Chapter-1: Estimating Project Cash Flows BBC – III

ESTIMATING PROJECT CASHFLOWS

INTRODUCTION
Investment appraisal process consists of the following steps:
i). Determine (estimate) the expected cash flows of available projects
ii). Apply decision criteria such as NPV and IRR

What are cash flows?

Cash flows refers to incomings and outgoings of cash, representing the trading (operating) activities of
a firm. Cash flows arise out of a measure of a company's financial health.

Cash Flow method is a better method of measuring financial viability

i). Accounting Profits/losses include Non-Cash Expenses (Depreciation) and will not give an accurate
picture of the EV of the Investment proposal. Cash Flows will describe the Cash Transactions the
company will experience once the Project is accepted.
ii). Cash Flow method recognizes the Time value of money where as Accounting profits are more
historical and on accrual basis.

To be consistent with wealth maximization principle, an evaluation of a project must be based on cash
flows and not on accounting profits.

PROJECTING AND ESTIMATING CASH FLOWS

To be able to use NPV technique or any other technique of capital budgeting analysis successfully and
accurately, we must have
i). An unbiased estimate of the expected future cash flows of the project
ii). Including time to completion and estimate initial investment/cost
iii). Extremely important and most difficult task

CASH OUTFLOWS
These consist of expenditure and costs that needs to be made before the assets become operational.
Money paid out by a firm as a result of its operating activities, investment activities, and financing
activities.
Types of Costs Considered when Determining Cash Outflows
It includes
i). Invoice Value. The cash or price value required to acquire the new equipment or build the new
plant.
ii). Sunk Costs are past, irrecoverable and irreversible costs. These costs have been already incurred by
the firm, and have no effect on present or future decision to accept or reject the project and therefore,
it should be ignored, for example research and development, market research, consultant’s fees.
 For example; suppose 100,000 had been spent last year to improve the production line site.
Should this cost be included in the analysis? NO. This is a sunk cost.
iii). Investment Allowances. These actually reduce the initial outlay and should be deducted, e.g. tax
incentives on the cost of the project.

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Prepared By Ddamba AbdulKarim ©2018
Department of Applied Computing & Information Technology
Faculty of Computing and Informatics
Makerere University Business School
Chapter-1: Estimating Project Cash Flows BBC – III

iv). Opportunity cost is the revenue or benefit or cash flow lost or given up by using your resources to
undertake the project. Opportunity cost occurs as a result of using some of the project resources,
under consideration. These resources might be rented out or sold, or used elsewhere.
 For example, by using your own building for your business, you forego the rent that you could
have earned by renting it to someone else, hence being relevant to the investment decision even
when no cash changes hands. Therefore, it should be charged to the cost of the project.
v). Incidental Costs. Incidental costs incurred in making the asset operational in the first instance e.g.
 Freight shipping or transportation costs,
 Forwarding, and clearing,
 Installation costs.
vi). Change in Net-Working Capital is defined as Current Assets minus Current Liabilities. A new
project many times requires investments in working capital, for instance inventory, this investment
in the working capital is a cash outflow during the year in which the investment takes place.
Increasing networking means a cash outflow and should be added to the initial outlay, otherwise
must be deducted.

vii). Project Externalities are the incidental effects of a new project (positive or negative) on an existing
project. For example, the introduction of a new model of the car on other exiting models produced
by the same firm.
 Externalities will be positive if the new project is a compliment to existing assets or projects.
 Externalities will be negative if the new project is a cost or a substitute to existing assets or
projects.

For Example
Ddamba Company Ltd is proposing to modernize its beverage bottling plant located in Wandegeya,
Kampala. The traditional equipment will cost Shs. 40m, while freight and carriage charges from Kenya
will be Shs. 8m. Clearing charges are estimated at Shs. 2m. The company currently spends about Shs.
2m on salary of specialists technicians who maintain the equipment. This is expected to increase to Shs.
3.5m as additional engineer will be engaged. The new equipment will be housed in an extension building
provided by the LC1 at no cost in appreciation of the company’s efforts to improve the welfare of the
area. It would otherwise have cost Shs. 5m to set up the facility. What is the initial outlay on the proposed
investment ventures?
Solution:
Particulars Shs Shs
Invoice value of an asset 40m
Add: Carriage and transport 8m
Clearing charges 2m
Increase in working capital (salaries) 1.5m
Building from council 5m 16.5m
Final: Initial Outlay 56.5m
Workings:
Increase in working capital: The amount by which salaries increased which also increased the working
capital but not the final figure should be considered as seen below;
Therefore: Final salary-Initial salary =3.5m-2m=1.5m
Opportunity cost: Building from the council is an example of an opportunity cost.
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Prepared By Ddamba AbdulKarim ©2018
Department of Applied Computing & Information Technology
Faculty of Computing and Informatics
Makerere University Business School
Chapter-1: Estimating Project Cash Flows BBC – III

