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The first step in calculating a project‟s NPV is to forecast the project‟s future cash flows. Cash is king.
It is cash flow, not profit, that investors really care about. If a company never generates cash flow,
there can be no return to investors. Also, profit can be manipulated by discretionary accounting
treatments such as depreciation method or inventory valuation. Regardless of accounting choices,
however, cash flow either materializes or does not. For these reasons, cash flow is the most important
variable to investors. A project‟s value derives from the cash flow it creates, and NPV is the value of
the future cash flows net of the initial cash outflow.
We can illustrate the method for forecasting cash flows with an example. Let us continue to explore
the brewery project. Suppose project engineers inform you that the construction costs for the brewery
would be $8 million. The expected life of the new brewery is 10 years. The brewery will be
depreciated to zero over its 10-year life using a straight-line depreciation schedule. Land for the
brewery can be purchased for $1 million. Additional inventory to stock the new brewery would cost
$1 million. The brewery would be fully operational within a year. If the project is undertaken,
increased sales for the beer company would be $7 million per year. Cost of goods sold for this beer
would be $2 million per year, and selling, administrative, and general expenses associated with the
new brewery would be $1 million per year. Perhaps advertising would have to increase by $500,000
per year. After 10 years, the land can be sold for $1 million, or it can be used for another project. After
10 years the salvage value of the plant is expected to be $1.5 million. The increase in accounts
receivable would exactly equal the increase in accounts payable, at $400,000, so these components of
net working capital would offset one another and generate no net cash flow.
No one expects these forecasts to be perfect. Paraphrasing the famous words of physicist Niels Bohr
(sometimes attributed to baseball player Yogi Berra), making predictions is very difficult, especially
when they are about the future! However, when investors choose among various investments, they too
must make predictions. As a financial analyst, you want the quality of your forecasts to be on a par
with the quality of the forecasts made by investors. Essentially, the job of the financial analyst is to
estimate how investors will value the project, because the value of the firm will rise if investors decide
the new project creates wealth and will fall if investors conclude the project destroys wealth. If the
investors have reason to believe that sales will be $7 million per year, then that would be the correct
forecast to use in the capital budgeting analysis. Investors have to cope with uncertainty in their
forecasts. Similarly, the financial analyst conducting a capital budgeting analysis must tolerate the
same level of uncertainty.
Exhibit 6.1 Initial year cash flow for brewery project (thousands).
Note that cash flow projections require an integrated team effort across the entire firm. Operations
and engineering personnel estimate the cost of building and operating the new plant. The human
resources department contributes the labor data. Marketing people tell you what advertising budget is
needed, and they forecast revenue. The accounting department estimates taxes, accounts payable,