The Practice of Cash Flow Estimation for Capital Budgeting - Financial Management

The analysis presented in this chapter and throughout the book suggests that generating accurate estimates of the cash flows from investment projects is extremely important to the success of the firm. A survey supports this conclusion and provides considerable insight regarding the cash flow estimation procedures used by larger firms (Fortune 500).

The majority of the firms responding to the survey had annual capital budgets of more than $100 million. Nearly 67 percent of the firms prepared formal cash flow estimates for over 60 percent of their annual capital outlays, and a majority produced detailed cash flow projections for capital investments requiring an initial outlay of $40,000 or more.

Firms with high capital intensity and high leverage were more likely to have one or more persons, such as a financial analyst, treasurer, controller, or department manager, designated to oversee the process of cash flow estimation. This reflects the larger number of projects associated with capital-intensive firms and the need to effectively manage the risk associated with high leverage.

Annual-Net-Cash-Flow-Worksheet-for-the-Briggs-&-Stratton-Drill-Press

When asked about the type of cash flow estimates that were generated, 56 percent indicated that they used single-dollar estimates, 8 percent used a range of estimates, and 36 percent used both single -dollar estimates and a range of estimates. There was a significant positive correlation between firms that use both types of estimates and measures of operating and financial risk, suggesting that the use of a range of estimates is one procedure for managing high risk. Forecasting methods employed by the respondent firms included subjective estimates from management, sensitivity analysis, consensus analysis of expert opinions, and computer simulation.

Many firms used multiple cash flow forecasting techniques. The longer the forecasting horizon —that is, the longer the economic life of the project —the more likely a firm is to use multiple methods for forecasting future cash flows.

Financial factors considered to be important in generating cash flow estimates include working capital requirements, project risk, tax considerations, the project’s impact on the firm’s liquidity, the anticipated rate of inflation, and expected salvage value. Important marketing factors considered include sales forecasts, the competitive advantages and disadvantages of the product, and product life. Important production factors include operating expenses, material and supply costs, overhead and expenses for manufacturing, capacity utilization, and start-up costs.

Three-fourths of the companies surveyed make comparisons between actual and projected cash flows, with nearly all the firms comparing actual versus projected initial outlays and operating cash flows over the project life; about two -thirds of these firms make comparisons of actual versus projected salvage values. The most accurate cash flow estimates are reported to be the initial outlay estimates, and the least accurate element of cash flow estimates is the annual operating cash flows.

Cash Flow Estimation in Financial Management

Cash flow forecasts were more accurate for equipment replacement investments than for expansion and modernization investments or for acquisitions of ongoing businesses. Firms with the information system in place to generate cash flow forecasts tend to produce more accurate forecasts than firms with less sophisticated capital project evaluation procedures.

Summary Project Cash Flows for Briggs & Stratton

Summary Project Cash Flows for Briggs & Stratton

ETHICAL ISSUES

Cash Flow Estimation Biases

The estimation of the cash flows associated with an investment project is the most important step in the capital expenditure evaluation process. If the cash flow estimates associated with a project are intentionally or unintentionally biased, a firm’s resources are unlikely to be allocated to the set of investment projects that will maximize shareholder wealth. There are several reasons why managers might produce biased cash flow estimates when preparing capital expenditure project proposals.

First, a manager might be tempted to overestimate the revenues or underestimate the costs associated with a project if the manager is attempting to expand the resource base over which he or she has control. By biasing the estimates of a project’s cash flows upward, a manager is likely to receive a larger share of the investment resources of the firm. Because managerial compensation is sometimes tied to the span of job responsibilities, managers may be tempted to expand this span of control at the expense of other areas in the firm.

Second, some firms tie employee compensation to performance relative to stated objectives —a compensation scheme often called management by objective. If a manager is confident that the best estimate of the cash flows from a proposed project is sufficiently large to guarantee project acceptance, the manager may be tempted to reduce these cash flow estimates to a level below the “most likely outcome” level, confident that the project will continue to be viewed as an acceptable investment and that it will be funded.

However, once the project is under way, the project manager will feel less pressure to meet projected performance standards. The downward bias in the cash flow estimates provides a cushion that permits suboptimal management of the project while achieving the objectives enunciated when the project was first proposed.

What impact does intentionally biasing cash flow estimates for investment projects have on achieving the goal of shareholder wealth maximization?


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