Cost of Capital: Applications and Examples, + Website, 5th Edition

CHAPTER 34

Estimating Economic Income

Introduction

Alternative Net Cash Flow Formulas

Financial Analysis of Historical Operating Results

Revenue and Profitability Estimates

Noncash Charges and Investments in Fixed Assets

Investments in Net Working Capital

Reasonableness of Estimated Profit Margins and Asset Turnovers

Testing Net Cash Flow Estimates

Using Projections in the Discounted Cash Flow Analysis

Measuring the Impact from Reinvesting Retained Net Cash Flows

Comparing DCF Analysis to Security Analysts' Projections

Comparing Closely Held and Publicly Traded Companies

Estimating Alternative Net Cash Flows

Terminal Value Model Considerations

Summary

Additional Reading

INTRODUCTION

Management and entrepreneurs are by their nature generally optimistic. Otherwise they would not be leading businesses. This optimistic tendency can easily lead to optimistic projecting. For example, in a 2007 survey of executives, approximately 50% of the respondents indicated that their sales and cost projections were “too optimistic.”¹ According to the same survey, corporate-level respondents indicated that 17% of the capital invested by their companies went toward underperforming investments that should be terminated and that 16% of their investments should not have been financed in the first place. Business unit heads and frontline manager respondents indicated that 21% of the investments should not have been approved and that another 21% should be terminated.

Changes in cash flow expectations ...