9- project cashflows

8/18/2019 9- Project Cashflows

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PAF-9

Project Cash Flows

Chapter 9


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Objectives

• Describe the elements of the project cash flowstream.

• Discuss the basic principles of cash flow

stream.• Calculate the cash flow stream for a

replacement project.

•Explain the different perspectives from whicha project may be viewed.

• Understand the biases in cash flow estimation


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Project Cash Flows elements

1. Initial Investment OutlayThese are the costs that are needed to start the project, suchas new equipment, installation, etc.

2. Operating Cash Flow over a Project's LifeThis is the additional cash flow a new project generates.

3. Terminal-Year Cash FlowThis is the final cash flow, both the inflows and outflows, atthe end of the project's life;

The key metrics for determining the terminal cash flow aresalvage value of the asset, net working capital and taxbenefit/loss from the asset.


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Example: Expansion Project

• Newco wants to add to its production capacity and islooking closely at investing in Machine B. – Machine B has a cost of $2,000, with shipping and installation

expenses of $500 and a $300 cost in net working capital.

– Newco expects the machine to last for five years, at which pointMachine B will have a book value (BV) of $1,000 ($2,000 minusfive years of $200 annual depreciation) and a potential marketvalue of $800.

• With respect to cash flows, Newco expects the newmachine to generate an additional $1,500 in revenues and

costs of $200. – We will assume Newco has a tax rate of 40%. The maximum

payback period that the company has established is five years.


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Initial Investment Outlay:Machine cost + shipping and installation expenses + change in net workingcapital = $2,000 + $500 + $300 = $2,800

Operating Cash Flow:

CFt = (revenues - costs)*(1 - tax rate)CF1 = ($1,500 - $200)*(1 - 40%) = $780CF2 = ($1,500 - $200)*(1 - 40%) = $780CF3 = ($1,500 - $200)*(1 - 40%) = $780CF4 = ($1,500 - $200)*(1 - 40%) = $780CF5 = ($1,500 - $200)*(1 - 40%) = $780

The terminal cash flow : Return of net working capital +$300Salvage value of the machine +$800Tax reduction from loss (salvage < BV) +$80Net terminal cash flow $1,180Operating CF5 +$780Total year-five cash flow $1,960

For determining the tax benefit or loss, a benefit is received if the book value ofthe asset is more than the salvage value, and a tax loss is recorded if the bookvalue of the asset is less than the salvage value.


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Cash Flow Components

31.60 31.06 30.60 30.21 29.88

50.00

End of Year

2. Operating Cash flows

100

1.Initial Investment

3. Terminal Cash flow


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Note that on investment side; we do not reflect financing costs

(interest in our example). If ROR > cost of capital… go.

Suppose a firm is considering a one-year project that requires an

investment of Rs. 1000 in Fixed assets and working capital at time

0.The project is expected to generate a cash inflow Rs. 1,200 at

the end of year 1 - this is the only cash inflow expected from theproject. The project will be financed entirely by debt carrying an

interest rate of15 percent and maturing after 1 year.

Separation Principle


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Another important feature of separation principle is that the interest rates on

the debt securities are excluded at the time of calculating the profits and

payable taxes. while bringing out the profit, if the applicable interest is

subtracted, the same amount should be added to the profit that remains after

paying the applicable tax. On the other hand, if the tax rate is imposed directly

on the profit (from which interest and taxes are not adjusted) the results are not

going to differ

PBIT = 1200. Tax rate = 25%. PBIT* .75 = 750

Three cases: Interest: 400,200 or 0Interest 400 200 0

PBIT 1200 1200 1200

PBT 800 1000 1200

Tax 200 250 300PAT 600 750 900

Interest expense 400*.75 200*.75 0*.75

PAT+ interest

expense

900 900 900


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Incremental Principle

• Cash flow with or without the project(incremental).

• Consider all incidental effects: – Increase or decrease of profitability of the existing

products

– Product cannibalization: may help

• Ignore sunk costs

•

Include opportunity costs: Is there any alternativeuse of the resource if the project is notundertaken

• Include only incremental overhead costs


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Incremental PrincipleEstimate Net Working Capital Properly:

• A portion of gross working capital is supported by non-interest bearing current liabilities (referred to asNIBCLs) such as trade credit, advances from customers,provisions, and so on.

• While fixed asset investments are made during theearly years of the project and depreciated over time,net working capital is renewed periodically and henceis not subject to depreciation.

• The net working capital at the end of the project life isassumed to have a salvage value equal to it book value.


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Post-tax Principle

• Cash flows should be measured on an after tax basis.

• Project Firm Action

Incurs losses Incurs losses Defer tax savings

Incurs losses Makes profits Take tax savingsMakes profits Incurs losses Defer taxes

Makes profits Makes profits Consider taxes

Stand alone

Incurs losses Defer tax saving until the project makesprofits


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Consistency Principle

• Cash flows and the discount rates applied to

these cash flows must be consistent with

respect to the investor group and inflation.

• Discount rate for cash flows to firm should be

WACC …. Used in capital budgeting as we

consider cash flow to all investors

• Discount rate for cash flows to Equity

shareholders should be cost of equity


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Viewing a project from other

perspectives


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Cash flows• Free cash flow = cash flow from operating activities - net capital

expenditures (total capital expenditure - after-tax proceeds fromsale of assets).

• The FCF measure gives investors an idea of a company's ability topay down debt, increase savings and increase shareholder value,and FCF is used for valuation purposes.

•

Free Cash Flow to the Firm (FCFF) • Free cash flow to the firm is the cash available to all investors, both

equity and debt holders.

• FCFF = PBIT*(1-tax rate)+depreciation- capital expenditure-changein working capital

Because FCFF is the cash flow allocated to all investors including debtholders, the interest expense which is cash available to debt holdersmust be added back.

• Free Cash Flow to Equity (FCFE), the cash available to stockholderscan be derived from FCFF. FCFE equals FCFF minus the after-taxinterest plus any cash from taking on debt (Net Borrowing)


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Cash flows for a replacement project

9- project cashflows

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