University of San Jose – Recoletos

School of Business and Management

Accountancy and Finance Department
Strategic Business Analysis
Mr. Jun Brian Alenton
CPA, CMA, CAT, RCA, MICB, MBA

Module 4
Cash Flow Estimation

INTRODUCTION
An important factor to make a sound decision for long-term assets is to properly estimate future cash
flows used in most capital budgeting techniques. This module is a preparatory topic for capital
budgeting and discusses the various methods and issues surrounding the estimation of cash flows. In
the real world, the cash flow is not just handed to the accountant, but rather, it must be estimated
based on information from various sources. Moreover, uncertainty surrounds the forecasted cash
flows, especially that some long-term assets are more uncertain and riskier than others.

CASH FLOW VS. ACCOUNTING INCOME – on DECISION MAKING

In the decision-making process, accounting income is not the information that is used as a basis or
reference, simply because there are items used in the accounting income that may not be a source to
reinvest or spend for long-term assets. Cash is the most common means of purchasing assets, not
the accounting income. There are also times that a capital expenditure would require adjustments to
the working capital (current assets and current liabilities) that would not directly affect accounting
income.

CONCEPTS IN ESTIMATING CASH FLOWS

The following are the most common concepts and/or techniques in estimating cash flows:
1. Timing of Cash Flows
2. Incremental Cash Flows
3. Sunk Costs
4. Opportunity Costs
5. Operating Cash Flows
6. Free Cash Flow

TIMING OF CASH FLOWS

Most business decision analyses would deal with cash flows exactly when they occur, hence, daily
cash flows theoretically would be ideal than annual cash flows. However, it would be more costly to
estimate and analyze daily cash flows and would not probably be more accurate than annual
estimates. Therefore, we generally assume that all cash flows occur at the end of the year.

INCREMENTAL CASH FLOWS

Incremental Cash Flows are flows that will occur, if and only if, some specific event occurs. In the
case of Capital Budgeting, the acceptance of a project marks the beginning of the projections of
incremental cash flows. Cash flows such as investments in buildings, equipment, working capital
needed for the project, sales revenue and operating costs related with the capital investment.

SUNK COSTS
A sunk cost is an outlay that was incurred in the past and cannot be recovered in the future
regardless of whether the project under consideration is accepted. These cash outlays are not
relevant in the making of decisions for capital expenditures, therefore should not be included in the
cash flow estimates. Common sunk costs include the cost of old equipment and irrecoverable
operational costs.

OPPORTUNITY COSTS
Opportunity cost represents the benefits foregone for choosing one alternative over another. In the
case of Capital Budgeting, these benefits might form part of the estimated cash flows because it
causes the reduction to the cash flows of the entity. Common opportunity costs include revenues
forgone from the usage of the long-term asset, among others.

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OPERATING CASH FLOWS
In estimating cash flows, the cash revenues and costs or cash outlays expected to be generated from
the eventual usage of long-term assets. In practice, this might be tedious to do, however is
necessary to establish the merits of proposed acquisitions. Assumptions for estimating operating cash
flows need to have valid and supported bases, to provide reasonable assurance in making a sound
decision for acquiring long-term fixed assets.

FREE CASH FLOW

Free cash flow is the amount of cash that could be withdrawn from a firm without harming its ability
to operate and to produce future cash flows. The equation for free cash flows is as follows:

FCF = EBIT (1-T) + Dep’n – (Capital Expenditures – Increase in Net Working Capital)

Where: FCF - Free Cash Flow

T - Tax Rate
Capital Expenditures - Amounts set aside for long-term asset acquisition
Inc. in Net WC - Difference in the change in current assets less change
in payables and accruals

The ideal situation is to have a positive free cash flow, which primarily means that the company can
distribute returns to its investors in the form of dividends or it can further be used to acquire more
fixed assets.

A negative free cash flow however does not necessarily mean an unfavorable thing for the entity, as
long as the investment for capital expenditures and net working capital will yield to a returns in the
future.

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Exercises:
1. A company is considering a new project. The company’s CFO plans to calculate the project’s NPV
by discounting the relevant cash flows (which include the initial up-front costs, the operating
cash flows, and the terminal cash flows) at the company’s cost of capital (WACC). Which of
the following factors should the CFO include when estimating the relevant cash flows?
a. Any sunk costs associated with the project.
b. Any interest expenses associated with the project.
c. Any opportunity costs associated with the project.
d. Statements b and c are correct.

