Cash Flow Estimation
Basic Concepts
Overview
• Most difficult aspect of capital budgeting
• Long time frame
▫ Leads to uncertainty
• Typical bias: overstate revenues and understate
costs
• Nevertheless, it must be carried out
Relevant Cash Flows Only
• These are called “incremental” cash flows
• That is, the CF’s that occur due to the
undertaking of the project
• Thus, “sunk costs” (expenditures already made)
must NOT be included
• Ex: Mktg study is done about feasibility
($8,000) before doing the project
• Do not include $8,000 into the CF’s
Opportunity Costs
• They must be included, though can be difficult to
calculate
• “What could have been earned otherwise” or
“best alternative if not this project”
• EX: Use your own land to build the factory
• Must include the opportunity cost of the land
(what could you have rent it for?)
Externalities
• “Impact of the project in consideration (the
capital budgeting project) onto existing projects”
• If the project benefits other existing projects,
include the benefit to the existing projects into
the CF’s of this project (positive)
• If the project hurts other existing projects
(cannibilize), include this cost into the CF’s
Depreciable Basis
• The amount of $$ that is used to calculate
depreciation (what we multiply the depreciation
rates by)
• Only long term assets plus shipping,
modifications, installation
• Does not include NWC investments
• Depreciation: use the fastest possible (MACRS)
Net Working Capital
• Initial investment needed to support the capital
investment
• Ex: inventories or cash
• Can be offset by “free” financing such as AP
• So the net effect is NWC
• Assume recovery of this investment at the end of
the project
Net Salvage
• At the end of the project, we assume that the
long term investment will be sold (salvage)
• This must be adjusted for tax effects (thus “net”)
• Salvage value +- tax impact= net salvage
• Tax impact:
▫ If gain (salvage > book value), pay taxes on that
gain (-) (reduces the salvage value)
▫ If a loss (salvage < book value), tax savings on the
loss (+) (increase the salvage value)