Chapter 14

Expected Cash Flows

 

Accounting For The Future (AFTF), as we have seen, depends on the market cost of capital and the cash flows expected by company management. Those expected cash flows should explicitly take into account all factors that significantly affect expectations. The development of expected cash flows is complex, difficult, and requires the active support and attention of management. That is a cost and a benefit of AFTF.

 

Feasibility 

Time and chance affect all future cash flows. The farther into the future a cash flow is, the less its discounted value. No future cash flow is certain; there is always a chance of it not being fully realized. Expected cash flows are the mechanism for coping with both the timing and magnitude of future cash flows. 

It may seem that estimating all future expected cash flows is so complex as not to be feasible. Indeed, the AFTF process requires substantial effort. The efforts, as we have seen, are shared by management, modelers, and accountants. It is the modelers who must project expected cash flows. We have already discussed the general feasibility of AFTF (Chapter 10) and the technical feasibility of the modeler’s role (Chapter 12). Is AFTF feasible from the standpoint of reliability or objectivity? 

 

Reliability 

It may seem that expected cash flows are just too unreliable. However, with careful development, expected cash flows will essentially be realized. This follows from several sources. 

First, expected values are financially centered; actual cash flows, for any cash flow model component, are just as likely to fall short of expected as to exceed expected. When a multitude of cash flow components are assembled, the law of large numbers makes it probable that a significant overall deviation will not occur. 

Second, the 5-year cash flow validation exerts a strong discipline on the accuracy and the continuity of projections. The foundations of the expected cash flows are the actual historic cash flows. These are generally available in the requisite detail from the company’s books of account. Some future cash flows may be specified or pre-determined, such as by agreement or contract. It is difficult for a model based on reasonable underlying patterns to subsequently deviate from a reasonable pattern. 

Third, new cash flow components arise only from new AFTF decisions, i.e., decisions for which a cost/benefit analysis and a commitment have been made. This analysis will be backed by the integrity of management and the modeler, both of whom will be required to express formal opinions. 

Fourth, as time passes new Dual Validations will force a poorly fit model to converge on the historic reality. 

Fifth, we have seen that the present value of expected cash flows is always normalized so that expected cash flows cannot appreciably distort the company valuation. This doesn’t increase the reliability of expected values per se, but it does remove the benefit and the motivation for bias or exaggeration. There are several other disciplines acting to encourage the reliability of expected cash flows (see Chapter 7: Additional Disciplines). 

Finally, AFTF has a specific purpose and specific methodology that creates an essential reliability. The theory and practice are well motivated and well defined. 

Actual events may deviate from expectations and this will be periodically revealed by AFTF. This is not a flaw, but a strength of AFTF. Such deviations may be due to the vicissitudes of an unreliable reality or they may be due to poor judgement, more likely the former. The five-year cash flow validation and the careful modeling effort are designed specifically to reflect an underlying pattern from which actual experience may be judged. In most business situations it would be nearly impossible to prove, even statistically, that expectations were misguided. We will accord the model substantial credibility. However, if management consistently overstates or understates net cash flows, the capital markets will draw their own conclusions. This is the ultimate discipline.

  

Objectivity 

Expectations (and expected cash flows) may be criticized as not being "objective". This may or may not be the case depending on the definition of "objective" that is chosen. 

If "objective" means not subject to bias or manipulation then expected cash flow may be "objective". To some degree this depends on the professionalism, independence, and integrity of the modeler. For the most part, the expected cash flow model is constrained by the 5-year validation process. Other constraints are: the public accounting auditing function, the complete disclosure of the AFTF financial reports, the management and modeler’s formal opinions, and the fact that any manipulation of results is soon, conspicuously, and unavoidably reversed in subsequent financial reports. Finally, the normalization process re-calibrates expected cash flows so that company valuations are not distorted. The disciplines inherent in AFTF may produce more "objective" measures than traditional accounting. 

If "objective" means having a significant existence, then expectations are "objective". First, even though they refer to the future, the expectations of management (or the modeler) certainly exist as expectations. They may be perfectly real, accurate and unbiased, like the expectation that a fair coin flip will land heads-up half the time. To accountants, probabilities may not exist, but they do have, at least, a theoretical existence. In addition, expectations have a real use and usefulness, especially in dealing with the future; in fact they are the only real way to deal with the future. Expectations have a more significant existence than retrospective accounting. 

