Part IV: CAPITAL BUDGETING
4.2. Estimation of Project Cash Flows
1
4.2.1 Project Cash Flows
The effect of taking a project is to change the firm’s
overall cash flows today and in the future.
 To evaluate a proposed investment, we must
consider these changes in the firm’s cash flows and
then decide whether or not, they add value to the
firm.
 The first and most important step, therefore is to
decide:

WHICH CASH FLOWS ARE RELEVANT ?
2
Relevant Cash Flows


The relevant cash flow for a project is a change in the firm’s
overall future cash flow that comes about as a direct
consequence of the decision to take that project.
Hence, the relevant cash flow is INCREMENTAL CASH
FLOW.
The incremental cash flows for project evaluation consists
of any and all changes in the firm’s future cash flows that
are a direct consequence of taking the project.
Any cash flow that exists regardless of whether or not a
project is undertaken is not relevant.
3
4.2.2 Basic Principles of the Cash Flow
Estimation
1.
2.
3.
4.
5.
Stand Alone Principle
Separation Principle
Incremental Principle
Post-Tax Principle
Consistency Principle.
4
1. Stand Alone Principle
•
•
•
•
Once we identify the effect of undertaking the proposed
project on the firm’s cash flows, we need only focus on the
project’s resulting incremental cash flows.
Once we have determined the incremental cash flows from
undertaking a project, we can view that project as a kind of
“minifirm” with its own future revenues and costs, its own
assets, and, of course, its own cash flows.
Then compare the cash flows from this minifirm to the cost
of acquiring it.
We will be evaluating the proposed project purely on its
own merits, in isolation from any other activities and
projects.
5
2. Separation Principle


There are two sides of a project, viz, the investment (or assets)
side and the financing side.
Cash flows associated with these sides should be separated.
Suppose a firm is considering a one-year project that requires an
investment of Rs 1,000 in fixed assets and working capital at time
0. The project is expected to generate a cash inflow of Rs 1,200 at
the end of year 1 and this is the only cash inflow expected from
the project. The project will be financed entirely by debt carrying
an interest rate of 15 % and maturing after a year. Assume there
are no taxes.
6
Separation Principle (contd…)
Project
Financing Side
Investment Side
Time
Cash Flow
Time
Cash Flow
0
1
+ 1,000
- 1,150
0
1
- 1,000
+ 1,200
Cost of Capital:15 %
Rate of Return: 20 %
7
Separation Principle (contd…)

The cost of capital is used as the hurdle rate against which
the rate of return on the investment side (which is 20 % in
our case) is judged.
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.

Operationally, this means that interest on debt is ignored
while computing profits and taxes thereon.
8
Separation Principle (contd…)

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 PAT.
PBIT (1- T) = (PBT + I) (1-T) = PBT (1-T) + I (1-T) = PAT + I (1-T)
Tax-Adjusted Interest

Whether the tax rate is applied directly to the PBIT figure or
whether the tax-adjusted interest is added to the PAT figure,
we get the same result.
9
3. Incremental Principle (4.2.3)

The cash flow of the project must be measured in
incremental terms.
Project Cash flow
for the year
t
=
Cash flow for
the firm with
the project for
year t
-
Cash flow for
the firm without
the project for
the year t
10
Guidelines to estimate incremental cash flow
a)


Consider all Incidental Effects :
Take into account the effect on profitability of the existing
activities of the firm because of the complementary or
competitive relationship between the project and the
existing activities of the firm.
For example: Issue of Product Cannibalization.
• The loss of profit resulting from the product cannibalization may
be treated as a negative incremental effect of the new product.
• This may however lead to the possibility of rejecting the new
project.
• What if competitor march on the firm by introducing that product ?
• How the loss of sales on account of product cannibalization is
treated will depend on whether or not a competitor is likely to
introduce a close substitute to the new product that is being
considered by the firm.
11
Guidelines (contd….)



