PAF-9

Project Cash Flows

Chapter 9

Objectives
Describe the elements of the project cash flow
stream.
Discuss the basic principles of cash flow
stream.
Calculate the cash flow stream for a
replacement project.
Explain the different perspectives from which
a project may be viewed.
Understand the biases in cash flow estimation

Project Cash Flows elements

1. Initial Investment Outlay
These are the costs that are needed to start the project, such
as new equipment, installation, etc.
2. Operating Cash Flow over a Project's Life
This is the additional cash flow a new project generates.
3. Terminal-Year Cash Flow
This is the final cash flow, both the inflows and outflows, at
the end of the project's life;
The key metrics for determining the terminal cash flow are
salvage value of the asset, net working capital and tax
benefit/loss from the asset.

Example: Expansion Project

Newco wants to add to its production capacity and is
looking closely at investing in Machine B.
Machine B has a cost of $2,000, with shipping and installation
expenses of $500 and a $300 cost in net working capital.
Newco expects the machine to last for five years, at which point
Machine B will have a book value (BV) of $1,000 ($2,000 minus
five years of $200 annual depreciation) and a potential market
value of $800.

With respect to cash flows, Newco expects the new

machine to generate an additional $1,500 in revenues and
costs of $200.
We will assume Newco has a tax rate of 40%. The maximum
payback period that the company has established is five years.

Initial Investment Outlay:

Machine cost + shipping and installation expenses + change in net working
capital = $2,000 + $500 + $300 = $2,800
Operating Cash Flow:
CFt = (revenues - costs)*(1 - tax rate)
CF1 = ($1,500 - $200)*(1 - 40%) = $780
CF2 = ($1,500 - $200)*(1 - 40%) = $780
CF3 = ($1,500 - $200)*(1 - 40%) = $780
CF4 = ($1,500 - $200)*(1 - 40%) = $780
CF5 = ($1,500 - $200)*(1 - 40%) = $780
The terminal cash flow :
Return of net working capital
Salvage value of the machine
Tax reduction from loss (salvage < BV)
Net terminal cash flow
Operating CF5
Total year-five cash flow

+$300
+$800
+$80
$1,180
+$780
$1,960

For determining the tax benefit or loss, a benefit is received if the book value of
the asset is more than the salvage value, and a tax loss is recorded if the book
value of the asset is less than the salvage value.

Cash Flow Components

3. Terminal Cash flow
50.00

2. Operating Cash flows

31.60

31.06

End of Year
100
1.Initial Investment

30.60

30.21

29.88

Suppose a firm is considering a one-year project that requires an

investment of Rs. 1000 in Fixed assets and working capital at time
0.The project is expected to generate a cash inflow Rs. 1,200 at
the end of year 1 - this is the only cash inflow expected from the
project. The project will be financed entirely by debt carrying an
interest rate of15 percent and maturing after 1 year.

Separation Principle

Note that on investment side; we do not reflect financing costs

(interest in our example). If ROR > cost of capital go.

Another important feature of separation principle is that the interest rates on

the debt securities are excluded at the time of calculating the profits and
payable taxes. while bringing out the profit, if the applicable interest is
subtracted, the same amount should be added to the profit that remains after
paying the applicable tax. On the other hand, if the tax rate is imposed directly
on the profit (from which interest and taxes are not adjusted) the results are not
going to differ

PBIT = 1200. Tax rate = 25%. PBIT* .75 = 750

Three cases: Interest: 400,200 or 0
Interest

400

200

PBIT

1200

1200

1200

PBT

800

1000

1200

Tax

200

250

300

PAT

600

750

900

Interest expense

400*.75

200*.75

0*.75

PAT+ interest
expense

900

900

900

Incremental Principle
Cash flow with or without the project
(incremental).
Consider all incidental effects:
Increase or decrease of profitability of the existing
products
Product cannibalization: may help

Ignore sunk costs

Include opportunity costs: Is there any alternative
use of the resource if the project is not
undertaken
Include only incremental overhead costs

Incremental Principle
Estimate Net Working Capital Properly:
A portion of gross working capital is supported by noninterest bearing current liabilities (referred to as
NIBCLs) such as trade credit, advances from customers,
provisions, and so on.
While fixed asset investments are made during the
early years of the project and depreciated over time,
net working capital is renewed periodically and hence
is not subject to depreciation.
The net working capital at the end of the project life is
assumed to have a salvage value equal to it book value.

Post-tax Principle
Cash flows should be measured on an after tax basis.
Project
Firm
Action
Incurs losses
Incurs losses
Defer tax savings
Incurs losses
Makes profits
Take tax savings
Makes profits
Incurs losses
Defer taxes
Makes profits
Makes profits
Consider taxes
Stand alone
Incurs losses Defer tax saving until the project makes
profits

Consistency Principle
Cash flows and the discount rates applied to
these cash flows must be consistent with
respect to the investor group and inflation.
Discount rate for cash flows to firm should be
WACC . Used in capital budgeting as we
consider cash flow to all investors
Discount rate for cash flows to Equity
shareholders should be cost of equity

Viewing a project from other

perspectives

Cash flows
Free cash flow = cash flow from operating activities - net capital
expenditures (total capital expenditure - after-tax proceeds from
sale of assets).
The FCF measure gives investors an idea of a company's ability to
pay down debt, increase savings and increase shareholder value,
and FCF is used for valuation purposes.
Free Cash Flow to the Firm (FCFF)
Free cash flow to the firm is the cash available to all investors, both
equity and debt holders.
FCFF = PBIT*(1-tax rate)+depreciation- capital expenditure-change
in working capital
Because FCFF is the cash flow allocated to all investors including debt
holders, the interest expense which is cash available to debt holders
must be added back.
Free Cash Flow to Equity (FCFE), the cash available to stockholders
can be derived from FCFF. FCFE equals FCFF minus the after-tax
interest plus any cash from taking on debt (Net Borrowing)

Cash flows for a replacement project