Chapter 9 Project Cash Flows

Outline
Elements of the cash flow stream Principles of cash flow estimation Cash flow illustrations Cash flows for a replacement project Viewing a project from different perspectives How financial institutions and Planning Commission define cash flows Biases in cash flow estimation

Elements of the Cash Flow Stream

Initial Investment Operating Cash Inflows Terminal Cash Inflow Time Horizon Physical Life of the Plant Technological Life of the Plant Product Market Life of the Plant Investment Planning Horizon of the Firm

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.

Incremental Principle
To ascertain a projects 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 Consider all incidental effects Ignore sunk costs Include opportunity costs Question the allocation of overhead costs Estimate working capital properly

Post-Tax Principle
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

Treatment of Losses
Scenario 1 2 3 4 Stand alone Project Incurs losses Incurs losses Makes profits Makes profits Incurs losses Firm Incurs losses Makes profits Incurs losses Makes profits Action Defer tax savings Take tax savings in the year of loss Defer taxes until the firm makes profits Consider taxes in the year of profit Defer tax saving until the project makes profits

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 Inflation The consistency principle suggests the following match up: Cash flow Nominal cash flow Real cash flow Discount rate Nominal discount rate Real discount rate

Project Cash Flows

(RS. IN MILLION)
0 1 2 3 4 5

A. FIXED ASSETS B. NET WORKING CAPITAL C. REVENUES D. COST (OTHER THAN DEPRN AND INT) E. DEPRECIATION F. PROFIT BEFORE TAX G. TAX H. PROFIT AFTER TAX I. NET SALVAGE VALUE OF FIXED ASSETS J. RECOVERY OF NET WORKING CAPITAL K. INITIAL OUTLAY L. OPERATING CASH FLOW (H+E) M. TERMINAL CASH FLOW (I+J) N. NET CASH FLOW (K+L+M) BOOK VALUE OF INVESTMENT

(80.00) (20.00) 120 80 20 20 6 14.0 120 80 15 25 7.5 17.5 120 80 11.25 28.75 8.63 20.12 120 80 8.44 31.56 9.47 22.09 120 80 6.33 33.67 10.10 23.57 30.00 20.00 (100.00) 34.0 32.5 31.37 30.53 29.90 50.0 (100.00) 100 34.0 80 32.5 65 31.37 53.75 30.53 45.31 79.90

Relevant Cash Flows for Replacement Projects

Initial Investment

Initial Investt to acquire New Asset

After Tax Cash Inflows from Liquidn .. Old Asset

Operating Cash Inflows

Operating Cash Inflows From New Asset After-tax Cash Flows from Termination of new Asset

Operating Cash Inflows from Old Asset After-tax Cash Flows from Termn of old Asset

Terminal Cash Flow

The advantage of selling the old m/c.. has been considered.. The disadv.. too should be considered

Cash Flows for the Replacement Project

RS. IN 000 YEAR I. INVESTMENT OUTLAY 1. COST OF NEW ASSET 2. SALVAGE VALUE OF OLD ASSET 3. INCREASE IN NET WORKING CAPITAL 4. TOTAL NET INVESTMENT (1 - 2+3) II. OPERATING INFLOWS OVER THE PROJECT LIFE 5. AFTER - TAX SAVINGS IN MANUFACTURING COSTS 6. DEPRECIATION ON NEW MACHINE 7. DEPRECIA TION ON OLD MACHINE 8. INCREMENTAL DEPRECIATION (6 -7) 9. TAX SAVINGS ON INCREMENTAL DEPRECIATION ( 0.4 X 8) 10. NET OPERATING CASH INFLOW (5+9) III. TERMINAL CASH INFLOW 11. NET TERMINAL VALUE OF NEW MACHINE 12. NET TERMINAL VALUE OF OLD MACHINE 13. RECOVERY OF INCREMENTAL NET WORKING CAPITAL 14. TOTAL TERMINAL CASH INF LOW( 11 - 12+ 13) IV. NET CASH FLOWS (4+10+14) 0 (1600) 500 (100) (1200) 1 2 3 4 5

180 400 100 300 120 300

180 300 75 225 90 270

180 225 56.3 168.7 67.5 247.5

180 168.8 42.2 126.6 50.6 230.6

180 126.6 31.6 95 38 218

800 160 100 740 (1200) 30 270 247.5 230.6 958

Viewing a Project from other Perspectives

Now, a project can be viewed from four distinct points of view. Equity point of view. Long-term funds point of view Explicit cost funds point of view Total funds point of view n capital budgeting, the explicit cost funds point of view is ommonly adopted that is why our discussion so far defined ash flows from that point of view. However, one can adopt ny other point of view as well. What is important is that the easures of cash flow and cost of capital must be consistent ith the point of view adopted.

Various Points of View

Equity Long-term
Total Explicit funds cost funds 220 190
Financing Equity Long-term debt 70 75 45 30 220 220 Current assets 100 Investment Fixed assets 120

70

funds 145 Current liabilities

Short-term debt Spontaneous current liab.

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 Operating cash flows : Equity funds committed to the project : Profit after tax Preference dividend + Depreciation + Other non-cash charges Liquidation and retirement : Net salvage value of fixed assets cash flow (Terminal cash + flow) 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 longterm funds consists of three components as follows : Initial investment : Long-term funds invested in the project. This is equal to: fixed assets + working capital margin 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) : Profit after tax + Depreciation + Other non-cash charges + Interest on long-term borrowings (1-tax rate) + Interest on short-term borrowings (1-tax : Net salvage value of fixed assets + Net salvage value of current assets

Operating cash inflow

rate) Terminal cash flow

How Financial Institutions Define Cash flows

In evaluating project proposals submitted to them, financial institutions define project cash flows as follows : Cash outflows Capital expenditure on the project (net interest during construction) + Outlays on working capital Cash inflows Operating inflow : Profit after tax + Depreciation + Interest and lease rental : Recovery of working capital (at book value) + Residual value of capital assets (land at 100% and other capital assets at 5% on initial cost)

Terminal inflow

How the Planning Commission Defines Costs and Benefits

. A project may be viewed from the point of view of equity capital or long-term funds. . Cost and return (benefit) streams have been defined consistently with the point of view adopted. Further, they are defined in pre-tax terms.

