Cash Flow Basics

Cash Flow Estimation Rules

What are Cash Flow Estimation Problems

• Decisions on whether or not to invest in a new investment opportunity like purchasing a fixed asset.
• Determines if the new project will yield a positive or negative net present value for the firm.

Inclusions and Exclusions

• EXCLUDE Sunk Costs: A cost that has already been incurred, and is independent of the investment decision.
• Example: A company may have hired a consulting firm to advise it on whether or not to invest in a particular project. Since they must pay the consultants whether or not they go ahead with the project, the consulting fees are considered a sunk cost, and are immaterial to the investment decision.

• INCLUDE Opportunity Costs: The most valuable alternative that we are giving up by undertaking a particular investment.
• Example: A company is considering building a factory on a piece of land they had purchased 10 years ago at a cost of $5m, it is now worth $1m. The $5m is a sunk cost because it is incurred whether or not the company builds the factory. The $1m is relevant however, because if the company does not go ahead with the project, it can be sold for its market value. The relevant cost is the opportunity cost of selling the land.
• INCLUDE Net Working Capital: Difference between current assets and current liabilities. A project usually adds to NWC with additional inventories or more receivables from having higher sales. NWC is decreased by using current liabilities to finance the project.
• Example: A company wants to produce t-shirts, before production can begin; it must invest in cotton for work in progress until the t-shirts can be sold.