Cash flows estimation

TABLE 8. Discounted cash flow estimations for a seasons LHS system... 

Other financial analyses that provide useful information as one seeks to determine whether the organization should proceed with the project include return on investment (ROI) and break-even (BE) analysis. ROI is the ratio of the net returns from the project divided by the cash outlays for the project. BE analysis seeks to determine how long it will take before the early cost outlays can be recouped. If the ROI is high and the BE point is small (i.e., reached quickly), the project becomes more desirable because cash flow estimates far into the future are much more difficult to forecast accurately. Table 2 is a simple spreadsheet that was used to determine economic feasibility. 

End of Period j Cash Flow Estimates Present Worth at 10% ... 

Table 5.5b Discounted Cash Flow Estimations for the Seasonal Latent Heath System...

The yearly cash flows estimated for a project involving the construction and operation of a chemical plant producing a new product are provided in the discrete CFD in Figure E9.12a. Using this information, construct a cumulative CFD. 

Items needed for cash flow estimates are as follows ... 

Simulation, on the contrary, incorporates uncertainty into the input variables. Simulation forces an understanding of the probability distributions that surround the variables. Simulation models are then performed thousands of times—called replications. The output provides a range of NPV possibilities. The range provides all possibilities from worst-case to best-case scenarios. In the NPV example, cash flows are estimated to be 1,500 for 3 years however, cash flows could realistically be higher or lower than 1,500. What if cash flow estimates and resultant NPV were based on revenue projections using a price of 20 per unit, but the units could be sold between 10 and 30, considering competitive and market forces. Simulation will show a range of NPVs based on the distribution of prices. 

Life cycle cost analysis is the proper tool for evaluation of alternative systems (11,12). The total cost of a system, including energy cost, maintenance cost, interest, cash flow, equipment replacement and/or salvage value, taxes, inflation, and energy cost escalation, can be estimated over the useflE life of each alternative system. A Hst of life cycle cost items which may be considered for each system is presented in Tables 3 and 4. Reference 14 presents a cash flow analysis which also includes factors such as energy cost escalation. 

Numerically, the difference between continuous and annual compounding is small. In practice, it is probably far smaller than the errors in the estimated cash-flow data. Annual compound interest conforms more closely to current acceptable accounting practice. However, the small difference between continuous and annual compounding may be significant when apphed to very large sums of money. 

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. 

No single value for a profitability estimate should be accepted without further consideration. An inteUigent consideration of the cumula-tive-cash-flow and cumulative-discounted-cash-flow curves such as those shown in Fig. 9-10, together with experience and good judgment, is the best way of assessing the financial merit of aprojec t. 

When considering future projects, top management will most likely require the discounted-cash-flow rate of return and the payback period. However, the estimators should also supply management with the following ... 

When to Scrap an Existing Process Let us suppose that a company invests 50,000 in a manufacturing process that has positive net annual flows (after tax) Acp of 10,000 in each year. During the third year of operation, an alternative process becomes available. The new process would require an investment of 40,000 but would have positive net annual cash flows (after tax) of 20,000 in each year. The cost of capital is 10 percent, and it is estimated that a market will exist for the product for at least 6 more years. Should the company continue with the existing process (project H), or should it scrap project H and adopt the new process (project 1) ... 

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. 

Numerical Measures of Risk Without risk and the reward for successfully accepting risk, there would be no business activity. In estimating the probabilities of attaining various levels of net present value (NPV) and discounted-cash-flow rate of return (DCFRR), there was a spread in the possible values of (NPV) and (DCFRR). A number of methods have been suggested for assessing risks and rewards to be expected from projects. 

Allocation of Overheads How overheads are allocated can affect the total cost of a produc t and, hence, the estimated future cash flows for a project. Since these cash flows are used in the net-present-value (NPV) and discounted-cash-flow-rate-of-return (DCFRR) methods for estimating profitabihty, erroneous allocations could result in the wrong choice of project. 

