Chapter 4

Cash flows of a project

Learning objectives
- Understand different assumptions on cash flows
- Understand different viewpoints about cash flows
- Apply different approaches to calculate cash flows

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 Chapter 4
Cash flows of a project

 Assumptions
 Different point of views
 Some approaches
 Net cash flows from different point of views
 Some principles

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 1 Assumptions

Timing of the cash flows (beginning or

ending of a year)
Disposal of fixed assets and recovering the
current assets at the end of a project.
Reinvestment of cash flows.

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 1 Assumptions
Timing of the cash flows (beginning or ending
of a year)
In reality, the cash flows happen everyday.
For example: BOT for a road. You will collect the
fee everyday so you will have the cash inflow
everyday (not only 1st of Jan or 31st of Dec)
The reasons why you need the assumptions:
- It may be impossible and inaccurate to predict the cash
flows each day or each month.
- It may be impossible to discount the cash flows each
day or each month to the present value terms. 4
 1 Assumptions
Disposal of fixed assets and recovering the
current assets at the end of a project.
Every value of a project is considered in terms of
cash flows. That’s why you need to assume that
everything which belongs to the project must be
converted into cash (Disposal of fixed assets and
current assets at the end of the project).

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 1 Assumptions
 Reinvestment of cash flows.
- If you only put the money you get under you bed then it
would not give you any interest and your money will loose
its value due to inflation.
- Therefore, you will not need to discount the cash flows
because it would not really follow the time value of money.
- You have to assume that you reinvest your cash flows at the
discount rate then you can discount your cash flows to the
present value term.
2010 2016

100 mil dong +100 mil dong

100*(1+6%)6
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 2 Different point of views

- Equity point of views (EPV)

(Quan điểm vốn chủ sở hữu)

- Total investment point of views (TIP)

(Quan điểm tổng vốn đầu tư)

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 Equity point of views

Stand on the owner’s viewpoint to consider

costs and benefits in terms of cash outflows
and cash inflows of a project.

The loan received is considered as the cash

inflows to the owner. The interest payment and
principal payment are cash outflows.

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 Total investment point of views

 Stand on the investors’ viewpoint (both owners and

lenders) to consider costs and benefits (cash inflows
and cash outflows) of a project.

 The loan received is the cash inflow to the owner but it

is the cash outflow to the lender. Therefore, they cancel
out each other. The interest payment and principal
payment are cash outflows of the owners but they are
cash inflows of the lenders. Therefore, they also cancel
out each other.

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 3 Approaches to cash flows

Top-down approach

Bottom-up approach

Tax-shield approach
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 3.1 Top-down approach

 Top down
 NCF = CIF – COF
 (NCF: Net cash flows)
 (CIF: Cash Inflow)
 (COF: Cash Outflow)
 We temporarily ignore the changes in net working
capital, cash flows from borrowing and investment, cash
flows from disposal of fixed assets. The NCF in its
simple form can be calculated from the income
statement as follows:
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 3.1 Top-down approach

CIF 1. Revenue
COF 2. Costs (Excluding depreciation and interests)
Earnings before taxes, depreciation and interests
COF 3. Depreciation
EBIT (Earnings before interests and taxes)
COF_ EPV 4. Interests
EBT (Earnings before taxes)
COF 5. Taxes
Net income
NCF EPV=Revenue-Costs (excluding depreciation)-Taxes-Principal payments
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 Revenue versus Cash inflows (CIF)
ITEMS REVENUE CASH INFLOWS
1. RECEIVABLES (Excluding VAT) YES NO
2. CIF FROM BORROWING NO YES
3. CIF FROM ISSUING SHARES NO YES
4. OUTPUT VAT COLLECTED NO YES

Expenses versus Cash outflows (COF)

ITEMS EXPENSES CASH
OUTFLOWS
1. DEPRECIATION YES NO
2. COF FROM BUYING FIXED ASSETS NO YES
3. COF TO PAY PRINCIPALS NO YES
3. INPUT VAT PAID NO YES

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 VAT-deduction method

P=50 P=70 P=100 Final

Cotton Fibre Cloths
Consumer

Firm1 Firm2 Firm3

VA 50 70-50=20 100-70=30

VAT 5 7-5=2 10 -7 = 3 Total: 10

payable

The total amount of VAT collected by the government

P: VAT exclusive price (Giá chưa bao gồm VAT)
VAT rate: 10%
Example: 70 is the VAT exclusive price; 77 is the VAT inclusive price.
VAT inclusive price = Price including VAT: Giá bao gồm VAT
Tài chính doanh nghiệp 3-14
VAT exclusive price = Price excluding VAT: Giá chưa bao gồm VAT
 3.2 Bottom-up approach

