Chapter 9

Project Cash Flows

Outline
Elements of the cash flow stream
Principles of cash flow estimation
Cash flow illustrations
Cash flows for a replacement project
Viewing a project from different perspectives
How financial institutions and Planning
Commission define cash flows
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 projects 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

1
2

Incurs losses
Incurs losses

Incurs losses
Makes profits

Makes profits

Incurs losses

Makes profits

Makes profits

Stand
alone

Incurs losses

Action
Defer tax savings
Take tax savings in
the year of loss
Defer taxes until
the firm makes
profits
Consider taxes in
the year of profit
Defer tax saving
until the project
makes profits

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
Cash flow to all investors
Cash flow to equity
shareholders

Discount rate
Weighted average cost of capital
Cost of equity
Inflation

The consistency principle suggests the following match up:

Cash flow

Discount rate

Nominal cash flow

Real cash flow

Nominal discount rate

Real discount rate

Project Cash Flows

(RS. IN MILLION)
0

120

120

120

120

120

D. COST (OTHER THAN DEPRN 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

A. FIXED ASSETS

(80.00)

B. NET WORKING CAPITAL

(20.00)

C. REVENUES

G. TAX
H. PROFIT AFTER TAX

7.5

8.63

9.47

10.10

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
L. OPERATING CASH FLOW (H+E)

(100.00)
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

BOOK VALUE OF INVESTMENT

100

80

65

53.75

45.31

79.90

Relevant Cash Flows for

Replacement Projects
Initial Investment

Operating Cash
Inflows

Terminal Cash Flow

Initial Investt to
acquire New Asset

Operating Cash
Inflows From New
Asset

After-tax Cash Flows

from Termination of
new Asset

After Tax Cash

Inflows from
Liquidn .. Old Asset

Operating Cash
Inflows from Old
Asset
After-tax Cash Flows
from Termn of old
Asset

The advantage of selling the old m/c.. has been considered.. The disadv.. too
should be considered

Cash Flows for the Replacement Project

RS. IN 000
YEAR
I. INVESTMENT OUTLAY
1. COST OF NEW ASSET
2. SALVAGE VALUE OF
OLD ASSET
3. INCREASE IN NET
WORKING CAPITAL
4. TOTAL NET INVESTMENT
(1 -2+3)

180

180

180

180

180

400

300

225

168.8

126.6

100

75

56.3

42.2

31.6

300

225

168.7

126.6

95

120

90

67.5

50.6

38

300

270

247.5

230.6

218

(1600)
500
(100)
(1200)

II. OPERATING INFLOWS

OVER THE PROJECT
LIFE
5. AFTER - TAX SAVINGS IN
MANUFACTURING COSTS
6. DEPRECIATION ON NEW
MACHINE
7. DEPRECIA TION ON OLD
MACHINE
8. INCREMENTAL
DEPRECIATION (6 -7)
9. TAX SAVINGS ON
INCREMENTAL
DEPRECIATION ( 0.4 X 8)
10. NET OPERATING CASH
INFLOW (5+9)
III. TERMINAL CASH
INFLOW
11. NET TERMINAL VALUE
OF NEW MACHINE
12. NET TERMINAL VALUE
OF OLD MACHINE
13. RECOVERY OF
INCREMENTAL NET
WORKING CAPITAL
14. TOTAL TERMINAL CASH
INF LOW( 11 - 12+ 13)
IV. NET CASH FLOWS
(4+10+14)

800
160
100
740
(1200)

30

270

247.5

230.6

958

Viewing a Project from other Perspectives

NNow, 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.

Various Points of View

Equity
Long-term
Total Explicit

70

funds 145

funds cost funds

220 190

Current
liabilities

Financing

Investment

Equity

70

Long-term debt

75

Short-term debt

45

Spontaneous
current liab.

30
220

Fixed assets

120

Current assets

100

220

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
Operating cash flows

: Equity funds committed to the project

: 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

Cash Flows Relating to Long-term Funds

As discussed earlier in this chapter, the cash flow stream relating to longterm 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

Cash Flows Relating to Total Funds

The cash flow stream relating to total funds consists of three components as
follows :
Initial investment

Operating cash inflow

rate)
Terminal cash flow

: 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)
: Profit after tax
+
Depreciation
+
Other non-cash charges
+
Interest on long-term borrowings (1-tax rate)
+
Interest on short-term borrowings (1-tax
: Net salvage value of fixed assets
+
Net salvage value of current assets

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)

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.

