cosr ofdebt) and ciating the capital investment immediately, rather than waiting for the revenues to
commence in year 5. The depreciation estimates are included in Table 9.3. We consider
R&D to be part of the capital investment, and it is amortized straight line over 15 years.
(Note that R&D is expensed for.accounting and tax income. we are assuming that the
effective tax rate.
)me on projects?
firm capitalizes it for internal-analysis.)
The projected operating earnings to Boeing are summarized in Table 9,4. The operat-
ing income is negative for the first five years, as Boeing invests in plant and equipment
but doEs not sell any planes. lt may seem surprising that we still multiply the pre-tax oper-
!8$ASt$ ating income by (1 - t), but this reflects our expectation that Boeing will use the negative
[0
operating income from this project to offset its operating income from other sources; this
will save the firm taxes. lf this had been the firm's only project, or if the firm had no other
operating income, we would have accumulated the losses over the first five years and
rcing expects to sell used these lossestosave on taxes in the first few years of positive earnings.
i to operating earn-

rveloping the Super e This is the expense associated rvirh replacing costly equipmenr and rerooling during rhe prcject life.
purposes of project l0 TVpicall-v, in doublc declining balauce'depreciation,
we double che srraight-line rate ofilepreciation. For a five-
-rear lit-e project, rhe straighr-line rate
-,\ould be 209,i, (ll:) each year. The double-declining balance rrre w.ill be
'109i. The depreciation each vear is computed as -107o of the remaining book value ol the asset.
266 CHAPTER NINE / ESTIMAIING EARNINGS AND CASH FLOWS ON PROJECTS

Table 9.3 Depreciation and Amortization Schedule: Boeing Super Jumbo Jet
Ending
Capital Book R&D Value Deprecation &
Year Expenditures Value lnvestment Amortization of R&D Amortization
0 $5oo $50o $2,soo $o $z;soo
1 1,000 $so 1,450 2,500 167 2,333 5217
2 1,500 145 2,805 2,333 '167 2,167 312
3 1,500 281 4,025 2,167 167 2,000 447
4 1,000 402 4,622 2,000 '167 1,833 569
5 . 250 462 4,414 1,833 167 1,667 629
o 250 441 4,219 1,667 167 1,500 608
7 250 422 4,047 1,500 167 1,333 589
'250 405 3,892
.

1,333 167 1,167 571

8
9 250 389 3,753 1,167 167 1,000 556
10 250 375 3,628 '1,000 't67 833 542
11 250 363 3,515 . 833 167 657 529
12 '250 351 3,413 667 167 500 518
13 250 341 3,322 500 167 333 508
'14 250 332 3,240 333 167 167 499
49t
15 250 324 3,1 66
2,849
167 167
' 317
16 317
17 285 2,564 285
18 256 2.308 256
19 231 2,077 231
20 208 1,869 208
21 187 1.683 147
22 158 1,514 168
't 51
23 151 1,363
.t
24 135 1,227 36
25 123 1,104 123

Table 9.4 Operating Earnings: Boeing Super Jumbo

Gs&A Depreciation and
Year Revenues COGS Expense Amortization EBIT EBIT(I - t)

0
1 $0 $o $0 i 217 $ (ztz) i (141)
2 0 0 0 312 (312) (203)
3 0 0 0 447 {447\ (2e1)
4 0 0 0 569 (s6e) (370)
5 10,000 9,000 400 629 (2s) (1s)
6 75,750 23,175 1,030 608 937 609
7 26,523 23,870 1,061 589 1.003 652
8 27,318 24,586 1,093 571 1,058 694
9 28,'t38 25,324 1,126 556 1,132 736
10 28,982 26,084 1,1 59 542 1,197 778
't1 29,85r1 26,866 1,194 529 1,262 820
12 30,747 27,572 1,234 518 1,327 . 852
13 31,559 28,502 1,267 508 1,392 905
14 32,619 29,357 1,305 499 1,458 948
15 33,598 30,238 1,344 491 1,52s 991
16 34606 31,145 1,384 3't7 1,764 1,1M
17 35,644 32,080' 1,426 285 1,854 1,205
'18 36,713 33,042 1,469 256 1,946 't,265
19 37,815 34,033 1,51 3 231 2,038 1,325
20 38,949 35,054 't,558 208 2,129 1,384
71 32,O94 2&88s 1,284 187 1,739 1,130
22 33,057 29,751 1,322 158 1,815 1,180
23 34,049 30,64 1,362 151 1,891 1,229
24 3s,o/p 31,563 1,403 136 1,958 1,2'19
36,122 32,51 0 1,445 123 2,O45 1,329
;
CON\,ERIING OPERATING FORECASTS INTO ACCOUNTING FOR-ECASTS
267
lumbo Jet
il^r----------- From Operating Income to Net fncorne on projects
lrl::
oi nao
Deprecation
nrirortliiion"
6, The operating income estimated in the preceding section is prior to financiar
exPenses' such as interest expenses. It measures the income earned on ail the capital
$2;500
2.333 invesred in a project. The net income on a project. which is the income avai.lable
$217 aflter
2,t67 312 interest expenses, represents earnings for equiry investors alone. To get lrom
2,000 operating
447 income to net income, we need to make the following adjustments:
1,833 569
1,667
1,500
629
608
' Determine how much debt will be used in funding the project: This determination can be
1,333 made in one of r,vo ways. For projects that are large enough to carry their
589 oq,-n debt.
1,167 571 the actual debt that the firm plans to raise for this project can be used. Thus, ifBoe-
1,000 556
833
ing decides ro finance 30% of the initial investment of g5.5 billion that it needs to
542
667 529 make in the Super Jumbo proJecr with debt, the debr used in the prqect analysis
500 5t8 will be 91.65 biilion. For projects that do nor carry their own debt, the 6rrn ..., ur.
333 508
167 its own debt ratio to estimate the dollar debt rhat will be issued. If Boeing were ro
499
491 use this approach, it wouid use its debt rario of 20yo (estimated in chapter 7 for
317 computing the cost of capital) to estimare the debt thar would.be raised for the prg_
285
256
ect. k is important that we be consistent about our treatment of debt in compuring
cost of capital at this stage in the process. If we assume that the cost of capitai
231
208
for;
project will be t,ased on the firmt debt ratio, for instance. we have to estimate the
187
r68 debt raised for rhe prqecr using that debt ratio.
151
136
" Estimate the interest expenses associatetl with the debt ra*etl: To estimate rhe interest
123 expenses on rhe debt raised for the project, we need an interest rate on the debt.
The most reasonable estimate of this interest rare is the pre-tax cost of debt used in
the cost of capital, since this measures the rate at which this firm can borrow today.
The interest rare used would be 5.5% for Boeing and 5.g% for The Home Depot.
" Determine the prindpal repaymefits on the debtt: principal repayments are not accounr-
8IT EBIT(I - r) ing expenses and thus do not affect the net income directiy, but they do afect inter-
est expenses in subsequent periods. Ifthe entire principal on the loan is due
at the
!17) t (r41) end of the loan period that is, it is a balloon-payment loan the interest
n2) -
expenses will remain fixed over the life of the 1oan. If the principal -is paid
(203)
47) (2s1) off over
6e) (370) the liG of the loan, rhe interest expenses wiil deciine over rime. when the loan is
2e) (1e)
paid offin equal annual installments, which include borh inrerest and principal, it is
37 609
03 652 called a term loan; the rnrerest expense portion of the payments wilL decline over
58 694 the life of the loan.
]2 736
l7

w
778
;2 820
17
. 862 $aE FrmmBEre $"4: ts{imatigl$ Nef lileCItlre off a pr$lsfiI; s f,{offiCI
t2 905
;8
r5
948 Be$st $lsre f,rsatysis
991
0 1,144 The Home Depot is considering opening a new store in Morristown, New Jersey. The store
4 1,205 will be a typical Home Depot store, with an area of 1oo,o0o square feet, selling primarily
5 1,265 home improvement products. The following information relates to the proposed store:
6 1,32s
9 1,384
. lt will require an initial investment of $20 million in land, building, and fixtures.
9 r,130 r The Home Depot plans to borrow $5 million, at an interest rate of 5.g0%, using
t,180 a 10_
year term loan (where the loan will be paid off in equal annual increments).
1,229
1,279 I The store will have a life of 10 years. During that period, the store investment will be
depreciated using straight-line'depreciation. At the end of the tenth year; the invest-
ments are expected to have. a s'dlvage value of $7.5 million.
268 CHAPTER NINE / ESTIIV1ATING EARNINGS AND CASH FLOWS ON PROJECTS

