Unit 3 - Cash Flow Forecasting

The purpose of this unit is to help managers

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 managers 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
firms 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 assets 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 investments 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