PROJECT
VALUATION
Estimating Cash Flows
In trying to decide whether to make an investment in new
product development, new sales offices, or new buildings and equipment, the pivotal question for the financial
manager in the analysis of the project is the amount of cash flow that will be generated. Therefore estimating
or forecasting projected cash flow is a key element in the decision process.
For this job a computer spreadsheet is a necessary tool in
that it permits a complete display of the year by year gross income provided by the investment, minus
any yearly expenses, and the application of the modified accelerated depreciation methods permitted by
the tax laws. In addition the alphanumeric spreadsheet display permits formulations and linkage which
allows the user to change a number and thereby change all other numbers referring to that number . This
permits the creation of "scenarios" and projections based on changes in the economy, competition, and
technology and permits a much wider basis for estimating future cash flows. Before spreadsheets such "what
if " techniques were prohibitively time consuming and costly.
In addition to the spreadsheet tools essential to making
cash flow estimations there are a number of time tested techniques used to forecast what revenues are
likely to be, and with what level of confidence and credibility. All rational forecasting techniques are
based on the concept that what has been is likely to be, and represent linear projections of past results.
The key is to find credible experience relevant to one's projections, including the analogous experience
of others with that type of product, plan, invention etc. In other words, forecasting techniques are only
as good as the models they are drawn from, and statistical validity will not save a projection that is
not based on relevant experience.
In addition, the term cash flow implies the actual dollars
received as opposed to "accrual dollars" produced by normal accounting projections, and necessitates a
profound understanding of the concept of "non cash charges", such as depreciation, and its impact on cash
flow generation. In fact, it can be truly said that there are three financially valid reasons for making
a business investment: increased revenue, reduced expense, and the timely increased cash flows generated
by the tax laws in the form of accelerated depreciation, which permit a reduction of tax in excess of
the actual loss in value of the income producing asset. Thus estimating cash flows requires a knowledge
of the Modified Accelerated Recovery System and its impact on the cash flows generated by the new investment
and its impact on replaced equipment as well.
Finally, cash flow estimation is a function of the competitive
environment the in which the company or industry finds itself . In technological fields, today's good
idea can be tomorrow's obsolescence, and while traditional forecasting is based on the "what's past is
prologue" idea, new paradigms may make credible cash flow estimations impossible. In such situations,
where there is no intelligent prior experience, computer simulation techniques may be appropriate to determine
the chance cash flows.
