Course: Financial theory

Topic 8:
Project cash flow and
Sensitivity analysis

Otabek Kurbonov, Assistant Professor of Financial

Management Department, Namseoul University
November 5, 2022, Cheonan
 Content

• Project cash flow principles

• Pro forma income statement
• Free cash flow
• Sensitivity analysis
 Project Cash Flow Principles
• - Overall, project cash flow analysis is similar to firm-level cash
flow analysis
• - Project cash flow principles
1) Stand-alone principle
2) Incremental cash flow principle
3) Salvage value
4) Sunk cost
5) Opportunity cost
6) Side effects
 1) Stand-Alone Principle

• Each project should be analyzed in isolation from

the firm
• We treat a project as if it is a small independent
company
• A project has its own balance sheet and income
statement
• Assets
• Revenues, costs, etc.
 2) Incremental Cash Flow
Principle
• We have to use only incremental cash flows related
to the investment decision
• Cash flows that occur as a consequence of the
decision, rather than total cash flows
• Incremental cash flow question:
Will this cash flow occur only if we accept the project?
 3) Salvage Value

• Estimated resale value of the project related asset at the

end of the project’s life
• - Somewhat similar to “terminal value” in a firm
valuation
• - Includes (1) resale value of fixed assets
• - Actual resale value can be different from the book
salvage value at the end of the project’s life
• - Also includes (2) salvaged net working capital
investments
 4) Sunk Cost

A cost that has already been incurred and cannot be

recovered
•- Sunk costs should NOT be considered in a project
analysis
•- Example: You are considering an invisible car
project, but you have already spent $500,000 in
prototype testing
 5) Opportunity Cost

Value from the most valuable alternative that has to be

given up if the project is taken
•- An opportunity cost arises when a project uses resources
that have been already owned by the firm
•- Opportunity costs should be considered in a project
analysis
•- Example: Your project includes building a plant on land
your company owns already. The land currently can be
sold for $1 million
 6) Side Effects

Your project could have either positive or negative

side effects to existing projects of your company
•- Synergy
•- Erosion, Cannibalism
•- Side costs should be considered in a project
analysis
 Project Valuation Procedure

• 1. We first estimate operating income (EBIT) from a pro forma

income statement of the project
• 2. Then we convert from operating income to operating cash
flow (OCF)
• 3. Finally we calculate total cash flows
- Operating cash flow
- Capital expenditure (CAPEX)
- Change in net working capital
- Salvage value
 Pro Forma Income Statement

• Stand-alone principle!
• Example:
 Annual Depreciation Cost

• If we use the straight-line depreciation method,

• - Example: You have purchased equipment for

$1,000. The project’s life is 5 years. Salvage value
is expected to be zero.
 Project Description

Suppose you are considering the following project:

- Your company has just developed a bubble gum that
enables chewers to “fly” momentarily
- You have already spent $5,000 developing the
product
- You need to invest $6,500 today to build the
production facility
- The project’s life is 6 years
 Project Description

Suppose you are considering the following project:

- The production facility is depreciated to $500 using
the straight-line method
- The actual resale value of the facility is expected to
be $1,000 at the end of Year 6
- To produce this special bubble gums, you have to
give up another project worth $1,000
 Project Description

Suppose you are considering the following project:

- In the first year of operation (Year 1), the sales volume
will be 500 packs
- Sales volume is expected to grow by 5% annually
- Unit price will be fixed at $15
- Each year the operating cost will be 60% of revenue
- Each year the net working capital requirement is 15% of
revenue
 Project Description

• Suppose you are considering the following project:

• - Tax rate is 25%
• - The appropriate discount rate of the project is
20%
 Free Cash Flow

• Cash Flow From Assets (CFFA) =

• Operating cash flow (OCF)
• – Capital expenditure (CAPEX)
• – Change in net working capital (ΔNWC)
• + Salvage value
 Operating Cash Flow (OCF)

Operating cash flow (OCF) =Operating income (EBIT)

– – Taxes+ Depreciation
 Capital Expenditure (CAPEX)

• Capital expenditure is usually incurred at the

beginning of the project
• For convenience, we will include the present value
of the opportunity cost in this item
 Change in Net Working Capital

• Net working capital = Current assets – Current

liabilities
• Key items include:
• - Account receivable, inventories, and account
payable
• Increase (decrease) in net working capital
requirement means a cash outflow (inflow)
 Salvage Value of Fixed Assets

• Sometimes your assets could have a positive resale

value at the end of the project
• After-tax salvage
• - Consider the tax effect if resale value differs from
the net book value of the asset
• - After-tax salvage =
• Resale value – Tax rate * (Resale value – Book
value)
 Salvage Value of Net Working
Capital
Do not forget to consider the salvage value of net
working capital at the end of the project
•- Net working capital “tied up to” the project is now
freed up
•- This means a cash inflow
 Sensitivity Analysis (Investment
Decision)

• What is the NPV of this project?

• What is the payback period of this project?
• What is the IRR of this project?
 Investment Decision

• We can show our decision in Excel using

• IF function
• - = IF(Logical test, Value if true, Value if false)
 Sensitivity Analysis

• How much can you trust your results?

• Remember that your analysis is only as strong as
its assumptions
- What if the true discount rate is 21%, not 20%?
- What if the true growth rate is 7%, not 5%?
• The impact of these assumptions on valuation is
tested using sensitivity analysis
 Sensitivity Analysis

• We perform a sensitivity analysis using What-if

Analysis in Excel
• - Go to “Data” tab What-if Analysis Data
Table