Forecasting Future Annual Net Cash Flows

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Forecasting Future Annual Net Cash Flows

• Definition of net cash flows
• Projecting future values
• Measurement of business risk
• Risk/return preferences
• Measurement of financial risk

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Measuring Annual Net Cash Flows
Item Before new investment After new investment Net change
1. Cash receipts 25,000 30,000 5,000
2. Cash operating expenses -15,000 -18,000 -3,000
3. Depreciation -3,000 -4,000 -1,000
4. Tax deductible expenses (23) 18,000 22,000 4,000
5. Taxable income (1 4) 7,000 8,000 1,000
6. Income tax payments (5 times 25) 1,750 2,000 250
7. Net income after taxes (1 4 6) 5,250 6,000 750
8. Net cash flow (7 3) 8,250 10,000 1,750
The value circled in red is the value which
appears in the numerator of each years
discounted annual net cash flows in the NPV
capital budgeting model.
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Forecasting Needs

• Forecast of annual price of products from your
  operations
• Forecast of annual cost per unit for inputs used
  in your operations
• Forecasts any expected changes in productivity
  (i.e., yields)

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Alternative Approaches

• Market outlook information approach
• Historical based approaches
• Naïve model (p. 64)
• Olympic moving average (p. 65)
• Time series econometric approach
• Flexibility coefficient approach (p. 66)
• Structural econometric approach (p. 65-67)

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Alternative Forecasting Approaches
Non-Econometric Forecasting Approach
Structural Econometric Forecasting Model
Demand
Supply
QD f(P, Y-T, W, ...) QS f(P, MIC, ) QD
QS Solve for PE and QE
PE
QE
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Stochastic simulation of random variable (yields)
generates an empirical probability distribution
for price
Subjective triangular probability distribition
assumed annually based upon recent trends in
local spot market prices
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This is the probability distribution for the
first year. One would expect the probability
associated with the most likely scenario to
decline over time, reflecting increasing
uncertainty in subsequent years.
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We would reject making this investment since the
NPV lt 0.
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Ignoring risk would have led to an over
evaluation of the projects NPV.
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Ignoring the increasing risk would have led to
the acceptance of this investment project.
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Portfolio Effect on Risk-Adjusted NPV
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Any Questions?