Table 9.5 lnterest and Principal Payments on Debt

Outstanding lnterest Total Principal Remaining
Year Debt Expense Payment Repaid Principal
,l
$s,000,000.00 $290,000.00 i672,917 .36 $382,917.36 $4,617,082.64
2 4,617,A82.64 267,790;19 672,917 .36 405,126.57 421't,956.08
4,211,956.08 244,293.45 672,917.36 428,623.91 3,783,332.17
4 3,783,332.17 219,433.27 672,917.36 453,484.09 3,329,848.08
5 3,329,848.08 193,131.19 672,917.36 479,786.17 2.850.061.9r
5 2,850,061.91 165,303.59 672,9\7 .36 507,513.7"1 2,342,M8.14
7 2,342,M8.14 135,861 .99 672,917.36 537,0s5.37 1,805,392.77
8 1,805,392.77 104,712.78 672,917.36 568,204.58 1,237,188.19
9 1,237,18A.19 71,756.92 672,917.36 601,160.M 636,027.75
10 636,027.75 36,889.61 672,917.36 636,027.75 0.00

. Based on our analysis of existing stores (ln Practice 9.1), the store is expected to gener-
ate revenues of $40 million in year 1, and these revenues are expected to grow 5% a
year for the remaining nine years of the store's life.
. The pre-tax operating margin, at the store prior to depreciation, is expected to be '10%
for the entire period.
To estimate the net income, we first estimate the interest and principal payments on the
debt used in financing the store, as shown in Table 9.5. Note that although the total pay-
ment remains unchanged each yea[ the breakdown into interest and principal payments
changes from year to year.
We next estimate the depreciation each period, based on the initial investment of $20
million, the salvage value of $7.5 million, and a straight-line depreciation schedule:

$20,000,000 - $7,soo,o0o
Depreciation each year =
10

= 91,2s0,000
Table 9.6 summarizes the net income from the store to The Home Depot each year for the
next 10 years.

Cl 9.2: The depreciation that we used for the project above is assumed to be the
same for both tax and reporting purposes. Assume now that The Home Depot uses
more accelerated depreciation methods for tax purposes and straight-line depreci-
ation for reporting purposes. ln estimating prolect earnings, which depreciation
should we use?

Table 9.6 Net lncome at The Home Depot Store

Operating lnterest Taxable
Year Revenues Expenses Depreciation EBIT Expense lncome Taxes Net lncome
1 $40,000.000.00 $36,000,000.00 $ 1,2s0,000.00 $2,7s0,000.00 $290,000.00 $2,450,000.00 $86 1,000.00 $1,s99,000.00
2 42,000,000.00 37,800,000.00 1,250,000,00 2,950,000.00 267,790.79 2,682,209.21 938,713.22 1,7 43,435.98

3 44,100,000.00 39,690,000.00 '1,250,000.00 3,1 60,000.00 244,293:45 2,91 5,706.55 1,020,497 .29 1,895,209.26
4 46,305,000.00 41,674,500.00 1,250,000.00 3,380,s00.00 219,433.27 3,1 61,066.73 1, r06,373.36 2,054,593.38
5 rA,620,250.00 43,758,225.00 1,2s0,000.00 3,612,025.00 193,131.19 3,41 8,893.8 1 1,1 96,61 2.83 2,222,280.98
6 51,051,262.50 45,946,136.25 1,250,000.00 3,85s,1 26.25 1 65,303.59 3,689,822.65 1,291,437 .93 2,398,384.73
7 53,603,825.63 48,243,U3.06 1,250,000.00 4,1 10,382.56 1 35,861.99 3,974,520.57 1,39 1,082.20 2,583,438.37
I 56,284016.91 50,655,61 5.22 1,250,000.00 4378,401.59 104,i12.78 4,273,688.91 1,495,791.12 2,777,897.79
.9 59,098,217.75 53,1 88,395.98 1,250,000.00 4,659,821.78 71,756.97 4,588,054.85 1,605,822.70 2,952,242.16
10 62,053,128.64 55,847,81 5.78 1,250,000.00 4,955,31 2.85 36,889.51 4,918,423.25 1,721,448.14 3,196,975.12
CONVERIING OPERATING FORTCASTS INTO
ACCOUNTING FOR-ECAST S 269

Remaining From Project Earnings to Froject Cash Flows

princioal
In Chapter 'r. we inrroduced rhe basic principres underlying
5 $4,617,082.M accounting errnings
7 measurement and noted che reasons why
4,211,956.08 earnrngs ancl cash floors *ay differ. Gener_
| 3,783,332.17 allv accepted accouncing principles req,ri.e
the reJognitio-.t1."."".1 *hen the serv-
, 3,329,848.08 ice for which the firm is getting paid has
| 2,850,051.91 been performed in fun or substanrialry, and
| 2342,448.14 the firm has received in return either cash or a receivable
| that is both observable and
1,805,392.77 measurabie. For expenses that are directly
| rinked ro the production of revenues (rike
1 ,237,188.19 labor and materials), expenses are recognized
| 636,027.75 in the same period in which revenues
;. are recognized' Any expenses that are not
0.00 directly hnked to the productio"
are recognized in the period in u,-hich
the firm consumes the services. "r.."."".,
Although the objective of distribudng revenues
and expenses fairry across time is
to normalize earnings over rime,
expected to gener_ [9 p.o..r, of accrual *.o,rrrti.rg io", ...rr. ,.,
accounting earnings numberTFat ca-n be very
,cted to grow
5% a different from the .rrf, flo* generated
by a prqect in any period. Accounting distinctions
betw-een operating expenses and
capitai expenditures, between cash and noncash
rxpected to be I0% charges, and between accruar and cash
revenues and expenses are the source of this
diilerence.
al payments on the
rugh the total pay-
Accounting Earnings Versus Cash Flows
principal payments operating Expenses and capitar Expenditures.
Accounrants distinguish betw.een expen_
ditures rhat yield benefirs only in the immediate
I investment of g20 period or periods (such as rabor and
ion schedule: material for a manufacturing firm) and those that
vield b..r.fim over murtiple periods
(such as land, buildings, and long-rir,-ed assets).
The former are calleci operating expenses
and are subtracted frorrr revenues rn compuring
the accounting income, while the 1at_
ter xe upital expenditures and are not subtracted
from revenues"in rhe period that they
are made. Instead, the capiral expendirure
is spread over muitiple_pe.ioL and deducted
,t each year for the as an expense in each period. These expenses
are carled d.pr..irtion (if the asset is a
tangible asset like a buiiding) or amorrization (if
rhe ,rr.t i, un irrtrrgibr. asset iike a
patenr or a rrademark).
;sumed to be the
Although the capitar expendirures made at the
Horne Depot uses -
Iargest and most prominent,-many projects
beginning of a pro.;ect are o{ien rhe
ight-line depreci- require capiral expenditures during their
lifetime' These capital expenditures urrrl.au..
ric-hdepreciation it e cash availabie in each of these peri-
ods' Thus, when projecting cash flows on
an in'estment, we need to consider both the
initial capiral expenditures and any subsequent
capital expenditures, designed to main_
rain rhe asser base. rhat *'e categorize rs capical
mainrenance e*p.ndir,rrer.
Noncash charges. The distinction rhat accounranrs draw berween
operating and cap_
ital to a number of accounting expenses, such as depreciation
expenses leads
Net lncome and
amortization. which are not cash expenses.
).oo $1,sgg,ooo.oo Thele .rorcash expenses, though depress-
t.22 1,743,435.98 ing accounting income, do not reduce cash flow-s.
,.29 1,895,209.26 In fact,,rr.y.r" rrr".l significant
positive impact on cash flowr, if rhev reduce
t.36 2,054693.38 rhe tax liabiliqv of the firm. For instance,
depreciation reduces taxable and net income,
r.83 2,222,280.98 but it does not cause a cash outflow.
'.93 2,398,3U.73 consequently, depreciation is added back to income
ro arrive at the cash flows on a
r.20 2,583,438.37 projecr.
.12 2,777,897.79 projects that generate rarge depreciation charges,
.70 2,982,242.16 .For a significant portion ofthe
.14 3,196,975.12 cash flows can be attribured ro the ta.x benefirs of depreciarion, rvhich can
be written
as a function of the firmt tax rate:
270 CHAPTER NINE,/ ESTIMATING EARNINGS AND CASH FLOWS ON PROJECTS

Tax Benefit of Depreciation = Deprecration x Marginal Tax Rate

A11 expenses rhar are tax deductible provide this tax benefit, but depreciation is unique
because the benefit is generated without a cash expense. Thus, paying a salary of$100
million rvill generate a tax benefit of $'10 million for a firm with a 40% tax rate, but
*
the firm will strli have a net cash outflow of $60 million ($100 miilion $40 million).
The same $40 million tax benefit from depreciation comes without a cash expense
and generates a cash inflow to the firm of $40 million.

Accntal uerstrs Caslt Revenues and Expenses. Under the accrual system of accoundng,
revenues are recognized when the sale is made rather than when the customer pays.
Consequently, accrual levenues may differ from cash revenues. This dilTerence may
arise in four situations. First, some customers who bought their goods and services in
prior periods may pay in this period. Second, some customers who buy their goods
and services in this period (and are therefore included in revenues in this period) may
defer pavment until futule periods. Third, some customers who buy goods and serv-
ices may never pay (bad debts). Finally, some customers maY pay in advance for prod-
ucts or services that will not be delivered until future periods. Because one or more
of these situations is likel.v to exist with most prqects, cash revenues will be difterent
from accounting revenues.
A similar probiem arises on the expense side. Firms have to report expenses as they
use material and services provided by third parties, but they might not pay for them I

untiJ subsequent periods. In addition, pavments might be made for material rnd serv-
1

ices acquired in prior periods. Accruai taxes will be dillerent from cash taxes for A

exacrlv rhe same reasons.

