11_LasherIM_Ch11

11_LasherIM_Ch11 - CHAPTER 11 CASH FLOW ESTIMATION...

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CHAPTER 11 CASH FLOW ESTIMATION OBJECTIVE Subjective FOCUS Cash flow estimation focuses on the numerical methodology used in putting together an estimate of a capital project. We keep the question of accuracy and risk in mind throughout, and continue in the next chapter with a discussion of the methods available to incorporate risk into the process. PEDAGOGY This chapter contains an important pedagogical point with respect to practicality. Most texts present capital budgeting as more accurate and reliable than it is, and students can get the incorrect impression finance has the precision of engineering. In real companies, the cash flow estimates associated with capital projects are generally very fluid. If an analysis results in an unfavorable IRR, the people behind the project often change the input numbers until they get the result they want. This reality creates a problem and a challenge at the same time. The problem is bias and inaccuracy. The challenge lies in the role created for finance in ensuring that estimated cash flows are reasonable and likely to come true. This chapter provides a thorough discussion of the sources of error and vagueness in estimated figures. TEACHING OBJECTIVES At the end of this chapter students should be fully aware of the difficulties and uncertainties associated with making cash flow estimates in a capital budgeting context. They should also be able to make estimates in fairly complex situations. OUTLINE I. CASH FLOW ESTIMATION A. Capital Budgeting Processes Conceptually divides capital budgeting into the calculation process and the more arbitrary and difficult estimation process. II. PROJECT CASH FLOWS - AN OVERVIEW AND SOME SPECIFICS A. The General Approach to Cash Flow Estimation A general outline. Consider the initial investment first, then periodic revenues, costs and expenses, or savings. Include tax effects and plan to acquire the required assets. B. A Few Specific Issues The typical cash flow pattern, the incremental concept, sunk costs, opportunity costs, impacts on the rest of the company, overheads, taxes, working capital, financing costs, and old equipment. C. Estimating New Venture Cash Flows A comprehensive example in a manufacturing context. D. Terminal Values Treating cash flows that can be expected to continue indefinitely. E. Accuracy and Estimates NPV and IRR give answers to several decimal places, but the accuracy isn't real, because the results are no better than input estimates of the future. This section contains an 3
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Chapter 11 important discussion of the practical sources of error in capital budgeting including well- meaning biases. F. Estimating Cash Flow for Replacement Projects Replacements are usually simpler projects, but the cash flows can be trickier to properly identify and quantify. A comprehensive example. QUESTION
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11_LasherIM_Ch11 - CHAPTER 11 CASH FLOW ESTIMATION...

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