Excel Finance Class 82: Relevant Costs For Discounted Cash Flow Analysis = Incremental Cash Flows

Welcome to Finance in
Excel video number 82. Hey, if you want to download
this workbook for chapter 9 or the PowerPoints
for chapter 9, click on the link
directly below the video, and scroll all the way down
to the Finance Excel Class section. Hey, we're in chapter 9. And we've already
done two videos. We're talking about capital
budgeting in more detail. In essence, what
we're talking about is how to estimate
the cash flow so we can do net present
value, internal rate of return calculations. So in turn, we can have
good information or decision criteria about whether to
buy a new asset or not. Now, let's go over
to PowerPoints here. We got to talk about cash
flows, estimating cash flows. And if you're going to
estimate cash flows, you got to know what
the relevant cash flows for a project are.

Here is our definition
of a relevant cash flow– incremental– what does that mean? The changes, the incremental
cash flow changes, the difference between
the future cash flows with a
project and without. Well, let's look
at some examples. Sunk costs. All right, so here we are. We're the firm. And we're going to
investigate whether we want to start a new project. So we do some marketing.

And we spend $500,000 on
marketing, or whatever it is. We spent it. We paid the marketer. They did the research. Now we're going to go and decide
what kind of assets to buy. But guess what? The marketing research
is already paid for. It has nothing to do– it is
part of the cost for the firm. And guess what? It'll happen whether or
not we take this project. Opportunity costs–
for example, if you have some land that you
paid for, $5 million, you paid for it five years ago. And now all of a
sudden you want to use that land for a new project. Well, the opportunity cost, you
can't use the historical cost. Guess what you have
to figure out– at minimum, what
the market value, what you could sell it for. And then, because we could
sell it and we're not– we're going to take
on this new project– that's an opportunity cost. So if it was worth
$6 million, we could sell it for
$6 million, we have to subtract that
from our cash flows, because we're giving
up that opportunity to sell that land
for $6 million. Side effects/erosion– another
relevant incremental cash flow.

For example, if we're
selling a new product and we're going to lose sales
from an existing product, that means– that's
called erosion. Or not only could
we have erosion, we could actually–
because we're going to market
our new product, it could increase the sales
of our existing products. So that would be a side effect. But those have to be
considered, and we'll see an example of
that coming up. Oh, changes in net
working capital– what is net working capital? Remember, that's current assets
minus current liabilities. That means things like cash. We might need extra cash
to run this project. We might have extra
accounts receivable. We might carry extra inventory. We might have extra
accounts payable. Those are all net
working capital. Those are relevant. This is just like
earlier in chapter 2, we did cash flows from assets. We had operating cash flows. We had to know what the cash
was for any new assets and this, in essence, the difference
between current assets and liability, which hopefully
is somewhat current assets.

So it's kind of like
a short-term asset. Got to include it in
your calculations. Guess what? Financing costs are not
going to be included here. That's an external
variable that's considered somewhere else. So when we look at our relevant
cash flows for the project, we're not going to
include financing costs. So before we did our earnings
before interest and tax.

Then we calculated
our interest and tax. Well, guess what? We're not going to
consider interest expense. All right, so those
are just some examples of relevant cash flows. Let's go over to
Excel, and we're going to see examples of
most all of these right here. Now let's take a look
here at this example here. We have land we bought six
years ago for $5.5 million. Today we have a market value
on this land of $6 million. We're considering
building a manufacturing plant on the land, which
would cost us $19 million. And we have to fix up the land. We got to do some grading,
get the excavators and the bulldozers out there
and fix up the land, which is going to cost $500,000. So what kind of costs are these? Well, this is a historical cost
we paid for this, this land, six years ago. It's a sunk cost– absolutely not part
of our calculation.

This is the relevant
calculation, because this is an
opportunity cost. This means if we
take on this project, we're giving up the $6 million
we could sell this for. And when looking at an
opportunity cost, at minimum, you look at what you
could sell the asset for. This is going to be
a cost going out. And same with this. This is included in
the price of the asset. This is not relevant. And the rest of these are
totally relevant for our cash flow– estimation of future cash flows
in doing our net present value, et cetera. Now let's go ahead
and figure out what the total cash flow out
at time 0 is for this asset.

This is not considering
net working capital, just the fixed asset. Well, we certainly are going to
have to include our opportunity cost. We gave up that amount. We are going to
certainly include the cost of our estimations
for building the plant and also our grading with all the
excavators and bulldozers. So $25,500,000 would be our
cash flow out at time 0. Now let's go look at
some other examples. I'm going to click on sheet 4. We'll talk about erosion. Oh, we're considering
building a new bulldozer. And we have two existing
bulldozers– a D9 and a D9Q. Now, we did a market study,
and we got some numbers. So for our new bulldozer
and our existing bulldozers, we estimated these were
the units we would sell. Here's the price
for each bulldozer. And we can go ahead
and calculate our sales for each one– whatever the units
are times the price.

And then I copy this down. But these are not the
relevant cash flows. These are relevant for
the firm as a whole. But when you're
analyzing a project, like considering
building a new bulldozer, you only look at the
incremental cash flows. The stand alone
principle says we can analyze all the relevant
cash flows for this one project alone and then come
to some decision. Certainly these hard cash flows
are great for the whole firm. But we're only interested
in the change, the change if the new line of bulldozers
right here are introduced. Well, this is erosion. We're going to lose
700 sales of this D9Q. But why would we
get some increase? Well, sometimes you have
a new marketing campaign. You got this new bulldozer,
the buzz about it. And so they discover
your product. So in this market study,
we got an increase of 3,000 for existing D9,
but a drop here. All right, so we're going to
calculate our incremental cash flows associated
with this project.

