The basic principles of capital budgeting were covered in Chapter 11. Given a proj-
ect’s expected cash! ows, it is easy to calculate the primary decision criterion—the
NPV—as well as the supplemental criteria, IRR, MIRR, payback, and discounted pay-
back. However, in the real world, cash! ows are not just handed to you—rather, they
must be estimated based on information from various sources. Moreover, uncer-
tainty surrounds the forecasted cash! ows, and some projects are more uncertain
and thus riskier than others. In this chapter, we review examples that illustrate how
project cash! ows are estimated, discuss techniques for measuring and then dealing
with risk, and discuss how projects are evaluated once they go into operation.
When you " nish this chapter, you should be able to:
• (^) Identify “relevant” cash! ows that should and should not be included in a capital
budgeting analysis.
• (^) Estimate a project’s relevant cash! ows and put them into a time line format that
can be used to calculate a project’s NPV, IRR, and other capital budgeting metrics.
• (^) Explain how risk is measured and use this measure to adjust the " rm’s WACC to
account for di# erential project riskiness.
• (^) Discuss how some projects can be altered after they have been accepted and how
these alterations can change a project’s cash! ows and thus its realized NPV.
• (^) Describe the post-audit, which is an important part of the capital budgeting
process, and discuss its relevance in capital budgeting decisions.
12-1 CONCEPTUAL ISSUES IN CASH FLOW ESTIMATION
Before the cash! ow estimation process is illustrated, we need to discuss several
important conceptual issues. A failure to handle these issues properly can lead to
incorrect NPVs and thus bad capital budgeting decisions.
12-1a Cash Flow versus Accounting Income
We saw in Chapter 3 that there is a difference between cash! ows and accounting
income. We also saw that cash is what people and " rms spend or reinvest; so the
present value of cash! ows, not accounting income, is the basis of a " rm’s value.
That’s why, in the last chapter, we discounted net cash! ows, not net income, to
" nd projects’ NPVs.
Many things can lead to differences between net cash! ows and net income.
First, depreciation is not a cash outlay, but it is deducted when net income is calcu-
lated. Second, net income is based on the depreciation rate the " rm’s accountants
decide to use, not necessarily the depreciation rate allowed by the IRS, and it is the
IRS rate that determines cash! ows. Moreover, if a project requires an addition to
working capital, this directly affects cash! ows but not net income. Other factors
also differentiate net income from cash! ow, but the important thing to keep in
associated with each potential project. In this chapter, we
describe techniques for estimating projects’ cash flows, as
well as projects’ risks. Companies such as Home Depot use
these techniques on a regular basis when making capital
budgeting decisions.
P U T T I N G T H I N G S I N P E R S P E C T I V E
Chapter 12 Cash Flow Estimation and Risk Analysis 365