If "objective" means based on real rather than artificial elements then expected cash flows may be more "objective" than traditional earnings. Cash flows are more "objective" than earnings both in the past and in the future. The timing of expected cash flows is real and exact. The measurement of expected cash flows is tied, via the historic cost of capital, to the reality of market prices. Traditional accounting measures of net worth are not "objective" in this sense. Traditional accounting measures of the financial progress (earnings) of a company are replete with the artificial. 

If "objective" means having a measure frozen in the accounting "realities" of the past then expectations are not "objective". 

Part of the feeling of lack of objectivity of expected values may be due to the accountant’s inexperience with concepts, such as, probabilities, expected values, variance, risk, uncertainty, contingencies, discounting, etc. Part of that feeling may be the accountant’s experience with less than objective managements.

   

Modeling Cash Flows

 

The Meaning of Expected Value 

The accounting profession has struggled with the concept of the probability of future outcomes and has reached a natural impasse, namely, the boundaries of the profession. Accountants are not statisticians, actuaries, risk analyzers, or risk takers. They do not have the experience, training, outlook, or inclination to deal with the complexities or uncertainties of expected values. Accountants desire, to their credit, a black and white world with no gray areas. They would prefer to 100% recognize or 100% not recognize, rather than attempt to partially recognize. Unfortunately, the future is uncertain and to ignore uncertainty is to ignore the future. It is not suggested that accountants attempt to evaluate uncertainty. It is suggested that they delegate this responsibility to those who specialize in such evaluations. This is part of the multi-disciplinary approach that AFTF suggests. 

Expected values are not simply most likely values, but take into account a range of possibilities and their financial impacts. An example will clarify the process. Suppose there is a project with 3 possible, mutually exclusive, outcomes in a particular future year: lose $80 with a 25% probability, gain $40 with a 50% probability, and gain $40 with a 25% probability, then the table below illustrates the expected cash flow for that year,

 

Outcome

Outcome Measure

x Probability

= Expected Gain

Outcome # 1

-$80

.25

-$20

Outcome # 2

+$40

.50

+$20

Outcome # 3

+$40

.25

+$10

Expected Cash Flow =

+$10


The expected cash flow is $10, which is not the most likely outcome ($40) and, indeed, is not even a possible outcome. It is, however, the best measure of the financial impact in the long run. Expected Cash Flows (ECF) are well explained in Chapter 4 of Special Report 158-A, The FASB Project on Present Value Based Measurements, by Wayne S. Upton, Jr., published in February of 1996. 

As mentioned previously in Chapter 8, AFTF encourages a long-term perspective. A profitable long-term investment will not have a negative short-term measure. It is also important to realize that we are dealing with uncertainty and that actual outcomes are not reliable or conclusive. We may be perfectly correct in asserting that a fair coin will come up heads half the time. The result of one, two, or even several coin flips does not permit us to make accurate judgments about the assertion. This is especially true in most business endeavors where each situation is unique and will not be repeated. In addition, the probability of success is often quite small. If the probability of success is 10%, what can we conclude about a single unfavorable or favorable result? Even a string of failures may be the result of good judgment. Of course, with low odds of success, the successes must be substantial to offset the failures expected to dominate. This is why we use expected values. 

Actual future cash flows are certain in time, but their magnitude is uncertain. Expected future cash flows, however, are certain both in time and in magnitude. The timing question can be eliminated by considering cash flows in every future year (or more frequent period), but assigning a magnitude of zero when they are not expected to or can not occur. Expected values automatically solve the timing question. If a certain cash flow will occur at some indefinite time then by assigning a probability of occurrence to each possible time we create expected values that capture the uncertain timing in an economically appropriate manner. For example, the payoff of a life insurance policy may be thought of as an initially small expected payoff increasing with time as the policyholder ages and his expected mortality increases. For a group of insured lives, the expected cash flows can be very accurate predictions. 

Expected cash flows have to take into account non-cash flows if they have an effect on cash flows. Accelerated depreciation is not a cash flow, but a special tax provision designed to encourage investment. Depreciation, depletion allowances, reserve increases, etc., will lower tax cash flows. It is necessary to incorporate all relationships affecting cash flows into the cash flow model. These may involve non-cash flows, intangibles, expected future actions, etc. 

