4.3.1 Estimating future cash flows
In this course, future cash flows have been presented to you as if they are concrete predictions of what will occur. However, this is not strictly what they are. The cash flows used when calculating NPV are the best estimates of future cash flows. The cash flows do not represent the best case scenario and the purpose of the discount rate is not to reflect the risk that the best case scenario may not occur.
The best estimate of a cash flow should be an unbiased estimate. This means that the actual outcome may be higher or lower than the estimate, however on average the errors in estimates should balance each other out. Another name for an unbiased estimate is the expected value, which was mentioned earlier in this section.
The discount rates reflect the risk that the best estimate of a cash flow could be wrong, and a higher risk means that the actual value could be further from the estimate than a cash flow with lower risk will be different from its estimate. At the extreme, an estimate which will definitely occur has no risk attached to it, since there will be no difference between the estimated cash flow and the actual cash flow (and it would be discounted at the risk-free rate).
It follows that you should avoid estimating best-case cash flows and then using a higher discount rate to try to adjust for the fact that the best-case estimate may not occur. The cash flows used should be a fair estimate of what is expected to happen, which is neither optimistic nor pessimistic.
Activity 8 Calculating unbiased estimates of cash flows
A company is considering a project and needs to estimate the sales the project will generate in year 1. The table below gives different levels of sales that might occur, with their respective probabilities. Calculate the unbiased estimate of the revenue from sales which should be used when calculating the NPV of the project.
| Sales revenue | Probability |
|---|---|
| £ | |
| 400,000 | 0.2 |
| 500,000 | 0.5 |
| 700,000 | 0.3 |
Answer
| Sales revenue | Probability | Probability weighted cash flow |
|---|---|---|
| £ | £ | |
| 400,000 | 0.2 | 80,000 |
| 500,000 | 0.5 | 250,000 |
| 700,000 | 0.3 | Total 210,000 |
| Total | Total 540,000 |
So in the discounted cash flow calculation to calculate NPV, £540,000 would be used as the year 1 sales figure.