If the firm is operating in an extremely competitive
business and is not protected by entry barriers,
product cannibalization will occur anyway.
Hence the cost associated with it are not relevant in
incremental analysis.
If the firm is sheltered by entry barriers like patent
protection or proprietary technology or brand
loyalty, the costs of product cannibalization should
be incorporated in investment analysis.
12
Guidelines (contd….)
b)
Ignore Sunk Costs

Sunk cost refers to an outlay already incurred in the past
or already committed irrevocably.
So it is not affected by the acceptance or rejection of the
project under consideration, and hence is irrelevant.

A company is debating whether it should invest in a project.
The company has already spent Rs 1 million for preliminary
work meant to generate information useful for this decision. Is
this 1 million a relevant cost for the proposed project ?
BYGONES ARE BYGONES
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Guidelines (contd….)
TANSTAFFL
“There ain’t no such
thing as a free
lunch”
c)
Include Opportunity Cost:

The value of most valuable alternative that is given up if a
particular investment is undertaken – Opportunity Cost
This is the cost created for the rest of the firm as a
consequence of undertaking the project.

Example:
If a project uses resources already available with the firm,
there’s a potential for an opportunity cost.
Is there any alternative use of the resource is the project is
not undertaken ?
14
Guidelines (contd….)
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.
 If a project uses an equipment which is currently
idle, its opportunity cost is its sales price, net of
any tax liability.
 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
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cost.

Guidelines (contd….)
What happens when a project uses a resource that has no
current alternative use, but some potential alternative use ?
Example: Excess Capacity on Some Machine AND Using
that excess capacity for a new product
Case I: May exhaust capacity much earlier than otherwise and
hence may call for creating new capacity earlier rather than
later
Opportunity cost = PV of creating capacity earlier – PV or
creating capacity later.
Case II: May reduce the output of some products in future.
Opportunity Cost = Loss in cash flows that would have
otherwise been generated by the sales of those products.
16
Guidelines (contd….)
d)
Question the allocation of Overhead Costs

Overhead Costs: Costs which are indirectly related to a
product (or service)
Eg: General Admin Expenses, Managerial Salaries, Legal
Expenses, Rent etc.
They are allocated to various products on some basis like
labor hrs, machine hrs, prime cost etc.
They are allocated to the new project too.
But for the purpose of investment analysis, what matters is
the incremental overhead costs attributable to the project
and not the allocated overhead costs.




17
Guidelines (contd….)
d)
Estimate Working Capital Properly

Project will require that the firm invest in net working
capital in addition to long-term assets.
Outlays on working capital has to be properly considered
while forecasting the project cash flows.
Its is NWC which is relevant
The requirement of WC is likely to change over time.
WC are not subject to depreciation.
Thus the WC at the end of the project life is assumed to
have a salvage value equal to its BV.





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4. Post-Tax Principle

Cash flows should be measured on an after-tax basis
Issues:
1.
2.
3.
What tax rate should be used to assess tax liability ?
How should losses be treated ?
What is the effect of non-cash charges ?
19
Relevant Tax Rate



The income from a project typically is marginal.
It is additional to the income generated by the assets
of the firm already in place.
Hence,
MARGINAL TAX RATE OF THE FIRM IS THE
RELEVANT RATE FOR ESTIMATING TAX
LIABILITY OF THE PROJECT.
20
Treatment of Losses
Scenario
Project
Firm
Action
1
Incurs Losses
Incurs Losses
Defer tax savings
2
Incurs Losses
Makes Profit
Take tax savings in the
year of loss
3
Makes Profit
Incurs Losses
Defer taxes until the firm
makes profit
4
Makes Profit
Makes Profit
Consider taxes in the year
of profit
Stand Alone
Incurs Losses
-
Defer tax savings until
the project makes profit
21
Effect of Non-cash Charges



Non-cash charges can have an impact on cash flows
if they affect the tax liability.
The most important of such non-cash charges is
depreciation.
The tax benefit of depreciation is:
Depreciation x Marginal Tax Rate
22
5. Consistency Principle

Cash flows and the discount rates applied to these cash
flows must be consistent with respect to the investor group
and inflation.
Investors’ 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 just equity
shareholders.
23
Consistency Principle (contd…)

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 investing needs of the
project, if any.
Cash flows to all investors = PBIT (1-T)
+ Depreciation
- Capital Expenditure
- Change in NWC
24
Consistency Principle (contd…)

