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Cash Flow Estimation

Cash Flow Estimation. Basic Concepts. Overview. Most difficult aspect of capital budgeting Long time frame Leads to uncertainty Typical bias: overstate revenues and understate costs Nevertheless, it must be carried out. Relevant Cash Flows Only. These are called “incremental” cash flows

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Cash Flow Estimation

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  1. Cash Flow Estimation Basic Concepts

  2. Overview • Most difficult aspect of capital budgeting • Long time frame • Leads to uncertainty • Typical bias: overstate revenues and understate costs • Nevertheless, it must be carried out

  3. Relevant Cash Flows Only • These are called “incremental” cash flows • That is, the CF’s that occur due to the undertaking of the project • Thus, “sunk costs” (expenditures already made) must NOT be included • Ex: Mktg study is done about feasibility ($8,000) before doing the project • Do not include $8,000 into the CF’s

  4. Opportunity Costs • They must be included, though can be difficult to calculate • “What could have been earned otherwise” or “best alternative if not this project” • EX: Use your own land to build the factory • Must include the opportunity cost of the land (what could you have rent it for?)

  5. Externalities • “Impact of the project in consideration (the capital budgeting project) onto existing projects” • If the project benefits other existing projects, include the benefit to the existing projects into the CF’s of this project (positive) • If the project hurts other existing projects (cannibilize), include this cost into the CF’s

  6. Depreciable Basis • The amount of $$ that is used to calculate depreciation (what we multiply the depreciation rates by) • Only long term assets plus shipping, modifications, installation • Does not include NWC investments • Depreciation: use the fastest possible (MACRS)

  7. Net Working Capital • Initial investment needed to support the capital investment • Ex: inventories or cash • Can be offset by “free” financing such as AP • So the net effect is NWC • Assume recovery of this investment at the end of the project

  8. Net Salvage • At the end of the project, we assume that the long term investment will be sold (salvage) • This must be adjusted for tax effects (thus “net”) • Salvage value +- tax impact= net salvage • Tax impact: • If gain (salvage > book value), pay taxes on that gain (-) (reduces the salvage value) • If a loss (salvage < book value), tax savings on the loss (+) (increase the salvage value)

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