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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/costextremely 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
doesnt 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 CostsA 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, Consultants 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.