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.
Cash flows to equity shareholders = PBIT (1-T)
+ Depreciation
- Preference Dividend
- Capital Expenditures
- Change in NWC
- Repayment of Debt
+ Proceeds from debt issues
- Redemption of preference capital
+ Proceeds from preference issue
25
Consistency Principle (contd…)

The discount rate must also be consistent with the
definition of cash flow
Cash Flow
To all investors
Cash flow to equity
Discount Rate
Weighted Average Cost of Capital
Cost of Equity
26
Consistency Principle (contd…)
Inflation:


Either incorporate expected inflation in the estimates of
future cash flows and apply a nominal discount rate to the
same.
Or estimate future cash flows in real terms and apply a real
discount rate to the same
Nominal Cash flowt = Real Cash flow (1+ Expected inflation rate)t
Nominal Discount rate =
(1+ Real discount rate)(1+Expected inflation rate) - 1
27
Elements of the Cash Flow Stream

The cash flow stream of a conventional project – a
project which involves cash outflows followed by
cash inflows – comprises of three basic components:
1.
Initial Investment – After tax cash outlay
Operating Cash Inflows – After tax cash inflows
resulting from the operations of the project during
its economic life
Terminal Cash Flow- After tax cash flow resulting
from the liquidation of the project at the end of its
economic life.
2.
3.
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4.2.4: Pro-Forma Financial Statements and
Project Cash Flows
Illustration:








Suppose we think we can sell 50,000 units of a new product per year
at a price of $ 4 per can.
It costs us about $ 2.50 per can to make the product, and a new
product such as this one typically has only a 3 year life
We require 20 % return on new products.
Fixed costs for the project, including such things as rent on the
production facility, will run $ 12,000 per year.
We will need to invest a total of $ 90,000 in manufacturing
equipment.
This $ 90,000 will be depreciated over the 3 year life of the project.
The cost of removing the equipment will roughly equal its actual
value in 3 years, so it will be essentially worthless on a market value
basis as well.
The project will require an initial $ 20,000 investment in net working
29
capital, and the tax rate is 34 %.
Illustration (contd…)
Projected Income Statement
Sales (50,000 units at $ 4/ unit)
Variable costs ($ 2.50/ unit)
$ 200,000
125,000
$ 75,000
Fixed costs
12,000
Depreciation ($ 90,000/ 3)
30,000
EBIT
$ 33,000
Taxes (34 %)
11,220
Net income
$ 21,780
Notice that we have not deducted any interest expenses
30
Illustration (contd…)
Projected Capital Requirements
Year
0
1
2
3
NWC
20,000
20,000
20,000
20,000
Net fixed assets
90,000
60,000
30,000
0
Total Investment
110,000
80,000
50,000
20,000
31
Illustration (contd…)
Project Cash Flow = Project Operating Cash Flow
– Change in net working capital
– Project capital spending
Project Operating Cash flow = EBIT + Depreciation – Taxes
EBIT
33,000
Depreciation
+ 30,000
Taxes @ 34 %
- 11,220
Operating Cash Flow
$ 51, 780
32
Illustration (contd…)
Projected Total Cash Flows
Year
0
Operating Cash Flow
Changes in NWC
- 20,000
Capital Spending
- 90,000
Total Project Cash
Flow
- 110,000
1
2
3
51,780
51,780
51,780
+ 20,000
51,780
51,780
71,780
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Illustration (contd…)
51,780 51,780 71,780
NPV  110 ,000 


 $ 10,648
2
3
1.20
1.20
1.20





NPV of the project is positive, and creates over $ 10,000
in value and should be accepted.
Return on this investment obviously exceeds 20 %
(because NPV is positive at 20 %)
We can find out that IRR works out to be 25.8 % > 20 %
Payback period is about 2.1 years ( ? )
ARR comes out to be 33.51 % ( 21,780 / 65,000)
34
Cash flows for a replacement project
Initial Investment
=
Operating Cash Flow =
Terminal Cash Flow =
Cost of the
new assets
+
NWC required for
the new assets
Operating Cash
inflows from the new
assets
After tax SV of the
new assets
+
Recovery of NWC
Associated with new
assets
-
-
After tax Salvage
Value realized from
the old assets
+
NWC required for
the old assets
-
Operating Cash
inflows from the old
assets
After tax SV of the
old assets
+
Recovery of NWC
Associated with old
assets
35
Illustration 1 – Cash Enterprises
Cash Enterprises is considering a capital project about
which the following information is available:


