Project’s Cash Flow Estimation And Risk
2 Market Factors/Considerations Economic Conditions Government Regulations and Rules Competitive Environment Firm Factors/Considerations Normal Operations Financing Policy Investing Policy Dividend Policy Investor Factors/Considerations Income/Savings Age/Lifestyle Interest Rates Risk Attitude Net Cash Flows, CF Rates of Return, r = CF 1 (1 + r ) 1 + CF 2 (1 + r ) 2 + ... + CF N (1 + r ) N = N Σ t = 1 CF t (1 + r ) t ^ ^ ^ ^
3 Cash Flow Estimation Most important and most difficult step in the analysis of a capital project Financial staff’s role includes: Coordinating other departments’ efforts Ensuring that everyone uses the same set of economic assumptions Making sure that no biases are inherent in forecasts
4 Relevant Cash Flows Cash Flow Versus Accounting Income Cash Flows that contributes to investment project
5 Cash Flow Versus Accounting Income 2009 Situation Accounting Profits Cash Flows Sales $50,000 $50,000 Costs except depreciation (25,000) (25,000) Depreciation (15,000) -- Net operating income or cash flow $10,000 $25,000 Taxes based on operating income (30%) (3,000) (3,000) Net income or net cash flow $7,000 $22,000 Net cash flow = Net income plus depreciation = $7,000 + $15,000 = $22,000
6 Cash Flow Versus Accounting Income 2013 Situation Accounting Profits Cash Flows Sales $50,000 $50,000 Costs except depreciation (25,000) (25,000) Depreciation (5,000) -- Net operating income or cash flow $20,000 $25,000 Taxes based on operating income (30%) (6,000) (6,000) Net income or net cash flow $14,000 $19,000 Net cash flow = Net income plus depreciation = $14,000 + $5,000 = $19,000
7 Project’s forecast Estimated sales for the next 4 years:$30,000 per yearVariable cost$18,000 per yearFixed cost $5,000 per yearInstalled Asset cost=$10,000, depreciated using MACRS 5-yr class. Yr1Yr2Yr3Yr4Yr5Yr620%32%19%12%12%5% 1. Prepare the Pro-Forma Profit & Loss Account (Income Statement)2. Determine the operating cash flow.
8 Capital Budgeting Project Evaluation Expansion Project: Expansion Project: A project that is intended to increase sales; provides growth to the firm Replacement Analysis: Replacement Analysis: An analysis involving the decision of whether to replace an existing, still productive asset with a new asset
9 Rules for Estimating Cash Flow Ignore financing costs Disregard sunk costs Include opportunity costs Include indirect costs Include only incremental cash flows (for replacement project) Adjust for taxes
10 Determining Relevant Cash Flows Financing Cost: Financing Cost: Taken in account when using WACC to discount the after-tax cash flows Sunk Cost: Sunk Cost: A cash outlay that already has been incurred and cannot be recovered Opportunity Cost: Opportunity Cost: The return on the best alternative use of an asset Externalities: Externalities: The effect of accepting a project on the cash flows in other parts of the firm
11 Depreciation Systematic charging of a portion of the costs of fixed assets against annual revenues over time. This non-cash charge is considered as a cash inflow. This non-cash expense is deducted from
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- Spring '09