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 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

• The marginal tax rate of the firm is the relevant rate

for estimating the tax liability of the firm

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

CONSISTENCY PRINCIPLECash flows and discount rates applied to these cash flows must be consistent with respect to the investor group and inflation

Investor GroupThe 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

InflationThe consistency principle suggests the following match up:

Cash flow Discount rate Nominal cash flow Nominal discount rate Real cash flow Real discount rate

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

BOOK VALUE OF INVESTMENT 100 80 65 53.75 45.31

RELEVANT CASH FLOWS FOR REPLACEMENT DECISIONS

= -

= -

= -

THE ADVANTAGE OF SELLING THE OLD M/C ..

HAS BEEN CONSIDERED .. THE DISADV ..

TOO SHOULD BE CONSIDERED

INITIAL INVESTMENT

OPERATING CASH INFLOWS

TERMINAL CASH FLOW

INITIAL INVEST’T TO ACQUIRE NEW

ASSET

OPERATING CASH INFLOWS FROM

NEW ASSET

AFTER-TAX CASH FLOWS FROM

TERMINATION OF NEW ASSET

AFTER TAX CASH INFLOWS FROM LIQUID’N .. OLD

ASSET

OPERATING CASH INFLOWS FROM

OLD ASSET,HAD IT NOT BEEN REPLACED

AFTER-TAX CASH FLOWS FROM

TERM’N OF OLD ASSET, HAD IT

NOT BEEN REPLACED

CASH FLOWS FOR THE REPLACEMENT PROJECT RS. IN ‘000

YEAR

0 1 2 3 4 5

I. INVESTMENT OUTLAY 1. COST OF NEW ASSET (1600) 2. SALVAGE VALUE OF OLD ASSET

500

3. INCREASE IN NET WORKING CAPITAL

(100)

4. TOTAL NET INVESTMENT (1-2+3)

(1200)

II. OPERATING INFLOWS OVER THE PROJECT LIFE

5. AFTER- TAX SAVINGS IN MANUFACTURING COSTS

180 180 180 180 180

6. DEPRECIATION ON NEW MACHINE

400 300 225 168.8 126.6

1. DEPRECIATION ON OLD MACHINE

100 75 56.3 42.2 31.6

2. INCREMENTAL DEPRECIATION (6-7)

300 225 168.7 126.6 95

3. TAX SAVINGS ON INCREMENTAL DEPRECIATION ( 0.4 X 8)

120 90 67.5 50.6 38

10. NET OPERATING CASH INFLOW (5+9)

300 270 247.5 230.6 218

III. TERMINAL CASH INFLOW

11. NET TERMINAL VALUE OF NEW MACHINE

800

12. NET TERMINAL VALUE OF OLD MACHINE

160

13. RECOVERY OF INCREMENTAL NET WORKING CAPITAL

100

14. TOTAL TERMINAL CASH INFLOW( 11-12+ 13)

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 under- statement of true project profitability