Cash Flow Estimation

The most important and difficult step in the analysis of a capital budgeting project is estimating its cash flows—the investment outlays and the annual net cash inflows after the project goes into operation. Many variables are involved in cash flow forecasting, and several individuals and departments participate in the process. For example, forecasts of unit sales and sales prices are normally made by the marketing department, based on its knowledge of price elasticity, advertising effects, the state of the economy, competitors' reactions, and trends in consumers' tastes. The size of necessary capital outlays associated with a new product are generally obtained from the engineering and product development staffs; operating costs are estimated by cost accountants, production experts, personnel specialists, purchasing agents, and so forth.

It is difficult to make accurate forecasts of the costs and revenues associated with a large, complex project, so forecast errors can be large. For example, when several major oil companies decided to build the Alaska pipeline, the original cost forecasts were in the neighborhood of $700 million, but the final cost was closer to $7 billion. Similar miscalculations are common in forecasts of new product design costs. As difficult as plant and equipment costs are to estimate, sales revenues and operating costs over the life of the project are generally even more uncertain.

In October 2001, for example, a slowing economy and sluggish customer acceptance finally spelled the end to one of the most expensive Internet access projects in the nation. After 3/2 years and $5 billion in expenses, Sprint FON Group (Sprint), a subsidiary of Sprint Corporation, pulled the plug on a project affectionately known as its integrated on-demand network, or ION. After attracting only 4,000 customers, ION proved to be an extravagant money pit. Sprint spent roughly $1.25 million per ION customer and staked ambitious growth plans on the prospect of marrying voice and data services. However, a sharp downturn in the telecom sector raised the risk of ION and other speculative spending projects aimed at connecting local telecom customers to high-speed broadband communications networks. In a company press release, Sprint CEO William T. Esrey killed the massive project with the terse comment: "We are taking significant steps to reduce our cost structure and sharpen our focus on the products and services that hold the best potential for growth and return on investment."

Unfortunately, although the Sprint ION fiasco represents a spectacular flop in corporate capital budgeting, it is not a unique example. In 1999, and only 6 months after launching the world's first global satellite phone network, Iridium LLC fell deep into the red as it failed to come close to meeting sales targets. At that time, Iridium reported a quarterly loss of $505 million on revenues of only $1.45 million. Bankruptcy followed when the company failed to find a market niche for its mobile phone handsets serviced by an expensive network of satellites. In the aftermath, investors and creditors sued Motorola, Inc., contending that Motorola had kept control of Iridium, a former subsidiary, after it went public in 1997. Creditors of Iridium contended in court filings that money lent to Iridium was actually funneled to Motorola and should be returned. At the time, creditors and investors sought more than $2 billion in damages from Motorola and another $3.5 billion for damages from Iridium. This litigation came at a bad time for Motorola, which announced its first quarterly loss in 15 years, plant closings, and worker layoffs.

Given enormous financial strength, Sprint has been able to absorb losses on the ION project, and Motorola has recovered from the Iridium debacle. Such miscues would have forced weaker firms into bankruptcy. Still, the enormous burden imposed on shareholders and creditors by such capital budgeting mistakes makes clear the importance of sound forecasting in the capital budgeting process.

The financial staff's role in the forecasting process involves coordinating the efforts of the other departments, such as engineering and marketing; ensuring that everyone involved with the forecast uses a consistent set of economic assumptions; and making sure that no biases are inherent in the forecasts. This last point is extremely important, because division managers often become emotionally involved with pet projects or develop empire-building complexes, leading to cash flow forecasting biases that make bad projects look good—on paper. For the capital budgeting process to be successful, the pattern of expected cash inflows and outflows must be established within a consistent and unbiased framework.

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