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The goal when reviewing a new project is to answer the question: Will investing in this project make the entire firm or company more valuable? As a result, the cash flows to look at in project finance are the cash flows the project creates for the company or business considering it (incremental cash flows).
When earnings and cash flows are different, as they are for many projects, we look at the one providing a more reliable measure of overall performance. Accounting earnings, specifically at the equity level (net income), could be fudged at least with regard to individual projects, by using creative accounting methods.
The second reason for using cash flow is much more direct. Businesses require payment with cash not earnings. So, a project with strong earnings and not so favorable cash flows will drain cash from the business. Conversely, a project with negative earnings and positive cash flows might make the accounting bottom line worse but will generate money for the business undertaking it.
Incremental and Total Cash Flows
The total and the incremental cash flows on a project will usually be different for two reasons. First, some of the cash flows on an investment could have occurred and are unaffected if a new project is accepted or not. Such cash flows are called sunken expenses and should be removed from the analysis. The second reason is that some of the project cash flows on an investment will be created by the firm, whether or not this investment is accepted or declined. Allocation of fixed expenses, such as general and administrative expenses, usually falls into this category. These types of cash flows aren't incremental, and the evaluation needs to be cleansed of their impact.
When analyzing new projects or investments it is easy to get tunnel vision and focus on the project or investment available, acting as if the reason of the exercise would be to maximize the value of the singular investment. There is the bias, along with perfect hindsight, to force new projects to cover all expenses they have generated for the company, regardless if these costs will never be recovered by declining the project. The goal in corporate budgeting is to increase the value of the company by investing in good projects. Consequently, it is the future cash flows that the investment will add to the company, that is, the incremental cash flows, that we should focus on.
Estimating Cash Flows
How do we evaluate a project's forecasted revenues and expenses? The important thing here in this question is estimate. Nobody, no matter what his or her qualifications at forecasting as well as their level of training, can forecast with certainty how a risky project will do. There are generally three methods in which we are able to prepare these forecasts:
1. Experience as well as History: The step to estimating project revenues and expenses is easiest for companies that do the same type of project repeatedly. These companies can use their experience from similar projects which are currently operational in order to estimate expected values for new project.
2. Market Testing: When the project being evaluated is different from the firm's existing business, one might need a market study prior to actually investing in the project. In a market study, potential customers are asked about the product or service being considered to gauge the interest they might have in buying it. The results are typically qualitative and reveal whether the interest is strong or weak, allowing the company to decide whether to make use of optimistic forecasts for revenues (strong) or pessimistic forecasts (weak). Companies that need more information will often test market the concept on smaller sized markets, before presenting it on a bigger scale. Test advertising not only allows companies to test out the product or service directly but additionally yields far more comprehensive information about the potential size of the market.
3. Computer Scenario Analysis: These are projects where a company is considering introducing a new product to a marketplace it knows well, but there is significant concerns introduced through independent factors that the firm cannot control. In such cases, a firm might choose to review other investments.
We have discussed three ways of estimating revenues and expenses, yet none of these approaches guarantees a perfect estimates. Although some project risk may come from estimation error, a big portion of risk comes from real uncertainty about the future. Improving estimating skills, expanding market testing to larger groups, along with scenario analysis may reduce estimating error but will never eliminate real uncertainty.
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