Forecasting

and valuing
cashflows

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Forecasting is tough: Even the experts
have trouble
Quotes from the Hall of Forecasting Shame will attest:
“I think there is a world market for maybe five computers.” Thomas Watson,
Chairman of IBM, 1943
“There is no reason anyone would want a computer in their home.”
Ken Olson, president, chairman, and founder of Digital Equipment Corporation,
1977
“640K ought to be enough for anybody.” Bill Gates, 1981

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Discounted Cash Flow Valuation (DCF)
The idea behind DCF valuation is simple:
The value of an investment is determined by the magnitude and the
timing of the cash flows it is expected to generate.
The DCF approach provides a basis for assessing the value of these
cash flows.
It is a cornerstone of financial analysis.

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 The 3-Step DCF Process
Step 1 (forecast Step 2 WACC Step 3 Discount
FCF) FCF using WACC

• Forecast the • Estimate risk • Present value of

amount and appropriated future cashflow
timings of future discount rate
cashflows • How risky are
• How much cash furture cashflow
is expected to & what do
be generated investors
and when currently
expects

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 Defining Investment Cash Flows
What cash flows are relevant to the valuation of a project or
investment?
Are the cash flow forecasts either conservative or optimistic?
What is the difference between equity and project cash flows?

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 Relevant Cash Flows
Relevant cash flows are often referred to as incremental cash flows
Cash flows directly generated by the investment
Indirect effects that the investment may have on a firm’s other lines of
business
Incremental Cash Flows
Projected revenues and costs of the new product
Potential cannibalization of other existing products
Sunk costs are not incremental cash flows and should be ignored

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 Conservative and Optimistic Cash
Flows
Biases exist because of managerial incentives and overconfidence
Conservatism in Forecast: May result if a cash flow forecast will serve as
future targets that will influence future bonuses

Optimism in Forecast: May result if manager gets a bonus for identifying a

promising investment opportunity that the firm initiates

“Hoped-for” vs. “expected” cash flows

“If all goes as planned, these are the cash flows that we expect to achieve.”

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Equity vs. Project/Firm Free Cash Flow
Investment cash flow is the sum of the cash inflows and outflows
from the project
Equity free cash flow (EFCF): cash flow available for distribution to
the firm’s common shareholders
Values the equity claim in the project
Includes cash dividends and share repurchases
Free cash flow (FCF): amount of cash produced (by a project or a
firm) during a particular time that is available for distribution to both
the firm’s creditors and equity holders
Values the project or firm as a whole (both equity and debt claims)

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 Calculating FCF

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 Calculating FCF
FCF = EBIT(1 - T) + DA -∆ONWC – CAPEX
FCF = NOPAT + DA -∆ONWC – CAPEX

EBIT: Earnings before interest and taxes

EBIT(1 - T): After-tax operating income or net operating profit after tax (NOPAT)
T: Tax rate
DA: Depreciation and amortization expense
∆ONWC: Change in operating net working capital
CAPEX: Additional Capital expenditures for property, plant, and equipment
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 FCF Definitions
Depreciation and amortization expense (DA)
Does not represent an actual cash payment
Arises out of the matching principle of accrual accounting, matches
expenditures made for long-lived assets (plant, machinery and
equipment) against the revenues they help generate
The actual expenditure of cash may have taken place many years
earlier when the assets were acquired

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 FCF Definitions: CapEx
To sustain productive capacity and provide for growth firms invest in long-
lived assets or capital expenditures
Net property, plant, and equipment is equal to the difference in the accumulated
cost of all property, plant, and equipment (gross PPE) less the accumulated
depreciation for those assets.
Maintenance CAPEX: Assets physically wear out and need replacement
Growth CAPEX: To achieve growth in future cash flows firms require added capacity
through investments in new PPE and acquisitions of businesses

CapEx can be calculated by analyzing how net PPE on the balance sheet
changes over time1

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 FCF Definitions
Changes in operating net working
capital (WC)1
Investments in current assets used in
a firm’s operations are partially
financed by increases in current
liabilities
The end result is an outlay for
working capital equal to the change
in operating net working capital

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1 Referred to as “change” rather than “increase” since the change can be both positive and negative.
 Lecion DCF Valuation
Discounting the Cash Flows
Opportunity cost of capital is 18% per year
Calculate the discount factor for each year’s cash flow

Sum the present values of the cash flows generated by the project
Initial investment 200000

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 Lecion: “The Numbers”

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 Lecion: “The Numbers”

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 Problem 2

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 Solution
Given
Growth rate in EBIT for 5%
years 1-5
EBIT (year 1) $ 100,000
CAPEX for year 0 $ 400,000
Depreciable life of fixed 5 years
assets
Tax rate 30%
New working capital for 20%of EBIT
years 1-5

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 Solution
Year
0 1 2 3 4 5
EBIT $ $ $ $ $
100,000 105,000 110,250 115,763 121,551
Taxes
(30,000) (31,500) (33,075) (34,729) (36,465)
NOPAT $ $ $ $ $
70,000 73,500 77,175 81,034 85,085
Plus: Depreciation
80,000 80,000 80,000 80,000 80,000
Less: CAPEX (400,000)
- - - - -
Less: Net working capital needs (20,000)
(1,000) (1,050) (1,103) (1,158) 24,310
Plus: Salvage value of the fixed assets in year 5
-
Firm Free Cash Flow (FFCF) $ (420,000) $ $ $ $ $
149,000 152,450 156,073 159,876 189,396

Change in Working capital

Year 0 1 2 3 4 5
WC requirement 0$ $ $ $ $
Compiled and edited by Prof Dipti Saraf 20,000 21,000 22,050 23,153 24,310
Change $ (20,000) $ $ $ $ $
(1,000) (1,050) (1,103) (1,158) 24,310
 Ex 2.6, 2.7, 2.10
From text book

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 Problem 4.
Television Ltd is a highly profitable firm, it has a proposal for manufacturing car televisions.
The project would involve cost of plant of `500 lakh (or `55 million), installation cost of
`100 lakh and working capital of `125 lakh. The annual capacity of the plant is to
manufacture 20,000 sets. The price per set in the first year would be `12,000. The variable
cost to sales ratio is expected to be 65 per cent. The fixed cost per annum would be `300
lakh (excluding depreciation). The company would have to incur promotion expenditure of
`120 lakh in the first year. Written-down depreciation rate for tax purposes is 25 per cent.
Working capital requirement is estimated to be 25 per cent of sales. The company expects
that the plant’s capacity utilization over its economic life of 7 years will be as follows:
Year 1 2 3 4 5 6 7
Capacity utilization (%) 40 40 50 75 100 100 100

Calculate the project’s NPV assuming a target rate of return of 14 per cent. The
corporate tax rate of 35 per cent and profit from the sale of the asset is taxed as
ordinary income.
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 Mutually Exclusive Projects
Often the analysis will entail consideration of multiple alternatives
or competing projects, where the firm must select only one.
Mutually exclusive investments: the selection of one alternative
precludes investment in the others.

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 Summary
The value of an investment project is determined by the
cash flows it produces. In this chapter, we have discussed
valuing investment opportunities using discounted cash flow
(DCF) analysis that incorporates the three-step process:

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 Summary and Best Practices

Investment opportunities can be evaluated using DCF analysis

Forecasting is hard work and is subject to potentially very large
errors
Incorporate the three-step process to minimize impact of estimation
errors and the subjectivity of forecasting
Important to identify and forecast incremental revenues and
costs
Maintain flexibility in the implementation of an investment to
allow for modification or response to unforeseen future events

Compiled and edited by Prof Dipti Saraf