Topic 7: Cash Flow Analysis
I. Computing Cash Flows
As discussed in the previous chapter, the most important part – and most difficult part – of a
capital budgeting analysis is the estimation of the cash flows that we would expect to realize over
an investment project’s life. (Of course, estimating the appropriate cost of capital is no picnic,
either.) Because no capital budgeting technique (Payback, IRR, or even NPV) can lead to good
decisions if the underlying dollar estimates are poorly made, it is essential that the analyst use as
much care, and as much information, as possible in estimating the cash flows for a proposed
capital investment project.
We are probably most correct in thinking of a cash flow estimate as the midpoint of a range of
possible values. For example, if we predict cash flow in year 2 of a project’s life to be $100,000,
it might be that we think the cash flow could be $75,000 if the economy is weak, $100,000 if the
economy is all right, and $125,000 if the economy is strong, with an average, or expected, value
of $100,000 (if the three possible economic states are equally likely).
A. Computing Cash Flow: The Basics
Cash flow is a concept related to accrual accounting-based net income, but there are some
important differences. Textbooks typically devote some space to distinguishing between
expansion projects and replacement projects, but they differ primarily in that an expansion
project’s expected cash flows result from higher revenues, while a replacement project’s
expected cash flows result from reduced expenses (since you would be likely to replace existing
assets only if the new assets would be more efficient).
An investment project’s projected income statement might appear as
Project’s expected revenues
– Cash costs of production/distribution
– Depreciation
Project’s expected earnings before taxes
– Income taxes
Project’s expected net income
$10,000
5,000
2,000
$ 3,000
1,200
$1,800
But the project’s expected operating cash flow, which is based only on activities that result in
cash being paid or collected in (or shortly after) the operating period in question, would be
computed as
Project’s expected revenues
– Cash costs of production/distribution
– Income taxes
Project’s expected operating cash flow
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$10,000
5,000
1,200
$3,800
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Unfortunately, we can not compute the operating cash flow without first computing net income
(toward which we subtract out depreciation), because we need the net income figure to know
the appropriate amount of income tax (which is a cash outlay). [More technically, the ability to
claim the non-cash depreciation as an operating expense provides an income tax shield.] But
then once we have computed the project’s expected net income, we can quickly compute an
estimate of operating cash flow as that net income value plus depreciation: net income $1,800 +
depreciation $2,000 = project’s expected operating cash flow (OCF) of $3,800.
[What we call OCF for an investment project is computed essentially the same way that we
compute OCF for a firm’s entire operation in Topic 2. The only difference is that here OCF is
(EBT)(1 – t), not (EBIT)(1 – t). We do not compute an EBIT for an individual project, since
we do not subtract projected interest payments from projected revenues in estimating a project’s
operating and net cash flows. Indeed, our goal in analyzing an individual project is to estimate
whether the money left after operating expenses are met will be enough to pay interest to lenders,
and a fair return on equity to owners.]
That net income + depreciation figure may be a good approximation of the net cash flow we
should use for a specified year in a capital budgeting analysis. But note that, because it comes
from an accrual-based net income figure, operating cash flow is also accrual-based. To truly
predict cash flows we would have to look at when cash is collected on sales, and when it is paid
for goods or services purchased.
Thus in addition to net income + depreciation, we have to look at the changes in net working
capital (current assets minus current liabilities, an investment rather than operating issue). An
increase in net working capital may sound good on the surface, but it actually indicates that, over
the measured period, the company suffered a cash drain by investing additional cash in short term
assets. Think of a simple example with inventory as the only current asset and notes payable as
the only current liability. If net working capital decreased over the past year, then short term
lenders provided the firm with more money than the firm spent on inventory, leaving the firm
with additional cash. But if net working capital increased, then the firm spent more on inventory
than it was provided by informal short-term lenders, thereby using up cash.
Of course, if the amount of year 1’s accrual-based sales that are collected in cash early in year 2
are roughly equal to the amount of year 2’s accrual-based sales that are collected in cash early in
year 3, and if the amount of year 1’s accrual-based expenses that are paid in cash early in year 2
are roughly equal to the amount of year 2’s accrual-based expenses that are paid in cash early in
year 3, then the change in net working capital should be minor, and net income + depreciation
does give a good approximation of the project’s true operating cash flow for the year in question.