Estimate the cash-flow profile for each alternative. The cash-flow profile should include the costs and revenues if they differ, for the alternative being considered during each period in the planning horizon. For public projects, revenues may be replaced by estimates of benefits for the public as a whole. If revenues can be assumed to be constant for all alternatives, only costs in each period are estimated. Cash-flow profiles should be specific to each alternative. We shall denote revenues for an alternative x in period t as B (t,x), and costs as C (t,x). By convention, cash flows are usually assumed to occur at the end of the time period, and initial expenditures to occur at the beginning of the planning horizon, that IS, m year 0. 

Perform sensitivity and uncertainty analysis. Calculation of life-cycle costs and net benefits assumes that cash-flow profiles and the value of MARR are reasonably accurate. In most cases, uncertain assumptions and estimates are made in developing cash flow profile forecasts. Sensitivity analysis can be performed by testing how the outcome changes as the assumptions and input values change. 

This method compares the initial capital cost with the cash flow over the life of the project. Thus, in this case an accurate estimate of the equipment life is required. When a project has a long life (considerably longer than the simple payback period) the results can be different. 

Net present worth (NPW) Estimated net cash flow in year n (NFW)... 

In Chapter 3 we discussed the formulation of objective functions without going into much detail about how the terms in an objective function are obtained in practice. The purpose of this appendix is to provide some brief information that can be used to obtain the coefficients in objective functions in economic optimization problems. Various methods and sources of information are outlined that help establish values for the revenues and costs involved in practical problems in design and operations. After we describe ways of estimating capital costs, operating costs, and revenues, we look at the matter of project evaluation and discuss the many contributions that make up the net income from a project, including interest, depreciation, and taxes. Cash flow is distinguished from income. Finally, some examples illustrate the application of the basic principles. 

Where CF is the cash flow from operation, HR is the hurdle rate or required minimum return and II is the initial investment. Advantages of NPV are that it accounts for the time-value of money, provides a value estimate for the lifetime of the project (10 years) and can always be calculated (unlike IRR). Hurdle rates are set by central finance groups or, in some cases, the project team. If a positive NPV is obtained at a given hurdle rate a project is considered profitable and should be executed based on competing priorities. 

Depreciation The Internal Revenue Service allows a deduction for the exhaustion, wear and tear and normal obsolescence of equipment used in the trade or business. (This topic is treated more fufly later in this section.) Briefly, for manufacturing expense estimates, straight-line depreciation is used, and accelerated methods are employed for cash flow analysis and profitability calculations. 

Land for the project is available at 300,000. The fixed capital investment was estimated to be 12,000,000. A working capital of 1,800,000 is needed initially for the venture. Start-up expenses based upon past experience are estimated to be 750,000. The project qualifies under IRS guidelines as a 5-year class life investment. The company uses MACRS depreciation with the half-year convention. At the conclusion of the prmect, the land and working capital are returned to management. Develop a cash flow analysis for this project, using a cumulative cash position table (Table 9-25). 

For economic evaluation purposes, another definition of working capital is used. It is the funds, in addition to the fixed capital, that a company must contribute to a project. It must be adequate to get the plant in operation and to meet subsequent obligations when they come due. Working capital is not a one-time investment that is known at the project inception, but varies with the sales level and other factors. The relationship of working capital to other project elements may be viewed in the cash flow model (see Fig. 9-9). Estimation of an adequate amount of working capital is found in the section Capital Investment. ... 

Figure 5 Estimates of the cash flows in GEL deemed necessary for funding the power system and to comply with the results of Figure 1, Figure 2 and Figure 3. (1 GEL corresponds to US 0.46 - economic conditions as per September 2003)...

It is not easy to get the necessary information to do a good cash flow analysis. Start with your checkbook, credit card statements, and tax records. The most difficult information to get will be what you spend on cash purchases. The best approach is to keep a journal for a couple of weeks to get a pattern and then estimate the amounts factoring in your personal experience. Income information should be available from your tax records. 

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