Project Cash Flows

Prof.ASHALATHA
J K S H I M, NITTE
 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

Prof.ASHALATHA
J K S H I M, NITTE
 Physical Life of the Project : Number of years the
plant would perform the function for which it had been
acquired. Useful to determine the depreciation charge.

 Technological Life of the Plant : The period of time

for which the present plant would not be rendered
obsolete by a new plant.

 Product Market Life of the Plant : Market for the

product may disappear or shrink .

 Investment Panning Horizon of the Firm : Time for

the purpose of investment analysis.

Prof.ASHALATHA
J K S H I M, NITTE
Basic Principles of Cash Flow
Estimation

• Separation Principle

• Incremental Principle

• Post-tax Principle

• Consistency Principle

Prof.ASHALATHA
J K S H I M, NITTE
 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.

Prof.ASHALATHA
J K S H I M, NITTE
 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

Prof.ASHALATHA
J K S H I M, NITTE
Considering the incidental costs

 Incidental effects on the rest of the firm must be

considered.

 Profitability Enhanced – Complementary relationship

 Detract from Profitability – Competitive relationship

 Product Cannibalisation

Prof.ASHALATHA
J K S H I M, NITTE
 Ignore Sunk Costs

 Outlay already incurred in the past or already

committed irrevocably.

Include Opportunity Costs

 Resource may be rented out

 Resource may be sold

 Resource is required elsewhere in the firm

Prof.ASHALATHA
J K S H I M, NITTE
Question the Allocation of Overhead Costs

Estimate Net Working Capital Properly

 Gross working capital – Total of current assets . A

portion of gross working capital is supported by non
interest bearing current liabilities (NIBCLs).
 Net working capital - Gross working capital less
NIBCLs.
 Fixed asset investments are depreciated , Net
working capital is renewed periodically and not subject
to depreciation. Net working capital at the end
assumed to have a salvage value equal to its book
value.
Prof.ASHALATHA
J K S H I M, NITTE
 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

Prof.ASHALATHA
J K S H I M, NITTE
 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

Prof.ASHALATHA
J K S H I M, NITTE
 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
shareholders
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

Prof.ASHALATHA
J K S H I M, NITTE
 Relevant Cash Flows for
Replacement Projects

Initial Invest’t to After Tax Cash

Initial Investment = acquire New Asset
- Inflows from
Liquid’n .. Old Asset

Operating Cash Operating Cash

Operating Cash = Inflows From New - Inflows from Old
Inflows Asset Asset

After-tax Cash Flows After-tax Cash Flows

Terminal Cash Flow = from Termination of - from Term’n of old
new Asset Asset
The advantage of selling the old m/c.. has been considered.. The disadv.. too
should be considered
Prof.ASHALATHA
J K S H I M, NITTE
 Viewing a Project from other Perspectives

Now, a project can be viewed from four distinct points of view.

 
   Equity point of view.
   Long-term funds point of view
   Explicit cost funds point of view
   Total funds point of view
In capital budgeting, the explicit cost funds point of view is
commonly adopted – that is why our discussion so far defined
cash flows from that point of view. However, one can adopt
any other point of view as well. What is important is that the
measures of cash flow and cost of capital must be consistent
with the point of view adopted.
Prof.ASHALATHA
J K S H I M, NITTE
•Long Term fund comprise of equity & long term debt
• Current liabilities comprise short term debt & trade credit &
provisions
• Long Term funds plus short term debt carry explicit cost
associated with them
• Total funds comprise long term funds & current liabilities
• FA are fully supported by long term funds & current
liabilities
• CA are partly supported by long term funds & partly
supported by current Liabilities
•The portion of current asset that is supported by long term
funds is called net working capital

Prof.ASHALATHA
J K S H I M, NITTE
 Cash Flows Relating to Equity
The equity-related cash flow stream reflects the contributions made
and benefits receivable by equity shareholders. It may be divided
into three components as follows :
 