. A fairly long planning horizon is envisaged. This perhaps reflects the fact that the projects considered by the Planning Commission, in general, have a long economic life.

Biases in Cash Flow Estimation Project executives often commit planning fallacy, implying that they display overoptimism which stems from the following:
Native Optimism Attribution error Anchoring Myopic euphoria Competitor neglect Organisational pressure Stretch targets

Tempering the Optimism

The human tendency for optimism is inevitable. Likewise, organisational influences that promise optimism will persist. Yet, optimism needs to be tempered. How can this be done? Dan Lovallo and Daniel Kahneman suggest that decision makers should use the outside view. This calls for looking at the outcomes of similar projects or initiatives and using that evidence to inject greater objectivity in forecasting exercise. Empirical evidence suggest that when people are asked to take the outside view, their forecasts become more objective and reliable. The advantage of the outside view is most pronounced for initiatives which have not been attempted earlier such as entering a new market or building a plant using a new technology. Ironically, the inside view is often preferred in such a case. As Dan Lovallo and Daniel Kahneman put it: Managers feel that if they dont fully account for the intricacies of the proposed project, they would be derelict in their duties. Indeed, the preference for the inside view over the outside view can feel almost like a moral imperative.

Understatement of Profitability
There can be an opposite kind of bias relating to the terminal benefit which may depress a projects true profitability Under-estimation of the terminal benefit of the project may be due to the following reasons: Salvage values are under-estimated Intangible benefits are ignored The value of future options is overlooked

Summary
Estimating cash flows- the investment outlays and the cash inflows after

the project is commissioned- is the most important, but also the most difficult step in capital budgeting

departments . The role of the financial manager is to coordinate the efforts of various departments and obtain information from them, ensure that the forecasts are based on a set of consistent economic assumptions, keep the exercise focused on relevant variables, and minimise the biases inherent in cash flow forecasting.

Forecasting project cash flows involves many individuals and

cash outflows followed by cash inflows comprises of three basic components : (i) initial investment, (ii) operating cash inflows, and (iii) terminal cash inflow

The cash flow stream of a conventional project a project which involves

The initial investment is the after-tax cash outlay on capital expenditure and net working capital when the project is set up. The operating cash inflows are the after-tax cash inflows resulting from the operations of the project during its economic life. The terminal cash inflow is the after-tax cash flow resulting from the liquidation of the project at the end of its economic life. The time horizon for cash flow analysis is usually the minimum of the following: physical life of the plant, product market life of the plant, and investment planning horizon of the firm The following principles should be followed while estimating the cash flows of a project: separation principle , incremental principle, post-tax principle, and consistency principle

the financing side. The separation principle says that the cash flows associated with these sides should be separated. While estimating the cash flows on the investment side do not consider financing charges like interest or dividend.

There are two sides of a project, viz., the investment (or asset) side and

ascertain a projects incremental cash flows you have to look at what happens to the firm with the project and without the project. The difference between the two reflects the incremental cash flows attributable to the project.

The cash flow of a project must be measured in incremental terms. To

following guidelines : (i) Consider all incidental effects. (ii) Ignore sunk costs. (iii) Include opportunity costs. (iv) Question the allocation of overhead costs (v) Estimate working capital properly.

In estimating the incremental cash flows of a project bear in mind the

 Cash flows should be measured on an after-tax basis. The important issues in assessing the impact of taxes are : What tax rate should be used to assess tax liability? How should losses be treated ? What is the effect of noncash charges ? Cash flows and the discount rates applied to these cash flows must be consistent with respect to the investor group and inflation.

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.

In dealing with inflation, you have two choices. You can incorporate expected

inflation in the estimates of future cash flows and apply a nominal discount rate to the same. Alternatively, you can estimate the future cash flows in real terms and apply a real discount rate to the same.

 Estimating the relevant cash flows for a replacement project is somewhat complicated because you have to determine the incremental cash outflows and inflows in relation to the existing project. The three components of the cash flow stream of a replacement project are : (i) initial investment (ii) operating cash inflows, and (iii) terminal cash flow. Generally, in capital budgeting we look at the cash flow to all investors (equity shareholders as well as lenders) and apply the weighted average cost of capital of the firm. A project can, of course, be viewed from other points of view like the equity point of view, long-term funds point of view, and total funds point of view. Obviously, the project cash flow definition will vary with the point of view adopted. Financial institutions look at projects from the point of view of all investors The Planning Commission suggests that a project may be viewed from the point of view of equity capital or long-term funds.

 As cash flows have to go far into the future, errors in estimation are
bound to occur. Yet, given the critical importance of cash flow forecasts in project evaluation, adequate care should be taken to guard against certain biases which may lead to overstatement or under-statement of true project profitability.

Knowledgeable observers of capital budgeting believe that profitability is

often over-stated because the initial investment is under-estimated and the operating cash inflows are exaggerated.The principal reasons for such optimistic bias are intentional overstatement, lack of experience, myopic euphoria, and capital rationing.

Terminal benefits of a project are likely to be under-estimated because

salvage values are under-estimated, intangible benefits are ignored, and the value of future options is overlooked.