They are not going to be these. And guess what? It's not going to
be this either. This marketing cost, sure, the
information we got from this help us create all
of our estimates and were an integral part
of deciding whether or not we should go ahead
with this project. But forget it. We did the marketing study. We paid them. That's a sunk cost. It's already incurred,
because guess what? We paid for this. If we decide to take this
new bulldozer project, we have to pay it. It's already paid. If we don't decide to take
this new bulldozer project, we still have to pay it.

So it's not relevant. It doesn't change in regard
to taking this or not. All right so the relevant
cash flows for our D9 is the change times our price. And now actually– yeah,
and then hit Enter. And that's going to be an
increase, which we like. But this will be a decrease,
some erosion in one of our products. And then the relevant cash
flows for our new bulldozer is just the total right there. All right, so when we add all
of these together, Alt-Equals, there is the relevant
sales cash flow. So that's in example number 1. Let's go do example
number 2 for erosion. We're talking about
relevant cash flows. Now, this one's a little
bit more involved. Well, we have an old product–
let's see if I can make this a little bit bigger– old printing machine, the price
of the old printing machine, the old printing machine
current yearly units sold, which we'll
use to estimate any differences in the future.

If the new unit, which is this
new printing machine here, is sold, old printing
machine yearly units sold. So they will go down. Here's the new product. We have a new printing machine. Notice if we get this
new printing machine, we're still going to sell
some of the old machine. It's just the sales are
going to go down a bit. The price of the new
printing machine, expected sales units for
the new printing machine. And we're going to manufacture
this printing machine. Variable cost, that's
VC, variable cost, as a percentage of sales– oh, so for our whole
company, we estimate whenever we make a
printing machine, the variable costs are
going to be 55% of the sales price or total sales. The depreciation on the
new printing equipment, so that's the whole
point of this. Do we take on this new– buy all the equipment to make
this new printing machine? The project is whether
we want to start making this new printing machine. All right, so we have
depreciation on that.

And fixed cost for
all of the equipment that we're considering
buying is a million. Our tax rate is 0.34. And in this example,
we just want to figure out if we could
calculate the operating cash flow. Well, first we got to figure
out our erosion in sales from the old printing machine. So well, we're going
to take the difference between this and
this, units before we took on this new project,
estimation after.

So we're going to lose some. So that's the difference. And the sales price
is right there. So that's going to be
ultimately a negative. We'll do all our
negatives down here. That's a reduction. Erosion in variable costs– wait a second. Actually let's go ahead
make this a negative. Now, wait a second. We're going to lose some sales. Oh, but when we make a sale,
we sell this one machine.

If we don't sell
one machine, we also don't have that variable cost. So in this example here,
this is the total sales we're going to lose. But if we also can
avoid some cost, this is going to be a plus. So I'm going to say
equals 0.555 times– and then I'm going to
do a negative to make this a positive, so 55%. We're going to lose
these sales, but we're going to avoid these costs. So what that means
is a cost is going to be added, the
incremental cost we avoid, the incremental sales we lose.

All right, sales from
new printing machine– so there is our new price
times our estimated sales. We're also going to
have to calculate– and that is going to be a plus. And I'll do this as a negative. How about that? That one times 55, that'll
give us our variable cost for the new printing machine. OK, total fixed costs for
the new, that's an outflow. So there's our fixed costs
for the new printing machine. And these are all
estimates, estimates per year for a number of years. In this first couple
examples, we're going to just stick
to the one year. Depreciation for new
printing machine. For tax purposes before
we figure out the tax, we're going to have
to subtract this. So there it is. That's the depreciation for
the new printing machine. And now we can
calculate EBIT, earnings before interest and tax. Now notice, we're not
going to include interest, because that is not a relevant
cash financing, whether used equity or debt, it's going to be
considered somewhere else, not in the cash flow analysis
for a new project.

All right, so I'm going to say– I think we can just
straight add all these. There's a subtraction
and sales there. It's this cost saving. That's the cash flows
from this new machine. Variable costs, we're going
to have to subtract that, S, subtract. So we can just add
these, Alt-Equals. So that's EBIT. And as– I don't think I
mentioned when we were looking over in the PowerPoints,
incremental cash flow means after-tax
incremental cash flow. In all situations, since any
new revenue or any new cost incurred, which is deductible
on your tax statement, is going to have a
cash flow implication.

So here we're going to
figure out the taxes. And now I'm actually
going to be a little inconsistent in this chapter. So far in this class whenever
we've calculated a tax, we've used the ROUND function. And I am going to
use it right here. I'm going to say EBIT
times our rate comma 0– means round to the dollar. However, later in
this class, we're going to use– learn a tax
shield approach to calculating operating cash flow.

And when I do those, I'm
not going to use the ROUND. Ultimately it's all
estimates here anyway. But in this chapter whenever
I'm doing the individual tax in this method, I'll use ROUND. Otherwise, I won't. All right, so we have our tax. The operating cash
flow then becomes– oh, look at this– our EBIT minus our taxes. And what do we have to do? We have to add
back depreciation. Well, this is a negative. So I'm going to subtract it. Now you add back
the depreciation, because that's a
non-cash expense.

Hey, this looks exactly
like what we did in what? Chapter 2 when we did
our cash flow analysis– EBIT minus taxes plus add
back the depreciation. All right, so there
is our estimate for operating cash flow. In this video, we looked
at what relevant costs– they are the
incremental cash flows. And we saw some great examples. We saw sunk cost. We saw opportunity cost. We saw erosion. In this video, all we did was
calculate operating cash flow.

Our ultimate goal is to
estimate all of the actual cash flows associated with a
project and then calculate net present value. Well, we'll do that for
the first time next video. See you then..

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