LQ*

Introduction to Financial Management

Estimating Project Cash Flows (Topic 8)

Brigham Ch13

1
Identifying Project Cash Flows
C1 C2 Cn
NPV  C0    ... 
(1  r )1 (1  r ) 2 (1  r ) n
 After deciding on a good investment decision rule, the next step is
to identify and value the cash flows from the project using the
discounted cash flows (DCF) techniques.
 So, what are the project’s relevant cash flows?
- The changes in cash flows to the firm if the project is
undertaken
- With/Without Principle:
CF(project) = CF(corporation)with – CF(corporation)without
- These project related cash flows are known as incremental
cash flows
 In Capital Budgeting, cash flows* are used, not accounting profits.
* Including opportunity cost (more on this issue later).
2
 Determining Project’s
Incremental Cash Flows
[i.e. C0, C1, C2, C3………. Cn]

C1 C2 Cn
NPV  C0    ... 
(1  r )1
(1  r ) 2
(1  r ) n

(SECTION 13.1)

3
 In determining incremental cash flows, the
following principles must be applied:
i) Sunk costs (沉沒成本) are cash flows that have already occurred or
been committed.
=> Examples: Fee for a feasibility study (可行性研究) of the project.
Past Research & Development expenditures (研究和開發研发费用).
=> These costs are there whether the project is accepted or not and
therefore irrelevant and therefore should NOT be included!
ii) Opportunity Costs (機會成本) are cash flows that are lost because of
accepting the current project.
=> Example: Building a plant on a piece of land owned by the firm
creates an opportunity cost equals the current market price of the
land (NOT the previous purchase cost) because the firm lost the
chance to sell the land on current market price.
=> These are incremental cash flows and should be included!
4
iii) Side Effects are the effects (positive or negative) that the
acceptance of a project may have on the cash flows to other
business activities of the firm.
(1) A negative effect is called cannibalization when a new
project takes away sales from an existing product.
=> Example: Coca Cola introduces another diet version
of Coke.
=> Erosions are often very difficult to quantify, but they
should be considered (as cash outflows)!
(2) A positive effect is called synergy (synergistic effect)
when the new project adds value to the existing projects
(R&D of the new and existing projects may “help” each
other).

5
iv) Overhead costs (i.e. general operating costs) that are due to
the project should be included. DO NOT, however, include
allocation of overhead costs that will be incurred with or
without the project (e.g. the salary of the CEO).

v) Include only after-tax cash flows:

Expected cash flows from the proposed project must be
measured on an after-tax basis, because the firm will not
have the use of any cash flows until it has satisfied the
government’s tax claims.
Cs are on an AT = BT(1-t)
after-tax basis

C1 C2 Cn
NPV  C0    ... 
(1  r )1 (1  r ) 2 (1  r ) n

6
(vi) Depreciation (折舊) is a non–cash expense
• Depreciation (折舊) is the allocation (分攤) of the cost of an
asset to expense over its estimated life to reflect the wear and
tear (損耗) on the asset as it is used to produce the company’s
goods and services.
• Example: A company purchased a truck for $10,000 and the
useful life of the truck is 4 years.

-10,000 -2,500 -2,500 -2,500 -2,500

0 1 2 3 4

7
vi) Depreciation matters because it has indirect cash
flow impact
 Depreciation itself is a non-cash expense; consequently, it is
only relevant because it reduces the tax bill.
 Depreciation tax shield = D.t (yearly tax savings that result
from depreciation deduction)
 D = depreciation expense (based on straight-line depreciation
method)
 t = marginal tax rate

8
vii) Financing costs are reflected in the project’s required
rate of return, NOT in the cash flows from the project
C1 C2 Cn
NPV  C0    ... 
(1  r )1 (1  r ) 2 (1  r ) n
 The cost of financing of an investment is certainly a relevant
cost when deciding to accept or not the project.
 If a project is analyzed using the NPV rule, the project’s
expected cash flow stream is discounted at the project’s cost
of capital. That is, the cost of financing the project is
already considered in the cost of capital.
 To avoid double counting, DO NOT include the cash flows
associated with interest payments or principal on debt,
dividends or other financing costs in computing the project’s
incremental cash outflows.
9
 Relevant cash flow - summary??
Principles determine incremental cash flows
Relevant
incremental CF?
Sunk costs – costs that have incurred in the past x
Opportunity costs – costs of lost options 
Side effects
Positive side effects – benefits to other projects

Negative side effects – costs to other projects
Financing costs – interest, dividends x

10
Estimating the project (incremental) cash flows by
following the timeline of the project

11
(1) Determine Total Investment Costs Upfront
(Initial Cash Outlay 開⽀, C0)
 Total investments cost upfront (at t=0)
The outlay includes:
(a) initial investment cost like purchase cost of assets, set-
up cost, installation, shipping/freight, training cost and
(b) increased working-capital requirements (ΔNWC)

12
(1) Changes in Net Working Capital are Part of
Incremental C0 from the Project
 Normally a new project will require additional working capital
(e.g. receivables(-), payables(+) and inventory(-)) to support it.
NWC = current assets - current liabilities
 This additional working capital is a cash outflow at the beginning
of a project*.
 At the end of the project’s life, NWC will return to its original
level (unless other changes occur in the meantime). In any event,
the recovery of NWC is a one-off cash inflow at the end of the
project’s life.
* Additional working capital may be required in other years of the
project (see in-class practice question).

