PROJECT CASH FLOWS

Project cash flows

• The estimated of cash flows are a key element in
investment evaluation.
• So far we assumed that cash flows were given
because we wanted to focus our discussion on
investment criteria.
• Estimating cash flows-the investment outlays
and the cash inflows after the project is
commissioned-is the most important, but also
the most difficult step in capital budgeting.
• Forecast error can be quite large, particularly in
gigantic, complex project. For example, when
several oil majors decided to construct the
 Cont….
• Alsaka pipeline, the initial cost estimate was
about US$ 70 million.
• The final cost, however, was about US$ 7 billion.
• While this may be an extreme example, it
highlight the pitfalls of forecasting.
• Forecasting project cash flows involves numerous
variables and many participate in this exercise.
• Capital outlays: Engineering and product
development department.
• Revenue: Marketing groups
 Cont…..
• Operating costs: Production people, cost
accountants, purchase managers, personnel
executives, tax expert and others.
• The role of finance manager is to:
 coordinate the efforts of various departments
and obtain information from them,
ensure that the forecasts are based on a set of
consistent economic assumptions,
keep the exercise focused on relevant variables,
and
minimise the biases inherent in cash flow
forecasting
 Element of cash flow stream
• To evaluate a project you must determine the
relevant cash flows, which are the incremental
after-tax cash flows associated with the project.
• The cash flow stream of a conventional project-a
project which involves cash outflows followed by
cash inflows-comprises three basic components:
i. Initial investment,
ii. Operating cash inflows, and
iii. Terminal cash flows
• The initial investment is the after-tax cash
outlay on capital expenditure and NWC when
the project is set up.
 Cont….
• The operating cash inflows are the after-tax cash
inflows resulting from operations of the project
during its economic life.
• The terminal cash inflow is the after-tax cash flow
resulting from the liquidation of the project at the
end of its economic life.
• BASIC PRINCIPLES OF CASH FLOW ESTIMATION
• The following principles should be followed while
estimating the cash flows of a project:
1. Separation principle
2. Incremental principle
3. Post-tax principle
4. Consistency principle
 1. Separation principle
• There are two parts of a project, viz., the
investment (or asset) side and the financing side.
• So the cash flows associated with these side
should be separated. Fore example,
• Suppose a firm is considering a one year project
that requires an investment of Birr 1,000 in fixed
assets and WC at time 0.
• The project is expected to generate a cash inflow
of Birr 1,200 at the end of year 1-this is the only
cash inflow expected from the project.
 Cont….
• The project will be financed entirely by debt
carrying an interest rate of 15% and maturing after
1 year.
• Assuming that there are no taxes, determine the:
i. cash flows associated with the investment side of
the project,
ii. the rate of return on the investment side of the
project,
iii.the cash flows associated with the financing side of
the project, and
iv.the cost of capital on the financing side are as
follows:
 Solution
Financing side: Investing side:
Time Cash flow Time Cost
0 +1,000 0 -1,000
1 -1,150 1 +1,200
Cost of capital 15% Rate of Return 20%

