Determining
Project Cash Flows
Steps to Capital Budgeting
1. Estimating cash flows (outflows & inflows)
2. Estimating discounting rate – Required rate of return, Cost of
capital also called Weighted average cost of capital (WACC)
3. Evaluating the project for making a decision – Using various
evaluation techniques
Cash Flows Versus Profits
Cash flow is not the same thing as profit due to the following reasons:
1. Profit, as measured by an accountant, is based on accrual concept.
2. For computing profit, expenditures are divided into revenue and
capital expenditures following matching concept.
Defining Free Cash Flows
• Profit + Non-cash items – Capital expenditure – Working capital
• Which profit?
• GP, EBITDA, EBIT, NOPAT, PBT or PAT?
• It should be post-tax for the investors (shareholders and lenders) of the
company
• PAT + Interest (1 – tax rate) = EBIT (1-t) = NOPAT
• Working capital Net Working Capital (NWC) = CA – CL
• EBIT (1-t) + Depreciation – Capex – Change in NWC
Project Cash Flows
• Cash flows associated with projects are classified under three
heads:
1. Initial cash flows – Cash outflow on setting up the project which
includes capital expenditure (Capex) and net working capital (NWC)
2. Operating cash flows – Cash flows generated by the project during its
useful life (until the project is terminated) and change in NWC if any
3. Terminal cash flows – Cash flow once project life is over (when the
project shut down) which includes after tax salvage value and the
recovery of NWC
Anatomy of Project Cash Flows of a Typical Investment
Project Life Initial Investment Period Interim Operating Terminal Period
Cycle Period
Relevant • Costs of purchasing plant • Incremental • Proceeds from the
cash and equipment revenues disposal of plant and
flows • Costs of installing equipment • Incremental equipment (net of
and training employees expenses taxes)
• Investment in working- • Incremental taxes • Cleanup or
capital requirements (e.g. decommissioning
• Increase/decrease in costs
investments in accounts working-capital
receivable and inventories requirements • Recapture of
less those in accounts working-capital
payable) • Incremental capital investment
expenditures for
plant and equipment
Relevant Cash Flows
Initial Cash Flow
• Capital Expenditure
• Working Capital Requirement
Operating Cash Flow
• EBIT (1-t) + Depreciation and Other Non-cash Charges
• Changes in the Net Working Capital
Terminal Cash Flow
• Salvage Value of the assets
• Tax effects
• Recovery of Working Capital
Incremental Cash Flows are what Matters
• Incremental cash flow Additional cash flow a firm receives
from taking on a new project.
Incremental Project Firm Cash Flows Firm Cash Flows
=
Cash Flows with the Project without the Project
Guidelines for Forecasting Cash flows
1. Timing of cash flows
2. Sunk costs
3. Overhead costs
4. Opportunity cost
5. Negative synergistic effect
6. Positive synergistic effect
7. Working capital
8. Financing cost
Guidelines for Forecasting Cash flows
1. Timing of the Cash Flows Although the cash flows for companies occur
throughout the year, we generally assume annual cash flows
2. Sunk costs are not incremental cash flows An outlay incurred in the past
as a result of past decisions and cannot be recovered in the future regardless
of whether the project under consideration is accepted e.g. market research
expense
3. Overhead costs are generally not incremental costs Consider only
incremental overheads e.g. electricity, rents etc.
4. Opportunity cost should be accounted for The best returns that could be
earned on assets of the firm if those assets are not used for the project
under consideration.
Guidelines for Forecasting Cash flows
5. Negative synergistic effect (Cannibalization) A project may compete with
the existing business and eat away the revenue generated from your existing
business so consider only incremental cash flows.
6. Positive Synergistic effect A project may increase your existing business so
consider the incremental cash flows should.
7. Working capital Net working capital (Current assets less current liabilities),
Additional requirement of NWC or release of NWC
8. Financing cost To be ignored to avoid double counting, as it considered as a
part of cost of capital (WACC, discount rate) i.e. cost of raising funds
