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CHAPTER 8
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
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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.
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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,
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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
projects life are even more uncertain.
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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.
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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.
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Incremental Cash Flow for a Project

Projects incremental cash flow is:

Corporate cash flow with the project

Minus
Corporate cash flow without the project.
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Project Cash Flow versus Accounting
Income
Just as a firms value depends on its free cash flows, so
does the value of a project
Free cash flow is calculated as follows
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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
projects life
the after-tax cash proceeds represent a positive cash flow
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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
projects cash flow
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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
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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 projects life working capital will be

returned by the end of the projects life
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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.
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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.
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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.
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If the new product line would decrease

sales of the firms 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.
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An Example
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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
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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.
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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.

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Example: If Sold After 3 Years (000s)

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.