The cash flow model produces expected future and expected past cash flows. The model, even though validated with perfect hindsight, will not perfectly fit the individual years in the validation period. We don’t want it to. It should also not be expected that the model will fit the future perfectly. We don’t want it to. The company should continue to progress, each year taking actions and making new decisions that constantly change the expected cash flows, and constantly change actual cash flows. We can only fit the model to the past by improving the model, and then not perfectly. For the future, we can also fit the future to our models by changing or improving the future. 

In addition to making decisions and initiating projects, management has the responsibility to motivate, support, guide, and successfully implement projects. If actual results deviate from expected, steps to change actual results or expected results may be required. If the deviation is favorable then the investment and/or expectations might be increased. If actual-to-expected results are unfavorable then remedial action is called for. This might be added resources, revised tactics, or corrective actions designed to change actual results. This might also be abandoning or scaling-back the project and project expectations.

  

Time Horizon 

It may, at first, seem that cash flows need to be projected indefinitely in order to capture the value of a company. First, it should be noted that most companies don’t last indefinitely, for one reason or another. Second, the discount rate makes the present value of distant cash flow negligible. For example, the present value at 15% of $1.00 each year for 30 years is $6.57, but the present value of $1.00 each year forever is only $6.67. Third, there is a tendency for projects that add value to add less value in the future and to eventually just cover their cost of capital. This occurs because of diminishing returns, competition, substitutions, or market saturation. There is also a tendency for projects that lose value to lose less value in the future and to eventually just cover their cost of capital. This occurs because of corrective actions, competitive casualties, innovations, or abandonment. Any project just covering its cost of capital adds nothing to the present value. If there is some significant residual value after 30 years its magnitude should be apparent and easily approximated. When discounted for 30 years the approximation error in the total present value will be negligible. Thirty years may seem like a very long projection period, but with computers a 30-year projection is not more burdensome than a 5 or 10-year projection. The main effort will be creating the historic validated model. 

Next year’s cash flow are more reliably projected than more distant cash flows. Offsetting this increasing unreliability is the discount, which attaches little value to distant cash flows or errors thereon. Errors in valuations, due to errors in expected cash flows, should be minimized by the normalization process. Errors in distant expected cash flows should not produce large errors in value added since value added is a difference; a consistent error has no differential effect.

  

Detail

When constructing assumptions and estimates, it is best to start with as much explicit and specific detail as practical. It may not be known, in advance, which factors are most important or whether there may be interactions that need to be modeled. Explicit assumptions are more easy analyzed and verified than implicit or hidden assumptions. If the model is more detailed, it should have greater predictive ability and need less adjustment, so that a substantial up-front investment may save later. The value of the expected cash flow approach "rests in the demand for explicit assumptions." 

Expected past (modeled) net cash flows must be validated to historic five-year net cash flows. The five-year trend of net cash flows should normally be reflected in the model. In addition, a similar matching requirement should be satisfied for the major cash flow components. It is advisable to develop models which produce very close approximations to the actual cash flow components and then to fine-tune by means of internal "validation multiples" which produce the required exact matches. These multiples will prove very valuable during development, with multiple model runs, or for updates. When these multiples deviate much from 100% it may be time to update the basic model. 

The assumptions used must be appropriate to the company and its environment, i.e., "entity-specific". FASB states that "The assumptions used in an entity-specific measurement reflect the entity’s expected use of an asset or settlement of a liability and the role of the entity’s proprietary skills in that use or settlement. Entity-specific measurement is sometimes referred to as value in use or value to the entity." Fair value measurement, in contrast, reflects the market value of that particular asset or liability. If we view the whole company’s assets and liabilities then the market is the capital market for the company’s stock. The structure and purpose of AFTF is to encourage the convergence of value in use and fair value, i.e., the convergence of the market valuation and the company valuation. 

With prospective accounting, we deal with an unreliable future and it makes no sense to attempt to be perfectly accurate. A model and expected cash flows are designed to be an abstraction and a simplification of reality. The cash flow model is designed to provide decision useful information, not to aspire to a theoretical perfection. The level of detail must always be within the range of practicality. For a very small business, the practical level of detail might be as simple as using last year’s net cash flow into the future. 