   Initial investment : Equity funds committed to the project
   Operating cash flows : Profit after tax – Preference dividend +
Depreciation + Other non-cash charges
   Liquidation and retirement : Net salvage value of fixed assets
cash flow (Terminal cash +
flow) Net salvage value of current assets
-
Repayment of term loans
-
Redemption of preference capital
-
Repayment of working capital advances
-
Retirement of trade credit and other dues
Prof.ASHALATHA
J K S H I M, NITTE
 Cash Flows Relating to Long-term Funds
As discussed earlier in this chapter, the cash flow stream relating to long-
term funds consists of three components as follows :
Initial investment : Long-term funds invested in the project.
This is equal to: fixed assets + working
capital margin
Operating cash inflow : Profit after tax
+
Depreciation
+
Other non-cash charges
+
Interest on long-term borrowings
(1-tax rate)
Terminal cash flow : Net salvage value of fixed assets
+
Net recovery of working capital margin
Prof.ASHALATHA
J K S H I M, NITTE
 Cash Flows Relating to Total Funds
The cash flow stream relating to total funds consists of three components as
follows : 
Initial investment : All the funds committed to the project.
This is simply the total outlay on the project
consisting of fixed assets as well as current
assets(gross)
 Operating cash inflow : Profit after tax
+
Depreciation
+
Other non-cash charges
+
Interest on long-term borrowings (1-tax rate)
+
Interest on short-term borrowings (1-tax
rate)
Terminal cash flow : Net salvage value of fixed assets
+
Net salvage value of current assets
Prof.ASHALATHA
J K S H I M, NITTE
 How Financial Institutions Define Cash flows
In evaluating project proposals submitted to them, financial institutions
define project cash flows as follows :
 
 
Capital expenditure on the project (net interest during construction)
+
Outlays on working capital
 
Cash inflows
 
Operating inflow : Profit after tax
+ Depreciation
+ Interest and lease rental
 
Terminal inflow : Recovery of working capital (at book
value) + Residual value of capital assets
(land at 100% and other capital assets
at
5% on initial cost)
Prof.ASHALATHA
J K S H I M, NITTE
 How the Planning Commission Defines
Costs and Benefits

1.  A project may be viewed from the point of view of equity

capital or long-term funds.
2.  Cost and return (benefit) streams have been defined
consistently with the point of view adopted. Further, they
are defined in pre-tax terms.
3.  A fairly long planning horizon is envisaged. This perhaps
reflects the fact that the projects considered by the
Planning
Commission, in general, have a long economic life.

Prof.ASHALATHA
J K S H I M, NITTE
 Biases in Cash Flow Estimation
Project executives often commit planning fallacy, implying
that they display over optimism which stems from the
following .
Overstatement of Profitability :
• Native Optimism
• Attribution error
• Anchoring
• Myopic euphoria
• Competitor neglect
• Organisational pressure
• Stretch targets
Prof.ASHALATHA
J K S H I M, NITTE
 Native Optimism – People tend to exaggerate their
own talents.
 Attribution Error – The native over optimism gets
amplified by the tendency to misperceive the causes
of certain events. People take credit for positive
outcome and attribute negative outcomes to external
factors.
 Anchoring – After forming opinion , people are
unwilling to change even after receiving new
information.
 Myopic Euphoria - Lack of objectivity due to mass
psychology. Referred as risky shift or Group
Polarisation Effect.
Prof.ASHALATHA
J K S H I M, NITTE
 Competitor Neglect – Neglect the abilities and
potential actions of competitor.

 Organisational Pressure - Project sponsors exaggerate

the benefits of projects proposed by them.

 Stretch Targets – Have a salutary effect on motivation

but can skew the forecasts of unit managers toward
unrealistic optimistic outcomes.

Prof.ASHALATHA
J K S H I M, NITTE
 Understatement of Profitability

• There can be an opposite kind of bias relating to the terminal

benefit which may depress a project’s true profitability

• Under-estimation of the terminal benefit of the project may be

due to the following reasons:

• Salvage values are under-estimated
• Intangible benefits are ignored
• The value of future options is overlooked

Prof.ASHALATHA
J K S H I M, NITTE