Estimating Cash Flows 297
The basic principles of capital budgeting were covered in Chapter 7. Given a proj-
ect’s expected cash flows, it is easy to calculate its payback, discounted payback,
NPV, IRR, MIRR, and PI. Unfortunately, cash flows are rarely just given—rather,
managers must estimate them based on information collected from sources both in-
side and outside the company. Moreover, uncertainty surrounds the cash flow esti-
mates, and some projects are riskier than others. In the first part of the chapter, we
develop procedures for estimating the cash flows associated with capital budgeting
projects. Then, in the second part, we discuss techniques used to measure and take
account of project risk.
Estimating Cash Flows
The most important, but also the most difficult, step in capital budgeting is estimating
projects’ cash flows—the investment outlays and the annual net cash flows after a
project goes into operation. Many variables are involved, and many individuals and
departments participate in the process. For example, the forecasts of unit sales and
sales prices are normally made by the marketing group, based on their knowledge of
price elasticity, advertising effects, the state of the economy, competitors’ reactions,
and trends in consumers’ tastes. Similarly, the capital outlays associated with a new
product are generally obtained from the engineering and product development staffs,
while operating costs are estimated by cost accountants, production experts, personnel
specialists, purchasing agents, and so forth.
It is difficult to forecast the costs and revenues associated with a large, complex
project, so forecast errors can be quite large. For example, when several major oil
companies decided to build the Alaska Pipeline, the original cost estimates were in the
neighborhood of $700 million, but the final cost was closer to $7 billion. Similar (or
even worse) miscalculations are common in forecasts of product design costs, such as
the costs to develop a new personal computer. Further, as difficult as plant and equip-
ment costs are to estimate, sales revenues and operating costs over the project’s life are
even more uncertain. Just ask Polaroid, which recently filed for bankruptcy, or any of
the now-defunct dot-com companies.
A proper analysis includes (1) obtaining information from various departments
such as engineering and marketing, (2) ensuring that everyone involved with the fore-
cast uses a consistent set of economic assumptions, and (3) making sure that no biases
are inherent in the forecasts. This last point is extremely important, because some
managers become emotionally involved with pet projects, and others seek to build em-
pires. Both problems cause cash flow forecast biases which make bad projects look
good—on paper.
It is almost impossible to overstate the problems one can encounter in cash flow
forecasts. It is also difficult to overstate the importance of these forecasts. Still, ob-
serving the principles discussed in the next several sections will help minimize fore-
casting errors.
What is the most important step in a capital budgeting analysis?
What departments are involved in estimating a project’s cash flows?
What steps does a proper analysis include?
The textbook’s web site
contains an Excelfile that
will guide you through the
chapter’s calculations. The
file for this chapter is Ch 08
Tool Kit.xls, and we encour-
age you to open the file and
follow along as you read the
chapter.
296 Cash Flow Estimation and Risk Analysis