Risk 

There are two principal types of risk. One type, variance, is the risk that the known probabilities will not be realized due to limited trials. For example, a single project or a single year’s experience could not match its underlying probability of success (like flipping a coin once). However, over the years and across many projects, it becomes increasing likely that expectations will be realized to a high degree of accuracy. This is a diversifiable risk; not all the eggs are put in a single basket. Indeed, a balanced portfolio of risky investments may be safer than any single "safe" investment. The proper perspective for assessing this type of risk is the whole company perspective. The variance of AFTF outcome is relatively small for a diversified company compared with a single project for a single year. The cost of capital automatically assesses variance for the whole company and does so through an unassailable pricing mechanism. Hence, for example, if shareholders were risk seekers, they would pay a premium for the shares of an un-diversified company. The cost of capital would be lower, and correctly so. The capital market is always right. 

The second type of risk (uncertainty risk) is the risk that the probabilities are not accurately known. This is where management experience and judgement comes into play. This is also where the discipline of the payroll comes into play. Those managers with good judgement will be retained or advanced. Those with a poor track record will be weeded out of the decision process.

Markets understand these risks. A diversified company with a long track record will generally command a higher price than a company that is dependent on a single product or has a short history. A company, whose management is experienced and successful, will command a higher price than a company with limited success or a spotty record. These price differentials translate directly into a higher cost of capital (risk premium) for the more risky company. Since AFTF uses the market cost of capital, it is using the market’s risk premium in the discount. This is very convenient; it means that the expected cash flows do not have to include any cost of risk (variance or uncertainty). The cost of risk would be very difficult to independently assess and would ultimately have to be reconciled and coordinated with market judgments. We assume that the market determines its own cost of capital perfectly through the pricing mechanism, including the cost of risk. 

There is a third type of "risk" whose only purpose is to be removed from consideration. This is the one-sided risk of an adverse deviation. This is probably the most common usage of the term risk. It is important not to use risk in this biased way in a business setting since it leads to irrational fear. A diversified or well-capitalized company may depend on expectations (two sided risk). 

There is a general reluctance to assume risk (low probability of success). Individuals are often risk adverse and justifiably so. They have limited resources, lifetimes, and cannot count on diversification (across investments or through time) to realize expected values. Companies or corporations are in a different situation; they have substantial resources, long lifetimes, and can count on diversification to realize expected values. Companies are often risk adverse and unjustifiably so. If risk aversion is a general reality then there will be a larger expected gain for those willing to undertake risk. Under AFTF we recognize expected values without regard to risk (except through the historic cost of capital) and, hence, AFTF will override irrational one-sided risk aversion and encourage prudent risk assumption.

  

 

The Cost of Capital and Expected Cash Flows 

With AFTF, the cost of equity capital is built into the discount rate. It is not necessary to subtract dividends or any imputed cost of capital as a cash flow. The cost of debt financing is not part of the discount rate and must be considered as part of expected cash flows. Hence the cost of debt is explicitly subtracted as a cash flow. 

As we have noted previously, the cost of capital includes a provision for inflation. It is necessary that expected cash flows also include provisions for inflation (in addition to being phrased in terms of nominal monetary units). Hence, if the company’s asset and liability flows are expected to vary in response to inflation, those variations must be built into the expected net cash flows. Since the discount rate is the 5-year historic rate, it may be most consistent to use a 5-year historic inflation rate in projecting nominal cash flows; this would produce the greatest valuation stability. Inflation may, however, increase liability flows faster than asset flows, especially in a competitive environment where a company is reluctant or unable to raise prices, so that inflation may do more harm than good. The impact of assumed inflation on expected cash flows must be carefully and consistently modeled. 

The one-sided risk of an unfavorable outcome, as discussed above, is not present when expected values are used. This risk is offset by the risk of a favorable outcome since we consider all outcomes, weighted appropriately. A general economic risk, for example, recession, should be provided for in the expected cash flows. 