'When material is used to produce a product or deiiver a service, there is an added
consideration. Some of the material that is used may have been acquired in previous
periods and was brought in as inventory into this period, and some of the material that
is acquired in this period may be taken into the next period as inventory'
Accountants define net working capital as the difference berween current assets
(such as inventory and accounts receivable) and current liabilities (such as accounts
payable and ra-xes payable). Difterences bervr;een accrua.i earnings and cash earnings' in
the absence ofnoncash charges, can be captured by changes in the net working capital.

Estimating Cash Flows to the Firrn and to Equity lnvestors When doing
investment analysis,*-e can esdmate the returns from the perspective ofjust the equiry
investors or estimate returns to all claim holders in the firm. The three factors out-
lined above can cause accounting earnings to deviate significantly from the cash flows.
To get from after-tax operating earnings, which measures the earnings to the firm,
to cash flows io all investors in the firm, lve have to
. Add back all noncash charges, such as depreclation and amortization, to the operat-
ing earnings.
. Subtract all cash outllows that represent capitai expenditures'

" Net our the effect of changes in

noncash working capital, that is, changes in
accounts receivable, i.rrr"rrtory and accounts payable. If noncash working capital
increased, the cash flows would be reduced by the change, whereas il it decreased,
there wouid be a cash inflow.
CONVERIING OPERAIING FOR-ECASTS INTO ACCOUNTING FOR,ECASTS 271,

The first rwo adjustments adjust operating earnings to account for the distinction
Tax Rate
drawn by accountanm berween operating and capital expenditures, whereas the_last
adjustment converts accrual revenues and expenses into cash revenues and expenses.

h,a 40yo tax trt.,

6o;
:. CashFrowroFirm=EBrrrr-r, * 'H:iHH:o - t$:il?iffiiln - r"[ll'jil..,
The cash flor,v to the firm is a pre-debt, after-tax cash flow that measures the cash gen-
hout a cash .*O.nr'.
erated by a project for a1i claim holders in the firm, after reinvestment needs have been
met.
'stem of accounlin*, To get from net income, which measures the earmngs of equir,v invesiors in the
) the customer pavs. firm, tocash flows to equiry investors requires the additional step of considering the
This difference rlxy net cash flou,' created by repaying old debt and taking on new debt. The difference
;oods and services in between ner,v debt issues and debt repayments is called rhe net debt, and it has to be
,,ho buy their goods added back to arrive at cash flows to equity. In addition, other cash flovrs to nonequiry
; in this period) may claim holders in the firm, such as preterred dividends, have to be netted from cash
ruy goods and serv- flow-s.
n advance for prod_ Cash Flow Net L)epreciation and Change in Noncash Capital
ecause one or more to Equiry = Income * Amortization - Workrng Capital - Expenditures
ues will be different
+ (New Debt issues - Debt Repaymenrs) - Preferred Dividends

ort expenses as they The cash flow to equiry measures the cash flows'generated by a project for equiry
ir not pay for them investors in the firm, after taxes, debt payments, antl reinvestment needs.
r material and serv_
rom cash taxes for d tC g.g: lf the earnings for a firrn are positive, the cash flows will aiso be positive. ls
this staternent true? lf not, why not?
:e, there is an added
'W'hen
:quired in previous The Case for Cash Flows earnings and cash flows are different, as they are
of the material that for many projects, $'e must determine which one provides a more reliable rrcasure of
/entory. performance. There are rwo reasons why cash flows provide a much better estimate of
veen current assets a project\ true returns.
; (such as accounts The first is that accounting earnrngs are the end result of a number of account-
rd cash earnings, in ing decisions, including what kind of depreciation method gets used and how inven-
ret working capital. tory gets valued. We would argue that accounting earnings in general, and net
income in particular, can be manipulated through the use of creative accounting
Drs When doing techniques. In a book entitled AccouniingJor Crowth, which gained national head-
e ofjust rhe equiry lines in the United Kingdom and cost the author his job, Terry Smith, an analvst at
three factors out- UBS Phillips & Dre.,r', examined 12 lega1 accounting techniques commonly used to
om the cash flows. mislead investors about the profitabiliry of individual firms. To shorv how creative
rnings to the firm, accounting techniques can increase reported profits, Smith highlighted such com-
panies as Maxrvell Communications and Pol1y Peck, both of which eventually suc-

ion, ro the operat- cr"rmbeCto bankrupto,'.

The second reason lor using cash flowr is a much nore direct one. No business
accepts earnings as payment lor
goods and services delivered; a1l of them require cash.
Thus, a prqect r,vith positive earnings and negative cash florvs w,i1l drain crsh lrom the
tat is, changes in business undertakingit. Conversely, a project l,u'ith negative earnings and positive cash
r working capiral flow-s might make the accounting botrom line lock u-orse but rn'ill generate cash for
:as ifit decreased, che business underrakrng ir.
: CHAPTER NINE / ESTIN,IATING EARNINGS AND CASH FLOWS ON PROJECIS

Table 9.8
ES gsr Fr*m*gEse $.ffi: [stimatln$ fiash Flsws $ar mm $lllime Infe$s8[
$a$tware $tone
After-tax C

Assume that lnfoSoft, the private software firm that we have been analyzing, is consider- + Deprecia
ing.an online software store to sell its software directly to the public. The primary advan- - Change i
After-tax C
tage to lnfoSoft is that it will save a'signif icant portion of the costs it usually incurs when
it sells through mail-order and retail outlets. The store will have two employees, and the
following information relates to the proposed store:
. The initial investment needed to start the service, including the installation of addi- Table 9.9
tional phone lines and computer equipment, will be $5 million. These investments are
expected to have a life of four years, at which point they will have no salvage value.
The investments will be depreciated straight line over the four-year life. After-tax (
r The revenues in the first year are expected to be $3 million, growing 20% in year 2 and + Deprecia
10% in the two years following. - Change i
- Capital E
. The salaries and other benefits for the employees are estimated to be $250,000 in year + Salvage'
1 and are expected to grow 1oo/o a lear for the following three years. FCFF from
. The firm will have to incur an advertising expense of $500,000 in year 1 promoting the
online store. and these expenses are expected to grow 10% a year for the remaining
three years. CT 9.3:
r The cost of materials at the store is expected to be 307o of revenues. tain adr
. The working capital, which i.ncludes the additional inventory the firm has to nraintain that lnl
to service online orders and the accounts receivable associated with selling software on have in
credit is expected to amount to 15o/o of the revenues. At the end of year 4, the entire
working capital can be liquidated to yield book value.
o The tax rate on income is expected to be 42o/o. Frora'r Froject Cash
\I,'hen ar
Table 9.7 summarizes the operating earnings from the online store each year for the four-
nrake th
year life of the project.
To get from operating income to cash flows, we add back the depreciation charges should lc
and net out the changes in working capital from year to year, as shown in Table 9.8. Note or businr
that there is an initial investment in working capital that is 10o/o ol the first year's rev- total ani
ehues, invested at the beginning of the. year. Each subsequent year has a change in work- rcaso n s.
ing capital that represents 10% of the revenue change from that year to the next. Bring-
alreadY a
ing the initial investment in computer equipment and phone lines into the analysis, as
cash flov
well as the salvage of working capital, provides us with a more complete picture of the
cash flows on this project in Table 9.9. The salvage value of investment represents the sal- ond is tl
vage value of the working capital investments made over the project life. the firm
such as g

are nor i
Table 9.7 Operating Earnings on Online Store
Y"*
Nonin
Reven ues $3,000,000 $3,600,000 $3,s50,000 $4356,000
Operating Expenses Ssnk C
Labor 250,000 275,000 302,500 332,750 ect anal.
Materials 900,000 1,080,000 1,1 88,000 1,306,800
assess thl
Depreciation 1,2s0,000 1.250,000 1,250,000 1,250,000
Operatinq lncome 500,000 995,000 '1,219,500 1,466,450 analvsis.
Taxes 252,000 417,900 512,190 51 5,909 increme
After-tax Operating lncome 348.000 517,100 707,310 850,541
Thrs coi
FROM PROJECT CASH FLOWS TO TNCREMENTAL CASH FLOWS 273

