Cash flow prediction

Because of its apparently precise nature, there is a tendency to put too much bust in DCF analysis. However precise the calculations, the cash flow predictions are inherently uncertain. An example of the case where uncertainty is comparatively low is the replacement of plant or equipment in the manufacturing or process industries. If the new plant is installed and functioning correctly by the scheduled date and if market conditions do not change dramatically, the cash flow predictions should be reasonably accurate and the major source of uncertainty is the cost of capital there are, of course, plenty of occasions when the assumptions about installation of the plant and market conditions will prove false but this is likely to be the exception rather than the rule. 

Interest is more eomplicated. A separate cash flow prediction is produced from which the eash needs of the eompany in 2000 can be established. Once it is decided how to fmanee these, the interest payments can be calculated. As a rule of thumb, a company such as Syniad needs working capital of about 25 per cent of its annual turnover, i.e. about 3 million for 1999. Depending on... 

The predicted cumulative cash-flow curve for a project throughout its life forms the basis for more detailed evaluation. Many quantitative measures or indices have been proposed. In each case, important features of the cumulative cash-flow curve are identified and transformed into a single numerical measure as an index. 

Predicting future cash flows for a project is extremely difficult with many uncertainties, including the project life. However, providing that consistent assumptions are made, projections of cash flows can be used to choose between competing projects. 

Discounted Ca.sh Flows. Because the flows below the cash flow box in Figure 1 tend to be arbitrary management decisions that are generally difficult to predict, the prediction of profitabiUty is based on the expected cash flows instead of earnings. As a result, some logical assumptions to account for the cost of capital and the recovery of the investment must be made. 

An (NPV) or (DCFRR) estimation will be no better than the accuracy of the projec ted cash flows over the life of the project. Clearly, one is likely to predict cash flows more accurately for 2 or 3 years ahead than, say, for 9 or 10 years ahead. However, since the cash flows for the later years are discounted to a greater extent than the cash flows for the earher years, the latter have less effec t on the overall estimation. Nevertheless, the difficulty of predicting cash flows in later years and the inherent lack of confidence in these predictions are serious disadvantages of the (DCFRR) method. In this respec t (NPV)s are more usefm since they are calculated for each year of a project. Thus, a project with a favorable (NPV) in the early years is a promising one. 

For many years, companies and countries have lived with the problem of inflation, or the faUing value of money. Costs—in particular, labor costs—tend to rise each year. Failure to account for this trend in predicting future cash flows can lead to serious errors and misleading profitabihty estimates. 

Risk and Uncertainty Discounted-cash-flow rates of return (DCFRR) and net present values (NPV) for future projects can never be predicted absolutely because the cash-flow data for such projects are subject to uncertainty. Therefore, when stating predicted values of (DCFRR) and (NPV) for projects, it is also desirable to give a measure of confidence in the predictions. 

A prerequisite to a corrodable material being used is that it is known to have a useful and reasonably predictable life. Planned, or unplanned downtime costs money and the intervals between planned replacements must be of reasonable duration. In practice, the replacement interval is usually conservative at first and then as experience accumulates, the intervals between planned replacements will usually extend. The main reason for choosing a planned maintenance policy is that on a discounted cash flow (DCF) calculation over the life of the plant, the cost of regular replacements including maintenance labour and downtime is less than the extra initial capital cost of a more durable material. 

Inflation depreciates money in a manner similar to, but different from, the idea of discounting to allow for the time value of money. The effect of inflation on the net cash flow in future years can be allowed for in a similar manner to the net present worth calculation given by equation 6.9, using an inflation rate in place of, or added to, the discount rate r. However, the difficulty is to decide what the inflation rate is likely to be in future years. Also, inflation may well affect the sales price, operating costs and raw material prices differently. One approach is to argue that a decision between alternative projects made without formally considering the effect of inflation on future earnings will still be correct, as inflation is likely to affect the predictions made for both projects in a similar way. 

A company has the option of investing in one of the two projects A or B. The capital cost of both projects is 1,000,000. The predicted annual cash flows for both projects are shown in Table 2.14. For each project, calculate the ... 

Three projects (A, B, C) all earn a total of 125,000 over a period of 5 years (after-tax earnings, nondiscounted). For the cash-flow patterns shown in the table, predict by inspection which project will have the largest rate of return. Why ... 

Year Predicted after-tax cash flow to project based on total income minus all costs except depreciation, S (expressed as end-of-year situation)... 

Expected return the owners of a business with predictable cash flows in a stable environment have to earn theCost of Equity... 

We believe that the visible successes of Cain, Huntsman, and a few other industry insiders (e.g., George Harris, Hal Sorgenti) have in recent years attracted a lot of imitators, especially financial buyers, into the chemicals sector (Fig. 8.1). Industry observers point out that given the low public valuations of chemical assets and the unprecedented levels of uninvested funds available today (shown in Fig. 8.2), chemical businesses make ideal LBO targets. Their logic is that the basic industrial sectors, such as chemicals, have reasonably predictable cash flows, unlike the... 

Fixed price Fixed price for completion of project defined up front Final price known Good for documentation and prediction of cash flow and for budgeting... 

Evaluating a predicted discounted net cash flow curve will determine to a large extent whether an R D result is worth commercialization. Uncertainties exist and have been incorporated in some analyses by increasing the discount percentage by an increment proportional to uncertainty. However, a prudent management must accept uncertainty risks and periodically reevaluate the decision to proceed. 

Good for documentation and prediction of cash flow and for budgeting... 

The inflation rate has been defined which allows one to predict price changes. However, economic analysis requires the use of an interest rate for discounting or compounding procedures in order to reduce a set of cash flows to a common measure for analysis, such as net present value. Because cash flows may or may not be inflated, two interest rates must be defined for use in analysis. 

Planned maintenance or regular replacement of plant equipment to avoid failure by corrosion is an essential adjunct to design and constitutes the third phase of control. The factors contributing to a policy of planned maintenance philosophy are (i) predictable and reasonable rate of corrosion for material (ii) discounted cash flow advantage over life of plant in using a cheaper less-resistant material (iii) factors other than corrosion dictating regular maintenance (iv) no feasible alternative to corrodible material (v) installed spare preferred policy for reliability of plant. 

Unpredictable cashflows While in fixed-rate securities the coupon payments are known with certainty, with floaters we cannot predict futiue cash flows ... 

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