Introduction

Every business entity continues to find sources and chances that they think will
thrive on. It costs millions to funds for new projects and its very important to perform
financial analysis to determine whether a potential project expected cash flows will
cover its costs. The company should use existing information to forecast its new
expected cash inflows and should consider that there are associated in every project
considering the economic environment.

This report discusses about free cash flows and timing, incremental cash flows,
replacement projects, sunk costs, opportunity costs associated with assets the firm
owns, externalities, analysis of an expansion project, effect of different depreciation
costs, cannibalization and replacement analysis.

Background
The most important, but also the most difficult, phase in capital budgeting is to
estimate the cash flow of projects — investment outlays and annual net cash inflows
after the project is put into action. There are many factors involved and many people
and departments are involved in the process. For example, unit sales and sales price
estimates are usually generated by the marketing department on the basis of their
knowledge of price elasticity, advertisement impacts, the state of the economy, the
reactions of rivals and customer taste patterns. Similarly, the capital expenditure
associated with the new product is usually derived from the manufacturing and product
development workers, while the running costs are determined by the cost accountants,
the production experts, the personnel professionals, the purchasing agents and so on.
The assessment of cash flow is a critical step for the evaluation of investment decisions
of any sort. In forecasting cash flows, the most significant variable is the projected
revenue growth and profit margins of the business. A significant determinant of cash
flow prediction is the estimation of growth rates. For cash flow calculation, modifications
to financial statements are made. Changes have to be made in the form of capital
expenditures and adjustments to finance expenses for such misclassifications. Instead
of capital expenses, research and development expenses are also viewed as operating
expenses. Examples of changes to financing costs are operating leases. One-time
expenditures such as acquisitions need to be changed as well.

Learning Insights
Conceptual issues in cash flow estimation
There are several significant conceptual issues before the cash flow estimation
process is illustrated. A failure to deal properly with these problems can lead to the
calculation of incorrect project NPVs, leading to poor decisions on capital budgeting.
These are:

(1) Free cash flow versus accounting income. Net income is the profit a company
has earned for a period, while free cash flow measures, in part, the cash going in
and out during a company's day-to-day operations. Net income is the starting
point in calculating free cash flow from operating activities. However, both are
important in determining the financial health of a company. Free cash flow is the
cash a company produces through its operations, less the cost of expenditures
on assets. In other words, free cash flow (FCF) is the cash left over after a
company pays for its operating expenses and capital expenditures, also known
as CAPEX. Free cash flow is an important measurement since it shows how
efficient a company is at generating cash. Investors use free cash flow to
measure whether a company might have enough cash, after funding operations
and capital expenditures, to pay investors through dividends and share
buybacks.

Calculating Free Cash Flow. To calculate FCF, from the cash flow statement,
locate the item cash flow from operations (also referred to as "operating cash" or "net
cash from operating activities"), and subtract the capital expenditure required for current
operations.

Step 1: Add Back Depreciation. Depreciation is a non-cash expense. It has been

reduced from the revenues to arrive at EBIT. Hence, to derive what the true cash flow of
the firm is, we need to add back the depreciation amount. This is the standard
procedure we use while preparing any cash flow statement.

Step 2: Adjust EBIT for taxes. Step 2 is where things get slightly complicated.
Now, notice the fact that we are working with EBIT which is earnings before interest and
taxes. This means that we haven’t accounted for interest as well as taxes and their
effects on the cash flow. Interest does not have any effect on the cash flow. We haven’t
subtracted it from EBIT and hence there is no need to add it back. Taxes on the other
hand are a different matter. They are a cash outflow which occurs at a later stage in the
income statement. Hence, while deriving free cash flows to the firm we must adjust the
EBIT for taxes. This is done by subtracting the tax amount from EBIT. For example, the
EBIT was $1000 and there was a 40% tax rate. At a later stage on the income
statement, the company will pay 40% of this $1000 as cash flow. Hence, its EBIT will be
reduced to $600. We therefore need to adjust the EBIT for taxes and make it a post-tax
EBIT number.

Step 3: Subtract Capital Expenditures + Net Operating Working Capital. Step 3 is

the standard procedure we use to calculate free cash flow to the firm. Here, we will
subtract our Capital Expenditures and Net Operating Working Capital from the amount
derived by performing step 1 and step 2.

Positive FCFF value indicates that the firm has cash remaining after expenses. A
negative value indicates that the firm has not generated enough revenue to cover its
costs and investment activities. In the latter case, an investor should dig deeper to
assess why costs and investment exceed revenues. It could be the result of a specific
business purpose, as in high-growth tech companies that take consistent outside
investments, or it could be a signal of financial problems.

