Cash Flow Estimation

and Risk Analysis

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Home Depot Inc. grew phenomenally during the 1990s, and it shows no sign of

slowing down. At the beginning of 1990, it had 118 stores and annual sales of $2.8 bil-

lion. By the end of 1999, it had more than 900 stores, and its sales were $37 billion.

The company continues to open stores at a rate of about two per week, and it opened

another 200 stores in fiscal 2001. The stock has more than matched the sales

growth—a $10,000 investment in 1990 would now be worth about $220,000!

It costs Home Depot, on average, $16 million to purchase land, construct a new

store, and stock it with inventory. (The inventory costs about $5 million, but about $2

million of this is financed through accounts payable.) Each new store thus represents a

major capital expenditure, so the company must use capital budgeting techniques to

determine if a potential store’s expected cash flows are sufficient to cover its costs.

Home Depot uses information from its existing stores to forecast new stores’ ex-

pected cash flows. Thus far, its forecasts have been outstanding, but there are always

risks that must be considered. First, sales might be less than projected if the economy

weakens. Second, some of Home Depot’s customers might in the future bypass it al-

together and buy directly from manufacturers through the Internet. Third, new stores

could “cannibalize,” that is, take sales away from, existing stores. This last point was

made in the July 16, 1999, issue of Value Line:

The retailer has picked the “low-hanging fruit;” it has already entered the most at-

tractive markets. To avoid “cannibalization”—which occurs when duplicative stores

are located too closely together—the company is developing complementary for-

mats. For example, Home Depot is beginning to roll out its Expo Design Center

chain, which offers one-stop sales and service for kitchen and bath and other re-

modeling and renovation work...

The decision to expand requires a detailed assessment of the forecasted

cash flows, including the risk that the forecasted level of sales might not be real-

ized. In this chapter, we describe techniques for estimating a project’s cash flows

and their associated risk. Companies such as Home Depot use these techniques

on a regular basis to evaluate capital budgeting decisions.

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