• Note that the cash flows on the investment side

of the project do not reflect financing costs
(Interest) .
• The financing cost are included in the cash flows
on the financing side and reflected in the cost of
capital figure (which is 15%)
 Cont……
• The cost of capital is used as the hurdle rate
against which the rate of return on the
investment side (which is 20%) is judged.
• The important point to be emphasised is that
while defining the cash flows on the investment
side, financing cost 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.
• Operationally, this means that interest on debt is
ignored while computing profits & taxes thereon.
 Cont….
• Alternatively, if interest is deducted in the process of
arriving at profit after tax, an amount equal to
‘interest(1-tax rate)’ should be added to ‘profit after
tax’.
• Note that:
• PBIT(1-tax rate)=(PBT + Interest)(1-tax rate)
• = (PBT)(1-Tax rate) + Interest(1-tax rate)
• = PAT + Interest(1-tax rate)
• Thus, whether the tax rate is applied directly to the
PBIT figure or whether the tax adjusted interest,
which is simply ‘Interest(1-tax rate)’ is added to the
‘PAT’ figure we get the same result.
 2. Incremental principle
• The cash flow of a project must be measured in
incremental terms.
• 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.
• The difference between the two reflects the
incremental cash flows attributable to the
project. That is,
• (PCF for year t) = (CF for the firm with the
project for year t) - (CF for the firm without the
project for year t).
 Cont……
 In estimating the ICF of a project, the ff guidelines
must borne in mind;
a) Consider all incidental effects: in addition to the
cash flows of the project, all its incidental effects
on the rest of the firm must be considered.
• The project may enhance the profitability of some
existing activities of the firm because it has a
complementary relationship with them; or
• It may detract from the profitability of some of the
existing activities of the firm because it has a
competitive relationship with them-all these
effects must be taken in to account.
 Cont…….
b) Product cannibalisation refers to the erosion in
the sales of the firm’s existing products on
account of a new product introduction.
• The firm may loses sales to a competitor or to
itself (because of the new product).
• If the firm is operating in an extremely
competitive business and is not protected by
entry barriers, product cannibalisation will occur
anyway.
• Hence the costs associated with it are not
relevant in incremental analysis.
 Cont….
• On the other hand, if the firm is sheltered by entry
barriers like:
 patent protection or
 proprietory technology or
 brand loyalty,
• the costs of product cannibalisation should be
incorporated in investment analysis.
c) Ignore Sunk costs: A sunk cost refers to an outlay
already incurred in the past or already committed
irrevocable.
• So it is not affected by the acceptance or rejection of
the project under consideration.
 Cont….
• Suppose, fore example, a company is debating
whether it should invest in a project.
• The company has already invest 1nillion birr for
preliminary work meant to generate information
useful for this decision.
• Is this 1 million birr a relevant cost for the
proposed project?
• Clearly not.
• 1millon birr represent a sunk cost as it can not be
recovered irrespective of whether the project is
accepted or not.
 Cont….
• Include opportunity cost: if a project uses a
resources already available with the firm, there is
a potential for an opportunity cost-this is the cost
created for the rest of the firm as a consequence
of undertaking the project.
• The opportunity cost of a resource is the benefit
that can be derived from it by putting it to its best
alternative use.
• So, to analyse the opportunity cost, ask the
question “is there any alternative use of the
resource if the project is not undertaken?”
 Cont....
• For most resources, there will be an alternative
use:
a)The resource may be rented out: In this case the
opportunity cost is the rental revenue foregone
by undertaking the project.
For example, if a project uses a vacant factory building
owned by the firm, the revenue that can be derived
from renting out this building represents the
opportunity cost.
b) The resource may be sold: In this case the
opportunity cost is the value realised from the
sale of the resource after paying tax.
 Cont….
For example, if the project uses an equipment which
is currently idle, its opportunity cost is its sales price,
net of any tax liability.
• The resource is required elsewhere in the firm:
In this case the cost of replacing the resource
represent its opportunity cost
Fore example, if a project requires the services of
some experienced engineers from an existing
division of the firm, the cost that is borne by that
division to replace those engineers represents the
opportunity cost.
 Cont…
• Question the allocation of overhead cost: Costs