The investment outlay on the project will be Rs 100
million. This consists of Rs 80 million on the plant and
machinery and Rs 20 million on net working capital. The
entire outlay will be incurred at the beginning of the
project.
The project will be financed with Rs 45 million of equity
capital, Rs 5 million of preference capital, and Rs 50
million of debt capital. Preference capital will carry a
dividend rate of 15 %; debt capital will carry an interest
rate of 15 %.
36
Cash Enterprises (contd…)


The life of the project is expected to be 5 years. At the
end of 5 years, fixed assets will fetch a net salvage
value of Rs 30 million, whereas net working capital
will be liquidated at its book value.
The project is expected to increase the revenues of the
firm by Rs 120 million per year. The increase in costs
on account of the project is expected to be Rs 80
million per year. (This includes all items of costs
other than depreciation, interest and tax). The
effective tax rate will be 30 %.
37
Cash Enterprises (contd…)

Plant and machinery will be depreciated at the rate of
25 % per year as per the written down value method.
Hence, the depreciation charges will be:
First year
Second year
Third year
Fourth year
Fifth year
: Rs 20.00 million
: Rs 15.00 million
: Rs 11.25 million
: Rs 8.44 million
: Rs 6.33 million
38
Illustration 2 – Pharma Limited
Pharma 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 Rs 2200
million. The company is considering the manufacture
of a new antibiotic preparation, K-cin, for which the
following information has been gathered.
39
Pharma Limited (contd…)

K-cin is expected to have a product life cycle of five
years and thereafter it would be withdrawn from the
market. The sales from this preparation are expected
to be as follows:
Year Sales (in million Rs)
1
100
2
150
3
200
4
150
5
100
40
Pharma Limited (contd…)


The capital equipment required for manufacturing Kcin is Rs 100 million and it will be depreciated at the
rate of 25 % per year as per the WDV method for tax
purposes. The expected net salvage value after 5
years is Rs 20 million.
The working capital requirement for the project is
expected to be 20 % of sales. At the end of 5 years,
working capital is expected to be liquidated at par,
barring an estimated loss of Rs 5 million on account
of bad debt. The bad debt loss will be a tax deductible
expense.
41
Pharma Limited (contd…)

The accountant of the firm has provided the
following cost estimates for K-cin:
Raw material cost
: 30 % of sales
Variable labor cost
: 20 % of sales
Fixed annual operating and maintenance cost : Rs 5
million
Overhead allocation (excluding depreciation,
Maintenance and interest )
: 10 % of sales
While the project is charged on an overhead allocation, it is
not likely to have any effect on overhead expenses as such
42
Pharma Limited (contd…)


The manufacturer 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 preparations of the firm. This
would entail a reduction of Rs 15 million of
contribution margin.
The tax rate applicable to the firm is 40 %.
43
Illustration 3 (Ojus Enterprises)

Ojus Enterprises is determining the cash flow for a
project involving replacement of an old machine by a
new machine. The old machine, bought a few years
ago, has a book value of Rs 400,000 and it can be sold
to realize a post-tax salvage value of Rs 500, 000. It
has a remaining life of 5 years after which its net
salvage value is expected to be Rs 160,000. It is being
depreciated annually at a rate of 25 % under the
WDV method. The working capital required for the
old machine is Rs 400,000.
44
Ojus Enterprises (contd…)

The new machine costs Rs 1,600,000. It is expected to
fetch a net salvage of Rs 800,000 after 5 years when it
will no longer be required. The depreciation rate
applicable to it is 25 % under the written down value
method. The net working capital required for the new
machine is Rs 500,000. the new machine is expected to
bring a saving of Rs 300,000 annually in manufacturing
costs (other than depreciation). The tax rate applicable to
the firm is 40 %.
45
Ojus Enterprises (contd…)
46