ESTIMATION OF

PROJECT CASH FLOWS

 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.

2
 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

3
 OUTLINE

• Elements of the Cash Flow Stream

• Principles of Cash Flow Estimation

• Cash Flows for a Replacement Project

• Biases in Cash Flow Estimation

 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

5
 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

 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 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
 POST-TAX PRINCIPLE

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

 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 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
 RELEVANT CASH FLOWS
FOR REPLACEMENT DECISIONS

= - INITIAL INVEST’T TO INFLOWS FROM

INITIAL INVESTMENT
ACQUIRE NEW ASSET LIQUID’N .. OLD ASSET

= - OPERATING CASH
OPERATING CASH INFLOWS FROM OLD
OPERATING CASH INFLOWS FROM NEW ASSET,HAD IT NOT
INFLOWS ASSET BEEN REPLACED
= -

AFTER-TAX CASH FLOWS FROM TERM’N

TERMINAL CASH FLOWS FROM OF OLD ASSET, HAD IT
FLOW TERMINATION OF NOT BEEN REPLACED
NEW ASSET
THE ADVANTAGE OF SELLING THE OLD M/C ..
HAS BEEN CONSIDERED .. THE DISADV ..
TOO SHOULD BE CONSIDERED
• 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 don’t 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.
 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
 Illustration 2
• ABC company purchased a machine three years ago at a cost of
Rs10,000.
• The machine had a life of 8 years at the time of its purchase.
• It is being depreciated at 15% on declining balance.
• The company is thinking of replacing it with a new machine costing
Rs20,000 with an expected 5 year life.
• The profit before depreciation is estimated to increase by Rs4,445 a
year.
• Assume that the old and new machines will be now depreciated at
25% on declining balance for tax purposes.
• The salvage value of the new machine is anticipated as Rs500 after 5
years.
• The market value of the old machine today is Rs11,500. It is
estimated to have zero salvage value after 5 years.
• The income tax may be assumed as 55%. The company’s after tax
cost of capital is 12 percent.
• Should the new machine be bought?
• The book value of the old machine today is Rs6,141 as shown below:

Year Depreciation (15%) Book-value

(balance)
0 - 10,000
1 1,500 8,500
2 1,275 7,225
3 1,084 6,141
• The total proceeds from the sale of the old machines Rs11,500. Since a
new machine (cost Rs20,000) is being acquired in the block to which the
old machine belonged, the depreciation base will be as follows:
• =Cost of new machine + Book value of old machine – Salvage value of old machine
• =20,000 + 6,141 – 11,500 = 14,641

• Net Cash Outlay

• Cost of new machine Rs20,000
• Less: Total sale proceeds of old machine 11,500
• _____________
• Rs8,500
• Today when the replacement is being considered the book value of the old machine
is Rs6,141, which will be taken as the basis for calculating depreciation at new rate
(viz. 25%). The differential depreciation is calculated as follows:

Year DEP on old DEP on New Differential

(BV=Rs6141) (DEP base depreciation
Rs14,641) Rs8,500
1 1,535 3,660 2,125
2 1,151 2,745 1,594
3 863 2,059 1,195
4 648 1,544 896
5 486 1,158 672
 Calculation of Net Cash Inflow

Year Profit before After tax Differential Tax shield on Net cash
depreciation profit Depreciation depreciation inflow
1 4,445 2,000 2,125 1,169 3,169
2 4,445 2,000 1,594 877 2,877
3 4,445 2,000 1,195 657 2,657
4 4,445 2,000 896 493 2,493
5 4,445 2,000 672 370 2,370
Salvage
value 500
 Calculation of NPV

Year Cash inflows PVF12% PV

1 3,169 0.893 2,830
2 2,877 0.797 2,293
3 2,657 0.712 1,892
4 2,493 0.636 1,585
5 2,870 0.567 1,627
_______
Total PV of inflow 10,227
Less: Net cash outlay 8.500
_______
NPV 1,727
 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