Biases in Cash Flow Estimation

Project executives often commit planning fallacy, implying
that they display overoptimism which stems from the
following:
Native Optimism
Attribution error
Anchoring
Myopic euphoria
Competitor neglect
Organisational pressure
Stretch targets

Tempering the Optimism

The human tendency for optimism is inevitable. Likewise,

organisational influences that promise optimism will persist. Yet,
optimism needs to be tempered.
How can this be done? Dan Lovallo and Daniel Kahneman
suggest that decision makers should use the outside view. This calls for
looking at the outcomes of similar projects or initiatives and using that
evidence to inject greater objectivity in forecasting exercise. Empirical
evidence suggest that when people are asked to take the outside view,
their forecasts become more objective and reliable.
The advantage of the outside view is most pronounced for
initiatives which have not been attempted earlier such as entering a
new market or building a plant using a new technology. Ironically, the
inside view is often preferred in such a case. As Dan Lovallo and
Daniel Kahneman put it: Managers feel that if they dont fully
account for the intricacies of the proposed project, they would be
derelict in their duties. Indeed, the preference for the inside view over
the outside view can feel almost like a moral imperative.

Understatement of Profitability
There can be an opposite kind of bias relating to the terminal
benefit which may depress a projects 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

Summary

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
Forecasting project cash flows involves many individuals and
departments . The role of the financial 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.
The cash flow stream of a conventional project a project which
involves cash outflows followed by cash inflows comprises of three basic
components : (i) initial investment, (ii) operating cash inflows, and (iii)
terminal cash inflow

The initial investment is the after-tax cash outlay on capital

expenditure and net working capital when the project is set up. The
operating cash inflows are the after-tax cash inflows resulting from
the 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.
The time horizon for cash flow analysis is usually the minimum of
the following: physical life of the plant, product market life of the
plant, and investment planning horizon of the firm
The following principles should be followed while estimating the
cash flows of a project: separation principle , incremental principle,
post-tax principle, and consistency principle


. There are two sides of a project, viz., the investment (or asset) side and
the financing side. The separation principle says that the cash flows
associated with these sides should be separated. While estimating the cash
flows on the investment side do not consider financing charges like interest or
dividend.
The cash flow of a project must be measured in incremental terms. To
ascertain a projects incremental cash flows you have to look at what
happens to the firm with the project and without the project. The difference
between the two reflects the incremental cash flows attributable to the
project.
In estimating the incremental cash flows of a project bear in mind the
following guidelines : (i) Consider all incidental effects. (ii) Ignore sunk costs.
(iii) Include opportunity costs. (iv) Question the allocation of overhead costs
(v) Estimate working capital properly .

 Cash flows should be measured on an after-tax basis. 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 ?
Cash flows and the discount rates applied to these cash flows must be
consistent with respect to the investor group and inflation.
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
just equity shareholders.
In dealing with inflation, you have two choices. 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.

Estimating the relevant cash flows for a replacement project is somewhat

complicated because you have to determine the incremental cash outflows
and inflows in relation to the existing project. The three components of the
cash flow stream of a replacement project are : (i) initial investment (ii)
operating cash inflows, and (iii) terminal cash flow.
Generally, in capital budgeting we look at the cash flow to all investors
(equity shareholders as well as lenders) and apply the weighted average
cost of capital of the firm. A project can, of course, be viewed from other
points of view like the equity point of view, long-term funds point of view,
and total funds point of view. Obviously, the project cash flow definition
will vary with the point of view adopted.
Financial institutions look at projects from the point of view of all
investors
The Planning Commission suggests that a project may be viewed from the
point of view of equity capital or long-term funds.

As cash flows have to go far into the future, errors in estimation are

bound to occur. Yet, given the critical importance of cash flow

forecasts
in project evaluation, adequate care should be taken to guard against
certain biases which may lead to overstatement or under-statement of
true project profitability.
Knowledgeable observers of capital budgeting believe that profitability
is
often over-stated because the initial investment is under-estimated and
the operating cash inflows are exaggerated.The principal reasons for
such optimistic bias are intentional overstatement, lack of experience,
myopic euphoria, and capital rationing.
T Terminal benefits of a project are likely to be under-estimated because
salvage values are under-estimated, intangible benefits are ignored, and
the value of future options is overlooked.