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 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
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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

Discount rate
Weighted average cost of capital
Cost of equity

Inflation
The consistency principle suggests the following match up:
Cash flow
Nominal cash flow
Real cash flow

Discount rate
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

(100.00)

L. OPERATING CASH FLOW (H+E)

34.0

32.5

31.37

30.53

M. TERMINAL CASH FLOW (I+J)

29.90
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 DECISIONS
INITIAL =
INVESTMENT

INITIAL INVESTT
TO ACQUIRE NEW
ASSET

OPERATING CASH
=
INFLOWS

OPERATING CASH
INFLOWS FROM
NEW ASSET

TERMINAL CASH
=
FLOW

AFTER-TAX CASH
FLOWS FROM
TERMINATION OF
NEW ASSET

THE ADVANTAGE OF SELLING THE OLD M/C ..

HAS BEEN CONSIDERED .. THE DISADV ..

AFTER TAX CASH

INFLOWS FROM
LIQUIDN .. OLD
ASSET
OPERATING CASH
INFLOWS FROM
OLD ASSET,HAD IT
NOT BEEN
REPLACED

AFTER-TAX CASH
FLOWS FROM
TERMN OF OLD
ASSET, HAD IT
NOT BEEN
REPLACED

CASH FLOWS FOR THE REPLACEMENT PROJECT

R S . IN 0 0 0
YEAR
I. IN V E S T M E N T O U T L A Y
1. C O ST O F N E W A SSE T
2. SA L V A G E V A L U E O F
O LD ASSET
3 . IN C R E A S E IN N E T
W O R K IN G C A P IT A L
4 . T O T A L N E T IN V E S T M E N T
( 1 -2 + 3 )
II. O P E R A T IN G IN F L O W S
O V E R T H E PR O JE C T
L IF E
5 . A F T E R - T A X S A V IN G S IN
M A N U F A C T U R IN G C O S T S
6 . D E P R E C IA T IO N O N N E W
M A C H IN E
1 . D E P R E C IA T IO N O N O L D
M A C H IN E
2 . IN C R E M E N T A L
D E P R E C IA T IO N (6 -7 )
3 . T A X S A V IN G S O N
IN C R E M E N T A L
D E P R E C I A T I O N ( 0 .4 X 8 )
1 0 . N E T O P E R A T IN G C A S H
IN F L O W (5 + 9 )
III. T E R M IN A L C A S H
IN F L O W
1 1 . N E T T E R M IN A L V A L U E
O F N E W M A C H IN E
1 2 . N E T T E R M IN A L V A L U E
O F O L D M A C H IN E
13. R E C O V E R Y O F
IN C R E M E N T A L N E T
W O R K IN G C A P IT A L
1 4 . T O T A L T E R M IN A L C A S H
IN F L O W ( 1 1 -1 2 + 1 3 )

180

180

180

180

180

400

300

225

1 6 8 .8

1 2 6 .6

100

75

5 6 .3

4 2 .2

3 1 .6

300

225

1 6 8 .7

1 2 6 .6

95

120

90

6 7 .5

5 0 .6

38

300

270

2 4 7 .5

2 3 0 .6

218

(1 6 0 0 )
500
(1 0 0 )
(1 2 0 0 )

800
160
100

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 understatement of true project profitability