Note also that we ignore interest costs in computing a project’s expected cash flows. First,
the payment of interest relates to a company’s financing, not its operations, so it is not part of
operating cash flow. But more importantly, our cash flow measure should be the amount of
money that the project should generate for the lenders and owners. Interest is the amount that
should be generated for the lenders, so subtracting out interest cost in the process of computing
cash flow would be a double-counting. [We adjust for the after-tax cost of interest by
discounting the cash flows at a cost of capital figure that incorporates the after-tax cost of debt.]
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B. The Role of Depreciation
A company can realize a time value benefit by using accelerated (typically based on the program
known as MACRS), rather than straight line, depreciation so that it pays fewer income tax dollars
in earlier years. Therefore the depreciation figure – an important component of cash flow – is
likely to differ from year to year. So our projection of operating cash flow should typically differ
from year to year, even if revenues and cash-based operating expenses are expected to be the
same from year to year.
Keep in mind that, in this chapter, we are computing cash flow rather than accrual-based income.
A company can legally report to investors an accrual-based income that is shown as a higher
figure because of straight-line depreciation, while reporting to the government a lower stated
taxable income that reflects accelerated depreciation. This accelerated depreciation does bring
about lower income tax – a true cash payment issue – and thus the use of accelerated depreciation
for tax reporting purposes is the assumption we typically incorporate into cash flow analysis.
(We might also ask whether investors can be fooled by higher stated income that results only
from the company’s choice of accounting technique. This “earnings management” issue has
been one of the hotter business news stories of the new millennium, based on alleged accounting
irregularities at Enron, Tyco, Xerox, and other companies.)
C. Other Components of Cash Flow
In analyzing a proposed capital investment project, we want to identify the incremental cash
flows. These are any cash receipts and payments that do not exist under the company’s current
business mix, but would exist if the project were to be undertaken. So the analyst looking at a
proposed investment project might want to consider some activities in addition to those affecting
OCF as described above.
One OCF-related concern is externalities: whether the project in question will enhance (perhaps
by increasing consumers’ awareness of the firm’s other products) or reduce (maybe through
cannibalizing) operating cash flows from the firm’s existing investment projects. Again, we are
interested in the incremental cash flows a project would provide, relative to the firm’s existing
situation. We might not wish to accept a project that looks good in isolation but whose existence
would cause sales of existing products to fall severely, or to reject a project that looks poor in
isolation but whose existence would cause sales of other products to rise appreciably. If making
new product Y would result in $1,000,000 in annual sales of Y and also an additional $200,000
in annual sales of existing product X, then the annual revenue attributed to Y in the OCF analysis
should be $1,200,000.
There are also some potentially important components of incremental net cash flow that are not
part of expected year-to-year operating cash flows (estimated as net income plus depreciation).
One is salvage value (an investment-related, not operations-related, cash flow): the amount for
which we think the equipment will be sold at the end of the project’s expected life (so we have to
ultimately compute its present value).
Another component of net cash flow – one that affects the initial investment and the final year of
the project – is a one-time added investment in net working capital. Operating at a higher output
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level requires the company to hold higher levels of current assets, probably best thought of as
extra inventory. Once the project is up and running, the replacement of that extra quantity of
inventory should be provided for through year-to-year cash flows. But what about buying that
first shipment of inventory, to put into the new machines before any revenue has been realized?
Investors’ money must provide for that initial purchase. Then that up-front expenditure is
expected to be recouped at the end of the project’s life, as inventory is sold off without being
replaced, but there is a time value loss that must be measured.
Two other components of net cash flow are opportunity costs and sunk costs. Let’s say that a
company spent $500,000 on some land several years ago, and then did not put that land to the
planned use. A team undertaking a new project within the company has now decided to use this
land, which is now worth only $300,000, in a new capital investment project. What “cost”
should be attributed to the land in the cash flow analysis?
Answer: $300,000, which is the opportunity cost (what the firm could receive if it sold the land
to an outside party). The $500,000 is a sunk cost; the decision to buy the land was made at an
earlier time, and that mistake should not be “billed” to the proposed new project as we try to
determine whether it makes economic sense. Forcing this new project to bear costs properly
incurred by another part of the company could cause it to be rejected even if, on its own merits,
it is expected to be profitable.
A final point affecting net cash flow is inflation. Money providers’ expectation of inflation will
be reflected in higher required rates of return, and thus a higher cost of capital. This higher
discount rate will give a project a lower NPV, all else equal. But would inflation not lead to
higher operating cash flows as well, as the company raises its products’ selling price by enough
to cover any increases in input costs? (Perhaps even some non-operating cash flows, such as
expected salvage values, would rise with inflation.) Failing to adjust cash flow estimates for
inflation can lead to illogical/inconsistent results.
