Project Cash Flows
PROF. HARNESH MAKHIJA
Content
 Elements of cash flow streams
 Principles of cash flow estimation
 Cash flow illustrations
 Cash flow for replacement project
 Viewing a project from different prespectives
Elements of cash flows
Initial Investment: Cash Outlay on capital
expenditure and net working capital
2. Operating cash inflows: The operating cash
inflows are the cash inflows resulting from the
operations of the project during its economic life.
3. Terminal cash inflow: Is the cash flow resulting
from the liquidation of the project at the end of its
economic life.
1.
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.
Example
Project
Financing Side
Time
0
1
Cash Flow
+1000
-1150
Cost of capital 15%
Investment Side
Time
0
1
Cash Flow
-1000
+1200
Rate of return 20%
Incremental Principle
 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.
Guidelines
1. Consider all incidental effects
2. Ignore Sunk cost
3. Include opportunity cost
Consider all incidental effects
 The project may enhance the profitability of some of
the existing activities of the firm, or it may detract
from the profitability of some of the existing
activities of firm.
 How should product cannibalization the erosion in
the sales of the firm’s existing products on account of
a new product introduction be handled?
Ignore Sunk Cost
 A 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
Include Opportunity Costs
 If a project uses resources already available with




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 project.
Is there any alternative use of the resources if the
project is not undertaken.
Resources may be rented out
Resources may be sold
Resources may require elsewhere in the firm.
Post Tax Principle
 Income from project typically is marginal.
 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.
Consistency Principle
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
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
:
Equity funds committed to the project

Operating cash flows
:
Profit after tax – Preference dividend +
Depreciation + Other non-cash charges

Liquidation and retirement cash
flow (Terminal cash flow)
:
Net salvage value of fixed assets
+
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 long-term funds
consists of three components as follows :

Initial investment
:
Long-term funds invested in the project.
fixed assets + working capital margin
This is equal to:

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
: 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)
Operating cash inflow
:
Profit after tax
+
Depreciation
+
Other non-cash charges
+
Interest on long-term borrowings (1-tax rate)
+
Interest on short-term borrowings (1-tax rate)
Terminal cash flow
:
Net salvage value of fixed assets
+
Net salvage value of current assets