Table 9.8 Cash Flows on Project

lmfm$effi

After-tax Operating lncome $348,000 $s77,100 $707,310 $8s0,s41

yzing, is consider- + Depreciatiori 1,250,000 1,250,000 1,250,000 1,2s0,000
re primary advan- - Change in Working Capital $450.000 90,000 54,000 59,400 0
;ually incurs when After-tax Cash flow from project ($4so,ooo) $1,so8,ooo $1,773,100 $1,897,910 t2,100,s41
nployees, and the

tallation of addi- Table 9.9 Cash Flow after lnvestments and Salvage
e investments are Year
no salvage value.
fe.
After-tax Operating lncome $348,000 ,100 $107,310
$s77 $8s0,s41
!0% in year 2 and + Depreciation 1,250,000 1,250,000
1,250,000 1r250,000
- Change in Working Capital $4s0,000 90,000 54,000 s9,400
: $250,000 in year
- Capital Expenditures 5,000,000
+ Salvage Vaue of Investment . 653.400
FCFF from project ($s,4s0,ooo) $1,s08,000 $1,773,100 $1,897,910 $2,7s3,941
1 promoting the
or the remaining
CT 9.3: ln the preceding analysis, we assumed that lnfoSoft would have to niain-
tain additional inventory for its online software store. lf, instead, we had assumed
r has to nraintain that lnfosoft could use its existing inventory would the cash flows on this proiect
lling software on have increased, decreased, or remained unchanged?
/ear 4 the entire

Froject Cash Flows to {ricremental Cash Ftrows

year for the four- When analyzing a project, the objective is to ansr,ver rhe quesrion: V'iil rhis project
make the entire firm or business more valuable? Consequentl-v, the cash flo,,vs we
.eciation charges should look at in investment analysis are the cash flor,vs the project creates for the firm
n Table 9.8. Note or business consiciering it. We rvill call these cash flou,s incrernental cash flows, The
e first year's rev- total and the incremental cash florvs on a project w-ill generally be different for tr,vo
change in work-
reasons. The first is chat some of the cash ilor'vs on an investment may have occurred
r the next. Bring-
r the analysis, as already and thereiore are unatTected b_v whether or nor \,'e take the investmenr. Such
te picture of the cash florvs are labeled sunk costs and shoulci be removed from the rnrlysis. The sec-
)presents the sal- ond is that some of the pro3ected cash flor.vs on an investment r,r,'i11 be generated b-v
r. the firm, u'hether or not this investmen! is accepted. Allocations of fi,xed expenses,
such as generai and administrative costs, usuallv fall into this category'. These cash flor.vs
are not incremental, and the analvsis needs to be cleansed of their impact.

Nonincrernental Cash Flows

$4,3s6,000
Seruk Costs A firm might incur some expenses related to a project before the proj-
332,750
ect analysis is done. One example is expenses associated r,vith a mrrket test done to
1,305,800
1,250.000 assess the potentiill marker for a oroduct prior to conducting a Iull-blorvn investnrent
1,466,450 anal,vsis. Since such costs rvill not be recovered if the projecr is rejected, they are nor
6r 5,909
850,s41
incremental and therefore should nor be considered rs part of the investment analysis.
This conrrasts v;ith their trea.trnent in accor,rnting statements, v,,hich do not distinguish
274 CHAPTER NINE / ESTiMATING EARNINGS AND CASH FLOWS ON PROJECTS

between expenses that have already been incurred and expenses that are still 1q
t(
incurred.
h
One rypical sunk cost ii researih and development, which occurs well bsfo..
product is even considered by the firm that funded the research. Firms that spend laqu
A,l

i r r---^l a^^^ l:1^**-

on fesearch and deveiopment, such as Merck and intel, face a^ dilemm, in
-
thai I
- st

"*ou.rr,
they can often analyze projects onlv after these expenses have been incurred.
c
'
n
Although sunk costs should not be treated as Part of investment anaiysls, a 6r*
does need to covef its sunk costs over time oI it w-il1 cease to exist. Consider, fs,
example, a firm like McDonald\, which expends considerable resoulces in test rnxl-
ryx1-
fl
keting products before introducing them. Assume, as in the il1-fated Mclean D.l;;.'
Delulg
,' E

(the lor,v-fat hamburger introduced in 1990), that the test market exPenses amounted ;
to g30 million and that the value the project created for the firm, without consider- ir

ing tesp market expenses, amounts to $20 rnillion. The project should be accepred. If r

thrs were the pattern for every McDonaldt project. however, it would
collapse undet

the weight of its test marketing expenses. For the firm to be successful, the total vxlp, ,
I

...rt.dLy successfui projects will have to exceed the total test marketing exPenses0n t
both its successiul and unsuccessful products'
:

Altrocated Costs An accounting device created to ensure that every part of a 1

business bears its fair share of costs is allocation, whereby that ale not dilectly
costs I

traceabie to revenues generated by individual products or divisions are ahocated

across these units, based on levenues, profits, or assets. Almost every
project analysis
done by iarge firms includes its share of costs that are allocated to it' For instance,
the Boeing SuperJumbo proJect had generai and administrative (G&A) costs ailo-

cated to it, and a new Home Depot store will have a share of the totai advertising

expenses allocated to it.

The question we need to ans\\'er when faced with an aliocated expense is whether
the expense is incremental. In other words,if Boeing \,vere to reject the SuperJumbo.
rvould w,e save the G&A expense allocated to the project? Let us consider the nvo
extreme responses. The first is that rejecting the project will not sar"e Boeing a cent of
the ailocated G&A expense and that the expense v;ill continue to exist and get real-
located elsewhere. In this case, none cf the expense is incremental and should
there-

fore not be part of the analysis. The second possibiliry is that rve rvouid, in fact, save

andlike
all the allocated G&A expense, in which case all of the expense is incremental
orher expenses, such as labor and material, should be considered as part of the
project

analysis. There is also an intermediate possibiliry it Boeing rejects the Super Jumbo,
rot be incurred and rvil1 be incremental expenses'
ffi
some of the allocated exPenses mav
They should be considered as part of the project analYsis'
A simple wa1 of puttrng this analysis inro practice is to ccnsider each of the ailo-
cated expenses and to .i.rrity them as fixed or variable expenses. Fired expenses,
such

building, are generally nonincremental and

as the cost of maintaining the headquarters
can be saGly eliminated fiom analysis. Variable expenses, such as the number of sales-

persons that the firm may hire to suppolt its product 1ine, are generally incremental

and should be included in project analysis.

As in the case of surik costs, the right thing to do in project analYsis - consider-
ing on-ly ,firect incrementai costs ma,v not resllli in a financiall,v healthy firm Thus'
-
if a companv hke The Home Depot does not require individual stores ihat it lnrlvzes
IS
FROM PROJECT CASH FLOXUS TO INCREMENTAL CASH FLOWS 275
3nses thar are still
to
to cover the allocated portions of the firm's advertisrng expenses, it is difllcult to see
ch occurs well how these costs will be covered at the levei of the firm. we would assume that these
h. Firms thar spend advertising costs serve a purpose, rn'hich otherwise would have to be borne by each
:1,face a dilemma If these costs tend to increase as the number of stores increases, the firm should
in store.
, been
incurred. charge each new store a portion of these costs, even though this cost might not be
estment anaiysis, x i,curred immediately or
; as a direct consequence of the new store opening.
: to exist. Consideq
e resources in test
l-fared Mclean
flm Pnmm&Hmm $.ffi: ffisaE6ra$ wcEtu &BECIcmae$ $msEa
ket expenses
lrm, without c
Case Ir Assume that you are analyzing a project for a retail firm wlth general and admin-
istrative (G&A) costs of $600,000 a year. The firm currently has five stores, and the new
t should be accepted.
project will create a sixth division. The G&A costs are allocated evenly across the stores.
it r,vould collapse With six stores, the allocation to each store will be $100,000.
rccessful, the total ln this case, assigning $tOO,Ooo for general and administrative costs to the new store
marketing expenses in the investment analysis would be a mistake, since it is not an incremental cost
total G&A cost will be $600,000 whether the project is accepted or rejected. - the
case 2: ln the analysis above, assume that all the facts remain unchanged except for one.
e that every part of The total general and administrative costs are expected to increase from $ioo,ooo to
its that are not $660,000 as a consequence of the new store. Each store is still allocated an equal amount
the new store will be allocated one-sixth of the total cost$ or g1 10,OOO.
ln this case, the allocated cost of $110,000 should not be considered in the investment
analysis fonJhe new store. The incremenfal cost of $60.000 t$660,000 _ $600,0001. how-
ever, should be considered as part of the analysis.

