Cash flow forecasting and analysis, a basic component of capital budgeting and investment analysis, requires that you forecast each of the variables that might affect cash flows on the forecasting horizon. These variables include the initial outlay to acquire an asset or investment, the cash inflows and the cash outflows from holding an asset or investment, and any cash flows from disposing of an asset or investment. Using these variables, you can forecast the initial cash investment, the operating cash flows, and any liquidation cash flows.

To these cash flows, you apply profitability and liquidity measures. Because all the profitability measures use discounting, it’s important to understand what discounting means. Discounting is the technique of reducing future cash to its equivalent in current cash, thereby providing a basis for an “apples-to-apples” comparison. To convert future cash amounts to current cash amounts, you first need to determine the time value of money, commonly called the interest rate, or the discount rate. The discount rate applied one period at a time is the period discount rate. To discount future cash into equivalent current cash, you divide the cash flow by the sum of one plus the period discount rate as many times as there are periods. For example, if the period discount rate equals 10% and you want to convert a $2,300 cash flow two years from now into equivalent current cash, you make the following calculation:

*2300/(1+10%)/(1+10%)*

or

*2300/(1+10%)2*

Similarly, if you have a cash flow of $5,000 occurring five years from now, you make the following calculation:

*5000/(1+10%)/(1+10%)/(1+10%)/(1+10%)/(1+10%)*

or

*5000/(1+10%)5*

In any of the discounted cash flow profitability measures, this is the basic calculation: discounting future cash into its equivalent in current cash by using the time value of money expressed as an interest rate. With this background, you will be better able to understand the definitions of the profitability measures employed in the cash flow forecast and analysis starter workbook.

The internal rate of return, another term used in the starter workbook, is the discount rate that equates all the future cash flows to the initial cash investment. In other words, given a stated initial cash investment and a set of stated cash flows, the internal rate of return calculates the assumed interest rate delivered by the investment.

The internal rate of return adjusted for reinvestment of the interim cash flows, sometimes called the adjusted rate of return, is like the internal rate of return measure except that it assumes cash flows occurring between the beginning and the end of the forecasting horizon are reinvested until the end of the forecasting horizon at some stated reinvestment rate and then are paid at the end of the forecasting horizon with the final cash flow.

Although the internal rate of return and adjusted rate of return measures calculate the assumed interest rate based on the stated initial investment and the stated future cash flows, the net present value measure calculates an assumed initial investment based on the stated future cash flows and a stated interest rate. By comparing the actual investment with the assumed investment, you discover whether the investment is falling short of, meeting, or exceeding your stated interest rate. When the assumed initial investment falls short of the actual initial investment, the internal rate of return that the asset delivers falls short of the discount rate. When the assumed initial investment equals the actual initial investment, the internal rate of return that the asset delivers equals the discount rate. When the assumed initial investment exceeds the actual investment, the internal rate of return delivered by the asset exceeds the discount rate.

The starter workbook also incorporates a common liquidity, or closeness to cash, measure: the payback period. The payback period measure indicates how many periods are required to pay back or return the initial cash investment. Although liquidity is generally less important than profitability, in some situations businesses prefer more-liquid investments to less-liquid investments.

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