CASH FLOW ESTIMATION

PRESENTER: RHEYBEL G. DE LEMON

Cash Flow Estimation
 Capital Budgeting consists of:
- Estimating cash flows associated with projects
- Evaluating the estimates using NPV and IRR

 Forecasting cash flows accurately is by far the most

difficult process and more prone to errors

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The General Approach to Cash Flow Estimation

 A sales forecast leads to an estimate of cash inflows from

customers
 A cost/expense projection leads to a pattern of outflows to
employees and vendors
 An equipment plan leads to a series of outflows for capital
assets

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The General Approach
Pre-startup, the initial outlay:
• Enumerate pre-start expenses (after tax) and all assets that must be
purchased
Sales Forecast
• Forecast incremental units over time in a spreadsheet
• Extend by prices for revenues
Cost of Sales and Expenses
• Base costs and expenses on a relationship with incremental
revenues or units sold
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The General Approach
Assets
• Plan new assets when needed
• Include working capital
Depreciation
• Plan depreciation for new and old assets
• A non-cash item but it impact taxes
Taxes and Earnings
• Summarize tax deductible items in each period to calculate the impact
of taxes and earnings
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THE GENERAL APPROACH TO CASH FLOW ESTIMATION

• Expansion Projects
- Requires the same elements as
new ventures
- Usually needs less new
equipment and facilities
• Replacement Projects
- Generally saves on cost without
generating new revenue
- Estimating process may be less
elaborate
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Project Cash Flows
The Typical Pattern
- Requires an initial outlay
- Subsequent cash flows tend to be positive

Project Cash Flows are incremental.

- Separable from existing business

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Project Cash Flows
• Impacts on other parts of company
• Overhead levels
• Taxes
• Cash v. accounting results
• Working capital
• Ignore financing costs
• Old equipment

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Estimating New Venture Cash Flows
• New venture projects tend to be larger and more elaborate than
expansions or replacements
- But incremental cash flows can be easier to isolate

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Concept Connection Example 11-1 New Venture Cash
Flows
• Wilmont Bicycle is considering a new business proposal to produce off-road
bikes. The following information is forecast:

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Concept Connection Example 11-1 New Venture Cash
Flows
• Last year purchased a gearshift design for are the same.
$50,000. • General overhead is about 5% of revenue.
• Facilities are at capacity, so a new shop is - Incremental overhead is estimated at
required. 2% of revenues.
• Company owns land nearby • Revenues collected in 30 days.
- New building will cost $60,000 • Incremental inventories
- Land purchased 10 years ago for $30,700 - $12,000 at startup and for the first year.
- Market value is now $150,000. - Then inventory turnover = 12 X
• Three percent of new units sold will come • Payables will be 25% of inventories.
from the old line. • Losses result in tax credits.
- Prices and direct costs in the two lines •
Marginal tax rate is 34%.

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Concept Connection Example 11-1 New Venture Cash
Flows
• Initial Outlay costs of hiring, training and advertising are tax deductible:

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Concept Connection Example 11-1 New Venture Cash
Flows

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Concept Connection Example 11-1 New Venture Cash
Flows

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Concept Connection Example 11-1 New Venture Cash
Flows

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Concept Connection Example 11-1 New Venture Cash
Flows

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Terminal Values
• Cash flows forecast to continue forever are compressed into finite terminal
values using perpetuity formulas
- A common but very aggressive assumption with new ventures
- A repetitive cash flow starting in year 7 is valued as a perpetuity

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Accuracy and Estimates
• NPV and IRR techniques give the
impression of great accuracy
• Capital budgeting results are no more
accurate than the projections used as
inputs
• Unintentional biases are a problem in
capital budgeting
Modified Accelerated Cost Recovery
System (MACRS)
- Sorts assets (equipment) into categories
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Estimating Cash Flows for Replacement Projects
• Fewer elements than new ventures
• Identifying what is incremental can be tricky
• Difficult to determine what will happen if you don’t do the project

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Example 11-3 Replacement Projects
• Harrington purchased a machine five years ago for $80,000.
• Depreciated straight-line over eight years
• New machinery depreciated straight line over five years.
• Considering replacing with a new one costing $150,000.
• Old unit can be sold for $45,000
• Old machine - three operators $25,000/year each
• New machine - two operators $25,000/year each

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Example 11-3 Replacement Projects
• The old machine has the following history of high maintenance
cost and significant downtime.

• Manufacturing managers estimate every hour of downtime costs

the $500, but have no backup data.
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Example 11-3 Replacement Projects
• New machine claims
Maintenance will cost $15,000/year and annual
Downtime about 30 hours.
However, no guarantee after warranty.
• The new machine is expected to produce higher quality output
resulting in better customer satisfaction and sales, but no one can
quantify this result.

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Example 11-3 Replacement Projects
Harrington is currently profitable with a 34% tax rate. Estimate the
incremental cash flows over the next five years associated with
buying the new machine.
Solution:
• There are two kinds of cash flows in this problem—those that can
be estimated fairly objectively and those that require some
degree of subjective guesswork.
First consider the objective items.

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Objective Items
Initial Outlay Selling an Old Asset Depreciation and Labor

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 Example 11-3 Replacement Projects
The subjective benefits (involve opinion) are hard to quantify and
lead to biases when estimated by people who want project
approval. The financial analyst should ensure reasonability.

The question is: Should we assume maintenance on the old

machine would have remained at $90.0 or increase as the machine
gets older? Also, will maintenance on the new machine rise as it
ages? 25
 Example 11-3 Replacement Projects
• Downtime: The new machine promises savings of 100 hours. But, how reliable are those
estimates?
• And how much does each hour of downtime savings cost? Arguments range from
nothing to $1,000 an hour.
• A middle-of-the-road approach of $400 an hour yields an estimated savings of $40,000
per year.

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 Example 11-3 Replacement Projects
• Combining these with the initial outlays yields the project’s
estimated cash flow stream.

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