Estimation of Project Cash Flows

ESTIMATION OF
PROJECT CASH FLOWS
OUTLINE
Elements of the Cash Flow Stream
Principles of Cash Flow Estimation
Cash Flows for a Replacement Project
Biases in Cash Flow Estimation
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
BASIC PRINCIPLES OF
CASH FLOW ESTIMATION
Separation Principle
Incremental Principle
Post-tax Principle
Consistency 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
The marginal tax rate of the firm is the relevant rate

for estimating the tax liability of the firm
TREATMENT OF LOSSES
S
C
E
N
A
R
I
OP
R
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J
E
C
T
1
2
3
4
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T
A
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D
A
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N
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F
I
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M
A
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I
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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
Cash flow to all investors
Cash flow to equity
Discount rate
Weighted average cost of capital
Cost of equity
Inflation
The consistency principle suggests the following match up:
Cash flow
Nominal cash flow
Real cash flow
Discount rate
Nominal discount rate
Real discount rate
PROJECT CASH FLOWS

(RS. IN MILLION)
0
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
A. FIXED ASSETS
(80.00)
B. NET WORKING CAPITAL
(20.00)
C. REVENUES
G. TAX
H. PROFIT AFTER TAX
7.5
8.63
9.47
10.10
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
M. TERMINAL CASH FLOW (I+J)
29.90
50.0
N. NET CASH FLOW (K+L+M)
(100.00)
34.0
32.5
31.37
30.53
BOOK VALUE OF INVESTMENT
100
80
65
53.75
45.31
79.90
RELEVANT CASH FLOWS

FOR REPLACEMENT DECISIONS
INITIAL =
INVESTMENT
INITIAL INVESTT
TO ACQUIRE NEW
ASSET
OPERATING CASH
=
INFLOWS
OPERATING CASH
INFLOWS FROM
NEW ASSET
TERMINAL CASH
=
FLOW
AFTER-TAX CASH
FLOWS FROM
TERMINATION OF
NEW ASSET
THE ADVANTAGE OF SELLING THE OLD M/C ..

HAS BEEN CONSIDERED .. THE DISADV ..
AFTER TAX CASH

INFLOWS FROM
LIQUIDN .. OLD
ASSET
OPERATING CASH
INFLOWS FROM
OLD ASSET,HAD IT
NOT BEEN
REPLACED
AFTER-TAX CASH
FLOWS FROM
TERMN OF OLD
ASSET, HAD IT
NOT BEEN
REPLACED
CASH FLOWS FOR THE REPLACEMENT PROJECT

R S . IN 0 0 0
YEAR
I. IN V E S T M E N T O U T L A Y
1. C O ST O F N E W A SSE T
2. SA L V A G E V A L U E O F
O LD ASSET
3 . IN C R E A S E IN N E T
W O R K IN G C A P IT A L
4 . T O T A L N E T IN V E S T M E N T
( 1 -2 + 3 )
II. O P E R A T IN G IN F L O W S
O V E R T H E PR O JE C T
L IF E
5 . A F T E R - T A X S A V IN G S IN
M A N U F A C T U R IN G C O S T S
6 . D E P R E C IA T IO N O N N E W
M A C H IN E
1 . D E P R E C IA T IO N O N O L D
M A C H IN E
2 . IN C R E M E N T A L
D E P R E C IA T IO N (6 -7 )
3 . T A X S A V IN G S O N
IN C R E M E N T A L
D E P R E C I A T I O N ( 0 .4 X 8 )
1 0 . N E T O P E R A T IN G C A S H
IN F L O W (5 + 9 )
III. T E R M IN A L C A S H
IN F L O W
1 1 . N E T T E R M IN A L V A L U E
O F N E W M A C H IN E
1 2 . N E T T E R M IN A L V A L U E
O F O L D M A C H IN E
13. R E C O V E R Y O F
IN C R E M E N T A L N E T
W O R K IN G C A P IT A L
1 4 . T O T A L T E R M IN A L C A S H
IN F L O W ( 1 1 -1 2 + 1 3 )
180
180
180
180
180
400
300
225
1 6 8 .8
1 2 6 .6
100
75
5 6 .3
4 2 .2
3 1 .6
300
225
1 6 8 .7
1 2 6 .6
95
120
90
6 7 .5
5 0 .6
38
300
270
2 4 7 .5
2 3 0 .6
218
(1 6 0 0 )
500
(1 0 0 )
(1 2 0 0 )
800
160
100
740
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
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 understatement of true project profitability

Estimation of Project Cash Flows

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Estimation of Project Cash Flows

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ESTIMATION OF

PROJECT CASH FLOWS

ELEMENTS OF THE CASH FLOW STREAM

Investment Planning Horizon of the Firm

will be reflected in the cost of capital figure against

Estimate working capital properly

The marginal tax rate of the firm is the relevant rate

PROJECT CASH FLOWS

D. COST (OTHER THAN DEPRN AND INT)

F. PROFIT BEFORE TAX

B. NET WORKING CAPITAL

I. NET SALVAGE VALUE OF FIXED ASSETS

J. RECOVERY OF NET WORKING CAPITAL

L. OPERATING CASH FLOW (H+E)

M. TERMINAL CASH FLOW (I+J)

N. NET CASH FLOW (K+L+M)

BOOK VALUE OF INVESTMENT

RELEVANT CASH FLOWS

THE ADVANTAGE OF SELLING THE OLD M/C ..

AFTER TAX CASH

CASH FLOWS FOR THE REPLACEMENT PROJECT

BIASES IN CASH FLOW ESTIMATION

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