The Argurnent for Incrernental Cash Flows

When analyzing investments, it is easy to consider oniy the project or,.investment at
hand, and to act as if the objectfve of the analysis is to maximize the value of the indi-
vidual investmenr. There is also ihe tendency, with perfect hindsight, to require proj-
: sar,'e Boetng a cent of ects to cover all costs that they have generated for the firm, even iisuch costs wiII not
i to exist and get real- be recovered by rejecting the project. The objective in investment analysis is to max-
rtal and should there- imize the value of the business or firm accepting the investment. consequently, we
ve would, in fact, save should focus on the cash flows that an invesrment will add on in the future to the busi-
incremental and like
s ness, that is, the incremental cash flows.
I as part of the prgecr
:cts the Super
incrementalexpenses.
Jumbo, :

;
ffil Bm FrmmgEsm ffi"F: fisfileltaEEmg $asrg FEmw$ E$ EgEs Finme f,er tha $aeimff

$leffiae'daeffiB$m
;ider each of the allo-
iixed ln Practice 9.3 estimated the after-tax operating income on'ffi&ibr,n! super Jumbo Jet.
. expenses, such
ln this illustration, we estimate the incremental cash flows to Boeing fro=m this investment:
,; nonincremenfal and To get from after-tax operating income to incremental cash flows, we will bring in the fol-
the numbel of sales- lowing factors
3enerallv incremental
' As part of our cash flows, we will consider the $5.5 billion in capital expenditures that
the firm will need to invest over the next five years to build new plant and equipment,
analysis consider- and the continuing capital maintenance expenditures of $250 million each year from
y heakh,v
- firm. Thus, years 5 to 15.

stores that it analvzes

r We will remove from the analysis the $2.5 billion in research expenditures that have
, already been incurred by the firm and the amortization associated with this expendi-
ture. Ttpis cost is a sunk cost, and the amortization is not incremental.
276 CHAPTER NINE i ESTIMATING EARNINGS AND CASH FLOWS ON PROJECTS

. We estimate the noncash working capital (primarily inventory) to be l0% of revenues.

This investment will drain cash flows, and we will assume that the investment has to bs
made at the beginning of each year. Thus, if revenues are expected to grow from ye1. :

1 to year 2, the working capital investment needed for the revenue growth in yeal 2
will have to be made at the beginning of year 2.
. We will add back the portion of the allocated general and administrative costs that are '
fixed and therefore not an incremental effect of the project; this amounts to two-thirds
of the allocated cost in each year from Table 9.4.
o At the end of the project life of 25 years, all the working capital investments made in it
will be salvaged, as will the remaining book value of any capital investments in plant
and equipment.
Table 9.10 summarizes the after-tax incremental cash flows on the Super Jumbo
ect. The operating income was re-estimated Using only the incremental depreciation
the 55.5 billion in investmentyetto be made. The adjusted operating income eachl

W ror""rrn".*
was computed from the operating income in Table 9.4 as follows:
Adjusted EBITt = (EBIT + R&D Amortization)t
ffi
Ab"dt
capbudg,xls allows You
to estimate the cash ln year 1, for instance, the EBIT of -5217 million, in conjunction with the R&D amortiza- you to (

tion of $t oz million in that year, yields an adjusted EBIT of -$50 million. The after-tax por- ,
'
flotarS to the firrn on a cash flo
+i^^ +r.:. cDrr i. .h^r^/^ in rraer tn he million. The salvaoe value
valUe of $4,716 million a proiet
project. ^{ this EBIT is shown in year 1 to be -$33
tion of 1 -(?1 salvage
includes the working capital at the end of the twenty-fifth year as well as the book value
of the assets at the end of that year.

Table I

Table 9.10 Operating Cash Flows on the Super Jumbo Jets Year
lncremental
Cash
0
Change in Fixed
1
Working Salvage Cash Flows Sunk G5&A Flows
Capital 2
Year EBti (t - g. Depreciation Expenditures tal Value to Firm Costb ('l r t) to Firm
3
$3,ooo $o $o $(3,000) $(2, s00) $(soo); i
0 So $o
(33) 50 1,000 0 0 (e83) 0$0 (s83)
5
2
1

(e4) 145 1,500 0 0 (1,449) 00 (1,449)

6
3 (1 82) 281 1,500 0 0 (1,402) 00 (1,402)

+ (262) 402 1,000 1,000 0 ( 1,8s9) 00 (1,8s9) e

5 90 462 2s0 1,575 0 (1,273) 0 173 (1,1 00)

9
6 718 M1 250 77 0 831 0 446 1,278 1n
7 750 422 250 80 0 852 0 460 1,312

8 802 405 250 82 0 875 0 474 1,349

I 844 389 250 84 0 899 0 488 1,387

10 886 375t 250 a1 0 925 0 502 1,427

11 928 363 250 90 0 952 0 517 1,469

12 971 351 92 0 980 0 533 1,513

13 1,013 341 250 95 0 1 ,010 0 549 1,558

14 1;os6 332 250 98 0 1,041 0 565 1,605

An
15 1,1 00 324 250 10'1 0 1,071 0 s82 1,655

15 1,1M 317 0 104 0 1,357 0 500 1,956

17 1,205 285 0 107 0 1,383 0 618 2,001

18 1,265 256 0 110 0 1,411 0 536 2,048

19 1,325 231 0 113 0 1,442 0 555 2,098

20 1,384 208 0 (685) 0 ) )77 a 675 2,952

21 1,130 187 C 96 0 1,221 0 556 1,777

22 1,180 158 0 99 g 1,249 0 573 1,822

): 1,229 151 0 102 0 1 )1q 0 590 1,859

24 1,279 136 0 105 0 1,310 0 608 1,918

25 1,329 123 0 0 4,716 6,1 68 o 626

a EBIT is adiusted for amortizatlon on R&D.
b This is the $2.5 billion investment in R&D.
AN ARGUMENT FOR TIME WEIGHTING CASH FLO\TS 277
to be 10% of revenues.
1e lnvestmentL-ras to
cted to grow from
,renue growth in y..,
be
RI $ffi ffirmmgamm ffi"ffi; fistimatilt$ Gnsil Ftows t0 tquity [0r a
i ffew llome $s$st $tore
nistrativb costs that are ln Practice 9.4 estimated the net income from investing in a new store for The Home
i amounts to two_thirds Depot. Here, we estimate the cash flows to equity investors at The Home Depot from

investments made in i+
it
:ar lnvestments in plant

r the Super Jumbo proi-

iffi
at the beginning of each period, the initial investment in working capital of $2 million
nental depreciation
ating income each year
on =Ii[]it]]***fl#.i}]Ti"'t*"*;;':::*",aremade
is made attime 0 and is 10% of revenues in year I. The.changeiin working capital in

ffi
!L"l Spreadsh""t
;::Jil:il:1'^1?i,ffi[J3ff lJ,l[?-lil,3,T,i:,i:Hffi,lii"i:"',;fl:
o Subtract the principal payments that are made to the bank in each period, since
*,he end of

these
vith the R&D amortiza- ..pb"dS"c*r" ril.*r are cash outflows to the iquity investors in the firm.
vos to estimate the
!lion. The after-tax por-
l,-.};;;i;ili{, ", ' Add the salvage value of the store of $7,5 million in year 10 to the total cash flows, since
value of $4,716 million a proje<r. this is a cash inflow to equity investors.
well as the book value
cash flows to equity measure the cash flows that equity investors at The Home Depot can
expect to receive from investing in the store and are presented in lable 9.11.

Table 9.11 Cash Flows to Equity from New Home Depot Store
Debt Issuedi Change in
Capital Principal Working Salvage Cash Flows
Year Net lncome Depreciation Repayment Capital Value to
lncremental
Fixed Cash 0 5(20,000,000) $s,000,000 $(3,200,000) $(18,200.000)
Gs&A Flows 1 $1,599,000 $1,2s0,000 (382,917) (r 60,000) 2,306,083
(1 - t) to Firm 2 1,743,436 1,250,000 (405,127) (168,000) 2,420,309
$(s00)
3 1,895,209 1,250.000 (428,624) (176,400) 2,5'10,185
$o (e83) 4 2,0s4,693 1,250,000 (4s3,484) (1 85,220) 2,665.989
2,222,281 1,250,000 (479,786) (194rtt!1)
'o0 (1,449)
(1,402) o 2,398,385 1,250,000 (s07,614) (204,20s)
2,798,014
2.936,566
0 (1,8s9) 7 2,583,438 '1,250,000 (s37,05s) 1214,415) 3,081.968
173 (r,100) 8 2,777,898 1,250,000 (s68,20s) (225,136) 3,234,557
446 1,278
9 2,982,242 1,250.000 (601,1 60) (236,393) 3,394,589
460 1,312
1f 3,196,975 1,250,000 (636,028) 4,964,2s0 $7,500,000 16,275,198
474 1,349
la8 1,387
502 1,427
cr 9,4: ln the preceding analysis, we assurned that The Horne Depot borrowed $5
517 1,469 rnillion to finance the new store. lf, instead, we had assumed that it had used no
533 1,5f3 debt, would the cash flows to equity have been higher, loweL or unchanged?
549 1,558
565 1,606
582 1,655 ,fua Argument for Tiree'Weighting Cash Flows
600 1,955
618 2,001 Very few projects with long lifetimes generate earnings or cash flows evenly over their
536 2,048 life. In sectors with huge investrnents in infrastructure, such as telecommunications
655 2,098
675 2,952
and online rerailing, the earnings and cash flows might be negative for an extended
li6 1,777 period (say 10 to 20 vears) before they turn positive. In other sectors, the earnings rnay
573 1,822 occur earlier in time. 'W'hatever the reason for the unevenness of cash florvs, a basic
590 1,869
508 1,918 question thar has to be addressed when measuring returns rs whether they should
626 6;794 reflect the timing of the earnings or cash flows. we will argue that they should, with
earlier earnings and cash flows being weighted more than earnings and cash flows later
in a project life.
278 CHAPTER NINE / ESTIMAIING EARNINGS AND CASH FLOTX/S ON PROJECTS

The Process ofTime Veighting

In our earlier discussion of rime value, we argued that discounting future cash flows
to the present made them comparable-. The process of discounting can be viewed as a
way of time-weighting cash flows. The present value of a cash flow can be written as

PV of Cash FIow in period r = Cash Flow, lt+l

L(1 + 4',1

Note that second term in the equation can be viewed as a weight actached to the cash
flow. The further into the future a cash flow the less it witlbe weighted in a projectt
returns.
The extent to which current cash flows wili be weighted.gnore than future cash
flows will depend on rhe discount, rate used. The discount rate, which will be the cost
of capital when discounting cash flows to the firm, and the cost of equiry when dis-
.o,rrriirg cash flows to equiry wili reflect both expected inflation anil the perceived
riskiness of the cash flows. As inflation and perceived risk increase,-the discount rate
will also increase, leading ro smaller weights being attached to cash ftows in the future
than to current cash flows.

