Chapter 12

ESTIMATION OF
PROJECT CASH FLOWS

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 OUTLINE

• Elements of the Cash Flow Stream

• Principles of Cash Flow Estimation

• Cash Flows for a Replacement Project

• Biases in Cash Flow Estimation

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 ELEMENTS OF THE CASH FLOW STREAM

• Initial Investment
• Operating Cash Inflows
• Terminal Cash Inflow

Time Horizon

• Physical Life of the Plant

• Technological Life of the Plant
• Product Market Life of the Plant
• Investment Planning Horizon of the Firm
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BASIC PRINCIPLES OF
CASH FLOW ESTIMATION

• Separation Principle

• Incremental Principle

• Post-tax Principle

• Consistency Principle

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 SEPARATION PRINCIPLE

• Cash flows associated with the investment side and the

financing side of the project should be separated.

• While defining the cash flows on the investment side,

financing costs should not be considered because they
will be reflected in the cost of capital figure against
which the rate of return figure will be evaluated.

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 INCREMENTAL PRINCIPLE
To ascertain a project’s incremental cash flows you have to
look at what happens to the cash flows of the firm with the
project and without the project

Guidelines
• Consider all incidental effects
• Ignore sunk costs
• Include opportunity costs
• Question the allocation of overhead costs
• Estimate working capital properly
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 POST-TAX PRINCIPLE

• Cash flows should be measured on a post-tax basis

• The marginal tax rate of the firm is the relevant rate

for estimating the tax liability of the firm

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 TREATMENT OF LOSSES

SCENARIO PROJECT FIRM ACTION

1 INCURS LOSSES INCURS LOSSES DEFER TAX SAVINGS

2 INCURS LOSSES
3 MAKES PROFITS
4 MAKES PROFITS
STAND INCURS LOSSES
ALONE
MAKES PROFITS TAKE TAX SAVINGS IN
THE YEAR OF LOSS
INCURS LOSSES DEFER TAXES UNTIL
THE FIRM MAKES
PROFITS
MAKES PROFITS CONSIDER TAXES IN
THE YEAR OF PROFIT
- DEFER TAX SAVING
UNTIL THE PROJECT
MAKES PROFITS

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 CONSISTENCY PRINCIPLE
Cash flows and discount rates applied to these cash flows must be
consistent with respect to the investor group and inflation
Investor Group
The consistency principle suggests the following match up:
Cash flow Discount rate
• Cash flow to all investors • Weighted average cost of capital
• Cash flow to equity • Cost of equity

Inflation
The consistency principle suggests the following match up:
Cash flow Discount rate
Nominal cash flow Nominal discount rate
Real cash flow Real discount rate
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 PROJECT CASH FLOWS

(RS. IN MILLION)
0 1 2 3 4 5

A. FIXED ASSETS (80.00)

B. NET WORKING CAPITAL (20.00)
C. REVENUES 120 120 120 120 120
D. COST (OTHER THAN DEPR’N AND INT) 80 80 80 80 80
E. DEPRECIATION 20 15 11.25 8.44 6.33
F. PROFIT BEFORE TAX 20 25 28.75 31.56 33.67
G. TAX 6 7.5 8.63 9.47 10.10
H. PROFIT AFTER TAX 14.0 17.5 20.12 22.09 23.57
I. NET SALVAGE VALUE OF FIXED ASSETS 30.00
J. RECOVERY OF NET WORKING CAPITAL 20.00
K. INITIAL OUTLAY (100.00)
L. OPERATING CASH FLOW (H+E) 34.0 32.5 31.37 30.53 29.90
M. TERMINAL CASH FLOW (I+J) 50.0
N. NET CASH FLOW (K+L+M) (100.00) 34.0 32.5 31.37 30.53 79.90
BOOK VALUE OF INVESTMENT 100 80 65 53.75 45.31

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 RELEVANT CASH FLOWS
FOR REPLACEMENT DECISIONS
AFTER TAX CASH
INITIAL INVEST’T INFLOWS FROM
INITIAL = - LIQUID’N .. OLD
TO ACQUIRE NEW
INVESTMENT ASSET
ASSET

OPERATING CASH
OPERATING CASH INFLOWS FROM
OPERATING CASH = INFLOWS FROM - OLD ASSET,HAD IT
INFLOWS NEW ASSET NOT BEEN
REPLACED
AFTER-TAX CASH AFTER-TAX CASH
TERMINAL CASH = FLOWS FROM - FLOWS FROM
FLOW TERMINATION OF TERM’N OF OLD
NEW ASSET ASSET, HAD IT
NOT BEEN
THE ADVANTAGE OF SELLING THE OLD M/C .. REPLACED
HAS BEEN CONSIDERED .. THE DISADV ..
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CASH FLOWS FOR THE REPLACEMENT PROJECT
RS. IN ‘000

YEAR 0 1 2 3 4 5

I. INVESTMENT OUTLAY
1. COST OF NEW ASSET (1600)
2. SALVAGE VALUE OF 500
OLD ASSET
3. INCREASE IN NET (100)
WORKING CAPITAL
4. TOTAL NET INVESTMENT (1200)
(1-2+3)

II. OPERATING INFLOWS

OVER THE PROJECT
LIFE
5. AFTER- TAX SAVINGS IN 180 180 180 180 180
MANUFACTURING COSTS
6. DEPRECIATION ON NEW 400 300 225 168.8 126.6
MACHINE
1. DEPRECIATION ON OLD 100 75 56.3 42.2 31.6
MACHINE
2. INCREMENTAL 300 225 168.7 126.6 95
DEPRECIATION (6-7)
3. TAX SAVINGS ON 120 90 67.5 50.6 38
INCREMENTAL
DEPRECIATION ( 0.4 X 8)
10. NET OPERATING CASH 300 270 247.5 230.6 218
INFLOW (5+9)

III. TERMINAL CASH

INFLOW
11. NET TERMINAL VALUE 800
OF NEW MACHINE
12. NET TERMINAL VALUE 160
OF OLD MACHINE
13. RECOVERY OF 100
INCREMENTAL NET
WORKING CAPITAL
14. TOTAL TERMINAL CASH 740
INFLOW( 11-12+ 13)

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 BIASES IN CASH FLOW ESTIMATION

• OVERSTATEMENT
• INTENTIONAL OVERSTATEMENT
• LACK OF EXPERIENCE
• MYOPIC EUPHORIA
• CAPITAL RATIONING

• UNDERSTATEMENT
• SALVAGE VALUES ARE UNDER-ESTIMATED
• INTANGIBLE BENEFITS ARE IGNORED
• VALUE OF FUTURE OPTIONS IS IGNORED
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 SUMMING UP

• The cash flow stream of a project comprises of three

components : initial investment, operating cash inflows,
and terminal cash inflow

• The following principles should be followed while

estimating the cash flows of a project : separation
principle, incremental principle, post-tax principle, and
consistency principle

• Adequate care should be taken to guard against certain

biases which may lead to over-statement or under-
statement of true project profitability

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