MAT 444 Module 6 Estimating Project Cash Flows Example

Only What Changes Counts: Forecasting the Cash Flows of a Laser Cutting Cell, Line by Line

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Business Administration Program, Aspen University

MAT 444: Finance for Managers

Instructor Name

Month Day, Year

Only What Changes Counts: Forecasting the Cash Flows of a Laser Cutting Cell, Line by Line

Haverstock Fabrication sends about $540,000 of laser cutting work each year to an outside shop in Huntington, waiting four to six days for parts it could cut itself in hours. A fiber laser cutting cell with an automated loading tower would bring that work in-house and let Haverstock bid on thin-gauge jobs it now turns away. The equipment vendor's quote is $2.4 million installed, including rigging, electrical work and operator training. Before the board can judge the project in Module 7, the cash it would bring and cost must be forecast. This paper builds that forecast. Haverstock, the project and every figure are composites written for teaching, and the tax treatment is simplified.

The Rule

A project's cash flows are the differences between the company's cash with the project and without it. Every proposed line must pass one test: does Haverstock's cash change because of this decision? Items that change are included, whether they appear in the accounting budget or not. Items that would happen anyway are left out, however closely they are associated with the project.

Sorting the Items

The net yearly operating benefit before tax is $540,000 + $380,000 minus $140,000, $90,000, $54,000 and $36,000, or $600,000.

Depreciation as a Tax Shield

Depreciation is not a payment, but it lowers taxable income and therefore taxes. The cell is seven-year property under the Modified Accelerated Cost Recovery System, with the half-year convention spreading deductions over eight tax years. Haverstock's tax adviser has elected not to take bonus depreciation in this base case to keep the forecast simple; Module 8 shows the effect of taking it.

Yearly Operating Cash Flows

Operating cash flow each year is the after-tax operating benefit, $600,000 × 0.75 = $450,000, plus the depreciation tax saving.

The Start and the End

At the start, Haverstock pays $2.4 million for the cell and ties up $150,000 in working capital, an outflow of $2,550,000. At the end of year seven, the working capital returns as inventory is used and receivables are collected. The vendor estimates the cell will then sell for about $400,000. Its book value will be $107,040, so the gain of $292,960 is taxed at 25%, leaving after-tax salvage of $400,000 minus $73,240, or $326,760.

Testing the Forecast Against Experience

Flyvbjerg et al. (2002) compiled data on 258 transport infrastructure projects in twenty nations Close to 90% had ended up costing more than forecast, by about 28% on average, and rail lines overran by much more. The errors had not shrunk over seven decades, which led the authors to conclude that strategic misrepresentation, not honest error, best explained them. A laser cell is far simpler than a rail line, but the lesson applies: the people proposing a project have reasons to make it look good.

Kahneman and Lovallo (1993) described why even honest planners forecast too boldly. Planners take an inside view, building the forecast from the details of their own plan, and neglect the outside view, the record of similar projects. The cure they proposed is to ask how comparable projects actually turned out. The vendor reports that customers installing similar cells took an average of nine months, not three, to reach full use. Applied to Haverstock, a slower ramp would cut the first year's benefit roughly in half, and Module 8 tests that case.

Guarding Against Sunk Cost Thinking

Arkes and Blumer (1985) reported a field study and a set of questionnaire studies in which people kept putting money or effort into a choice largely because they had already paid for it. In one field study at a campus theater, buyers randomly charged the full season price showed up to more of the early performances than buyers given a discount, even though neither group could get its money back. The $45,000 study sits outside this forecast for that reason. The same rule will apply later: if the cell disappoints in its third year, the decision to keep or sell it must rest on future cash flows, not on the $2.4 million already paid. Haverstock's board minutes should record the forecast assumptions now, so that a later review compares results with what was expected instead of with what people remember expecting, and so that a decision to stop is judged on the same incremental rule used to start.

Conclusion

The laser cell requires $2,550,000 at the start and returns operating cash flows of about $504,000 to $597,000 a year, plus about $477,000 of recovered working capital and after-tax salvage at the end. Only items that change Haverstock's cash are included. Flyvbjerg and colleagues, Kahneman and Lovallo and Arkes and Blumer explain why the forecast should be checked against similar projects and why money already spent should never steer the decision.

References

Arkes, H. R., & Blumer, C. (1985). The psychology of sunk cost. Organizational Behavior and Human Decision Processes, 35(1), 124-140. https://doi.org/10.1016/0749-5978(85)90049-4

Flyvbjerg, B., Holm, M. S., & Buhl, S. (2002). Underestimating costs in public works projects: Error or lie? Journal of the American Planning Association, 68(3), 279-295. https://doi.org/10.1080/01944360208976273

Kahneman, D., & Lovallo, D. (1993). Timid choices and bold forecasts: A cognitive perspective on risk taking. Management Science, 39(1), 17-31. https://doi.org/10.1287/mnsc.39.1.17