The two-sided risk of a deviation from expected (variance) is a function of lack of diversification. The market requires a higher yield if a company has all its eggs in one basket or has a single egg. It will be assumed that the market cost of capital fully reflects the market price of the diversification risk. Most companies are well diversified so that this risk is normally small. The premium that the market will pay for steady results may be small. It may be made smaller by AFTF, which emphasizes the long-term future rather than the oscillations of the past period. 

The risk that management misjudges (uncertainty risk) or misstates the underlying probabilities is a reflection of the experience and integrity of management. The capital market pays a premium for what it considers to be good management, i.e., a lower cost of capital. It will be assumed that the cost of capital fully reflects the uncertainty risk. AFTF has mechanisms for measuring and coping with this risk: the sensitivity analysis, the normalization of the present value of expected cash flows, actual-to-expected disclosures, and the cash flows validation which continually refits expected to actual. 

The cost of capital is assumed to provide: 

  1. a risk free rate of return plus
  2. an expected inflation return plus
  3. a compensation for variance plus
  4. a compensation for uncertainty.

The expected cash flows are designed to provide for all other contingencies. As markets begin to understand AFTF, they will adjust to it so that expected values and the cost of capital will become complementary, i.e., no overlap or gap in discounting the future. Hence the above assumptions, although fairly standard, are not necessarily relied upon.

  

Other Considerations 

Future economic conditions will affect expected values. Once approach is to assume that recent average economic conditions will remain unchanged. This is unbiased and coordinates well with the 5-year cash flow model validation and the historic cost of capital. It is the generally recommended scenario. Even if economic changes are expected, they may be temporary so that, over the life of the projection period, changes may not be significant. If the current conditions are aberrant (differ substantially from long-term averages) and are unlikely to persist then some more typical assumption should be considered. 

Possible future legal or tax requirements should be ignored until enacted. This is a simplification and follows the FASB study consensus. 

AFTF is very liberating in that it measures the future even for decisions not yet fully executed. There are some limits that AFTF imposes. AFTF requires that decisions be AFTF decisions; they must be accompanied a business plan, cash flow projections and a public commitment. They cannot be future decisions or contingent decisions. This means that there may be factors other than the current situation that legitimately could be considered, but which will not be translated into expected cash flows. For example, it may be decided to delay an investment in order to take later advantage of some possible better future or better contingent investment. The decision to delay may have a cost (idle capital) which must be measured. The possible offsetting future benefits would not be measured. 

External factors, such as, hoped for tax law changes, should not be anticipated in expected cash flows since they are future decisions of others and not current management decisions or commitments. AFTF does not allow general decisions that are not specified by a business plan, or not accompanied by a cash flow projection or a public commitment. A general goal of, say increasing ROE from 10% to 12% over 5 years, has no place in AFTF. The specific decisions, which must be made to achieve the goal, are measured by AFTF, when they become AFTF decisions. 

In addition, any assumptions used must be certifiably complete and balanced. It is perfectly proper, even desirable, for management to make optimistic assumptions about the future, but it should be part of a plan of action and a commitment which can bring about that future. This plan must take full account of the costs as well as the benefits and their timing. Hence, for example, optimistic assumptions about new sales will have to be appropriately balanced with such things as increased costs for development and production; advertising or marketing costs; sales commissions, bonuses and fringes; service and maintenance costs, etc. 

Changes in any assumption can be made and should be made, as appropriate, but any change will have to be disclosed and justified. AFTF is purely prospective and requires the use of current information and assumptions (fresh start measurement). It is not "locked in" as with GAAP. On the other hand, assumptions should not be changed more frequently than necessary to produce reasonable expected values. This means that there must be some reliable fact of experience that changes the outlook. The present value of the effect of changing assumptions during a period then becomes a reported fact of experience for that period. The shareholders are interested in the outlook for the company, especially if it changes. 

 

 Conclusions 

In prior chapters we touched on the feasibility of AFTF from political and technical standpoints. In this chapter we argued that expected cash flows are sufficiently reliable and objective. The accounting profession must be further exposed to the concept of expected value in order to become familiar and comfortable with its uses. We saw that expected cash flow models require only a practical level of detail and accuracy and need not be projected forever. Models must be logical, internally consistent, complete and balanced. We observed that risk (both variance and uncertainty) is incorporated in the discount (cost of capital) rate, along with a provision for expected inflation, and a risk free component.

   

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