Future cash flows

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. 

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. 

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. 

The net profit is the total income minus operating costs minus depreciation minus tax. The ROI is often calculated for the anticipated best year of the project the year in which the profit is greatest. This criterion is also used for small investments. In general, acceptable ROT are about 20 %, but typical values are difficult to give. Both POT and ROI provide a one-moment-in-time view and do not take into account future cash flows, which may not be constant in the lifetime of the venture. 

IRR is the rate of return (interest rate, discount rate) at which the future cash flows (positive plus negative) would equal the initial cash outlay (a negative cash flow). The value of the IRR relative to the company standards for internal rate of return indicates the desirability of an investment ... 

Net present value (NPV) the present value (including the time value of money) of initial and future cash flows given by Equation (13.4). 

The reward criterion covers those areas related to the expected financial performance of the project. An important method for determining the financial success of a project is the net present value (NPV) calculation. This method calculates the present value of future cash flows. If the NPV is positive, the investment is beneficial from a financial standpoint. Additionally, a financially successful project is expected to have an average return on capital employed (ROCE) above a selected level, which makes commercial sense with regards to industry/branch standards. 

The project team must detail all past costs that the project has incurred since its inception (start of EvP) on an annual basis. In addition, an annual project financial information table (ProFIT) data sheet should be presented. This sheet contains the revenue and cost forecasts for the upcoming ten-year period. It computes net present value (NPV) of future cash flows and return on capital employed (ROCE) automatically. At this stage, the team is expected to include detailed production costs data as well as estimates of plant costs (based on an engineering estimate, for example). The ten-year projection should be provided for three scenarios base, optimistic, and pessimistic. These cases are not meant to be simple percentage changes of the sales projections. Instead, the team should try to identify the drivers of the project s success and construct alternatives for the future that lead to different results for the project. The base case should be the most likely case. The optimistic scenario should be based on the positive development of some (not all) key success factors. The pessimistic scenario is usually the minimum feasible case, meaning a situation where the organization would still prusue the project, but some factors do not develop in a positive way. 

The fundamental value of a company, on the other hand, is the net present value of the expected future cash flows, discounted by the cost of capital (DCF). This only alters for the better or the worse if fundamental changes occur, for example if prices change, new technologies are introduced or the company achieves a breakthrough into new markets. 

All debt contracts require payment of interest on the loan and repayment of the principal (either at the end of the loan period or amortized over the period of the loan). Interest payments are a fixed cost, and if a company defaults on these payments, then its ability to borrow money will be drastically reduced. Since interest is deducted from earnings, the greater the leverage of the company, the higher the risk to future earnings, and hence to future cash flows and the financial solvency of the company. In the worst case, the company could be declared bankrupt and the assets of the company sold off to repay the debt. Finance managers therefore carefully adjust the amount of debt owed by the company so that the cost of servicing the debt (the interest payments) does not place an excessive burden on the company. 

The net present value (NPV) of a project is the sum of the present values of the future cash flows ... 

The net present value is always less than the total future worth of the project because of the discounting of future cash flows. Net present value is easily calculated using spreadsheets, and most spreadsheet programs have an NPV function. 

The internal rate of return (IRR) is that value of i that makes NPV equal to 0. Therefore, if NPV is set to 0, the IRR that makes the future cash flows equal to the investment (the break-even point) can be estimated. Equation 9-12 then becomes ... 

Discount rate The interest rate used to convert future cash flows to their present value. 

This factor finds the equivalent present value, F, of a single future cash flow, F, occurring at n periods in the future when the interest rate is /% per period. Note that this factor is the reciprocal of the compound amount factor (single payment). For example, what amount would you have to invest now to yield 2829 in nine years if the interest rate were 10% ... 

The asset swap is an agreement that allows investors to exchange or swap future cash flows generated by an asset, usually fixed rates to floating rates. It is essentially a combination of a fixed coupon bond and an IRS. We define it thus ... 