Project Decisions and Tirae-Veighted Cash Flows

Since cash flor.vs rhat occur €arlier are weighted nore than cash flo.,vs that occur later
in time, any decision made by the firm that will shift cash flows to earlier time peri-
ods from later periods will make project returns more attractive. Let us consider two
such decisions:

1 . Choice of depreciation met.hod: As we noted eariier, assets can be depreciated using

either straight-line or accelerated depreciation scheduies. Although both
approaches yielcl the same nominal tax benefits to the firm over the life of the
assit, accelerared depreciation schedules will generate higher tax benefits in ear-
lier years and lower tax benefits in later ,vears lhan straight-line depreciation.
When the rax benefits are rime-weighted (discounted), accelerated depreciation
will generally make project returns more attractive.
2. Expensing and Capitalizing; There are some expenses that firms have the option
of ixpensing (by reducing income in rhe current period by the expense) or capi-
talizing (by depreciating or amortizing the amount over several period$. When
fi.*s e*p.rrse, they receive the tax benefit from expensing in the current period.
'When
they capitalize, the same tax benefits are received over several periods and
contribute less to the time-w'eighted relurns on the project.

d CC g.A: Firms in the United States often maintain two sets of books, one for tax pur'
poses and one for reporting purposes. Since firms like to report higher incorne to
their stockholders and pay Nower taxes, what depreciation rnethods would you
expect to see in each set of books? Sumrnary

RE Aaa Prmegfimm ffi.ffi: $lraigkt"Lin& uen$rrs &uceEerated fllepreciatloil

ln our earlier..Bnalysis of The Home Depot store, we used straight-line depreciation to
compute the net income and cash flows to equity on the store. ln this illustration, we com'
pare the tax benefits from depreciation, using straight-line and accelerated depreciation
SUM]\,4,TRY 279

Table 9.12 'lhx Benefits from Straight-Line and Accelerated Depreciation

StlalOht-Line Depreciation ' - Accelerated Depreciation
lre cash flows Year Tax Benefit tion Tax Benefit
)e viewed as a
1 $1,250,000 $437,s00 $3e8,s24 g4ooo,ooo $1,400,000 $1,27s,278
be written as 2 1,250,000 437,500 353,021 3,2oO,OOO 1,12o,OOO 929,333
3 1,250,000 437,500 330,580 2,560,000 896.000 677,233
4 1,250,000 437,500 301,221 2,O48,OOO 716,800 493,520
5 1,250,000 437.500 274,386 592,000 242,200 1 51,900
6 1,250,000 437.500 249,942 o o
ed to the cash 7 1,25A,000 437,500 227,673 o o
1in a project's 8 1,250,000 437;500 207,392 O O
9 1,250,000 437,500 188,916 o o
10 1.250,000 437,500 172,086 o 0
an future cash
rill be the cost
riry when dis-
the perceived and consider when we get the benefits with each. Table 9.'12 shows the tax benefits cal.
) discount rate culated both ways. Note that the tax benefit for each period is estimated using The Home
rs in the future Depot's tax rate of 35o/ot
Tax benefit = Depreciation x Tax rate

we discounted the cash flows back at The Home Depot's cost of equity of g.7go/o because
we were looking at equity cash flows when analyzing the project, Although both depre-
ciation methods yield the same tax benefits in nominal terms, the accelerated deprecia-
tion method yields a higher present value of tax benefits.
:hat occur later
rlier cime peri-
is consider rwo The Case for Time-\ffeighted Cash Flows
If we accept the arguments that cash flows measure returns more accurately than earn-
eciated using ings and that the incremental cash flows more precisely estimate returns than total cash
both flows, we should logically follow up by using time-weighted cash flows rarher rhan
e life ot the nominal cash flows for two reasons:
:nefits in ear-
rreciation.
1. Nominal cash flows at difGrenr points in time are not comparable and cannop be
aggregated to arrive at returns. Discounted cash flows, on the other hand, convert
depreciation
ail cash flows on a project to today's terms and.ailow us to compute returns more
consistendy.
/e the option
pense) or capi-
2. l{the objective in investment analysis is to maximize the value of the business taking
the investments, we should be weighting cash flows that occur early more than cash
riods).'W'hen
flows that occur later because, as we noted in chaptei 5, the value of a firin is the
:urrent period.
present value ofthe expected cash flows generated by it.
:a1 periods and

CT 9.5: When cash flows on investments are time-weighted {disebunted), we are

one for tax pur- biasing ourselves against investirig in long-term pro;ecL. ls this statement true? lf
gher income to yes, why? lf not, why not?
ods would yott
Suraumary

In this chapter, we considered how best ro estimate earnings and cash flows on a pro-j-
ilr$siaglsBB ect in order to provide a basis for comparison to hurdle rates. The process of estimat-
ing revenues and direct expenses for a project begin by using experience as a guide, if
) depreciation to
stration, we com- similar projects were undertaken in the past, or more generally by using market sur-
rted depreciation veys. test marketin., or scenario analysis. Nthough more information can reduce the
280 CHAPTER NINE,/ ESTIMATING EARNINGS AND CASH FLOWS
ON PROJECTS

uncertainry associated with estimation, rhere

wiil still be error in the estimates, due malntenance exr
real uncertainry abou.t the future.
ing $100 million
Projections ofrevenues, arlow us to derive repa-ving the deb
the after-tax accounting earnings
proJect' using rhe accounting cacegorizarion oq
Iive years. Esdma
of expenses irr" .p;;;r;; and cal
exp1ns11, and the subsequenr depreciation on this project.
ofcapital expenses. r..*"s 3r" u" ,ri int
ro atl investors in the firm or 9. Lands'End is
.:*::l::.:::T::,:"?."1nings
equity investors after debt payments.
as iet earnings
alog is expected
next year. Lands'
gto of 20%o on
needs are 15% oi
The cash flow's provide a much cleare, picture :
of what a project actually and a tax rate of
a firm. In investment decision making, #:r.r.:til
ii is onty those cash flows that are a direct result next year. fiou ,

of the project that matter. we call these incremental investment will c

cash flows, and we estimate theyl
by eliminating costs that have aiready been incurred
(sunk costs) and fixed alocated 10. Answer true or f
expenses.
a. The return or
higher than t
--^;-^.

weighting cash flows. The discount rate we

use is the cost of capital when we
looking at returns from the perspecrive of are Problerns
all claim holders in the fi.m and the cost In the probiems belory vc
of equiry when we measure ..,urn, to equiry
investors.
1. You have been a

ings on a new st
firm currently ha
Questions
enues of $4.7 bill
1' ln 1999 circuit city had 600 stores open not including de
and rotai 5. (Based on questi-gn 3.) The firm will have tr
revenues of $6 biltion' If you were asked to estimate rest marketing that Kel-
loggi did fo, tt,.,....rI cosr $25 million in the
the annual revenues for the next year on
a new store -ix;;;.;; comput-
ing the incrementa.l cash flows for this investment,
ne'
ciated straight 1in
;,,:;T,.:'l:,Xil,:I::,'j"ffi ir.vou
estimate be, rvourd vou i".r,J"-,r,.1.';;;;;',;;l.k.ting ,, zero. In addition,
art of the initial investment..W.hv or why not? expenses of $'i70
2
2. \x/^,,t.I i,
would ^_^.-.^_ L^
r!? anslr'er r:r
vour be differenr that ,. ;#,:;:?jr: ;"."ffi,[H#:J,,1,"
iryo, *... told
Circuit Ciry had 100 stores in large towns ,n.
existing stores. If
and cities, inflation rate is :
$1 s biiiion ii,.".;,;;;;;';;; ;#;:::"",L::,::ilTJ:li:::,i#,:,ji;#:,i,7
soffwardn,arket In rnmr,,ri-_ rL^ ^,_-^-,-r
:3,":TL:::?:e^d income on a nel
generatins $4 { hilli^- in rot,^-..^-) \yrl ;:ffi ;#"#,'iill;ii,iJTll,l:1";',",f ::,,:YTli: years.

