Future cash flows estimation

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 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 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 ... 

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. 

Step 1 Estimate the expected future cash flows. 

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... 

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. 

In order to model the asset s cash flow, it uses a Monte Carlo simulation to generate expected default times for each piece of collateral and utilizes Copula functions and equity indexes to estimate correlation in the default times. The default times allow CDOManager to determine the cash flow expected from each asset over the life of a transaction. Summing up the cash flow from all of the assets generates a picture of the expected future cash flow from the CDO collateral pool. 

Once the asset s future cash flows are estimated, it is necessary to model the liability structure. CDOManager allows users to model various waterfall structures to accommodate for reinvestment into new collateral, payments of interest, reserve accounts, fee accounts, etc. 

When using NPV for decision making, there is a need to provide an appropriate discount rate and an accurate estimate of future operating cash flows. The discount rate is a rate that is assigned based on the risk of the project and the cost of capital. The risk of a project is related to the possibility that future cash flows will be less than anticipated. If a risky project is undertaken, there must be a higher reward for taking it on. The discount rate will be higher for riskier projects. Further, if the cost of capital is 10%, the project needs to at least earn that amount to ensure all investors earn a return commensurate with their risk. 

One of the most challenging aspects of conducting NPV analysis is forecasting future cash flows of a project. Many factors play into these forecasts making it difficult to obtain accurate estimates. Many departments within the organization share in the development of individual forecasts for revenue, costs, and demand. 

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 ... 

The critical element of the strategy for accounting for inflation in design estimates is to present the results in the form of present worth (present value, profitability index, discounted cash flow) with all future dollars discounted to the value of the present dollar at zero time. The discount factor must include both the interest required by the company as minimum return and the estimated interest rate of inflation. If profits on which income taxes are charged are involved, then the present worth based on the after-tax situation should be used. 

Using the prices of index-linked bonds, it is possible to estimate a term structure of real interest rates. The estimation of such a curve provides a real interest counterpart to the nominal term structure that was discussed in the previous chapters. More important it enables us to derive a real forward rate curve. This enables the real yield curve to be used as a somce of information on the market s view of expected future inflation. In the United Kingdom market, there are two factors that present problems for the estimation of the real term structure the first is the 8-month lag between the indexation uplift and the cash flow date, and the second is the fact that there are fewer index-linked bonds in issue, compared to the number of conventional bonds. The indexation lag means that in the absence of a measure of expected inflation, real bond yields are dependent to some extent on the assumed rate of future inflatiOTi. The second factor presents practical problems in curve estimation in December 1999 there were only 11 index-linked gilts in existence, and this is not sufficient for most models. Neither of these factors presents an insurmountable problem however, and it is stiU possible to estimate a real term structure. 

To calculate the net present value (NPV) of an investment, a firm s accounting department estimates the firm s minimum desired rate of return. This is used to discount the cash flows above. For the cash flow example above, if we assume that the minimum desired rate of return for that firm is 10%, then the cash flow for each period is multiplied by the present value of a dollar for that period (i.e., P = S/(l -F r)° where S = 1, r is the interest rate or the desired rate of return, and n is the number of periods in the future) to find the present value of that cash flow. This is shown in Table 3.2. 

Indexation is a method of escalating cash flows based on independent measurements of price level development over time. Costs or income estimates for a future period are corrected for inflation over that specific period. 

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