Forecasting Future Annual Net Cash Flows 1.Definition of net cash flows 2.Projecting future values 3.Measurement of business risk 4.Risk/return preferences 5.Measurement of financial risk
Item: Before new investment After new investment Net change 1. Cash receipts$25,000$30,000$5, Cash operating expenses-15,000-18,000-3, Depreciation-3,000-4,000-1, Tax deductible expenses (2+3)18,00022,0004, Taxable income (1 – 4)7,0008,0001, Income tax payments (5 times 25%)1,7502, Net income after taxes (1 – 4 – 6)5,2506, Net cash flow (7 + 3)8,25010,0001,750 Page 44 The value circled in red is the value which appears in the numerator of each year’s discounted annual net cash flows in the NPV capital budgeting model. Measuring Annual Net Cash Flows
Forecasting Needs Forecast of annual price of products from your operations Forecast of annual cost per unit for inputs used in your operations Forecasts any expected changes in productivity (i.e., yields)
Alternative Approaches Market outlook information approach Historical based approaches: –Naïve model (p. 64) –Olympic moving average (p. 65) Time series econometric approach Flexibility coefficient approach (p. 66) Structural econometric approach (p )
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DemandSupply PEPE QEQE Q D = f(P, Y-T, W,...) Q S = f(P, MIC, …) Q D = Q S Solve for P E and Q E Q D = f(P, Y-T, W,...) Q S = f(P, MIC, …) Q D = Q S Solve for P E and Q E - 1 SD Mean + 1 SD Structural Econometric Forecasting Model Page 109 Page 65 Stochastic simulation of random variable (yields) generates an empirical probability distribution for price Non-Econometric Forecasting Approach Subjective triangular probability distribition assumed annually based upon recent trends in local spot market prices Alternative Forecasting Approaches
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This is the probability distribution for the first year. One would expect the probability associated with the most likely scenario to decline over time, reflecting increasing uncertainty in subsequent years.
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Page 75 We would reject making this investment since the NPV < 0.
Page 76 Ignoring risk would have led to an over evaluation of the projects NPV.
Page 76 Ignoring the increasing risk would have led to the acceptance of this investment project.
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Portfolio Effect on Risk-Adjusted NPV Page 79
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Any Questions?