Saturday, May 1, 2010


Cash Flows for Investment Analysis

The first difficult problem to be resolved in applying the NPV rule in practice is: what should be discounted? In theory, the answer is obvious: we should always discount cash flows.

In reality, estimating cash flows is most difficult task. The difficulty in estimating cash flows arises because of uncertainty and accounting ambiguities. Events affecting investment opportunities change rapidly and unexpectedly. There is no easy way to anticipate changes in events. Mostly accounting data forms the basis for estimating cash flows. Accounting data are the result of arbitrary assumptions, choices and allocations. If care is not taken in properly adjusting the accounting data, errors could be made in estimating cash flows.

We consider the cash flow estimation as the most critical step in investment analysis. A sophisticated technique applied to incorrect cash flows would produce wrong results. The management of a company should devote considerable time, effort and money in obtaining correct estimates of cash flows. The financial manager prepares the cash flow estimates on the basis of the information supplied by experts in accounting, production, marketing, economic and so on. It is his responsibility to check such information for relevance and accuracy.

The second major problem in applying the NPV rule is: what rate should be used to discount cash flows? In principle, the opportunity cost of capital should be used as the discount rate.

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