CASH FLOW

ESTIMATION - 1
An Introduction
Corporate Valuation, Cash Flows, and Risk Analysis
Cash flow identification – the conceptual
issue
• Many variables are involved, and many individuals and
departments participate in the process of cash flow 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 realistic economic assumptions, and
3. Making sure that no biases are inherent in the forecasts.
Cash flow (CF) Vs Accounting Income (NI)
• In finance cash flows and free cashflows are
identical.
• Net Income ≠ Cash flow available for distribution to
investors!
• There are important differences between cash flow
and accounting income!
Measure of Cashflows - FCF
• Free Cash flows (FCF) - The cash available for distribution to investors.
• FCF
= Net Operating profit after taxes (NOPAT) or [ EBIT (1-T)]
+ Depreciation
- Gross fixed asset expenditures
- Change in Net operating working capital [Δ Operating Current assets -
Δ Operating Current Liabilities]
CF vs. NI- CF effect on Asset purchases
& depreciation
• Depreciation is the most common non-cash expense.
• It must be added back when estimating a project’s
operating cash flow.
• Just as with depreciation, all other noncash expenses
should be added back when calculating a project’s
net cash flow. e.g. amortization, depletion, stock-
based compensation, and asset impairments etc.
CF vs. NI- Changes in Net operating
WC
• AP & accruals increase as a result of the expansion
=> 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.
Items not part of Cashflows

1. Interest expense: A common mistake made by many

students and financial managers is to subtract
interest payments when estimating a project’s cash
flows.
• It is a financing expense not operating expense.
• The cost of debt is already embedded in the cost of
capital.
• Therefore, you should not subtract interest expenses
when finding a project’s cash flows.
CF Vs NI-Timing of Cash Flows: Yearly versus
Other Periods
• Generally, it is more appropriate to assume that all cash
flows occur at the end of the various years.
• But for projects with highly predictable cash flows, such as
constructing a building and then leasing it on a long-term
basis (with monthly payments) to a financially sound
tenant, we would analyze the project using monthly
periods.
CF Vs Incremental Cash Flows
• The relevant cash flows to be used in project analysis are
called incremental cash flows:

Incremental CF for Expansion Project: the cash expenditures on

buildings, equipment, and required working capital are obviously
incremental, as are the sales revenues and operating costs associated
with the project.
Incremental CF for Replacement Project: these are complicated by
the fact that most of the relevant cash flows are the cash flow
differences between the existing project and the replacement project.
Sunk Cost
• A sunk cost is an outlay related to the project that was
incurred in the past and cannot be recovered in the future
regardless of whether or not the project is accepted.
• Therefore, sunk costs are not incremental costs and thus are
not relevant in a capital budgeting analysis.
• Suppose, Home Depot spent $2 million to investigate sites for
a potential new store in a given area. That $2 million is a sunk
cost—the money is gone, and it won’t come back regardless of
whether or not a new store is built.
Opportunity Costs Associated with Assets
the Firm Already Owns
• Opportunity costs are the revenues that are lost (or
additional costs that arise) from moving existing
resources from their current use and are therefore
considered to be incremental cash flows arising in the
future to be taken into account.
• opportunity costs related to assets the firm already owns.
• E.g land already owned by homedepot company worth $2
Million.
Externalities
Externalities are the effects of a project on other parts of
the firm or on the environment.
There are three types of externalities:
1. Negative within-firm externalities,
2. Positive within-firm externalities,
3. Environmental externalities.
Externalities
1. Negative within-firm externalities: This type of
externality is also called cannibalization, because the
new business eats into the company’s existing business.
- Many businesses are subject to cannibalization.
- Good judgment is an essential element for good financial
decisions.
Externalities
2. Positive within-firm externalities: A new project can also
be complementary to an old one.
• In this case cash flows in the old operation will be
increased when the new one is introduced.
• Consideration of positive externalities often changes a
project’s NPV from negative to positive.
Externalities
3. Environmental Externalities: The most common type of
negative externality is a project’s impact on the
environment.
• Government rules and regulations constrain what
companies can do, but firms have some flexibility in
dealing with the environment.
Analysis of an expansion project
Cash flow Projections could be analyzed as follows:
• Cash Outlay
• Starts with Cash outlay or initial investment
• Adjust for opportunity cost if applies
• Include initial net working capital if applies
• Net Cash flows- Make after tax adjustments in the
following:
• Adjust for Sales
• Depreciation method and then add back
• Cannibalization/complementary effects
• Salvage value
• Change in WC
Analysis of an Expansion
Project: Inputs and Key
Results (Thousands of
Dollars)
Further information
Word Problems & Toolkit
Word Problem:
11-1, 11-2, 11-3,11-6

11-5

11-7
11-1

b. No, last year’s $50,000 expenditure is considered a sunk cost and does not
represent an incremental cash flow. Hence, it should not be included in the
analysis.

c. The potential sale of the building represents an opportunity cost of conducting the
project in that building. Therefore, the possible after-tax sale price must be charged
against the project as a cost.
11-2
11-3
11-6
11-6
• The depreciation expense in each year is the depreciable basis,
$120,500, times the MACRS allowance percentages of 0.33, 0.45, and
0.15 for Years 1, 2, and 3, respectively.
• Depreciation expense in Years 1, 2, and 3 is $39,765, $54,225, and
$18,075. The depreciation tax savings is calculated as the tax rate
(35%) times the depreciation expense in each year.
11-6 part c & D
11-5
MACRS depreciation (appendix 11A)