CASH FLOW ESTIMATION IN PRACTICE Now that we have described how firms ideally estimate cash flows, we turn

CASH FLOW ESTIMATION IN PRACTICE Now that we have described how firms ideally estimate cash flows, we turn

to the question of how managers actually make these important decisions. Surveys of U.S. corporations provide the following important information: 7

7 Randolph A. Pohlman, Emmanuel S. Santiago, and F. Lynn Markel, “Cash Flow Estimation Practices of Large Firms,” Financial Management (Summer 1988), pp.

EXHIBIT 12.5 Estimated Incremental Cash Flows from the Replacement of Facilities at the Hirshleifer Company

End of Year

Year 4 Year 5

Investment cash flows Purchase and sale of new equipment

+$100,000 Tax on sale of new equipment

− 28,952 Sale of old equipment

− 10,000 Tax on sale of old equipment

− 7,000 +3,500 Change in working capital

+$54,548 Change in operating cash flows Change in revenues, ∆ R

Investment cash flows

Less: change in expenses, ∆ E +60,000

14,560 14,560 Change in taxable income

Less: change in depreciation, ∆ D 40,000

–15,904 –15,904 Change in income after tax,

Less: taxes, τ ( ∆ R −∆ E −∆ D)

− $13,000 − $10,400 +$14,560 +$29,536 +$29,536 (1 −τ )( ∆ R −∆ E −∆ D)

+14,560 +14,560 Change in operating cash flows, ∆ OCF

Add: depreciation, ∆ D +40,000

+$53,000 +$65,600 +$52,160 +$44,096 +$44,096 Net cash flows

Capital Budgeting: Cash Flows

■ The person estimating cash flows is an accountant, an analyst, Trea- surer, Controller, Vice President of Finance, or a person reporting directly to the Treasurer or Vice President of Finance.

■ Most firms have standard procedures for estimating cash flows. ■ Most firms rely mainly on the subjective judgment of management. ■ Most firms consider working capital requirements in their analysis of

cash flows. ■ Sales and operating expense forecasts are a key ingredient in estimating cash flows.

Estimating cash flows for capital projects is perhaps the most diffi- cult part of the investment screening and selection process. With regard to the process of capital budgeting, most firms use some type of post- completion auditing, yet few firms have well developed, sophisticated systems for evaluating ongoing projects. 8

We know that it is necessary to consider cash flows related to acquiring the assets, to disposing of the assets, and to operations. In our analysis, we must not forget to consider working capital and the cash flows related to taxes. But all the while, we are working with esti- mates—forecasts of the future. Thus, when managers estimate cash flows, they rely on their best guess as to:

■ The cost of the assets. ■ The benefits or costs of disposing the assets at the end of the project. ■ Sales in each future period. ■ Expenses in each future period. ■ Tax rates in each future period. ■ Working capital needs in each future period.

Implicit in cash flow forecasts are judgments pertaining to: ■ Competitors’ reactions to the investment.

■ Changes in the tax code. ■ The costs of materials and labor. ■ The time it takes to get the project underway.

Looking at how cash flows are estimated, we see that corporations analyze all the key elements—sales, expenses, taxes, working capital—yet apply judgment in arriving at the estimates of these elements. Thus, cash flow estimation does not lend itself well to the application of mechanical

8 Kimberly J. Smith, “Postauditing Capital Investments,” Financial Practice and Education (Spring/Summer 1994), pp. 129–137.

LONG-TERM INVESTMENT DECISIONS

formulae. Though managers can apply formulas that help them put the key elements together, they must always remember that cash flow esti- mates are determined, in large part, through marketing analyses, engi- neering studies, and, most important, managerial experience.