Principles of Estimating Cash Flows - Financial Management

The capital budgeting process is concerned primarily with the estimation of the cash flows associated with a project, not just the project’s contribution to accounting profits. Typically, a capital expenditure requires an initial cash outflow, termed the net investment. Thus it is important to measure a project’s performance in terms of the net (operating) cash flows it is expected to generate over a number of future years.

Principles of Cash Flow Estimation

Figure shows the estimated cash flows for a particular project. After an initial net investment of $100,000, the project is expected to generate a stream of net cash inflows over its anticipated 5-year life of $50,000 in year 1; $40,000 in year 2; $30,000 in year 3; $25,000 in year 4; and $5,000 in year 5. This type of project is called a conventional or normal project.

Illustration of Estimated Cash Flows for a Normal Capital Investment Project

Estimated Cash Flows for a Normal Capital Investment Project

Nonnormal or nonconventional projects have cash flow patterns with either more than one or no sign change. Table illustrates the cash flow patterns for three sample projects. Projects X and Y can cause some analytical problems, as we shall see in the discussion of the internal rate of return criterion in the following chapter. Project X might require that certain equipment be shut down and rebuilt in year 3, and Project Y could be an investment in a mining property, with the negative cash flow in year 5 representing abandonment costs associated with closing down the mine after its mineral wealth has been depleted.

Finally, Project Z, which generates negative cash flows over the entire life of the investment, such as an investment in pollution control equipment, can be difficult to evaluate using the decision- making criteria developed in the next chapter.

Regardless of whether a project’s cash flows are expected to be normal or nonnormal, certain basic principles should be applied during their estimation, including the following:

  • Cash flows should be measured on an incremental basis. In other words, the cash flow stream for a particular project should be estimated from the perspective of how the entire cash flow stream of the firm will be affected if the project is adopted as compared with how the stream will be affected if the project is not adopted. Therefore, all changes in the firm’s revenue stream, cost stream, and tax stream that would result from the acceptance of the project should be included in the analysis. In contrast, cash flows that would not be changed by the investment should be disregarded.
  • Cash flows should be measured on an after -tax basis. Because the initial investment made on a project requires the outlay of after -tax cash dollars, the returns from the project should be measured in the same units, namely, after-tax cash flows.
  • All the indirect effects of a project should be included in the cash flow calculations. For example, if a proposed plant expansion requires that working capital be increased for the firm as a whole —perhaps in the form of larger cash balances, inventories, or accounts receivable —the increase in working capital should be included in the net investment required for the project.

    A firm may also have to provide for further working capital increases as sales increase over the life of the project. These additional working capital requirements should be included in the yearly net cash flows as outflows.However, as the project winds down, net working capital balances decline; these should be included as inflows when determining yearly cash flows. Other indirect effects may occur when one division of a firm introduces a new product that competes directly with a product produced by another division. The first division may consider this product desirable, but when the impact on the second division’s sales is considered, the project may be much less attractive.

    For example, in the Ford capital expenditure decision discussed earlier in the chapter, the company should consider the impact of the increased output of Volvos on the demand for Ford’s other luxury -car brands —namely, Lincoln and Jaguar.

    Sample Cash Flow Patterns for Nonnormal Projects

    Sample Cash Flow Patterns for Nonnormal Projects
  • Sunk costs should not be considered when evaluating a project. A sunk cost is an outlay that has already been made (or committed to be made).

    Because sunk costs cannot be recovered, they should not be considered in the decision to accept or reject a project. For example, in 2004, the Chemtron Corporation was considering constructing a new chemical disposal facility. Two years earlier, the firm had hired the R.O.E. Consulting Group to do an environmental impact analysis of the proposed site at a cost of $500,000.

    Because this $500,000 cost cannot be recovered whether the project is undertaken or not, it should not be considered in the accept –reject analysis taking place in 2004. The only relevant costs are the incremental outlays that will be made from this point forward if the project is undertaken.

  • The value of resources used in a project should be measured in terms of their opportunity

    costs. Opportunity costs of resources (assets) are the cash flows those resources could generate if they are not used in the project under consideration. For example, suppose that the site Chemtron is considering to use for its disposal facility has been owned by the firm for some time. The property originally cost $50,000, but a recent appraisal indicates that the property could be sold for $1 million.

    Because Chemtron must forgo the receipt of $1 million from the sale of the site if the disposal facility is constructed, the appropriate opportunity cost of this piece of land is $1 million, not the original cost of $50,000. These five principles of cash flow estimation may be applied to the specific problem of defining and calculating a project’s net investment and net cash flows.

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