2. When evaluating potential projects, which of the following factors should be incorporated as part
of a project’s estimated cash flows?
a. Any sunk costs that were incurred in the past prior to considering the proposed project.
b. Any opportunity costs that are incurred if the project is undertaken.
c. Any externalities (both positive and negative) that are incurred if the project is undertaken.
d. Statements b and c are correct.

3. Which of the following is not a cash flow that results from the decision to accept a project?
a. Changes in net operating working capital.
b. Shipping and installation costs.
c. Sunk costs.
d. Opportunity costs.

4. Which of the following items should Bev’s Beverage Inc. take into account when evaluating a
proposed prune juice project?
a. The company spent P300,000 two years ago to renovate its Cincinnati plant. These
renovations were made in anticipation of another project that the company ultimately did not
undertake.
b. If the company did not proceed with the prune juice project, the Cincinnati plant could
generate leasing income of P75,000 a year.
c. If the company proceeds with the prune juice project, it is estimated that sales of the
company’s apple juice will fall by 3 percent a year.
d. Statements b and c are correct.

5. Which of the following is not considered a relevant concern in determining incremental cash flows
for a new product?
a. The use of factory floor space that is currently unused but available for production of any
product.
b. Revenues from the existing product that would be lost as a result of some customers switching
to the new product.
c. Shipping and installation costs associated with preparing the machine to be used to produce
the new product.
d. The cost of a product analysis completed in the previous tax year and specific to the new
product.

6. Which of the following rules are essential to successful cash flow estimates, and ultimately, to
successful capital budgeting analysis?
a. The return on invested capital is the only relevant cash flow.
b. Only incremental cash flows are relevant to the accept/reject decision.
c. Total cash flows are relevant to capital budgeting analysis and the accept/reject decision.
d. Statements a and b are correct.

7. Free cash flow equals cash provided by

A. operations less capital expenditures and cash dividends.
B. operations less cash dividends.
C. investing activities less capital expenditures and cash dividends.
D. operations less capital expenditures.

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8. A measure that describes the cash remaining from operations after adjustment for capital
expenditures, net working capital and dividends is
A. adjusted cash from operations.
B. cash provided by operations.
C. free cash flow.
D. net cash provided by operating activities.

9. Last year, Owen Technologies reported negative net cash flow and negative free cash flow.
However, its cash on the balance sheet increased. Which of the following could explain these
changes in its cash position?
A. The company had a sharp increase in its depreciation and amortization expenses.
B. The company had a sharp increase in its inventories.
C. The company issued new common stock.
D. Statements a and b are correct.

10. A stock market analyst has forecasted the following year-end numbers for Raedebe Technology:
Sales P70 million
EBITDA P20 million
Depreciation P 7 million
Amortization P0
The company’s tax rate is 40 percent. The company does not expect any changes in its net operating
working capital. This year the company’s planned gross capital expenditures will total P12 million.
(Gross capital expenditures represent capital expenditures before deducting depreciation.) What is the
company’s forecasted free cash flow for the year?
A. P 2.8 million C. P 8.0 million
B. P 7.0 million D. P12.8 million

11. A stock market analyst has forecasted the following year-end numbers for Raedebe Technology:

Sales P70 million

EBITDA P20 million
Depreciation P 7 million
Amortization P0
The company’s tax rate is 40 percent. The company does not expect any changes in its net
operating working capital. This year the company’s planned gross capital expenditures will total
P12 million. (Gross capital expenditures represent capital expenditures before deducting
depreciation.) What is the company’s forecasted free cash flow for the year?
a. P 2.8 million
b. P 7.0 million
c. P 8.0 million
d. P12.8 million

Beckham Broadcasting Company (BBC) has operating income (EBIT) of P2,500,000. The company’s
depreciation expense is P500,000 and it has no amortization expense. The company is 100 percent
equity financed (that is, its interest expense is zero). The company has a 40 percent tax rate, and its
net investment in operating capital is P1,000,000.
12. What is BBC’s net operating profit after taxes (NOPAT)?
a. P1,000,000
b. P1,200,000
c. P1,250,000
d. P1,500,000

13. What is BBC’s free cash flow?

a. P 0
b. P 500,000
c. P 900,000
d. P1,000,000

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1
C
2
D
3
C
4
D
5
D
6
B
7
A
8
C
9
C
10
A
11
A
12. D
13. B

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