SZABIST
Financial Management
Lecture 7
Estimation of Project Cash Flows
Given a project’s expected cash flows, it is easy to calculate its
payback, discounted payback, NPV and IRR. Unfortunately, cash
flows are rarely just given—rather, financial managers must
estimate them based on information collected from sources both
inside and outside the company. Thus, in this lecture we try and
develop procedures for estimating the cash flows associated with
capital budgeting projects.
Faizan Ahmed
1
SZABIST
Financial Management
Capital Budgeting
Estimation of Cash Flows…
• The most important, but also the most difficult, step in capital budgeting is
estimating projects’ cash flows — the investment outlays and the annual net
cash inflows after a project goes into operation;
• The financial manager’s role in this exercise is to:
– Obtain information from the various departments involved such as marketing and
engineering;
– Ensure that everyone involved should follow a consistent set of assumptions;
– Make sure that no biases are inherent in the forecasts (Overestimation of revenues
and underestimation of costs).
Faizan Ahmed
2
SZABIST
Financial Management
Relevant Cash Flows
Identification…
• Capital budgeting decisions must be based on cash flows, not accounting
income:
– Cost of fixed assets is not reflected in the actual income statement;
– Calculation of net income accommodates a certain set of noncash charges;
– Changes in net working capital as a result of the project are not a part of the
income statement;
– Interest expenses are not deducted from project cash flows as it already is a part of
the discount rate used to estimate the present value.
• Only incremental cash flows are relevant:
– Forget sunk costs;
– Include opportunity costs;
– Include all the positive as well as the negative externalities.
Faizan Ahmed
3
SZABIST
Financial Management
Relevant Cash Flows
Estimation…
•
While we were determining the fair values of financial assets, we used
dividend/selling price and coupon interest/principal repayment as proxies for the
cash flows involved. Similarly, we calculate the free cash flows associated with the
project as a proxy of the relevant cash flows;
•
Free cash flow, in general, is the amount of cash available for distribution to
investors. Since we are solely focusing on relevant cash flows, free cash flow in this
context represents the additional amount of free cash flow available to investors if
they go ahead with the project;
•
From a project’s perspective, it represents that quantum of cash flow which is
available after all project-related funding needs have been met. This includes the
initial capital expenditure, subsequent injections, working capital requirements,
operating costs and other expenses;
•
In addition to the quantum, the timing of cash flow also plays a pivotal role in the
entire capital budgeting process.
Faizan Ahmed
4
SZABIST
Financial Management
Relevant Cash Flows
Calculation…
Free Cash
=
Flow
After-tax
Changes in
Capital
- Net Working
Operating + Depreciation Expenditure
Income
Capital
Free Cash
=
Flow
Changes in
Capital
+ Depreciation - Net Working
Expenditure
Capital
EBIT(1-t)
• Capital expenditure includes the initial cash outlays and subsequent injections
in a particular project;
• Depreciation represents the noncash charges which have been deducted from
the income statement but are not actual outflows themselves;
• Changes in net working capital represents the consequent increase/decrease
in current assets and/or current liabilities because of the project itself.
Faizan Ahmed
5
SZABIST
Financial Management
Relevant Cash Flows
Calculation…
• The formula presented in the previous slide needs to be applied on a periodic
basis in order to estimate the cash flows of the particular project. Project cash
flows can be categorized into:
– Initial investment outlay: Represents the upfront cost of the fixed assets which are
to be acquired as well as the preliminary investment in net working capital;
– Operating cash flows: These are the incremental cash flows which the project is
expected to generate over its life. It usually includes the after-tax operating cash
flow and noncash charges. However, there are times when subsequent injection of
funds is required either for the maintenance of fixed assets or for the changes in
net working capital. If that is the case, they will also be included in the calculation;
– Terminal year cash flow: In addition to the recurring operating cash flows, some
extra cash flows are generally received during the final year of the project. These
include the salvage value of the fixed asset (On after-tax basis) and the recovery of
funds dedicated towards the procurement of net working capital.
Faizan Ahmed
6
SZABIST
Financial Management
Relevant Cash Flows
Calculation…
• Observe the below-mentioned formula carefully and try and identify the
variables which will contribute towards the net cash flow depending upon
when that cash flow is occurring:
– Initial investment is most likely to have…
– Subsequent operating cash flows are most likely composed of…
– Terminal year cash flow will likely have…
Free Cash
=
Flow
Faizan Ahmed
EBIT(1-t)
Changes in
+ Depreciation - Capital
- Net Working
Expenditure
Capital
7