Cash Flow Estimation Chapter 7 in the book Financial Policy and Planning (MB 29)

Project Cash Estimation  Significance of Cash Flows and Cash Flow Estimation  The concept of “relevant” versus “irrelevant” cash flows  Points to watch in estimating cash flows  How to estimate project operating cash flows?  How to estimate project total cash flows?  Evaluating Project with Unequal lives

Cash Flows  To be consistent with wealth maximization principle, an evaluation of a project must be based on cash flows and not on accounting profits  To be able to use NPV technique or any other technique of capital budgeting analysis successfully and accurately, we must have an unbiased estimate of the expected future cash flows of the project including time to completion and estimate initial investment/cost—extremely important and most difficult task

 Projects have failed or succeeded due to incorrect or correct estimates of the cash flows of the project.  If cash flow estimates are incorrect, it doesn’t matter which technique we use, the project is doomed to fail

“Relevant” versus “Irrelevant” Cash Flows  The results of an acceptance of a project is to change the cash flows of a firm.  Cash flows of a firm that change because of the project are called “relevant” cash flows; any cash flows that does not change irrespective of the acceptance/rejection of the project is “irrelevant” to decision making and should not be considered.

Points of Consider  Sunk Costs  Opportunity Costs  Project Externalities  Change in Net Working Capital

Sunk Costs  Sunk Costs—A cost that has already been incurred and cannot be recovered irrespective of the decision to accept or reject the project.  Is it relevant or irrelevant? R&D, Market Research, Consultant’s Fees

Opportunity Costs  Opportunity Costs--The cash flow foregone by using your resources in a particular way.  Resources have multiple uses  You can use them in one way to the exclusion of other uses and this gives rise to opportunity costs  By using your own building for your business, you forego the rent that you could have earned by renting it to some one else.  Is it relevant or irrelevant to decision making?

Project Externalities  Project Externalities--the effect of a new project (positive or negative) on an existing project or division of a firm.  For instance, introduction of a new model of a car on other existing models produced by the same firm.  Is it relevant or irrelevant to decision making?

Net Working Capital  Change in Net Working Capital--Net working capital is defined as current assets minus current liabilities.  Any positive change in Net Working Capital in particular year means investment in working capital is needed for that particular year, leading to cash outflows for that year.  Negative change in net working capital in a particular year means less investment in working capital in comparison to previous year, which means investment in working capital will go down, leading to some cash inflow for that particular year

Net Working Capital  Any investment in working capital is a cash inflow during the last year of the project and must be treated accordingly

Estimating Project Cash Flows  Total Cash Flows of a Project in year t, where t ranges from year 0 to year n. = Project Operating Cash Flows for that particular year – change in Net Working Capital – initial investment There is no project operating cash flows for year 0

Estimating Project Operating Cash Flows  Cash flows from operations for any year –Estimated Sales Revenue***** –Total Costs***** –Variable Costs *** –Fixed Costs per year*** –Depreciation***  Sales Revenue minus Total Costs = Earnings Before Interest and Taxes (EBIT) –Deduct Taxes from EBIT*** –Net Income***

 Operating Cash Flows = Net Income + Depreciation OR  = EBIT – Taxes + Depreciation

Evaluating Projects with Unequal Lives  Replacement Chain Analysis  Equivalent Annual Cost Method  If two machines are unequal in life, we need to make adjustment before computing NPV.