13
Example on NWC
ABC Ltd. is considering a 5-year project which will require
additional inventory of $250,000 and will also increase accounts
payable by $220,000 as suppliers are willing to finance part of
these purchases. Accounts receivable are currently $200,000 and
are expected to increase by 10 percent if this project is accepted.
What is the size of the net working capital required at the
beginning of the project?
In terms of CF,
NWC(t=0) = Inv(t=0) + A/P(t=0) + A/R(t=0)
= -$250,000 + $220,000 - ($200,000) x 10%
= -$50,000 (This is part of the initial cash outlay at
t=0)

14
(2) Estimate yearly operating cash flows (OCF)

 OCF
= AT Operating cash incomes (OCI) + Tax savings from
depreciation of “depreciable” assets (such as plant,
machinery and equipment, BUT NOT land)
 Note that BOTH cash flows are occurring every year and
therefore estimating the PV involves multiple cash flows and
the use of PVIFA.
( )
 PV(OCF) = C(1-t) x ( )
+ PV(tax savings from assets’ depreciations)
where “n” is the expected project life

15
(3) Estimating the PV of tax savings from
depreciation of (depreciable) assets
 Consider an asset that last for m years (≥ n):
PV (tax savings from deprec. of asset i)
() ( )
=( . t) x ( )
𝐦

16
(4) Estimating the Terminal Cash Flows

 Terminal cash flows are the cash flows resulting from the
termination of a project at the end of the project’s life.
 In the final year of a project, the assets acquired during the life
of the project will be sold (to the firm or other parties) AND
the working capital that has been invested will be recovered
(partly or fully).
 The proceeds represent a one-off cash inflow to the project:
(a) after-tax salvage value (殘值) of assets and
(b) recovery of working capital as working capital is no
longer required.

17
 (4a) After-tax Salvage (Incremental CFs)
 If the salvage value is different from the book value of the
asset, then there is a tax effect.
Book value (at t=n) = Initial cost – Accumulated depreciation
殘值
 After-tax salvage value*
= Resale price – t.(Resale price – Book value at t=n)
m>n >0
𝐈𝐧𝐢𝐭𝐢𝐚𝐥 𝐂𝐨𝐬𝐭 n
= 𝐑𝐞𝐬𝐚𝐥𝐞 𝐏𝐫𝐢𝐜𝐞 − [𝐑𝐞𝐬𝐚𝐥𝐞 𝐏𝐫𝐢𝐜𝐞 − (𝐈𝐧𝐢𝐭𝐢𝐚𝐥 𝐂𝐨𝐬𝐭 − 𝒏
𝐱 𝒎)] 𝐱𝐭
m n m
where n is asset’s economic life and m project’s life D

 IF m = n (ass et life = project life), the above formula can be

simplified to: After-tax salvage value = Resale price (1 – t)
𝟏
 PV (AT Salvage value) = AT Salvage value x
(𝟏 𝐫)𝐧

* A one-off cash inflow to the firm at the end of the project 18

NPV project = C0 + AT(C)[1-(1+re)^(-n) / re] +
(Di.t) [1-(1+re)^(-n) / re] +
ATSal. Value x (1/(1+ re)^n) +
$$ x (1/(1+re)^n)
(4b) Recovery of net working capital

 “FULL Recovery” of the NWC at the end of the project means

the total “nominal amount/surface value” invested (NO
MATTER when they occurred) is recouped.
 Example:
Suppose WC was required at t=3 and t=8 (of n 8-year project).

PV of the “fully recovered NWC”

𝟏
= [NWC(t=3) + NWC(t=8)] x
(𝟏 𝐫)𝐧

Note that the recovery of the NWC is a one-off cash inflow to

the project.

19
Refer to the attached case now

20
Estimating the PV of tax savings from depreciation
of (depreciable) assets
 Consider an asset that last for m years (≥ n):
PV (tax savings from deprec. of asset i)
() ( )
=( . t) x ( )
𝐦

Page 18
(3) Estimating the Terminal Cash Flows

 Terminal cash flows are the cash flows resulting from the
termination of a project at the end of the project’s life.
 In the final year of a project, the assets acquired during the life
of the project will be sold (to the firm or other parties) AND
the working capital that has been invested will be recovered
(partly or fully).
 The proceeds represent a one-off cash inflow to the project:
(a) after-tax salvage value (殘值) of assets and
(b) recovery of working capital as working capital is no
longer required.

Page 19
a) After-tax Salvage (Incremental CFs)
 If the salvage value is different from the book value of the
asset, then there is a tax effect.
Book value (at t=n) = Initial cost – Accumulated depreciation
 After-tax salvage value*
= Resale price – t.(Resale price – Book value at t=n)
𝐈𝐧𝐢𝐭𝐢𝐚𝐥 𝐂𝐨𝐬𝐭
= 𝐑𝐞𝐬𝐚𝐥𝐞 𝐏𝐫𝐢𝐜𝐞 − [𝐑𝐞𝐬𝐚𝐥𝐞 𝐏𝐫𝐢𝐜𝐞 − (𝐈𝐧𝐢𝐭𝐢𝐚𝐥 𝐂𝐨𝐬𝐭 − 𝒏
𝐱 𝒎)] 𝐱 𝐭
where n is asset’s economic life and m project’s life
 IF m = n (ass et life = project life), the above formula can be
simplified to: After-tax salvage value = Resale price (1 – t)
𝟏
 PV (AT Salvage value) = AT Salvage value x
(𝟏 𝐫)𝐧

* A one-off cash inflow to the firm at the end of the project 23

Readings and Exercises: Chapter 13

Readings:
Required Textbook: Brigham 5th Edition

Chapter 13
(Section 13.2b, 13.2c, 13.2d on p.470, and those
sections related to the lecture notes)

Exercises:
Supplementary Exercises: Ex 8 (hard copies)

24