CIF 1. Revenue

COF 2. Costs (Excluding depreciation and interests)

Earnings before taxes, depreciation and interests
COF 3. Depreciation
EBIT
COF theo EPV 4. Interests
EBT
COF 5. Taxes
Net income

NCF EPV = Net income + Depreciation – Principal payment

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 3.3 Tax-shield approach

NCF EPV = ( Revenue–Costs excluding Depreciation) (1-Tax rate)+

Depreciation * Tax rate-Principal payments

Tax savings from depreciation

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 4. Cash flows from different viewpoints

4.1 EPV:

 NCF EPV
= Net income + Depreciation – Principal payment

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 4. Cash flows from different viewpoints

 4.2 TIP:
 NCF EPV
= NI + Dep – Principal payment
 NCF LENDER
= Interests (1-T) + Principal payment
 NCF TIP
= NI + Depreciation + Interests (1-T)

Note: We assume that the lenders are banks and other institutions
who have to pay income tax:
NCFLENDER = Interests- Interests*T+Principal payments
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 4. Cash flows from different viewpoints

 4.3 TIP’ (At some banks in Vietnam):

 NCF EPV
= NI + Dep – Principal payment
 NCF LENDER
= Interests + Principal payment
 NCF TIP
= NI + Depreciation + Interests
Note: We assume that lenders do not have to pay income
tax on the interests they receive.

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 4. Cash flows from different viewpoints

What is tax savings from interests?

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 Tax savings from interests

When a corporation borrows money, the interest is an

accounting cost. Therefore, the taxable income
decreases as much as the interest cost. The corporate
income tax also decreases. The decrease in corporate
income tax is as follow:

Interests x Corporate income tax rate

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 Tax savings from interests

Example:
A project with total investment of $ 400 mil has expected
EBIT of $ 50 mil. From two different financing schemes,
please calculate the tax savings from interests from the
difference between profits for common shareholders. Corporate
income tax rate is 20%.
Scheme 1: $ 300 mil from common shares, $ 100 mil from
preferred shares with 10% dividend.
Scheme 2: $ 300 mil from common shares, $ 100 mil from
borrowing with 10% interest rate.
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 Tax savings from interests

 Scheme 1:  Scheme 2:
 1.EBIT: 50 (mil USD)  1.EBIT: 50 (mil USD)
 2. Interests: 0  2. Interests: 10
 Income before tax: 50  Income before tax : 40
 3. Tax: 10  3. Tax: 8
 Net income: 40  Net income: 32
 4. For preferred shares: 10  4. For preferred shares : 0
 5. For common shares: 30  5. For common shares : 32

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 Tax savings from interests

 Tax savings from interests = 32- 30 = 2 (tr USD)

 = 10 x 20%

Interests Corporate income tax rate

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 5. Relevant cash flows

 The cash outflows or inflows which occur as a result of a

decision to invest in a project.
 The cost which arise as a consequence of the investment
decision under evaluation.
 The annual profits from a project can be calculated as the
incremental contribution earned minus any incremental
fixed costs.

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 5. Relevant cash flows
For example:
- You dropped VND 500,000 from home to the university and
cannot get it back.
- Then you receive a call saying you will receive VND 300,000 if
you support an event.
- If you go to the event, you have to take a cab which costs a total
of VND 100,000.
- If you go to the event, you have to forgo the personal tutor in
math for a high school student for which you can get 200,000
dongs.
What should you consider when you decide whether to go to
the event?
NPV = -500,000 + 300,000 -100,00 -200,000 ???
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 Relevant cash flows
In capital investment appraisal, the ‘Relevant cash flows’
are:
o Future
o Incremental
o Cash-based

Ignore:
 Sunk costs – the cost already incurred and cannot be
recovered
 Non-cash items – e.g. depreciation
 Committed costs – the cost will incur anyway no matter
the project runs or not 27

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 Relevant cash flows
Other costs should be considered

Opportunity cost:
 that can be lost if a specific investment project is undertaken.
The extra tax cost:
 that should be paid on the extra profit.
Residual value:
 at the end of the project life.
Working capital cost:
 during the life of the project.
Other relevant cost:
 (i.e. infrastructure cost, marketing cost and human resource
costs). 28 28
 Relevant cash flows

Relevant benefits of investment

 Savings because assets used currently must also be evaluated.
Extra savings or revenue benefits because of improvement caused.
Revenue benefits from sale of assets.
Intangible benefits i.e.
 customer satisfaction,
 improved staff morale and
 better decision making.

