8.3: Pro-Forma (Projected) Cash Flow Analysis

Estimating future cash flows : Whether s/he is internal or external , the analyst is involved in projecting future (accounting) profits and often, more importantly, projected net cash flows. In order to gather these data, the internal analyst must involve d ifferent departments , thereby playing corporate “politics ” in order to complete the job .

For each of the following, indicate from which department the projections may come (e.g., economics, marketing, purchasing, etc.) .

First, the internal analyst may receive unit sales projections from the marketing department.

The analyst must also be aware of the issue of Cannibalization – the detrimental effect on other sales of the introduction of the new project. For example, if Microsoft projects sales of two million units of Windows Vista, of which one million would have otherwise gone to Windows XP sales, the analyst would recognize on his spreadsheet only the one-million-unit increment. This is because the decision to introduce a new product came, in a sense , at the expense of the old product’s sales. Analysts are interested only in what the new product contributes incrementally – above and beyond present matters.

In order to project future revenues, the analyst will thus possibly need to obtain both unit sales data (i.e., expected quantities sold) and “pricing” information (i.e., expected price per unit).

This information may be derived from many different parties, e.g., purchasing, operations, etc. Operating costs may include:

In “spreading the numbers,” the internal analyst will pay attention only to projected operating data, and not to any capital or other non-operating data / costs. S/he is interested usually only in what the potential project will produce as a business enterprise alone. Capital costs include the cost of paying interest on debt, and the dividend and “growth” costs of equity.

As a heads-up, t he cost of capital is an issue with which we shall deal later in great depth. Once the analyst has arrived at the yearly operating numbers, usually projected cash flow (rather than accounting profits), the cost of capital will then be brought in as the “discount rate,” rather than as a dollar figure. This is the rate at which the future cash flows will be “discounted , ” or translated , to present values, thereby enabling a level playing field, in terms of time. In other words, by discounting, we are able to equate the value of a dollar paid tomorrow with a dollar today. This way, an investment decision may be made based on profitability and possibly other measures.

As we continue through these readings, pay careful attention to the words “expense” and “ expenditure.” They are not the same. “Expense” is an accounting phrase reflected on the Income Statement ; expense i s a reduction to Net Income – it may or may not involve cash . “Expenditure” refers to the deployment of funds – it will involve cash but may or may not be expensed. Expenditures may be capitalized or expensed.