Cash Flow Estimation
Chapter 7 in the book
Financial Policy and Planning (MB
29)
Project Cash Estimation
 Significance of Cash Flows and Cash Flow
Estimation
 The concept of “relevant” versus “irrelevant”
cash flows
 Points to watch in estimating cash flows
 How to estimate project operating cash flows?
 How to estimate project total cash flows?
 Evaluating Project with Unequal lives
Cash Flows
 To be consistent with wealth maximization
principle, an evaluation of a project must be
based on cash flows and not on accounting
profits
 To be able to use NPV technique or any other
technique of capital budgeting analysis
successfully and accurately, we must have an
unbiased estimate of the expected future cash
flows of the project including time to completion
and estimate initial investment/cost—extremely
important and most difficult task
Projects have failed or succeeded due to
incorrect or correct estimates of the cash
flows of the project.
If cash flow estimates are incorrect, it
doesn’t matter which technique we use, the
project is doomed to fail
“Relevant” versus “Irrelevant”
Cash Flows
 The results of an acceptance of a project is
to change the cash flows of a firm.
Cash flows of a firm that change because
of the project are called “relevant” cash
flows; any cash flows that does not change
irrespective of the acceptance/rejection of
the project is “irrelevant” to decision
making and should not be considered.
Points of Consider
Sunk Costs
Opportunity Costs
Project Externalities
Change in Net Working Capital
Sunk Costs
Sunk Costs—A cost that has already been
incurred and cannot be recovered
irrespective of the decision to accept or
reject the project.
Is it relevant or irrelevant? R&D, Market
Research, Consultant’s Fees
Opportunity Costs
 Opportunity Costs--The cash flow foregone by
using your resources in a particular way.
 Resources have multiple uses
 You can use them in one way to the exclusion of
other uses and this gives rise to opportunity costs
 By using your own building for your business,
you forego the rent that you could have earned by
renting it to some one else.
 Is it relevant or irrelevant to decision making?
Project Externalities
Project Externalities--the effect of a new
project (positive or negative) on an existing
project or division of a firm.
For instance, introduction of a new model
of a car on other existing models produced
by the same firm.
Is it relevant or irrelevant to decision
making?
Net Working Capital
 Change in Net Working Capital--Net working capital
is defined as current assets minus current liabilities.
 Any positive change in Net Working Capital in
particular year means investment in working capital
is needed for that particular year, leading to cash
outflows for that year.
 Negative change in net working capital in a particular
year means less investment in working capital in
comparison to previous year, which means
investment in working capital will go down, leading
to some cash inflow for that particular year
Net Working Capital
Any investment in working capital is a
cash inflow during the last year of the
project and must be treated accordingly
Estimating Project Cash Flows
Total Cash Flows of a Project in year t,
where t ranges from year 0 to year n.
= Project Operating Cash Flows for that
particular year – change in Net Working
Capital – initial investment
There is no project operating cash flows for
year 0
Estimating Project Operating
Cash Flows
Cash flows from operations for any year
– Estimated Sales Revenue *****
– Total Costs
*****
– Variable Costs
– Fixed Costs
per year
– Depreciation
***
***
***
 Sales Revenue minus Total Costs = Earnings Before Interest and Taxes
(EBIT)
– Deduct Taxes from EBIT
– Net Income
***
***
 Operating Cash Flows = Net Income +
Depreciation OR
 = EBIT – Taxes + Depreciation
Evaluating Projects with
Unequal Lives
Replacement Chain Analysis
Equivalent Annual Cost Method
If two machines are unequal in life, we
need to make adjustment before computing
NPV.