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 Relevant cash flows
Elsie is considering the manufacture of a new product which would involve the use of both
a new machine (costing $150,000) and an existing machine, which cost $80,000 two years
ago and has a current net book value of $60,000. There is sufficient capacity on this
machine, which has so far been under-utilised. Annual sales of the product would be 5,000
unit, selling at $32 per unit. Unit costs would be as follows.
$
Direct labour (4 hours at $2 per hour) 8
Direct materials 7
Fixed costs including depreciation 9
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The project would have a five-year life, after which the new machine would have a net
residual value of $10,000. Because direct labour is continually in short supply, labour
resources would have to be diverted from other work which currently earns a contribution of
$1.50 per direct labour hour. The fixed overhead absorption rate would be $2.25 per hour
($9 per unit) but actual expenditure on fixed overhead would not alter.
Working capital requirements would be $10,000 in the first year, rising to $15,000 in the
second year and remaining at this level until the end of the project, when it will all be
recovered. The company’s cost of capital is 20%. Ignore taxation.
You are required to identify the relevant cash flows for the decision as to whether or not
the project is worthwhile.
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Relevant cash flows

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Relevant cash flows

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 Relevant cash flows
Example:
Company A is considering implementing an investment project
on its existing land.
- The land was purchased 3 years ago for VND 10 billion.
-The current market value of this land is VND 11 billion
-- To protect the land, the company built a surrounding fence at

a cost of VND 100 million

- If the project is accepted, the company will have to demolish
the fence. The cost of demolition is VND 45 million. The
remaining from the fence is expected to be sold at 30 million
dong.
What are the relevant cash flows of the project.
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 Example on the incremental cash flows
 Replacement project
Company X is considering replacing an old inventory management
system with an automated system worth $ 200,000. This system will be
fully depreciated over 4 years, expected liquidation at the end of year 4 is $
1000. If this system is installed, X will save $ 60,000 (before tax) on
inventory management costs each year. Corporate income tax is 20%.
Because of this automated inventory management system, $ 45,000
investment in working capital would be reduced. Should X replace the
system? Note that the old system has a carrying amount of $ 80,000. The
market price is $ 85,000. When buying new system, X will sell old
equipment. If the system continues to be used, the system will be
depreciated evenly and fully in the remaining 4 years. The liquidation price
of the old system is estimated to be $500 at the end of year 4. The
company's discount rate is 15%.
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 Example on the incremental cash flows
Year 0 1 2 3 4
Investment - 200,000
Changes in NWC -45,000 +45000
Liquidation of the old 85,000-5000*20%
system in the beginning
CF each year CF CF CF CF
Liquidation of the new 1000*(1-20%)
system
Liquidation of the old -500*(1-20%)
system at the end
NCF -71,000 54,000 54,000 54,000 9400

Depreciation of the new system: 200,000/4 = 50,000.

Depreciation of the old system: 80,000/4 = 20,000.
Difference in depreciation: 50,000 – 20,000 = 30,000
CF = 60,000(1-20%)+30,000*20%=54,000
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ANOTHER APPROACH TO SOLVE THE PROBLEM
Year 0 1 2 3 4
Revenue 0 0 0 0
Decrease in Inv.Man cost -60,000 -60,000 -60,000 -60,000
Increase in depreciation 30,000 30,000 30,000 30,000
Operating profit before tax 30,000 30,000 30,000 30,000
Profit from disposal of the old system 5000
Profit from disposal of the old system -500
which is lost.
Profit from disposal of the new system 1000
Total profit before tax 5000 30,000 30,000 30,000 30,500
Corporate income tax 1000 6000 6000 6000 6100
Net income 4000 24,000 24,000 24,000 24,400
Investment in fixed assets 200,000
Carrying amount of the fixed assets 80,000 0
Changes in NWC -45,000 +45,000
Net cash flows -71,000 54,000 54,000 54,000 9400

NCF=Net income + Depreciation –Investment in fixed assets+Residual value36-

Changes in NWC.
 Relevant cash flows

5.3 Stand-alone principle

A project can be considered an independent company
with its revenue, assets, and cash flows. It can be considered
independent from other activities of a company.