CASH INFLOWS
These are the returns expected from the investment. Cash inflows are generated from; operations and the
terminal value. There are two types of cash inflows expected on an investment project and these include;
the intermediate and terminal cash flows as explained below;
a) Intermediate cash inflows are interim incremental net cash inflows expected to occur after the initial
cash investment but not including the final period’s cash flow, i.e. from the period 1 up to the period
n-1 of the useful life of the investment or asset. For example, an asset with a five-year lifespan will
have intermediate cash flows accruing from year 1 to 4.
 Represents annual cash inflows generated from the investments on account of sales/ revenue
generation minus cash out flow on account of expenses, i.e. these benefits or revenues are
adjusted for costs incurred in order to derive the final cash flow.
 Depreciation. The cash inflows should also take into account of the depreciation, which is a non-
cash expense that need to be adjusted in the determination of the net earnings during a given
period.
 Include effects of inflation. Inflation has a direct impact on the final outcome of investment
appraisals. It affects both the future cash flows, and cost of capital. If inflation is not properly
adjusted, the future cash flows are increased, over and above, what they would be. For the
adjustment of inflation, cash flows have to be either presented in the real terms or money
(nominal) terms.

Derivation & Computation of the Intermediate Cash Inflows

Deriving the cash flows requires the construction of a projected income statement over the
intermediate period under review. These statements normally take the following format.

Projected Income Statement for the Intermediate & Terminal Cash inflows
PERIOD (YEARS)/PARTICULARS 0 1 2 3 4

INITIAL OUTLAY (CASH OUTFLOW)

Cash Outflow (Cost of the Project)
Invoice Value XXX
Add: Incidental Costs xx
Opportunity Cost xx
Increase in Working Capital xx
Less: Investment Allowances xx
Decrease in Working Capital xx
Total Cost of the Investment XXX
TOTAL PROJECTED REVENUES
Revenues xx xx xx xx
Sales/Qty/Output * Selling Price xx xx xx xx
Add: Cost Savings xx xx xx xx
Total Projected Benefits XXX XXX XXX XXX
LESS OPERATING COSTS

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Prepared By Ddamba AbdulKarim ©2018
Department of Applied Computing & Information Technology
Faculty of Computing and Informatics
Makerere University Business School
Chapter-1: Estimating Project Cash Flows BBC – III

Salaries & Wages xx xx xx xx

Selling Expenses xx xx xx xx
Water Bills xx xx xx xx
Electricity xx xx xx xx
Maintenance Costs xx xx xx xx
Production Costs (Fixed & Variable Costs) xx xx xx xx

Total Projected Operating Costs XXX XXX XXX XXX

EBIDT XXX XXX XXX XXX
Less: Interest xx xx xx xx
EBDT XXX XXX XXX XXX
Less: Depreciation xx xx xx xx
EBT XXX XXX XXX XXX
Less: Tax xx xx xx xx
EAT XXX XXX XXX XXX
Add Back: Depreciation xx xx xx xx
Net Cash Inflow XXX XXX XXX XXX
Add: Terminal Cash Inflow xx
FINAL CASH INFLOWS XXX XXX XXX XXX

b) Terminal Cash Inflows are cash flows that accrue in the final year of the useful life of the asset.
 It includes the net cash generated from the sale of the assets, tax effects from the termination of
the asset and the release of net working capital. The terminal cash flows differ from the
intermediate ones with respect to the expected net realizable value from the disposal of the assets
in its final year of use.
Derivation & Computation of the Terminal Cash Inflows
 The net salvage value would be SV (1-t), where SV is the realizable value on the selling scrap of
the asset and t is the tax rate to which incomes of the business are subjected.
For example: if 50m was expected on the selling of the scrap of an asset, and the business was
subjected to 30% tax rate, then the net salvage value would be; 50 (1-0.3) = 35m. The 35m is an
additional cash flow that must be reflected in the terminal cash flow of the asset which would
represent the cash flow of the fourth year as seen above.

Page 4 of 4
Prepared By Ddamba AbdulKarim ©2018
Department of Applied Computing & Information Technology
Faculty of Computing and Informatics
Makerere University Business School