The cash flow concepts used for most net present value or internal rate of return projects assume a simplified decision process where funding occurs once at the beginning of the project, after which a steady and predictable series of cash flows occur over a multi-year period. In reality, there is a possibility for several additional decisions occurring during the investment period that can dramatically alter the value of a project. They are as follows:
- Deferred start date. There may be a sufficient level of uncertainty regarding a project that it makes sense to hold off on its initiation until additional research can be conducted. However, delaying the project may also result in a reduction in the level of market share attained, since competitors will have a better opportunity to position their products in the market first. Thus, additional variables in the cash flow scenario are a combination of a delay in cash outflow and reduced long-term revenues.
- Early cancellation. If the expenditure of funds occurs over a lengthy period of time or requires additional investments at discrete intervals, then management has the option to cancel the project early in order to minimize potential losses. If there appears to be a significant probability of early cancellation, then consider creating an additional cash flow model that includes this scenario.
- Add more capital later in project. If there is a possibility that a project may yield additional profits through additional investments at various points in the future, then an added scenario may include the amount of any additional investments and the cash flows to be gained from them. Conversely, more cash may be needed when the project being created is of the experimental variety, and there is a risk that construction and implementation problems will require an additional investment. If considered significant, these options should be included in the cash flow model.
- Alter project cost structure. It may be possible to pay less cash up front in exchange for higher variable costs over the remainder of the project, as would be the case when more staffing is used instead of automated equipment (or vice versa). Depending on the changes in the timing and amounts of cash flows resulting from such decisions, it may be necessary to construct a separate cash flow forecast for each option.
The scenarios noted above bring up the prospect of having multiple possible variations on the cash flows from a prospective new project. Which one should be included in the formal cash flow analysis that is presented to management for approval? All of them. To do so, create a decision tree that outlines all cash flow options, with each option assigned a probability of occurrence. For each node on the decision tree, calculate its probability times its value outcome, and then sum all the nodes. This approach gives management valuable insight into the probability of different cash flow alternatives. The only problem with the decision tree model is that the calculation becomes cumbersome after more than a few cash flow options are added to it.