which are only indirectly related to a product (or
service) are referred to as overhead costs.
• They include items like general administrative
expenses, managerial salaries, legal expenses,
rent, and so on.
• Accountants normally allocate overhead costs to
various products on some basis like labour hours,
or machine hours, or prime cost which appear
reasonable.
• Hence when a new project is proposed, a portion
of the OHCs of the firm is usually allocated to it.
 Cont….
• The OH allocated to it, however may hardly have
any relationship with the incremental OHC, if
any, associated with it.
• For purposes of investment analysis, what
matters in the incremental OHCs (along with
other incremental costs) attributable to the
project and not the allocated OHCs.
• Estimate Working Capital Properly: A part from
fixed assets, a project requires working capital.
• Outlays on WC have to be properly considered
while forecasting the project cash flows.
 Cont….
• In this context, the following points must be
remembered:
Working capital (or more precisely, NWC) is defined
as: CA-CL and provision. Note that CL & provisions,
also referred to as non-interest bearing current
liabilities, are deducted from CA because they
represent non-investor claims.
The requirement of WC is likely to change overtime.
When a project is set up, there is an initial
investment in the WC. This tend to change over time
as the output of the project changes.
 Cont….
While fixed asset investment are made during the
early years of the project and depreciated over time,
working capital is renewed periodically and hence is
not subject to depreciation. Thus the WC at the end
of the project life is assumed to have a salvage value
equal to its book value.
 3. Post-tax principle
• Cash flow should be measured after-tax basis.
• Some firm may ignore tax payments and try to
compensate this mistake by discounting the pre-tax cash
flows at a rate that is higher than the cost of capital of
the firm.
• Since there is no reliable way of adjusting the discount
rate, you should always use after-tax cash flows along
with after tax-discount rate.
• The important issues in assessing the impact of taxes
are:
 What tax rate should be used to assess tax liability?
 How should losses be treated?
 What is the effect of noncash charges?
 Cont…
• Tax Rate: Let us examine the choices in terms of
taxes.
• The average tax rate is the total tax burden as a
proportion of the total income of the business.
• The marginal tax rate (MTR) is typically higher than
the average tax rate because tax rates are often
progressive.
• The income from a project typically is marginal.
• Put differently it is additional to the income
generated by the asset of the firm already in place.
• Hence, the MTR of the firm is the relevant rate for
estimating the tax liability of the project.
 Cont….
• Treatment of losses: because the firm as well as
the project can incur losses, let us look at various
possible combinations and the ways to deal with
them.
• The different scenarios are summarised below:
Scena Project Firm Action
rio
1 Incur Incur Defer tax savings
losses losses
2 Incur Makes Take tax saving in the year of loss
losses profits
3 Make Incur Defer taxes until the firm makes profit
profit losses
4 Incur ---- Defer taxes saving until the project
losses makes profits
 Cont….
• Effect of noncash charges: noncash charges can
have an impact on cash flows if they affect
liability.
• The most important of such noncash charges is
depreciation.
• The tax benefit of depreciation is:
Depreciation * marginal tax rate
 4. Consistency principle
• Cash flows and the discount rates applied to
these cash flows must be consistent with respect
to the investor group and inflation.
• Investor group: The cash flow of a project may be
estimated from the point of view of all investors
(equity shareholders as well as lenders) or from
the point of view of equity shareholders.
• The cash flow of a project from the point of view
of all investors is the cash flow available to all
investors after paying taxes and meeting
investment needs of the project, if any.
 Cont……
• It is estimated as follows:
• Cash flow to all investor =PBIT(1-Tax rate)
+ Depreciation & non cash charges
- Capital Expenditure
- Change in working capital
• The cash flow of a project from the point of view
of equity shareholders is the cash flow available
to equity shareholders after paying taxes,
meeting investment needs, and fulfilling debt-
related commitments.
• It is estimated as follows:
 Cont….
• Cash flow to equity shareholders = Profit after tax
+ Depreciation & other noncash charges
- Preferred dividend
- capital expenditures
- change in working capital
-repayment of debt
+ proceeds from debt issues
- redemption of preferred capital
+ proceeds from preferred issue
 Cont….
• The discount rate must be consistent with the
definition of cash flow:
Cash flow Discount rate
Cash flow to all investors WACC
Cash flow to equity Cost of Equity

