Module 3 – Background CASH FLOW ESTIMATION AND CAPITAL BUDGETING

Module 3 – Background
CASH FLOW ESTIMATION AND CAPITAL BUDGETING

As a financial manager, you are to focus on maximizing shareholder
wealth. You do that by accepting positive NPV projects and rejecting
negative NPV projects. In order to run a NPV calculation, you need cash
flows which need to be estimated.
There are several steps to estimate a project’s cash flows.
First, some assumptions need to be made regarding how many units of the
goods are to be sold and at what price per unit. The tax rate will also need
to be determined.
Second, depreciation needs to be calculated. You need to decide which
depreciation methodology you will use such as straight-line depreciation or
MACRS.
Third, you need to calculate the salvage value on the property and/or
equipment that is disposed of at the end of the project’s life.
Fourth, you can now proceed to put things together and estimate the
project’s cash flows:
At Time 0 (today), you are likely to have the following cash outflows:
Building and/or equipment
Increase in net working capital
= total investment outlays (negative value)
At Time 1 through Time N (the end of the project’s life), you are likely to
have the following cash flows each year:
Listen
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Sales revenue (units sold x sales price)
– Variable costs (usually some percentage of the sales revenue)
– Fixed operating costs
– Depreciation
= EBIT (earnings before interest and taxes)
-Taxes on the operating income
= NOPAT (net operating profit after taxes)
+ Depreciation add-back
= Operating cash flow
Then at Time N (the end of the project’s life), you have terminal year cash
flows likely consisting of the following:
+ Return of the net working capital
+ net salvage value
= Total terminal cash flows
The project cash flows can finally be determined by adding together for the
appropriate year the total investment outlays, the operating cash flows, and
the total terminal cash flows.
Now that you have the project cash flows, you can apply the various capital
budgeting methodologies including net present value (NPV), internal rate
of return (IRR), modified internal rate of return (MIRR), profitability index
(PI), regular payback period, and the discounted payback period.
Many of these can be calculated with Excel.
=NPV calculates a project’s NPV in Excel.
=IRR calculates a project’s IRR in Excel.
=MIRR calculates a project’s MIRR in Excel
Review this video that focuses on NPV:
JohnFinance (2014). Net Present Value. Retrieved June 2014
from http://www.youtube.com/watch?v=GiNG9Va00fI
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NPV is the best out of all the capital budgeting methodologies. It takes into
all of a project’s cash flows, it uses the time value of money, doesn’t have
problems with non-normal cash flows like IRR can have when it can result
in multiple IRRs, assumes reinvestment of the cash flows at the more
conservative cost of capital instead of the higher less realistic IRR
reinvestment rate assumption, gives consistent results with mutually
exclusive and independent projects.
Optional Resources
Bookboon.com. (2008). Corporate Finance. Retrieved
from http://bookboon.com/en/economics-and-finance-ebooks
Welch, Ivo. (2014). Corporate Finance (3rd Ed.). Chpts 4 and 12. Retrieved
from http://book.ivo-welch.info/ed3/toc.html