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 5.4 Add opportunity costs

Example:
A paper producing company is planning to replace an old
pulp mill that had been bought many years ago for $ 100,000
with an automatic pulp mill, filtration, and drying line. The
opportunity cost of using a new machine is the liquidation
price of the old one. Would it be included in the cash flow of
the replacement project?

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 5.5 Eliminate sunk costs
Vinamilk Dairy Company hires a financial expert to
evaluate whether to invest in a chocolate milk production
line. When this expert submitted the appraisal report to
the company, the company protested because the expert
did not include the consulting cost (quite large) in the
cost of this project. So who is right?

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 5.6 Net working capital

 What is NWC?
 Recovering NWC at the end of a project?

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 5.6 Net working capital

 NWC = Current assets – Current liabilities

 Changes in NWC = NWCt-NWCt-1

= Changes in current assets – Changes in current liabilities

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 5.7 NCF from disposal of fixed assets

 The remaining fixed assets in the final year of the project

must be assumed to be liquidated or disposed.
 NCF from selling fixed assets =
 = Net selling price - CIT on sales of fixed assets
= Profit after tax from the sale of fixed assets + Carrying
amount of the assets
Note that: Profit from disposal of fixed assets =
= Net selling price – Carrying amount at the time of the disposal.

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 5.7 NCF from liquidation of fixed assets

 Example: A fixed asset has historical cost of 100 million dong,

expected useful life of 5 years, and is invested and used from year 0
in a project with a period of 4 years. The fixed asset is depreciated
evenly to zero over 5 years. Corporate Income Tax rate is 20%.
Determine NCF from the disposal of fixed assets if the expected net
selling price of such fixed asset in the final year of the project is:
 Case 1: 30 million
 Case 2: 20 million
 Case 3: 10 million

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 Methods of depreciation

 Straight line method

 Reducing balance method with adjustment
Sum-of-the-Years Digits
MACRS (Modified Accelerate Cost
Recovery System)

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 MARCs

Year 3 years 5 years 7 years

1 33.33% 20.00% 14.29%
2 44.44% 32.00% 24.49%
3 14.82% 19.20% 17.49%
4 7.41% 11.52% 12.49%
5 11.52% 8.93%
6 5.76% 8.93%
7 8.93%
8 4.45%

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 Reducing balance method
(Decision 206-BTC)
 First:
 + Depreciation rate each year:

1
Tk  * The adjustment coefficient
T
+ Depreciation of the year i:
 Mi = Tk * Residual value at the beginning of i

Adjustment coefficient
 T<=4 1,5
 4<T<=6 2
 T>6 2,5 46
 Reducing balance method
(Decision 206-BTC)

In the year i*, when:

Residual valuei*
Tk * Residual Value i* 
T  i * 1
Then the depreciation each year from the year
i* is as follow:
Residual value i*/(T - i* + 1)
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 Sum-of-the-Years Digits

+ Depreciation rate of the year i:

2 * (T  i  1)
Tk i 
T * (T  1)
+ Depreciation of the year i:
Mi = Tki * History cost

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 Sum-of-the-Years Digits
 Example: A fixed assets has the history cost of VND
30 million and expected useful life of 5 years will be
depreciated by sum-of-the-year Digits method.

Year Tki Mi
1 0.333 10
2 0.267 8
3 0.2 6
4 0.133 4
5 0.067 2 49
 Reducing balance method
(Decision 206-BTC)
 Example: A fixed assets has the history cost of VND 100
million and expected useful life of 5 years will be
depreciated by reducing balance method.
Year Tki RVi Mi
1 40% 100 40
2 40% 60 24
3 40% 36 14.4
4 Not applied 21.6 10.8
5 Not applied 10.8 10.8 50
 6. Summary
- There are different views on the project's cash flow.
Two noteworthy views are the equity point of view
(EPV) and the Total investment point of views (TIPV).
- When calculating the cash flow of a project, some
assumptions are required.
- There are three methods of determining the project's
cash flow: top-down method, bottom-up method and
tax saving method.
- When determining the project cash flow, it is necessary
to comply with a number of principles.

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