Cash Flow Estimation
1. Topic Objective: Last week we started discussion on capital budgeting – the investment decision. Recall that the rule of all investment decisions is: if we expect to make more than what we should be making (given the level of risk) then it is a good investment. In other words, if the value is greater than price then it is a good project. Last week, we learnt three rules (payback period, NPV, and IRR) to make this comparison. Value is defined as the present value of future cash flows discounted using the required rate of return. Last week, we learnt to calculate the required rate of return (WACC). This week, we will focus on estimating cash flows. This will complete our discussion on capital budgeting. The discussion is organized as following: 2. Estimating cash flows 2.1 Incremental cash flows 2.2 Depreciation and tax implications 2.3 Evaluating a new project 2.4 Evaluating a cost saving project 2.5 Evaluating a replacement project
Estimating Cash Flows
2. Estimating cash flows Capital budgeting or the investment decision involves evaluating cash flows to compare expected return with the required return. Cash flows related to a project are often classified in three categories: 1. 2. Initial investment outlays: This includes all costs incurred in the beginning (year 0). Annual project cash flows: This refers to the free cash flow generated by the project. Recall, FCF = NOPAT – Increase in operating capital where, NOPAT = EBIT(1-tax rate) OC = NOWC + Net fixed assets or OC = (CA – ST Investments) – (CL – Notes) + Net fixed assets Thus, FCF = NOPAT – Increase in NOWC – Increase in Net FA The above definition of FCF can be restated in terms of gross fixed assets. This is useful for capital budgeting scenarios where we are dealing with gross values. FCF = NOPAT + Depreciation – Increase in NOWC – Increase in gross FA 3. Terminal year cash flow: At the end of the life of the project, there is extra cash flow in terms of sale of assets....