Perhaps the most powerful life-cycle cost technique is net present value (NPV) analysis, which explicitly accounts for inflation and foregone investment opportunities by expressing future cash flows in present dollars [16]. 

The principles of pricing in the bond market are exactly the same as those in other financial markets, which states that the price of any financial instrument is equal to the net present value today of all the future cash flows from the instrument. In Chapter 3, bond pricing will be explained. In this chapter we will just present the basic elements of bond pricing. 

A fundamental property is that an upward change in a bond s price results in a downward move in the yield and vice versa. This result makes sense because the bond s price is the present value of the expected future cash flows. As the required yield decreases, the present value of the bond s cash flows will increase. The price/yield relationship for an option-free bond is depicted in Exhibit 1.9. This inverse relationship embodies the major risk faced by investors in fixed-income securities—interest rate risk. Interest rate risk is the possibility that the value of a bond or bond portfolio will decline due to an adverse movement in interest rates. 

The capital costs of a company are used to discount its future cash flows. The discount rate often is proxied by the weighted average cost of capital (WACC). The company s value can be computed from the sum of the discounted cash flows. The company s value increases with higher cash flows or a lower discount rate. The WACC is calculated by weighting the costs for debt and equity with their proportions of total capital ... 

The fundamental principle of valuation is that the value of any financial asset is equal to the present value of its expected future cash flows. This principle holds for any financial asset from zero-coupon bonds to interest rate swaps. Thus, the valuation of a financial asset involves the following three steps ... 

Step 1 Estimate the expected future cash flows. 

Step 3 Calculate the present value of the expected future cash flows found in Step 1 by the appropriate interest rate or interest rates determined in Step 2. 

For securities that fall into the first category, a key factor determining whether the owner of the option (either the issuer of the security or the investor) will exercise the option to alter the security s cash flows is the level of interest rates in the future relative to the security s coupon rate. In order to estimate the cash flows for these types of securities, we must determine how the size and timing of their expected cash flows will change in the future. For example, when estimating the future cash flows of a callable bond, we must account for the fact that when interest... 

The preceding three scenarios illustrate an important general property of present value. The higher (lower) the discount rate, the lower (higher) the present value. Since the value of a security is the present value of the expected future cash flows, this property carries over to the value of a security the higher (lower) the discount rate, the lower (higher) a security s value. We can summarize the relationship between the coupon rate, the required market yield, and the bond s price relative to its par value as follows ... 

Then the present value of each expected future cash flow to be received t years from now using a discount rate i assuming the next coupon payment is w years from now (settlement date) is ... 

The most common measure of yield in the bond market is the yield to maturity. The yield to maturity is simply a bond s internal rate of return. Specifically, the yield to maturity is the interest rate that will make the present value of the bond s cash flows equal to its market price plus accrued interest (i.e., the full price). To find the yield to maturity, we must first determine the bond s expected future cash flows. Then we search by trial and error for the interest rate that will make the present value of the bond s cash flows equal to the market price plus accrued interest. 

Issues are initially priced and sold at a fixed spread over the reference rate. The price of an FRN can fluctuate considerably during the life of the issue, mainly depending on trends in the issuer s credit quality. The frequent resets in the reference rate means that changes in market interest levels have a minimal impact on an FRN s price. For investors, movements in an FRN s price are reflected in changes in the discount rate. The discount rate is effectively the yield needed to discount the future cash flows on the security to its current price. It thus functions in the same way as the yield to maturity for a fixed-rate instrument. And like a fixed-rate bond, the market convention is to use a constant spread... 

Applying the indexation lag, this allows us to calculate estimated nominal values of all future cash flows which, knowing the current dirty nominal price, P, allows us to solve for an internal (nominal) rate of return—a nominal, semi-annual, gross redemption yield, y. Having applied our 3% inflation assumption, /, to get nominal future payments, we now remove it from the nominal yield using the simple formula... 

This is relatively simple to perform on a spreadsheet, setting up a look-up table of estimated RPI values to apply to future cash flows. 

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