Kathmandu University School of Management
Concept Note
On
Cash Flow estimation and Risk Analysis
FINANCIAL DECISIONS
Group No- 2
Submitted To: Submitted By:
Mr. Sabin Bikram Panta Rajina Khadka (19316)
Associate Professor Evana Manandhar (19320)
Financial Decision Nivida Pandey (19323)
Utsav Raj Pant (19324)
Ronjent Thapa (19337)
MBA Spring 2019
07/15/2019
In finance, the most important and most difficult step in capital budgeting estimating projects, cash
flow- the investment outlays and the annual net cash inflows after a project goes on operation. The
financial staff’s role in forecasting process includes obtaining information from various
departments such as engineering and marketing; ensuring that everyone involved with forecast
uses a consistent of the economic assumptions and no biases inherent on forecast.
The first step in capital budgeting is to identify the relevant cash flows, which is the specific set of
cash flow that should be considered with the decisions. There are two cardinal rules to help in
minimizing; capital budgeting decision must ben based on cash flows not the accounting income;
only incremental cash flows are relevant.
Project Cash Flow Versus Accounting Income
Free Cash Flow = Net Operating profit after taxes (NOPAT) – Depreciation – Gross
Capital expenditure – Change in Net operating working capital.
=EBIT(1-T) + Depreciation – Gross capital expenditures- ∆Current
operating assets-∆current operating liabilities
Evaluating Capital Budgeting Projects: A potential project creates values for the firm’s
shareholders if and only if the net present value of the incremental cash flows from the project is
positive. There is new expansion project and in contrast replacement project occurs when the firm
replaces on exiting assets with the new one. Initial investment outlay, operating cash flows over
the projects’ life, terminal year cash flows.
Adjusting for inflation: NPV (No inflation)
𝑅𝐶𝐹𝑡 𝑁𝐶𝐹𝑡
= ∑𝑛𝑖=0 = ∑𝑛𝑡=0
(1+ 𝑘𝑟 )𝑡 (1+𝑘𝑛 )𝑡∗
If the cost of the capital includes an inflation premium, as it typically does, but the cash flows are
all stated in constant in adjusted dollars, then the calculated NPV will be downward biased.
Sensitivity analysis is a technique that indicates how much NPV will change in response to the
given change in an input variable, other things held constant. The steeper the slope the more
sensitive NPV is to change in the variable.
Scenario analysis provides useful information about a project’s stand-alone risk. However, it is
limited in that it considers only a few discrete outcomes (NPV’s), even though there is infinite
number of possibilities. We have discussed three types of risk normally considered in capital
budgeting analysis- standalone risk, within- firm risk or corporate risk; and market risk.
In the process of analyzing projects and determining the worth of the investment, estimating the
projects' cash flow is very important. Even when the capital budgeting technique is correct, if the
cash flow estimation of the project is incorrect; it can lead the manager to take irrational decisions.
Correctly estimating projects' cash flow can help to demarcate the costs and benefits of each
project, and then prioritize and select by comparing each of their expected returns. This will lead
the manager to allocate the resources to the projects that will maximize the shareholders'
wealth. However intentional reducing of the cash flow estimates might occur when a manager
wants to guarantee the project acceptance. Such biasness might not necessarily lead to
shareholders' wealth maximization.
Uncertainty is often involved in capital budgeting decisions. If there are any errors in future cash
flow estimates, the project may fail to generate the expected cash flow. Such risk evaluation
depends upon the manager's ability to identify the nature of the risk and apply appropriate
techniques to assess it. Proper risk assessment and management is necessary, especially for
investments with high costs and benefits.