D. An Example
A firm is considering purchasing new machinery, with an expected 4-year life (treated under the
federal income tax laws as having a 3-year depreciable life, and thus in the 3-year MACRS
class), for $200,000. The cost of having the machinery delivered and set up would be another
$40,000, so that the depreciable basis of the machinery would be $240,000. The project would
also necessitate a $20,000 initial purchase of added inventory (net of increased accounts
payable), which would then be recouped in the project’s final year. So the total cash outlay in
period 0 would be $260,000. Expected salvage value in year 4 is $25,000, and since the
machinery will have been fully depreciated by then (i.e., firm will be deemed to have no money
still invested in it for income tax purposes), the entire sale price will be a taxable gain.
The increase in annual revenues is expected to be $180,000 per year. Cash operating expenses
are expected to be $100,000 per year. You find the accelerated depreciation percentage for the
year(s) in question by looking at a Modified Accelerated Cost Recovery System (MACRS) table,
typically provided in finance textbooks (the percentages would be given to you if needed for an
exam question). MACRS depreciation for this 3-year asset would be as follows (MACRS treats
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Topic 7 Outline: Cash Flow Analysis
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three years of depreciation as being applied over 4 yearly operating periods: a half-year + a full
year + another full year + the remaining half-year):
Year
1
2
3
4
MACRS%
33%
45%
15%
7%
100%
x
Depreciable Basis
$240,000
$240,000
$240,000
$240,000
=
Depreciation
$ 79,200
$108,000
$ 36,000
$ 16,800
$240,000
So the project’s incremental net cash flows are expected to be as follows:
Year
Revenue
 Cash Costs
 Depreciation
= EBT
 40% Tax
= Net income
+ Depreciation
Operating Cash Flow
Machinery
Installation
Net Working Cap
Salvage
Tax on Salvage
Net Cash Flow
0
1
$180
100
79.2
$ .8
.3
$ .5
79.2
$79.7
2
$180
100
108
($28)
(11.2)
($16.8)
108
$91.2
3
$180
100
36
$ 44
17.6
$26.4
36
$62.4
($200)
(40)
(20)
($260)
$79.7
$91.2
$62.4
4
$180
100
16.8
$63.2
25.3
$37.9
16.8
$54.7
$20
25
(10)
$89.7
[See how it’s a little odd to assume that net cash flows would be equal from year to year? When
we do project periodic net cash flows as equal, it is typically an approximation for simplicity.]
Then we use these cash flow projections in completing an NPV (or other capital budgeting)
analysis. In this instance, if the cost of capital for a project of this risk level is 9%, then the net
present value is computed as
$260  $79.7  $91.2  $62.4  $89.7
NPV =
1.090 1.091 1.092 1.093 1.094
= ($260) + $73.12 + $76.76 + $48.18 + $63.55 = $1.61 .
The NPV is positive, so the project should be accepted (unless another project to which it is
mutually exclusive has a higher NPV). Accepting the project adds $1,610 to the wealth of the
stockholders (recall that our values here are in thousands).
Note that it is important for us to get the “when” analysis correct (to place numbers into the
columns that relate to the appropriate years). If we do not, then we are not discounting expected
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Topic 7 Outline: Cash Flow Analysis
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cash flows for the correct number of periods – building in the appropriate cost for the money
invested. Consider, in the example above, the $20 working capital investment made in year zero
and recouped (we expect) in year 4. Since it represents $20 out and then $20 back in, why not
just ignore the $20 amount? Answer: you would not be willing to give up $20 today and then
get back just $20 four years later, because that arrangement would impose costs on you. In the
same manner, spending $20 today and then getting $20 back after four years imposes costs on
a business. The business must account for those costs, and it does so by discounting the $20
expenditure for zero periods and the $20 receipt for four periods, and then accepting the project
only if the project can be expected to cover this time value cost (along with all the other costs
involved).
[What we actually achieve by showing a $20 outflow in period 0 and offsetting $20 inflow
in period 4 is to show expected cash costs as equal each year, in keeping with equal expected
annual levels of output. Think of the $20 working capital investment as the cost of a shipment
of inventory, and assume that each year’s $100 projected cash cost includes three expected
inventory purchases: one to be made 1/3 of the way into the year, one 2/3 into the year, and one
at the end of the year (12 total expected purchases over the project’s life).