2. Abercombie and
3' You work for Kellogg's and wanr ro conducr
a marker costs and'thar H.;;r:;;"fiffilT.":?;;;; ments that amou
is enough demand for a nerv cereal estimate the adjustment you would need for working capital ;
:::i^? ::,-rrnere
constructing the test? cash flows.
;;;;;;;:";:ffi1l this item
thermore, half of
each year are 6x,
4" @ased on question 3 ) You estimate that Kellogg's 7. A projecr wirh a IO-year rvith the
rvill life is expected to have after- numbe
be able ro sell 10 million boxes of the r.r.il
r,lir*rr rax operating earnings of $100 million each y.ear
for
after-tax operatin
and iabor) of p-j,.- the next 10-yean. ii the d.p...iado,, .*p..,,. Abercombie and
*j:,:.tfj::f:'j
ing each box is $0.50, !Ti,::,* .,.h
and Kelioggt a'ticipates that it year is $60 million and the fiim hr, . years.
will have markedng expenses of $15 million.
..piiJ-rirr.-
The nance expense each year of $30 million, esrimate
the -t- You heve been as
manufacturing facilities you will need to produce after-tax cash flow each vear.
the built by Internltir
cereal wiil cost $50 m:ilion and will
be depreciated 8. cyclops systems, a sofrware firm, is considering $50 mi1lion, and t
straight line to a salvage value ofzero
tt tht *d of 10 investing in
a new project. The project is expected to a 1O-year balloon
years wirh a marginal tax rate of 35%;
estimate the 2 net
earn a innn-o of
ner income {(^ *ii1:^-- , , year for the The factory is ex1
pre-tax and rfrer-tax operadng inccme .,.*, ^r $50 million each
Estimate the after-tax cash flow next year.
y..r. nexr five y.r.r. r# H.#;Ttil'J:f ;::J';
tax operating inc(
expected ro be $10 million, and there after depreciation
are no capiral
l
PROBLETV{S 291
n the estimates, maintenance expenditures. The firm will be borrow_
due b. If the rerurn on capital is
ing $100 million to finance the in!-esrment and will be less than the cost of
equiry rhe project should be rejected.
unting earnings repa.ving the debr in equal installments over the nexr
on c. Prcjects with high financial leverage will
operating and five years. Estimate the cash flows to equiry each year have
on rhis projecr. higher interest expenses and lower.,.iin.orr. rhrn
Sarnings can be
projects with low financial leverage and thus
9. Lands'End is introducing an online catalog. The car_ end
up with a louer rerurn on equirv.
alog is expected to generate $100 million i., ..rr.rr,r.,
.h s6counting next year. Lands,End earns a pre_tax operating mar_ d. Increasing the depreciation on an asset will increase
charges
grn of 20o/o on its revenues, and its working capital the estimated return on capital and equiry on
g5 the
1n working capita.l project.
needs are 15% ofrevenues. Assuming.ro depr..iriio.,
acrually generares and a tax rate of 4A%o. estimate the after_tax cash flows e. The
for average return on equity on a project over
its
that are a direcr resu.h nexr year. (You can assume that the working capital lifetime wrll increase rf we switch from straighrline
rnd we estimare investment will occur at [he end of the next year) to double-declining balance depreciation.
then
s) and fixed allocared 10. Answer true or false to the {bl1owing statements:
a. The rerurn on equity for a project wiil alwavs be
rta.l cash florvs on higher than the rerurn on capital on th. ,r-"
the
:ighred less than project.
cash
echantsm for time_
capital when we
lte firm and the
are Probiertrs
cost In rhe problems below, you can use a marker risk premium
of 5.5% and a tax late ol 40026 where none is specified.

1. You have been asked to estimate the expected earn-

net income each vear for the next 10 years if rhe finn.
ings on a new store for Abercombie and Fitch.
The has a tax rute of 40%0.
firm currently has 235 stores open and had toral rev_
enr-res of 94.7 biljion last year. The
4. Estimate the after-tax cash flolvs to equity
each vear
cost of goods sold,
not including depreciation, is 60% of revenues. The for rhe next 10 years on the Internario.rrj H.r,r"rr.,
t marketing that Kel_ firm will factory
j million. in comput_ have to make an initial invesrmenr of
$10
rnillion in rhe new store, and the store will be depre_ 5. You are analvzing a project wirh a life of five
vears.
lor this lnvestment, ciated straight line over 10 vears to a salvage which requires an inida1 invesrmenr in equipmenc
test marketing value of and
.the as zero. In addition, rhe firm has selling and machinery of $10 million. The equipment is expected
hy or why not? advertising
expenses of $.i70 million that are allocated
equally to
to have a 6ve-year liGtime and no salvage value and
expanding into the existing stores. Ifrhe tax rare is _t0% and che to be depreciated strarght line. The p.qe.i i, expecred
expected
he expecred earnings inflation rate is 3%, estimate the after_tax operating to generate revenues of $5 million each year for the
s allocated 10% income on a new store each year for the next five years and have operaring expenses rnor including
of iis 6ve
,f $200milion to vears. depreciation) amounting to 30% of revenues.
'these the The tax
costs are fixed 2. Abercombie and Fitch rate is'{0%, and the cost of capital is 11%.
has working capital require_
ras a tax rate of 35%, a. Estimate the after-tax operating income each
ments that amounr to g/o of revenues and inv.esrs in vear
Id need for this item working capital at the beginning of each year.
Fur_
on rhis project
) get to incremental thermore, half of the selling and advertisinj
expenses b. Estimate rhe after-ta-x operating cash flow each
each year are fixed and are not expected'ro
.h..rg. ,vear on this project.
pected to have after- r'vith the number of stores. Estimate the expectJd
rillion each year for c. Assume that the firm thattakes this project is los_
after-tax operating cash flows on the new store
tbr 1ng money currently and expects to continue
ratron expense each Abercombie and Fitch each year Ibr the next los_
five ing money for the first three years. Estimate the
ras a capital mainte_ years.
after-tax operating income and cash flows on this
ru1lion, estimare rhe 3,, You have 6een aiked rc analyze a nerv factory
being project.

rm, is !:ilt Uy Intern/tioiral Harvester. The factory will cosr 6, You are considering a capital budgeting proposal
to
considering $50 million, and the firm will borrow $25 mrllion on
make "glow-in-the-dark,, pacifiers for an-xious fi.st_
o;ect rs expected to a 1O-year balloon payment 1oan, at.a 7oZ interest
rate. time parents. You estimate that the equipment to
r each ,vear for the The {actory is expected to generare
$5 million in pre_ make the pacifiers would cosr you $50:00b (which
n in each year is tax operating income each year lor the next 10 years,
you can depreciate straight line over rhe liferime
here are no capital after depreciation of g5 million a year. Estimate of the
the project, which is 10 years) and thar you can seli
15,000
282 CHAPTER NINE i ESTIMATING EARNINGS AND CASH FLOWS ON PROJECTS

believes th
unirs a year at g2 a
unit. The cost ofmaking each paci_ rniliion bottles you estimate
se.ll 1 a year at g1 a bcttle. by investin
fier would be $0.80, and the tax rare vou *.ould face yorir-c 6scs as follows : (which can
would be 10%. Ydu also esrimate that you will need to -farWti
costs/bottle = 50 cents years to a s
maintain- an inventory at.25% of revenues for the
Ftxed Costs,zyear = $200,000 lion a yeat
period ofthe project and that you can i;alvage g0% of
proposes t(
this working capitai at the terminaaon of the project. Adding up srare, local, and federal taxes, vou nore thlr
7Oo/o of anr
' a. Estimate the after-tax operating income each year -vou lvil1 be in the 50%o tax bracket. To be conserva-
tive, you assume thar you will terminate the business a. What is
on rhis projecr.
in five years and rhat you will get nothing from the b. What is
b. Estimare the after-tax operating cash flows on rhis project?
plant and equipment as salvage. f/ou also use straight_
project.
line depreciation.) What would your after-rax cash 13. Assume, in
c.'Assume rhar vou have already spent g20,000 flows be on rhis projecr? $5 million
researching the project. 'Would you show these
10. Assume thar you had borrou'ed 60% of vour initiai tribution s
expenses as part of your accounring income?-Wha!
invesrment in the last example, using a five-year term loan with a

about your incremental cash florvs?

