# Module 3 – Background CASH FLOW ESTIMATION AND CAPITAL BUDGETING

Module 3 – BackgroundCASH FLOW ESTIMATION AND CAPITAL BUDGETINGAs a financial manager, you are to focus on maximizing shareholderwealth. You do that by accepting positive NPV projects and rejectingnegative NPV projects. In order to run a NPV calculation, you need cashflows which need to be estimated.There are several steps to estimate a project’s cash flows.First, some assumptions need to be made regarding how many units of thegoods are to be sold and at what price per unit. The tax rate will also needto be determined.Second, depreciation needs to be calculated. You need to decide whichdepreciation methodology you will use such as straight-line depreciation orMACRS.Third, you need to calculate the salvage value on the property and/orequipment that is disposed of at the end of the project’s life.Fourth, you can now proceed to put things together and estimate theproject’s cash flows:At Time 0 (today), you are likely to have the following cash outflows:Building and/or equipmentIncrease in net working capital= total investment outlays (negative value)At Time 1 through Time N (the end of the project’s life), you are likely tohave the following cash flows each year:ListenPage 1 of 3Sales revenue (units sold x sales price)– Variable costs (usually some percentage of the sales revenue)– Fixed operating costs– Depreciation= EBIT (earnings before interest and taxes)-Taxes on the operating income= NOPAT (net operating profit after taxes)+ Depreciation add-back= Operating cash flowThen at Time N (the end of the project’s life), you have terminal year cashflows likely consisting of the following:+ Return of the net working capital+ net salvage value= Total terminal cash flowsThe project cash flows can finally be determined by adding together for theappropriate year the total investment outlays, the operating cash flows, andthe total terminal cash flows.Now that you have the project cash flows, you can apply the various capitalbudgeting methodologies including net present value (NPV), internal rateof return (IRR), modified internal rate of return (MIRR), profitability index(PI), regular payback period, and the discounted payback period.Many of these can be calculated with Excel.=NPV calculates a project’s NPV in Excel.=IRR calculates a project’s IRR in Excel.=MIRR calculates a project’s MIRR in ExcelReview this video that focuses on NPV:JohnFinance (2014). Net Present Value. Retrieved June 2014from http://www.youtube.com/watch?v=GiNG9Va00fIPage 2 of 310/28/2016Privacy Policy | ContactNPV is the best out of all the capital budgeting methodologies. It takes intoall of a project’s cash flows, it uses the time value of money, doesn’t haveproblems with non-normal cash flows like IRR can have when it can resultin multiple IRRs, assumes reinvestment of the cash flows at the moreconservative cost of capital instead of the higher less realistic IRRreinvestment rate assumption, gives consistent results with mutuallyexclusive and independent projects.Optional ResourcesBookboon.com. (2008). Corporate Finance. Retrievedfrom http://bookboon.com/en/economics-and-finance-ebooksWelch, Ivo. (2014). Corporate Finance (3rd Ed.). Chpts 4 and 12. Retrievedfrom http://book.ivo-welch.info/ed3/toc.html

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