ESTIMATION OF

PROJECT CASH FLOWS

2
Introduction
Sound investment decisions should be
based on the net present value (NPV) rule.
Problem to be resolved in applying the NPV
rule:
What should be discounted? In theory, the answer is
obvious: We should always discount cash flows.
What rate should be used to discount cash flows? In
principle, the opportunity cost of capital should be
used as the discount rate.
3
Cash Flows Versus Profit
Cash flow is not the same thing as profit, at
least, for two reasons:
First, profit, as measured by an accountant, is based on accrual
concept.
Second, for computing profit, expenditures are arbitrarily
divided into revenue and capital expenditures.
CF = (REV EXP DEP) (1-T) + DEP CAPEX
CF = (EBIT)(1-T) + DEP CAPEX
= PROFIT + DEP - CAPEX
OUTLINE
Elements of the Cash Flow Stream
Principles of Cash Flow Estimation
Cash Flows for a Replacement Project
Biases in Cash Flow Estimation
5
Components of Cash Flows
Initial Investment
Net Cash Flows
Revenues and Expenses
Depreciation and Taxes
Change in Net Working Capital
Change in accounts receivable
Change in inventory
Change in accounts payable
Change in Capital Expenditure
Free Cash Flows
Terminal cash flows
Salvage Value
Salvage value of the new asset
Salvage value of the existing asset now
Salvage value of the existing asset at the end of its normal
Release of Net Working Capital
Net Working Capital
Change in receivable
Change in inventory
Change in payable.

Instead of adjusting each item of working capital, we can
simply adjust the change in networking capital, viz. the
difference between change in current assets (e.g., receivable
and inventory) and change in current liabilities (e.g. accounts
payable) to profit.
Increase in net working capital should be subtracted from
and decrease added to after-tax operating profit.
Thus, net cash flow:
NCF = EBIT (I -T) + DEP NWC (6)
Where NWC is net working capital.
Free Cash Flows
In addition to an initial cash outlay, an investment project may
require some reinvestment of cash flow (for example,
replacement investment) for maintaining its revenue-
generating ability during its life. As a consequence, net cash
flow will be reduced by cash outflow for additional capital
expenditures (CAPEX). Thus, net cash flow equation will be as
follow:

NCF = EBIT (1 -T) + DEP -NWC -CAPEX

Time Horizon (mimimum of the following)

Physical Life of the Plant
Technological Life of the Plant
Product Market Life of the Plant
Investment Planning Horizon of the Firm
BASIC PRINCIPLES OF CASH FLOW ESTIMATION
Separation Principle
Incremental Principle
Post-tax Principle
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.
INCREMENTAL PRINCIPLE
To ascertain a projects 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
POST-TAX PRINCIPLE


Cash flows should be measured on a post-tax basis



TREATMENT OF LOSSES
SCENARIO PROJECT FIRM ACTION

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

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

1 INCURS LOSSES INCURS LOSSES DEFER TAX SAVINGS
2 INCURS LOSSES MAKES PROFITS TAKE TAX SAVINGS IN
THE YEAR OF LOSS
3 MAKES PROFITS INCURS LOSSES DEFER TAXES UNTIL
THE FIRM MAKES
PROFITS
4 MAKES PROFITS MAKES PROFITS CONSIDER TAXES IN
THE YEAR OF PROFIT
STAND INCURS LOSSES - DEFER TAX SAVING
ALONE UNTIL THE PROJECT
MAKES PROFITS
Illustration 1
Investment outlay Rs 100 mn, i.e., plant & machinery
Rs 80 mn and net working capital Rs 20 mn.
The project will be financed by Rs 50 mn of equity
capital and Rs 50 mn of debt @ 15% interest rate.
Project life 5 years. After tax salvage value of fixed
assets after 5 years Rs 30 mn. Net working capital will
be liquidated at book value.
Expected increase in revenues and costs are Rs 120 mn
and Rs 80 mn per year. (Costs are other than
depreciation, interest and tax).
Tax rate 30%. Depreciation @ 25% as per WDV
method.

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 DEPRN 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

RELEVANT CASH FLOWS
FOR REPLACEMENT DECISIONS

= -


= -


= -




THE ADVANTAGE OF SELLING THE OLD M/C ..
HAS BEEN CONSIDERED .. THE DISADV ..
TOO SHOULD BE CONSIDERED
INITIAL INVESTMENT
OPERATING CASH
INFLOWS
TERMINAL CASH
FLOW
INITIAL INVESTT TO
ACQUIRE NEW ASSET
OPERATING CASH
INFLOWS FROM NEW
ASSET
AFTER-TAX CASH
FLOWS FROM
TERMINATION OF
NEW ASSET

INFLOWS FROM
LIQUIDN .. OLD ASSET
OPERATING CASH
INFLOWS FROM OLD
ASSET,HAD IT NOT
BEEN REPLACED
FLOWS FROM TERMN
OF OLD ASSET, HAD IT
NOT BEEN REPLACED
Suppose you own a plot of land that presently
has a market value of Rs 1 mn. If you keep it
for a year, it is expected to fetch you Rs 1.2
mn. You come across another plot of land that
will cost you Rs 1.5 mn now. If you buy this
land you hope to sell it for Rs 2 mn a year
hence.
Should you replace the existing plot? Assume
no taxes and no operating cash flows.
Cash flows for the replacement
decision
Initial investment = Cost - After tax salvage
value of the old plot.
Rs 1.5 mn 1 mn = Rs 0.5 mn.
Operating cash flow = 0
Terminal flow = After tax salvage value from
the new plot After tax salvage value of the
old plot had it been retained.
= Rs 2 mn Rs 1.2 mn = Rs 0.8 mn
Thus, the relevant cash flow stream of this
replacement proposal is:
Year Cash flow
0 -Rs 5,00,000
1 Rs 8,00,000
If you dont subtract the salvage value of the existing plot
a year from now, you get the following cash flow
stream for the replacement proposal:
Year Cash flow
0 - Rs 5,00,000
1 Rs 20,00,000
This is erroneous because it considers the advantage from
selling the plot today but overlooks the disadvantage
expected a year from now.

Illustration 2
Project: Installation of a computer system
Estimated costs and benefits:
Cost of computer and accessories Rs 1.5 mn
Operation and maintenance Rs 0.25 mn p.a.
Savings in clerical cost Rs 0.6 mn p.a.
Savings in space cost Rs 0.1 mn p.a.
Life 5 years depreciation 33.33% WDV.
After 5 years, disposed of at book value.
Tax rate 50%.

Illustration 3
Proposal: To replace one machine.
Existing machine was bought two years ago for Rs 1
mn. Depreciated @ 33.33% p.a.
Sale value now = book value now.
Remaining life 5 years. Disposal value then = book
value then.
New machine cost Rs 1.6 mn. Dep rate of 33.33%.
Salvage value after 5 years = book value then.
Increase in revenues with new machine is Rs 2,00,000
and reduce operating costs by Rs 1,50,000 per year.
Tax rate 50%.
Depreciation Base
In a replacement decision, the depreciation base of a new
asset will be equal to:
Cost of new equipment
+Written down value of old equipment
-Salvage value of old equipment
BIASES IN CASH FLOW ESTIMATION

OVERSTATEMENT
INTENTIONAL OVERSTATEMENT
LACK OF EXPERIENCE
CAPITAL RATIONING

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

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