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 assetb) 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 assetb) 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 taxesplus DepreciationEquals 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.                  The after-tax proceeds from selling the asset in place2. Less any costs associated with termination or disposal3.                  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