1. Cash Flow Estimation and Risk Analysis
Estimating cash flows:
Relevant cash flows
Working capital treatment
Inflation
Risk Analysis: Sensitivity Analysis, Scenario Analysis, and Simulation Analysis

2. CASH FLOW ESTIMATION
The most important, but also the most difficult, step in capital budgeting is estimating projects’ cash flows
the forecasts of unit sales and sales prices are normally made by the marketing group, based on their knowledge of:
price elasticity,
advertising effects,
the state of the economy,
competitors’ reactions, and
trends in consumers’ tastes.

3. Who Estimates Outlays?
Similarly, the capital outlays associated with a new product are generally obtained from the engineering and product development staffs,
while operating costs are estimated by cost accountants, production experts, personnel specialists, purchasing agents,

4. It is difficult to forecast the costs and revenues associated with a large, complex project, so forecast errors can be quite large.
Further, as difficult as plant and equipment costs are to estimate, sales revenues and operating costs over the project’s life are even more uncertain.

5. Important points in estimation
A proper analysis includes
(1) obtaining information from various departments such as engineering and marketing,
(2) ensuring that everyone involved with the forecast uses a consistent set of economic assumptions, and
(3) making sure that no biases are inherent in the forecasts.

6. Identifying the Relevant Cash Flows
The first step in capital budgeting is to identify the relevant cash flows,
Analysts often make errors in estimating cash flows, but two cardinal rules can help you minimize mistakes:
(1) Capital budgeting decisions must be based on cash flows, not accounting income.
(2) Only incremental cash flows are relevant.

7. Incremental Cash Flow for a Project
Project’s incremental cash flow is:
Corporate cash flow with the project
Minus
Corporate cash flow without the project.

8. Project Cash Flow versus Accounting Income
Just as a firm’s value depends on its free cash flows, so does the value of a project
Free cash flow is calculated as follows

9. 1. Costs of Fixed Assets asset purchases represent negative cash flows
the full cost of fixed assets includes any shipping and installation costs
the full cost of the equipment, including shipping and installation costs, is used as the depreciable basis
Note too that fixed assets can often be sold at the end of a project’s life
the after-tax cash proceeds represent a positive cash flow

10. 2. +Noncash Charges
In calculating net income, accountants usually subtract depreciation from revenues
Depreciation itself is not a cash flow. Therefore, depreciation must be added to NOPAT when estimating a project’s cash flow

11. 3. Changes in Net Operating Working Capital
Normally, additional inventories are required to support a new operation, and expanded sales tie up additional funds in accounts receivable
However, payables and accruals increase as a result of the expansion, and this reduces the cash needed to finance inventories and receivables
The difference between the required increase in operating current assets and the increase in operating current liabilities is the change in net operating working capital

12. 3. Changes in Net Operating Working Capital (CONTINUED)
If this change is positive, then additional financing, over and above the cost of the fixed assets, will be needed.
Toward the end of a project’s life working capital will be returned by the end of the project’s life

13. Should you subtract interest expense or dividends when calculating CF?
NO. We discount project cash flows with a cost of capital that is the rate of return required by all investors (not just debtholders or stockholders), and so we should discount the total amount of cash flow available to all investors.
They are part of the costs of capital. If we subtracted them from cash flows, we would be double counting capital costs.

14. Suppose $100,000 had been spent last year to improve the production line site. Should this cost be included in the analysis?
NO. This is a sunk cost. Focus on incremental investment and operating cash flows.

15. Suppose the plant space could be leased out for $25,000 a year
Suppose the plant space could be leased out for $25,000 a year. Would this affect the analysis?
Yes. Accepting the project means we will not receive the $25,000. This is an opportunity cost and it should be charged to the project.
A.T. opportunity cost = $25,000 (1 - T) = $15,000 annual cost.

16. If the new product line would decrease sales of the firm’s other products by $50,000 per year, would this affect the analysis?
Yes. The effects on the other projects’ CFs are “externalities”.
Net CF loss per year on other lines would be a cost to this project.
Externalities will be positive if new projects are complements to existing assets, negative if substitutes.

17. An Example

20. Why is it important to include inflation when estimating cash flows?
Nominal r > real r. The cost of capital, r, includes a premium for inflation.
Nominal CF > real CF. This is because nominal cash flows incorporate inflation.
If you discount real CF with the higher nominal r, then your NPV estimate is too low.
Continued…

21. Inflation (Continued)
Nominal CF should be discounted with nominal r, and real CF should be discounted with real r.
It is more realistic to find the nominal CF (i.e., increase cash flow estimates with inflation) than it is to reduce the nominal r to a real r.

22. What if you terminate a project before the asset is fully depreciated?
Cash flow from sale = Sale proceeds
- taxes paid.
Taxes are based on difference between sales price and tax basis, where:
Basis = Original basis - Accum. deprec.

23. Example: If Sold After 3 Years
Original basis = $240.
After 3 years = $16.8 remaining.
Sales price = $25.
Tax on sale = 0.4($25-$16.8) = $3.28.
Cash flow = $25-$3.28=$21.72.