Financial Management

Lecture:
Estimating Cashflows
Syed Karim Bux Shah (PhD)
Assistant Professor
IBA, University of Sindh, Jamshoro.
 Outline
• Introduction
• Some key considerations
• Taxes and depreciation
• Expansion and Replacement Cases
– Cashflow estimates in expansion case
– Cashflow estimates in replacement case

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 Introduction
• Estimating cashflows is most important task in capital
budgeting.
• Accuracy of capital budgeting decisions depends upon
accuracy of cashflow estimations.
• Capital budgeting decisions are based on cashflows, not
accounting profits.
• Cashflow analysis include only operating cashflows.
Cashflows related to financing (such as interest and
principal payments are excluded.
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 Some key considerations
• Cash flows should be determined on an after-tax basis.
• Only incremental cash flows matter.
– The difference between the cash flows of the firm with and without the project.
• Sunk costs must be ignored.
– Unrecoverable past costs are irrelevant and should not enter into the decision process.
• Opportunity cost must be included.
– A building used for project that could otherwise be sold for $100,000 should be
included.
• Take account of Net Working Capital.
– Investment in current assets less current liabilities.
– For example, with the acceptance of a new project it is sometimes necessary to carry
additional cash, receivables, or inventories.
• Anticipated inflation must be taken into account.
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Checklist

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 Tax considerations
• Method of Depreciation: Depreciation is the systematic allocation of
the cost of a capital asset over a period of time for financial reporting
purposes, tax purposes, or both.
• Depreciation lowers taxable income.
– The greater the depreciation charges, the lower the taxes paid.
• Although depreciation is a noncash expense, it does affect the firm’s
cash flow by directly influencing the cash outflow of taxes paid.
• Alternative procedures - straight-line and various accelerated
depreciation methods.
• Profitable firms prefer to use an accelerated depreciation method for
tax purposes – one that allows for a more rapid write-off and, therefore,
a lower tax bill.
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 Revisiting MACRS
• Modified Accelerated Cost
Recovery System (MACRS)
• The half-year convention must
generally be applied to all
machinery and equipment.
• There is a half-year of
depreciation in the year an asset
is acquired and in the final year
that depreciation is taken on the
asset.
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 Calculating the Incremental Cash Flows
• Project cash flows categories based on timing:
– 1. Initial cash outflow: the initial net cash investment.
– 2. Interim incremental net cash flows: those net cash flows
occurring after the initial cash investment but not
including the final period’s cash flow.
– 3. Terminal-year incremental net cash flow: the final
period’s net cash flow. (This period’s cash flow is singled
out for special attention because a particular set of
cash flows often occurs at project termination.)
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 Initial Cash Outflow.
• The cost of the asset is subject to adjustments to reflect the totality of cash flows associated
with its acquisition.
• These cash flows include Installation costs, changes in net working capital, sale proceeds
from the disposition of any assets replaced, and tax adjustments.

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 Interim Incremental Net Cash Flows.
• These are cash inflows generated by the project.

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 Terminal Cash flows
• Cash flow for the last year of the project when the
project terminates.

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 Example
Data
• Cost of equipment = $90, 000
• Useful life = 4 years
• MACRS = 3-years
• Shipping and installing = $10, 000
• Salvage Value = $16, 500
• Revenue estimate

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Step A: Estimate initial cash outlay

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Estimating Interim and terminal cashflows

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 Expected incremental net cash flows from the
project
• The expected incremental net cash flows from the project are

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