Estimating Cash Flows for

Capital Budgeting Decisions

Neeraj Amarnani
Goa Institute of Management
Estimating the Cash Flows
First priority: Cash flows not accounting income
Incremental implies:

Cash Flows of Cash Flows of the

the Firm WITH Firm WITHOUT the
the Project Project
Incremental Effects
Sunk Costs:
Costs (cash outflows) incurred prior to the decision;
Ignore
Opportunity Costs
Resources that could have been used elsewhere to generate cash;
Take into account
Side Effects
Erosion (product cannibalism, diversion of resources) &
Synergy (increased benefits on existing businesses) ;
Include in decision framework
Incremental Effects contd.
Allocated Costs
Only consider to the extent of incremental costs that occur due to the project
under consideration
Depreciation
Consider as per tax norms; since that results in cash implications
Taxes
As per the prevalent rules, to be applied on estimated EBIT
No interest deduction to be made, if Cash flows to the firm are being
computed.
Salvage Value: Tax to be computed on capital gain / loss ; depending on
difference between book value of assets and sale / salvage value
Incremental Effects contd.
Net Working Capital
Considered at incremental levels
Salvage Value
To be considered on after-tax basis
Cash Flows, broadly divided into
Two parts:

Operating Cash Flows

Includes cash related to revenues, costs, taxes

Investment Cash Flows

Includes cash outflow for upfront investment, net working capital changes,
salvage value of project investments at the end of the project
Can be further sub-divided into: Initial Cash Flows & Terminal Cash Flows
Operating Cash Flows
Can be computed as either of:

Top-Down Approach : Revenues Cash Costs Taxes

Bottom-up Approach : Net Income (Net income-Taxes) + Depreciation

Tax-shield Approach : (Sales Cash Costs) X (1-tc) + Depreciation X tc

Inflation and Capital Budgeting
Capital Budgeting cash flows can be either Real or Nominal

Important consideration is consistency between cash flows and

discount rates.
In case of Nominal cash flows, the discount rates have to be in
nominal terms
In case of Real cash flows, the discount rates have to be in real terms
Replacement Decisions
Usually taken in the context of replacing existing machinery with new
one(s).

Can be done by either

1. Evaluating the PV of costs of each alternative, A and B and
comparing them, or
2. Performing a difference of cash flows analysis, i.e.
S PV (CFA CFB)