Project Cash flows

Project Cash flow

What is Cash flow : It an accounting term that refers to the amounts of cash being
received and spent by a business during a defined period of time ,tide to a specific
project/s.

Cash flow projection : The project of income and expense during the life of a project
can be developed from several time-scheduling aids used by the contractor
 Elements of the Cash flow stream
Cash Inflow Cash outflow

v Cash Sales v Wages and Salaries

v Payment from v Payment of
Trade suppliers
v Investment from v Buying of
Share Capital equipment
v Govt Grants v Payment of Rents
v Sales of spare assets v Payment of Taxes
 Elements of the Cash flow stream
Initial investment : After tax cash outlay on capital expenditure and net working capital
when the project set up

Operating cash inflows : After tax cash inflows resulting from the operations of the project
during it’s economic life

Terminal Cash inflow : After tax cash flow resulting from the liquidation of the project at
the end of it’s economic life

Time horizon for cash flow : minimum of Physical life, Technological life , Product life of
a project & Investment planning horizon
Financial Analysis & Project Financing
 Project Evaluation methods

• Discounting Criterion
• Net Present Value (NPV)
• Benefit Cost Ratio
• Internal Rate of return (IRR)
• Non-Discounting Criterion
• Payback period
• Accounting Rate of Return
Project Evaluation methods -
NPV
Project Evaluation methods -
NPV
Project Evaluation methods -
NPV
Project Evaluation methods -
NPV
 Project Evaluation methods – NPV with
Time varying discount rate
$ Year Cash flow Discount
𝑪𝑭! Rate
NPV =! ! − 𝑖𝑛𝑖𝑡𝑖𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
!"# #'(! 0 -40000 --
1 10000 14%
CFt = cash flow at the end of year t 2 12000 15%
kt = discount rate for a given year t 3 15000 16%
4 10000 18%
5 7000 20%
 Project Evaluation methods – NPV with
Time varying discount rate
Year Cash flow Discount Rate Present Value (PV) of CFt
(t) (CFt) (kt)
NPV = 8771.9 +
0 -40000 -- --
9153.3+9863.4+5572.5
1 10000 14% 10000/1.14 = 8771.9 +3250.6 - 40000
2 12000 15% 12000/(1.14 x 1.15) = 9153.3 = -3388.3
3 15000 16% 15000/(1.14 x 1.15 x 1.16) = 9863.4 Since NPV is negative
4 10000 18% 10000 /(1.14 x 1.15 x 1.16 x 1.18) = 5572.5 project is rejected
5 7000 20% 7000 /(1.14 x 1.15 x 1.16 x 1.18 x 1.2) = 3250.6

Class discussion : In which situations NPV will be positive ? What it means in terms of business ?
 Project Evaluation methods – Benefit
Cost ratio (profitability Index)
"#$ Year Cash flow Cost of Present value
BCR =
%
𝑤ℎ𝑒𝑟𝑒 capital
BCR = Benefit Cost ratio 0 -40000 --
PVB = present value of benefits
1 10000 10000/1.13 = 8849.55
I = initial investment
NBCR = Net Benefit cost ratio 2 12000 12000 / (1.132 ) = 9397.7

If 3 15000 13% 15000 /(1.13 3) = 10395.7

BCR > 1 or NBCR > 0 then ACCEPT 4 10000 10000/ ( 1.134 ) = 6133.18
BCR = 1 or NBCR = 0 then INDIFFERENT
5 7000 7000 / ( 1.135 ) = 3799.32
BCR < 1 or NBCR < 0 then REJECT
BCR = 38575.58/ 40000 = 0.964
Total = 38575.58
NBCR = BCR -1 = 0.964 – 1 = -0.036
REJECT the project
 Project Evaluation methods – Internal
rate of return (IRR)
IRR of a project is the discount rate at which the NPV value will be zero
NPV
)
𝑪𝑭!
=% ! − 𝑖𝑛𝑖𝑡𝑖𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
&'( (,-! Accept the project If
IRR is greater than cost of capital
CFt = cash flow at the end of year t Else reject
kt = discount rate for a given year t
IRR is that value of kt which will make NPV = 0
 Project Evaluation methods – Internal
rate of return (IRR)
@ 13% @ 12% @ 11.4%
CF k PV CF k PV CF k PV
40000 40000 40000 40000 40000 40000
10000 1.13 1.13 8849.558 10000 1.12 1.12 8928.571 10000 1.114 1.114 8976.661
12000 1.13 1.2769 9397.76 12000 1.12 1.2544 9566.327 12000 1.114 1.240996 9669.652
15000 1.13 1.442897 10395.75 15000 1.12 1.404928 10676.7 15000 1.114 1.38247 10850.15
10000 1.13 1.630474 6133.187 10000 1.12 1.573519 6355.181 10000 1.114 1.540071 6493.207
7000 1.13 1.842435 3799.32 7000 1.12 1.762342 3971.988 7000 1.114 1.715639 4080.112
TOTAL 38575.58 TOTAL 39498.77 TOTAL 40069.78
NPV -1424.42 NPV -501.23 NPV 69.78057
NPV @ 12% = (501.23)
NPV@ 11.4 = 69.78
Sum of absolute values = 501.23+69.78 = 571.01
Ratio of NPV of smallest discount rate to sum = 69.78/571.01 = 0.122
Add this ratio to smallest discount rate = 11.4 + 0.122 = 11.522
 Project Evaluation methods – Internal
rate of return (IRR)
Challenges with IRR : non Conventional cash flows
• In this case we will get quadratic question in the form of
ak2 + bk+ c which will have 2 roots or answer for k
Year Cash flow

0 -40000 !"""" #))))

0 = -40000 + -
!#$ #'( "
1 10000

2 -10000
• If both the roots are positive then we will get 2 IRRs and both will be
valid & it will not be possible which IRR value is correct value
 Project Evaluation methods –
Payback period
Payback period is length of time required to recover initial cash outlay on the project
Year Cash flow Cumulative
(t) (CFt) Cash flow
0 -40000 --
Payback period is simple for application but does not consider
1 10000 10000 time value of money
2 12000 22000

3 15000 37000

4 10000 47000 Payback period ~ 4 years

5 7000
 Project Evaluation methods –
Accounting rate of return
ARR or Average Rate of Return is a measure of profitability which relates to income to investment ,
both measure in accounting terms
Various ways to measure ARR
• Avg Income after tax/ Initial Investment
• Avg income after tax / Avg Investment
• Avg income after tax but before interest / Initial investment
• Avg income before interest and taxes/ Initial investment
 Basic principles of Cash flow estimation
Following are the some basic principles to be followed for cash flow estimation

v Separation Principle
v Incremental Principle
v Post-Tax Principle
v Consistency Principle
 Basic principles of Cash flow estimation
Separation Principle

There are two sides of a project Project

from cash flow perspective
v The investment side
v The Finance Side Financing Investment
v Cash flows associated with these Side Side
sides should be separated
 Basic principles of Cash flow estimation
Separation Principle
v Consider following project : Project
v Duration : 1 year
v Investment : $ 100000 Financing Investment
Side Side
thro Debt financing @
15% interest rate Time Cash Flow Time Cash Flow
v Cash flow expected to 0 +100000 0 -100000
be generated at the end 1 -115000 1 +120000
of 1 year : $120000 Cost of Capital 15% Rate of return 20%