Cash Flow Estimation

The three basic steps in determining whether a project is worthwhile or not are: Estimate project cash flows Establish the cost of capital(hurdle rate) Apply a suitable decision or appraisal criteria

Projects have failed or succeeded due to

incorrect or correct estimates of the cash flows of the project. If cash flow estimates are incorrect, it doesnt matter which technique we use, the project is doomed to fail

Relevant versus Irrelevant Cash Flows

The results of an acceptance of a project is

to change the cash flows of a firm. Cash flows of a firm that change because of the project are called relevant cash flows; any cash flows that does not change irrespective of the acceptance/rejection of the project is irrelevant to decision making and should not be considered.

Determination of Cash Flows

The project cash flows are defined with the help of inputs

provided by marketing, production, engineering, costing, purchase and other departments For developing the stream of financial costs and benefits, the following principles must be kept in mind: Incremental Principle Long-term funds principle Exclusion of financing cost principle Post tax principle

Incremental Principle
Consider all Incidental Effects
Ignore sunk cost-sunk cost refers to an outlay incurred in

the past or already committed. So it is not affected by the acceptance or rejection of the project under consideration.(Ex-cost incurred on market research) Include opportunity costs-the use of existing resources with the firm, opportunity cost of a resource is the present value of net cash flows that can be derived from it if it were put to its best alternative use. Only incremental overhead cost should be considered

Long Term Funds Principle

A project can be evaluated from various point of view Total funds point of view Long term funds point of view Equity point of view The measurement of cash flows and determination of discount rate for evaluating cash flows depend on the point of view adopted. It is generally recommended that a project may be evaluated from the point of view of long term funds(which are provided by the equity stockholders, preference holders and term lending institutions)

Exclusion of financing cost

While defining the cash flows, financing cost of long term

funds(interest on long term debt and equity dividend) should be excluded from the analysis The weighted average cost of capital used for evaluating the cash flows takes into account the cost of long term funds. Since interest is usually deducted in the process of arriving at profit after tax, an amount equal to interest(1- tax rate) should be added back to the profit after tax. Post tax Principle- Cash flows must be defined in post tax terms. Cost of capital is also measured in post-tax terms

Components of the cash flow stream

Initial investment
Operating cash inflows Terminal cash flow

Cash Flows relating to equity

Initial Investment : Equity funds committed to project
Operating cash flows : Profit after tax

preference dividend + depreciation Terminal cash flows : net salvage value of fixed/current assets repayment of term loan repayment of preference capital repayment of working capital advances and trade credit

Cash Flows relating to long-term funds

Initial investment : Long term funds

invested in the projects(fixed assets + working capital margin) Operating cash flows : Profit after tax + Depreciation + Interest on long-term borrowings(1 tax rate) Terminal cash flows : Net salvage value of fixed assets + recovery of working capital margin

Cash Flows relating to total funds

Initial Investment : Total outlay on the

project consisting of fixed as well as current assets Operating cash flows : Profit after tax + Depreciation + interest on long-term borrowings(1- tax rate) + interest on short term borrowings(1- tax rate) Terminal cash flows : Net salvage value of fixed and current assets