loan, with an interest rete of 7.50/o. Estimate the cash a. Estimate
7. Assr.rme, in the previous example, thar you trad bor- flows to equicy on.this projecr. menl fol
row'ed $25,000 of the $50,000 rnitial inv-estment, using
11. You are an expert at working lvirh pCs and are con- b. Estima*
a 10-year balloon paymenr loan wtth an interest rate
sidering setting up a software development business. year for
of 7%. Estimate the net income and cash flows ro
To set up the enterprise, you anticipate that you will
equity on rhis project, each year for the next 10 vears. 14. You run a
need !o acquire computer hardware costing You are co
8. You have been obseiving the progressive gentrifica- $100,000. (The lifetime of this hardw.are is five yerrs system wt
tion of your ciq/ with interest. You realize thar the for depreciarion purposes, and srraighr-line depreci- operations
time is ripe for you to open and run an aerobic exer- ation will be used.) In addition, you wiil have to rent the cash flt
cise center. You find an dbandoned warehouse that an office for $50,000 a year. you eslimate that you
will meet your needs. It renrs for $48,000/year. you . The con
rvill need to hire five software specialists at $50,000
estrmate thar it will initially cosr $50,000 to renovate instail an
a year to work on the software and that your mar-
the place and buy Nautilus equipment for the center. replace a
keting and selling costs will be $100,000 a year. you
(There will be no salvage, and the entire inirial cosr is lion to o
expect ro price the software you produce at $100 per
depreciable.) Your marker research indicates tirat you unit and to sell 6,000 units in the first year, The . The syste
can expect to get 500 members, each paying actual cost of materials used to produce each unit is no salvag
$500/year. V:u have also found five instructors you $20. The number of units soid is expected to ' The con
can hire for $2,1,000 a year each. Your tax rate, ifyou increase 1,0%o a year {br the remaining four years, and annual rt
start making profits, wili be 40%, and you choose to the revenues and costs are expected to increase at 3% the next
use straight-line depreciation on ,vour initial invest- a year, reflecting inflation. The actual cost of materi-
" The cost
ment. Ifyour cost ofcapital is 15% and you expecr to als used to produce each unit is $20, and you u'i1l
of revent
redre to the Bahamas in 10 years, answer the folow- need to maintain working capital at 10% ofrevenues.
ing quesrions: (Assume that rhe rvorking capiral investment is made
The tax :

a. Estimate the after-tax operating income each year at the beginning of each year.) Your tax rate wilj be . As a resr
on this projecr. 40%, and the cost of capiral is 7Z%. lvill be a

enues to
b. Estimate the aiter-tax cash flows on this project. a. Estimate the after-tax operaring income on this
change
c. Esrimate the time.weighted cash flows on this Prqect.
COmPOn(
project. b. Estimate the cash flows each year on this project.
The cost o
9. You are graduating soon and woulcl iike to start _vour c. Estimate rhe time-weighted cash flows on this
own business manufacturing wine c.uricrs. you colle ct -*^:^^"
the following information on the inirial costs: L2. You have been hired as a capital budgeting analyst by
Cost of Planc and Equipment = g500,000 x sporting goods firm that manufactures athletic
shoes and has captured 10% ofthe overall shoe mar-
Licensing and Legal Costs = $50,000
ket. (The total marker is worth $100 million a year.)
You can clain an investmenr tax credit of 10% on
The 6xed costs associared with rnanufacturing these
plant and equrpment, and the licensrng and 1egal costs
shoes is $2 n'rillion a year, and variable costs are ,l09,ro
have aiready been incurred. You estimare 4hat you can
of revenues. The conrpanv's tax rate is -10%, The 6rnr
PROBLEMS 283

you estimate believes that it can increase its market share to 20% a. What is your expected cash flow today?
r bcttle.
by investing $10 million in a new distribution system b. What are the expected incremental annual cash
rwhich c.rn be depreciated over rhe \ystem s life of l0 flows from compucerizing the system?
years ro a salvage value ofzero) and spending $1 mi1-
c. What are the dme-weighted cash flows on this
lion a year in additional advertising. The companv
investmenr?
taxes, ,vou proposes to continue to maintain working capital at
note that 15. You have acquired new equrpment lbr a project, cosr-
:et. To be conserva_ 10% ofannual revenues.
ing $15 nillion. The equipment is expecteci to have a
'nrirrate the a. What rs the initial investment tbr rhis project?
business salvage value of $3 million and a depreciable iife of 10
)t norhing fron-i the b. What is the annual after-tax cash f,olv from this vears. Tlie cost of capital is 12%. and the firm faces g
ou also use straight_ proj ecr? rax rate of 10%.
your after_rax cash
L3. Assume, in the prior example, that the iirm borrowed a. Estimate the present value and the nominal value oi
$5 million of the $10 million needed for the new dis- the tax benefits from depreciation, assuming that
'>0%
of your initial tribution system, using a 10-year balloon payment you use straight-line depreciation.
ng a five_year ter6 loan with an interest rate of 89/0.
. Estinrate the ca,sh
b. Estimate the present value and nominal value of
a. Estimate the equiry portion of the initial invest* the tax benefics from depreciadon, assuming that
ment for this prqect. yoLr use double-declinrng balance depreciation.
L PCs and are con_
b. Estimate the after-tax cash flows to equity each c. Why does double-deciining balance depreciation
lopment business. year for the next 10 years on this projecr.
ipate that you vield a higher present value?
will
ardwire costing
tl. You run a mail-order firm, selling upscale clothing. 16. In the example above, there is an estimated saivage
dware is five years You are considering replacing yolir manual ordering value. Assuming that you have to pay capital gains
ight-line depreci_ system wrth a computerized system to make your taxes at 209/0 on any excess ofsalvage value over book
r wili operarions more etlicient and to increase sales. (A11 .:alue, .,vou1d you garn or lose bl deprecrating the
have to rent
estimate that you
the cash florvs given below are in real rerms.) assets down to zero and paving the capital gainitaxed
:ialists ar $50,000 . The computerized system r.vil1 cost $10 million to 17. You have just acqurred equrpment for $10 million,
d that your mar_
instail and $500,000 to operate each vear. It will with a depreciable lite of 6ve years and no salvage
3,000 a year. you replace a manual order s.vstem that costs $1.5 mi1- value. You must decide whether you should be using
rduce a. $100 per lion to operate each -vear. straight-line or double-declining balance merhod in
e first year. The " The svstem is expected to last 10 vears-and rvill'have estimating taxes and cash flows. Your tax rate is
luce each unit is no salvage value at the end oithe period. expected to increase over the five years.
is expected ro . The computerized system is expected to increase Year Thx Rate
g four years, and
annua.l revenues from $5 miLlion ro $8 million for L 20a/a
:o increase at 3%
I cost of materi-
the next 10 years. 225
r0, and
. The cosr of goods sold is expected to remain at 509'o 330
you ,,vill
0% ofrevenues. of revenucs.- 435
estment is made ' The tax rate is 40%. 5+o
tax rate will be . As a resuit of the compurerized s,vsCem, the firm a. Which depreciation method provides rhe larger
r.vil1 be able to cut its invenrorv irorn 509./o of rev- nominal tax benefits?
ncome on rhis enues to 2506 of revenues ianedtately. There is no b. Whrch depreciation method provides rhe larger
change erpected in rhe other rvorking capital present'value in rax benefrts, assuming your cost of
,n this projecr. components. capital is 129./o?

Ilows on this The cost o[capirel is 8%.

:ring analyst by
ctures athleric
:rall shoe mar_
nilLon a year.)
acturing these
costs are 40,0/c
{0%. The 6rnr

:'-'i:nj'
--
284 CI{APTER NINE i ESTIMAIING EARNINGS AND CASH FLOWS ON PROJECTS

ESTIMATING EARNINGS AND CASH FLO\X/S

Objective
To estimate earnings and cash flows on a rypical project for the firm.

Key Questions
ffimffil . Does vour firm have a rypical rnvestment?
. If so, can you estimate the earnings and cash flows oo a rypicai investment?
Framework for Analysis
l,Typical Inuestment
. Does your firm take a few or several investmen[s each vear?
. Do these investments have much in common?
. If so,what do thev have in common and what are the differences?
2. Eamings arcd Cash Flows
. What is the rypical life of an invesrmenr made by vour firm?
" What is the pattern of earnings on such an investment?
. V'hat is the pattern of cash flor.vs on such an inr-estmenc?
. Based on the companv\ aggregace numbers, can you estimare the earnings and cash
flows on a hypothetical investment?

Getting Inf,ormation on Frojects

Firms describe their investments in their annual reports, though not in significant
detail. The statement of cash ilorvs will provide some breakdol,,.n, as will the tbotnotes
to the financial statements.

Ref,erences
Articles and Books Referenced in the Chapter Lrvnat,J., and K.J. Hackei, 1995, Cash Flow and Security AnaQ,t:,
Smith Terrv 2l)OA, Arounting.ior Crowth:llrc BookTheyTiied to New York: iVlcGrarv-Hi1l.
Baa, London: Random House UK. 'Whice, G. I. A. Sondhi, and D. Fried, 1998,The,4nalysis
and Llse aj
'What Is an
Financicl Statetnenrs, New York:John Wiley & Sons.
General Ref'erences
The follorving books provide a revierv oi the issues related to Related Web Sites
measuring earnings and cash Eoy,s: hctp :,rrw.ru:rviiey'. com,'college /damodaran.,