(2) Timing of Cash Flows. Business firms must learn to manage revenues and
expenses, on the one hand, and cash inflows and outflows on the other. Cash
flows should in theory be treated exactly when they occur, so theoretically daily
cash flows should be better than the yearly flows. It would, however, be costly to
estimate and analyze daily cash flows, and they would probably not be more
accurate than annual estimates, because we simply can not accurately forecast
 every day for 10 years or so in the future. As a result, we generally assume that
all cash flows will occur at the end of the year. Note, however, that for projects
with highly predictable cash flows, it may be useful to assume that cash flows
occur at mid-year (or even quarterly or monthly) levels. But for most purposes,
we assume that there are end-of-year flows
(3) Incremental Cash Flows. The additional operating cash flow received by an
organization from taking on a new project is incremental cash flow. A positive
incremental cash flow means that with the approval of the project the cash flow of
the business can improve. A positive incremental cash flow is a good indicator of
a company investing in a project. Incremental cash flows are flows that will occur
if and only if there is a certain significant event. In capital budgeting, the
occurrence is the approval of a project by the company and the incremental cash
flows of the project are those that arise as a consequence of this decision. As
with sales revenues and operational expenses associated with the project, cash
flows such as investments in facilities, equipment, and working capital required
for the project are obviously incremental.
(4) Replacement Projects. Two types of capital projects that a firm may consider
are: Expansion Projects: these are projects where the firm seeks to profitably
increase sales of current products or introduce new products into the market, and
Replacement Projects: these are projects where the firm must either: replace
worn out equipment or invest in new equipment that is expected to lower current
production costs and/or increase current sales. It is possible to differentiate
between two types of projects: expansion projects, where the company makes an
investment, such as a new Home Depot store, and replacement projects, where
the company replaces old properties, normally to minimize costs.
(5) Sunk Costs. A sunk cost applies to cash that has already been expended and
that cannot be recovered. The equation in business that one must "spend money
to make money" is represented in the sunken cost phenomenon. A sunk price
varies from future costs that a company could face, such as choices about
inventory purchasing costs or product pricing. Sunk costs are exempt from future
 company decisions because, regardless of the consequence of a decision, the
cost will remain the same.
(6) Opportunity Costs Associated with Assets the firm owns. The cost of an
opportunity is the cost of a missed opportunity. That is the reverse of the
advantage that would have been achieved if an action had been made, not
taken, the missed opportunity. In economics, this is a concept used. Applied to a
business decision, if these assets were used in a different way, the opportunity
cost would apply to the benefit a business might have received from its money,
equipment, and real estate. For several different cases, the principle of
opportunity cost can be applied. Whenever conditions are such that scarcity
necessitates the preference of one alternative over another, it should be
considered. Opportunity costs are commonly defined in terms of money, but they
can also be taken into account in terms of time, personal hours, mechanical
production, or any other limited resource.

(7) Externalities. Externalities are the effects of a project on cash flows in other
parts of a firm. Although they are difficult to quantify, they should be considered.
Externalities can be either positive or negative: Positive externalities create
benefits for other parts of the firm. For example, the coffee shop may generate
some additional customers for the bookstore (who otherwise may not buy books
there). Future cash flows generated by positive externalities occur with the
project and do not occur without the project, so they are incremental. Negative
externalities create costs for other parts of the firm. For example, if the bookstore
is considering opening a branch two blocks away, some customers who buy
books at the old store will switch to the new branch. The customers lost by the
old store are a negative externality. The primary type of negative externality is
cannibalization, which occurs when the introduction of a new product causes
sales of existing products to decline. Future cash flows represented by negative
externalities occur regardless of the project, so they are non-incremental. Such
cash flows represent a transfer from existing projects to new projects, and thus
should be subtracted from the new projects' cash flows.
Analysis of An Expansion Project
An expansion project in the world of finance is literally any project that works to
expand a company's reach. Such ventures include, in most cases, the development of
new goods or the movement into new markets. It can also include simply growing the
sales and introduction of existing products into new markets. Projects for expansion are
a form of capital investment project designed to help a business develop and grow.
Research and development ( R&D) is also part of the process when a business spends
money in creating and selling new goods or in entering into new markets. Initiatives in
research and development also support not only the business, but also the global
market and the economy as a whole. New research and development means new
insights that all industries, businesses and investors will gain from. Typically, when a
business invests in an expansion project, it ventures into a new target market.
Expansion Project Analysis is used by a company’s management to evaluate
capital projects. The methodology builds on the net present value (NPV) methodology.
The most important step when applying project analysis is to identify the relevant cash
flows. In particular, capital budgeting looks at the incremental after-tax cash flows. Once
we have the cash flows, it is easy to calculate the NPV of IRR.

Replacement Analysis
The study of the planning, rationale and execution of the effective replacement of
an existing asset, such as a roof or a boiler, or a group of assets, with a new asset(s).
The scope of the analysis includes, but not limited to some of the following: The timing
of the replacement, The business case for the replacement, The preparations for the
replacement, The costs of replacement, and the procurement process. Replacement
analysis is a broad topic that can be organized, for discussion purposes, into six general
facets, as follows: The following series of questions illustrate some of the challenges in
the decision-making process surrounding the replacement of assets: How do we know
that it is absolutely necessary to replace the asset?, Can we do anything to extend the
life of the asset and postpone the project?, What preparations need to be made when
replacing large and expensive assets?, How much advance notice will we be given
before having to replace the asset?, Will we have enough money for the project?, What
will happen if we do not replace the asset or replace it with something different?

Conclusions
The most important (and most difficult) step in analyzing a capital budgeting
project is estimating the incremental after-tax cash flows the project will produce.
Project cash flow is different from accounting income. Project cash flow reflects: (1)
cash outlays for fixed assets, (2) the tax shield provided by depreciation, and (3) cash
flows due to changes in net operating working capital. Project cash flow does not
include interest payments. In determining incremental cash flows, opportunity costs (the
cash flows forgone by using an asset) must be included, but sunk costs (cash outlays
that have been made and that cannot be recouped) are not included. Any externalities
(effects of a project on other parts of the firm) should also be reflected in the analysis.
Cannibalization occurs when a new project leads to a reduction in sales of an existing
product. Capital projects often require an additional investment in net operating working
capital (NOWC). An increase in NOWC must be included in the Year 0 initial cash
outlay, and then shown as a cash inflow in the final year of the project. The incremental
cash flows from a typical project can be classified into three categories: (1) initial
investment outlay, (2) operating cash flows over the project’s life, and (3) terminal year
cash flows

References:
Brigham. E & Houston J. (2007). Fundamentals of Financial Management
(11 th Ed.). U.S.A.: Thomson South-Western
Eugene F. Brigham and Joel F. Houston (2019), Fundamentals of Financial
Management, Fifteenth edition