Unit 3 - Cash Flow Forecasting
• The purpose of this unit is to help manager’s
learn economically correct techniques for
forecasting future cash flows
• Cash flow forecasting is critical for making
capital (long-term) investment decisions
• Managers that become proficient at cash flow
forecasting have the advantage of making
investment decisions that are more likely to
increase the value of the firm
Cash Flow versus Accounting
Income
• As managers, we wish to make decisions that will
make money, and thus increase the value of the
firm
• Investment decisions should be based on real
money flows, not accounting income
• Remember, accounting income is used for
financial reporting and tax purposes, but you
cannot pay the bills with net income – you need
actual money (euros)!
Terminology for Cash Flow
Forecasting
• Mutually exclusive versus independent
decisions
• Accept-reject versus ranking decisions
• Conventional versus nonconventional cash
flow streams
Independent versus Mutually
Exclusive Decisions
• If multiple investment alternatives are being
considered, and they are unrelated (for example,
a new product line and replacing the existing
photocopy machine), then they are considered
independent of each other
• If multiple investment alternatives are being
considered, and choosing one precludes choosing
the other (for example, the city can expand
existing bus service or build a new subway
system), then they are considered mutually
exclusive projects
Accept-Reject versus Ranking
• Projects under consideration by themselves
are considered independently, with a
decision to accept and invest or reject the
project being the manager’s objective
• When multiple projects are under
consideration, the goal is to be able to rank
the projects on the basis of most to least
profitable
Conventional and
Unconventional Cash Flows
• A conventional project proposal will have an
initial cash outflow (cost), followed by a series of
cash inflows in the form of cost savings or
increased after-tax profits
• An unconventional project proposal will have
additional outlays within the future cash flow
stream, such as required additional investment for
computer upgrades or the environmental costs
associated with terminating a project such as a
landfill or oil drilling operation
Three Important Components of a Cash Flow
Forecast for an Investment Proposal
• The initial cash flow
• The operating cash flows
• The terminal cash flow
A Basic Format for Determining the Initial
Investment Requirement
The installed cost of a new asset =
• The installed cost of the new asset, which consists of
a) the cost of the new asset
b) Plus any installation or training costs for the new asset
• Minus the after-tax proceeds from the sale of the old asset (if applicable),
which consists of
a) The proceeds from selling the old asset
b) Plus any tax due on sale of the old asset
•Plus or minus any required change in net working capital
Restating Initial Cash Flow
Computation as an Equation
The initial cash flow = Installed cost of new asset + the after-tax proceeds from
selling the old machine + or - any required change in net working capital
Defining Changes in Net
Working Capital
• Net working capital = current assets –
current liabilities
• Examples of net working capital
investment requirements would be an
expected increase in accounts receivable
(associated with a new product or service)
or required inventory purchases associated
with the implementation of new machinery
A Basic Format for Calculating
Cash Flows from Operations
-
Revenue (Sales)
less
Expenses
Profits Before Depreciation and Taxes
less
Depreciation
Net Profit before taxes
less
Taxes
Net Profit after taxes
plus
Depreciation
Equals
Operating Cash Flow
Some notes on Operating Cash Flows
• By U.S. tax law, depreciation is the allowed charge for aging assets.
It is an expense that reduces taxable income, but it is not a real cash
flow paid out by the firm
• Therefore, depreciation is deducted to as an expense to determine the
firm’s tax liability, but added back to determine after-tax cash flow
• Remember, when making investment decisions we as managers are
concerned with actual money flowing in and out of the firm, not
reported income for accounting and tax purposes
• Managers should forecast operating cash flow for each period,
normally each year, of the expected life of the investment being
considered
The Final Component of the Cash Flow Forecast –
Terminal Cash Flow
• One aspect often overlooked when forecasting
cash flows for investment analysis is the terminal
cash flow
• Managers need to consider the costs associated
with ending a project or asset’s useful life
• For some types of investments, such as real
estate, the terminal cash flow may represent a
major component of profitability or cost
associated with the investment proposal
A Basic Format for Determining Terminal
Cash Flow
1.
2.
3.
The after-tax proceeds from selling the asset in place
Less any costs associated with termination or
disposal
Plus or minus any change in net working capital
Reviewing the Basic Components of a Cash
Flow Forecast
• First, determine the net, after-tax cost associated
with making the initial investment
• Second, forecast the after-tax incremental cash
flows associated with the operation of the asset or
investment
• Finally, forecast the terminal cash flow
associated with the end of the investment’s life
Some additional thoughts on
Cash flow forecasting
• Cash flows should be incremental – if you are
considering replacing one machine with another,
what matters is the marginal, or incremental, cash
flows associated with having the new machine
versus having the old. This highlights the
difference in profitability associated with
replacement
• NEVER include sunk costs. As managers, we
are concerned with making decisions in the
present that affect future profits; any costs or
expenses already incurred in the past do not
affect the present and future
More Cash Flow Thoughts
• Managers should consider opportunity costs in cash flow forecasts
• For example, if a new product line would require the use of
warehouse space that would otherwise have been leased out, using
the space for new product foregoes the lease revenue. This should be
deducted from expected operating cash flow
• Changes in net working capital normally occur when a project is
initiated, and when it is terminated. For example, having to purchase
additional inventory when buying a new machine is part of the initial
outlay. When the machine is retired, these funds are freed up for
other investment, and thus treated as a cash inflow in the terminal
cash flow forecast