Estimation of

project cash flows

Dr. Satish Kumar
 Cash flow vs profit
• Accrual concept

• Other non-cash charges – accounting rules

• Time value of money

 Basic elements
• Initial investment (cash outflow)

• Operating cash inflows

• Terminal cash inflows

 Time horizon for analysis
• Physical life of the plant

• Technological life of the plant

• Product market life of the plant

• Investment planning horizon of the firm

 Basic principles
• Separation principle

• Incremental principle

• Post-tax principle

• Consistency principle
 Separation principle
Project

Financing side Investment side

Cost of capital = 15% Rate of return = 20%

Time Cash flow Time Cash flow

+1000 0 – 1000
0
1 –1150 1 +1200
 Incremental principle
• The cash flows of a project must be measured in incremental terms.
That is, cash flows of the firm with the project minus the cash flows
of the firm without the project.

• Always ignore sunk costs

• Include the opportunity cost

• Estimate working capital properly

 Post-tax principle
• Cash flows must be considered purely on post-
tax basis.

• Non-cash charges can have an impact on cash

flows if they affect tax liability.
 Consistency principle
The cash flows may be estimated from the point of view of all investors
(shareholders and lenders) or from the point of view of just equity
shareholders.

Cash flows to all investors = PBIT (1 – tax rate)

+ Depreciation and other non-cash charges
– Capital expenditure

– Change in net working capital

The discount rate used for cash flow to all investors must be the weighted
average cost of capital while it must be the cost of equity for cash flow to
just equity shareholders
LPT Ltd is a highly profitable firm specializing in manufacturing home appliances.
Currently, the company is analyzing a proposal to set up a plant to manufacture
water heaters. The project would involve a plant costing INR 450 lakh, installation
cost of INR 50 lakh and working capital of INR 200 lakh. The annual capacity of
the plant is to manufacture 40,000 water heaters. The selling price per water heaters
would be INR 6,000. The variable cost to sales ratio is 70%. The fixed cost per
annum would be INR 200 lakh (excluding depreciation). The company would have
to incur promotion expenditure of INR 40 lakh in the first year. The depreciation
rate is assumed to be 25% based on written down value. Working capital
requirement is estimated to be 30% of sales. The company expects that the plant’s
capacity utilization over its economic life of 5 years would be as:

Year 1 2 3 4 5
Capacity Utilization (%) 65 75 80 90 100

The residual value of the plant is net of the accumulated depreciation. Assuming a
target rate of return of 12% and corporate tax rate of 40%., provide your
recommendation to the company whether to accept or reject the proposal.
 in lakhs
Year 0 1 2 3 4 5
Initial Outlay
Investment 500
NWC 200
700
Operating Cash flows
Capacity 65% 75% 80% 90% 100%
Units 26000 30000 32000 36000 40000
Sales U*P 1560 1800 1920 2160 2400
VC 70% 1092 1260 1344 1512 1680
FC 200 200 200 200 200 200
Promotion 40 40
EBDIT 228 340 376 448 520
BV of Plant 500 375.00 281.25 210.94 158.20 118.65
Dep 25% 125.00 93.75 70.31 52.73 39.55
EBIT 103.00 246.25 305.69 395.27 480.45
Tax 40% 41.20 98.50 122.28 158.11 192.18
PAT 61.80 147.75 183.41 237.16 288.27
Add Dep 125.00 93.75 70.31 52.73 39.55
PAT + Dep 186.80 241.50 253.73 289.89 327.82
Working Cap 30% 468 540 576 648 720
Change in NWC 268 72 36 72 72
OCFs -81.20 169.50 217.73 217.89 255.82
Terminal Cash flow
Salvage Value 118.65
Release NWC 720
TCF 838.65
Net Cash Flows -700 -81.20 169.50 217.73 217.89 1094.47
PVIF 12% 0.89 0.80 0.71 0.64 0.57
PV of CIF -72.50 135.12 154.97 138.48 621.03
Total CIF 977.11
NPV 277.11
Sunrise Engineering Company is considering replacement of its existing
fabrication machine by a new machine, which is expected to cost Rs
160000. The existing machine has a book value of Rs 40000 and can be
sold for Rs 20000 now. It is utilizable for the next five years and if sold
after five years, the salvage value of the existing machine can be
expected to be Rs 10000. The new machine will have a life of five
years. The estimated salvage value of the new machine is Rs 40000. It is
expected to save costs and improve the quality of the product that would
help to increase the sales. The savings in annual costs will be Rs. 20000
and revenue from operations will increase by Rs. 30000 each year. The
company pays tax at 30% and writes off depreciation at 25% on the
written-down value (WDV) of the asset. The cost of capital for the
company is 15%. Should the company replace the existing machine?
 Years
Particulars 0 1 2 3 4 5
I Initial Cash Flows
1 Investment in new Machine 160000
2 Salvage value of the old machine 20000
3 Book Value of the old machine 40000
4 Capital Loss 20000
5 Tax benefit on capital loss 6000
6 Net investment in new machine 134000
II Operating Cash Flows
7 Savings in annual costs 20000 20000 20000 20000 20000
8 Increase in annual revenue 30000 30000 30000 30000 30000
9 Total incremental income 50000 50000 50000 50000 50000
10 Book Value of the new machine 160000 120000 90000 67500 50625 37969
11 Depreciation of new machinery 40000 30000 22500 16875 12656
12 Book Value of the old machine 40000 30000 22500 16875 12656 9492
13 Depreciation of old machinery 10000 7500 5625 4219 3164
14 Incremental depreciation 30000 22500 16875 12656 9492
15 Profit before tax 20000 27500 33125 37344 40508
16 Tax 6000 8250 9938 11203 12152
17 NOPAT 14000 19250 23188 26141 28355
18 Operating Cash Flows (17+14) 44000 41750 40063 38797 37848
19 Discounted operating cash flows 38261 31569 26342 22182 18817
III Terminal cash flows
20 Salvage value of the new machine 40000
21 Book Value of the new machine 37969
22 Tax on capital gain (609)
23 Net proceed from sale of new M (20+22) 39391

24 Salvage value of the old machine 10000

25 Book Value of the old machine 9492
26 Tax on capital gain (152)
27 Net proceed from sale of old M (24+26) 9848

28 Net salvage value 29543

29 Discounted Net salvage value 14688
30 Total Present value of Inflows 151859
31 Present value of net outflows 134000
32 NPV 17859
Practice question

HGL Ltd is a highly profitable firm specializing in manufacturing home appliances.

Currently, the company is analyzing a proposal to set up a plant to manufacture washing
machines. The project would involve a plant costing INR 1100 lakh, installation cost of INR
100 lakh and working capital of INR 400 lakh. The annual capacity of the plant is to
manufacture 30,000 washing machines. The selling price per washing machines would be
INR 15,000. The variable cost to sales ratio is 65%. The fixed cost per annum would be INR
300 lakh (excluding depreciation). The company would have to incur promotion expenditure
of INR 70 lakh in the first year. The depreciation rate is assumed to be 25% based on written
down value. Working capital requirement is estimated to be 25% of sales. The company
expects that the plant’s capacity utilization over its economic life of 5 years would be as:

Year 1 2 3 4 5
Capacity Utilization (%) 50 60 70 80 100

The residual value of the plant is net of the accumulated depreciation. Assuming a target rate
of return of 12% and corporate tax rate of 40%., provide your recommendation to the
company whether to accept or reject the proposal.

NPV = 641.61