Of course, to start production at the start of year 1 (maybe think of it as tomorrow morning – in
this simple example we are conveniently buying the equipment on the last day of a reporting
period) we must have inventory available now – and if the project is to be finished after four
years there will be no reason to restock inventory at the end of year 4. So we must buy a load of
inventory today, to get us through the first third of year 1. The three shipments we buy in year 1
will take care of the second third of year1, the final third of year 1, and the first third of year 2.
Years 2 and 3 will proceed accordingly, and then we will make only two purchases in year 4. So
we could show year 4 as having only $80 in expected cash costs – but doing so might seem to
indicate that we expect year 4’s output to be less than the other years’. Our solution is to show
the same $100 expected cash cost each year, but then show an offsetting imaginary inflow in year
4 to reflect the staggering of the periods when inventory is purchased and used.]
II. Risk and Other Considerations in Capital Budgeting Analysis
A. Scenario and Sensitivity Analysis
Recall that our estimate of cash flows might best be viewed as the midpoint of a range of
possible outcomes; there can be no guarantee that an expected level of revenue or expense will
be realized. This inherent riskiness can be especially troubling for a large project, in which the
failure to realize the expected cash flows could bankrupt the company. Managers might try to
deal systematically with this uncertainty through scenario or sensitivity analysis (or a more
sophisticated simulation analysis).
In scenario analysis we look at a series of possible outcomes, with a middle-level “base case”
accompanied by “best case” and “worst case” scenarios (and perhaps others in between; there is
no limit to how many cases can be considered, but 3 – 7 might be common). The cash flow
value used in an NPV analysis would likely be the base case figure, but we would recognize that
other outcomes could occur (note our initial example of a $100,000 expected cash flow reflecting
$75,000/$100,000/$125,000 possibilities).
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With sensitivity analysis, we could measure whether cash flow is highly sensitive to changes
in an important input figure (e.g., sales), when other input values are held constant. With
simulation analysis, we could use special computer software to produce an average cash flow
value based on thousands of computational “runs” in which a series of important input values
change randomly according to specified value ranges and probability distributions (e.g., sales
normally distributed over a $5 million to $10 million range).
B. Risk-Adjusted Discount Rates and Certainty Equivalents
If a project is deemed to be riskier than a standard project – as measured by the degree to which
possible outcomes could vary from the expected values (perhaps based on the results of a
scenario or sensitivity analysis) – then it is less valuable. The lower net present value of a riskier
project becomes apparent when the analyst makes an adjustment for the added risk, in one of two
ways. One is to adjust the expected cash flows downward, to more conservative estimates called
certainty equivalents.
A more common approach is to apply an added risk adjustment to the cost of capital that would
be used for projects of standard risk. Discounting the expected cash flows at a higher discount
rate results in a lower NPV estimate. However, there is no scientific way to make the risk
adjustment; sometimes managers must use “gut instinct” or apply arbitrarily chosen adjustment
factors that the firm consistently uses (e.g., add 4% to the standard WACC estimate when
evaluating riskier-than-average projects, subtract 4% from the standard WACC estimate when
evaluating projects with less-than-average risk).
C. Real Options
Because the cash flow and cost of capital estimates are subject to so much question, the numbers
in a capital budgeting analysis may not tell the whole story. In recent years financial analysts
have devoted more attention to the idea that valuable “real options” exist in any business
situation. For example, recall that the cash flow used in a traditional capital budgeting analysis is
the midpoint of a range of possible values. So potentially low cash flows (as when the economy
would be weak) put downward pressure on the computed midpoint, and the result could be a
negative computed NPV, resulting in the proposed project’s being rejected. But there are some
options that the company’s managers might exercise before or after getting into this particular
project, such as:
1) Wait to enact the project until a later date when new information (such as the actions of
competitors, or of the government) might reduce the risk that unfavorable results would be
realized.
2) Abandon a project that turned out to be unexpectedly bad, thereby cutting the losses and
avoiding further realization of the bad results that had been factored into the average cash flows
used in the original analysis.
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3) Expand a project that turned out to be unexpectedly successful, thereby making it more
profitable than what had been factored into the average cash flows used in the original analysis.
4) Accept a project even if it did not appear acceptable under traditional capital budgeting
criteria if that project offered flexibility, such as the ability to convert the assets for making
different products, or the ability to gain knowledge of a new technology or establish a presence in
a new market area.
The value of these real options might cause managers to accept a proposed investment project
that would be rejected if their decision were based solely on traditional net present value analysis.
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