When we estimate a project’s cash flows and then discount them at the project’s risk-adjusted cost of capital, r, the result is the project’s NPV, which tells us how much the project increases the firm’s value. Cash flow estimation is the foundation of capital budgeting for projects.
Cash Flow VS Accounting Income
The most important but also the most difficult step in capital budgeting is estimating project cash flows. Many variables are involved, and many individuals and departments participate in the process. For example, the forecasts of unit sales and sales prices are normally made by the marketing group based on their knowledge of price elasticity, advertising effects, the state of the economy, competitors’ reactions, and trends in consumers’ tastes. Similarly, the capital outlays associated with a new product are generally obtained from the engineering and product development staffs, while operating costs are estimated by cost accountants, production experts, personnel specialists, purchasing agents, and so forth.
Free cash flow is cash flow that is available for distribution to investors; hence free cash flow is the basis of a firm’s value. It is common in the practice of finance to speak of a firm’s free cash flow and a project’s cash flow (or net cash flow), but these are based on the same concepts. In fact, a project’s cash flow is identical to the project’s free cash flow, and a firm’s total net cash flow from all projects is equal to the firm’s free cash flow. We will follow the typical convention and refer to a project’s free cash flow simply as project cash flow, but keep in mind that the two concepts are identical.
Because net income is not equal to the cash flow available for distribution to investors, For capital budgeting purposes, it is the project’s net cash flow, not its accounting income, that is relevant. Therefore, when analyzing a proposed capital budgeting project, disregard the project’s net income and focus exclusively on its net cash flow.
Cash Flow Estimation
Depreciation expenses: Most projects require assets, and asset purchases represent negative cash flows. Even though the acquisition of assets results in a cash outflow, accountants do not show the purchase of fixed assets as a deduction from accounting income. Instead, they deduct a depreciation expense each year throughout the life of the asset. Depreciation shelters income from taxation, and this has an impact on cash flow, but depreciation itself is not a cash flow. Therefore, depreciation must be added back when estimating a project’s operating cash flow.
Changes in Net Operating Working Capital: Normally, additional inventories are required to support a new operation, and expanded sales tie up additional funds in accounts receivable. However, payables and accruals increase as a result of the expansion, and this reduces the cash needed to finance inventories and receivables. The difference between the required increase in operating current assets and the increase in operating current liabilities is the change in net operating working capital. If this change is positive, as it generally is for expansion projects, then additional financing—beyond the cost of the fixed assets—will be needed. Toward the end of a project’s life, inventories will be used but not replaced, and receivables will be collected without corresponding replacements. As these changes occur the firm will receive cash inflows; as a result, the investment in net operating working capital will be returned by the end of the project’s life.
Interest expense should be excluded. Interest is a cash expense, so at first blush it would seem that interest on any debt used to finance a project should be deducted when we estimate the project’s net cash flows. However, this is not correct. We discount a project’s cash flows by its risk-adjusted cost of capital, which is a weighted average (WACC) of the costs of debt, preferred stock, and common equity, adjusted for the project’s risk and debt capacity. This project cost of capital is the rate of return necessary to satisfy all of the firm’s investors, including stockholders and debtholders. Therefore, you should not subtract interest expenses when finding a project’s cash flows.
Factors to consider in Cash Flow Estimation
Sunk Costs. A sunk cost is an outlay related to the project that was incurred in the past and cannot be recovered in the future regardless of whether or not the project is accepted. Therefore, sunk costs are not incremental costs and thus are not relevant in a capital budgeting analysis.
Externalities. Externalities are the effects of a project on other parts of the firm or on the environment. As explained in what follows, there are three types of externalities: negative within-firm externalities, positive within-firm externalities, and environmental externalities. These externalities exam the impact of the new business on the existing business