• Generally, in capital budgeting we look at the

cash flow to all investors and apply the WACC of
the firm.
• Inflation: In dealing with inflation, you have two
choices.
 Cont….
• You can incorporate expected inflation in the
estimates of future cash flows and apply a
nominal discount rate to the same.
• Alternatively, you can estimate the future cash
flows in real terms and apply a real discount rate
to the same.
• Note that the following relationship holds b/n
nominal & real values:
• Nominal CFt = Real CFt (1-Expected inf. Rate)t
• Nominal DR = (1+ Real DR) (1+ Expected Inf. Rate)-1
 Cont…
• The consistency principle, in essence, suggests
the following match up:
Cash flow Discount Rate
Nominal cash flow Nominal Discount rate
Real cash flow Real discount rate
• Generally, in capital budgeting analysis nominal
cash flows are estimated and nominal discount
rate is used.
 Cash flow illustration
• Illustration 1.
• ABC enterprises is considering a capital project
about which the following information is
available:
The investment outlay on the project will be 100
million Birr. This consists of 80 million on plant
and machinery and 20 million on net working
capital. The entire outlay will be incurred at the
beginning of the project.
The project will be financed with 45 million of
equity capital, 5 million of preference capital, and
 Cont…..
50 million of debt capital. Preferred capital will
carry a dividend rate of15%, debt capital will
carry an interest rate of 15%.
The life of the project is expected to be 5 years.
At the end of 5 years, fixed asset will fetch a net
salvage value of 30 million whereas net working
capital will be liquidated at its book value.
The project is expected to increase the revenue
of the firm by 120 million per year. The increase
in costs on account of the project is expected to
be 80 million per year (this includes all items of
 Cont…..
Costs other than depreciation, interest, and tax).
The effective tax rate will be 30%.
Plant and machinery will be depreciated at the
rate of 25% per year as per the declining book
value method of depreciation. Hence the
depreciation charges will be
First year 25% of 80 million 20 million
Second year 25% of 60 million 15 million
Third year 25% of 45 million 11.25 million
Fourth year 25% of 33.75 million 8.44 million
Fifth year 25% of 25.31 million 6.33 million
 Cont……
•Required: given the
above detail,
prepare the project
cash flows
 Solution
• Project cash flow (in millions of Birr0
Years 0 1 2 3 4 5
1. FA (80.00) - - - - -
2. NWC (20.00) - - - - -
3. Revenues 120 120 120 120 120
4. Cost (other than depr. & int) 80 80 80 80 80
5. Deprec. 20 15 11.25 8.44 6.33
6. PBT 20 25 28.75 31.56 33.67
7. Tax (30%) 6 7.5 8.63 9.47 10.10
8. PAT 14 17.5 20.12 22.09 23.57
9. Net salvage value of FA - - - - 30
10. Recovery of NWC - - - - 20
11. Initial outlay (100.00)
12. Operating Cash inflow(8+5) 34 32.5 31.37 30.53 29.90
13. Terminal Cash inflow (9+10) 50
14. Net Cash flow (11+12+13) (100.00) 34 32.5 31.37 30.53 79.90
 Illustration 2
• FARMID Ltd. Is engaged in the manufacture of
pharmaceuticals. The company was established in
1991 and has registered a steady growth in sales
since then. Presently the company manufactures
16 products and has an annual turnover of 2200
million birr.
• The company is considering the manufacture of a
new antibiotic preparation. K-cin, for which the
following information has been gathered:
1. K-cin is expected to have a product life cycle of
five years and thereafter it would be withdrawn
from the market.
 Cont….
• The sales from this preparation are expected to
be as follows:
Year Sales (birr in millions)
1 100
2 150
3 200
4 150
5 100
2. The capital equipment required for
manufacturing K-cin is birr 100 million and it will
be depreciated at the rate of 25% per year as
per DBV method for tax purpose.
 Cont…
• The expected net salvage value after 5 years is
birr 20 million.
3. The WC requirement for the project is expected
to be 20% of sales. At the end of five years, WC
is expected to be liquidated at par, barring an
estimated loss of birr 5 million on account of bad
debt. The bad debt loss will be a tax deductable
expense.
4. The accountant of the firm has provided the
following cost estimate for K-cin:
 Cont……
RM Cost 30% of sales
Variable labour cost 20% of sales
Fixed annual operating & 5 Million birr
maintenance cost
OH allocation (Excluding Deprec, 10% of sales
Maintenance & Interest
5. The manufacture of K-cin would also require
some of the common facilities of the firm. The
use of these facilities would call for reduction in
the production of other pharmaceutical
preparation of the firm. This would entail a
reduction of 15 million birr of CM.
 Cont…..
6. The tax rate applicable to the firm is 40%.

• Required: based on the

above information
prepare the cash flow for
the project
 Cash flow for the K-cin project
Year 0 1 2 3 4 5
1. Capital Requirement (100) - - - - -
2. Level of WC (ending) (20) 30 40 30 20 0
3. Revenues 100 150 200 150 100
4. RMC 30 45 60 45 30
5. Labour cost 20 30 40 30 20
6. Oper. & Maint. cost 5 5 5 5 5
7. Loss of Contribution 15 15 15 15 15
8. Depreciation 25 18.8 14.1 10.5 7.9
9. Bad debt loss - - - - 5
10. PBT 5 36.2 65.9 44.5 17.1
11. Tax 2 14.5 26.4 17.8 6.8
12. PAT 3 21.7 39.5 26.7 10.3
 Cont….
Year 0 1 2 3 4 5
12. Profit after tax (BBF) - 3 21.7 39.5 26.7 10.3
13. Net salvage value of capital - - - - 20
Requirement
14. Recovery of WC - - - - 20
15. Initial Inv ‘t (100) - - - - -
16. Operating Cash inflow (12+8+9) - 28 57.9 53.6 37.2 23.2
17. Increase in WC 20 10 10 (10) (10) -
18. Terminal cash in flow (14+15 - (120) 18 47.9 63.6 47.2 63.2
16+17

 The loss of contribution (item 7) is an opportunity cost.

 OH expenses allocated to the project have been ignored
as they do not represent incremental OH expense for
the firm as a whole.
 Cont…
 It is assumed that the level of WC is adjusted at
the beginning of the year in r/n to the expected
sales for the year.
Fore example, WC at the beginning of year 1 (i.e
at the end of year 0) will be 20 million birr that is
20% of the expected revenue of 100 million birr
for year 1.
Like wise, the level of WC at the end of year one
(i.e at the beginning of year 2) will be 30 million
that is 20% of the expected revenue of 150
million for year 2.