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Chapter 2: Project Cash Flows

The definition, identification, and measurement of cash flows relevant

to project evaluation.

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Study objectivesAfter studying this chapter the reader should be able to:

• Identify a project’s incremental cash flows.• Calculate initial investment outlay, operating cash

flows, and terminal cash flows for asset expansion and asset replacement projects.

• Determine the effects of depreciation on after-tax cash flows.

• Separate the investment decision from the financing decision and distinguish between project flows and financing flows.

• Calculate after-tax cash flows to be used in project valuation.

• Gain an insight into the differences between accounting income and cash flows

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What To Discount

Only Cash Flow is Relevant

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Types of cash flows

• Capital cash flows1. The initial investment .

2. Additional ‘middle-way’ investments such as upgrades and increases in working capital investments,

3. Terminal flows.

• Operating cash flows

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Why Cash Flows?

Cash flows, and not accounting estimates, are used in project analysis because:-

1. They measure actual economic wealth.

2. They occur at identifiable time points.

3. They have identifiable directional flow.

4. They are free of accounting definitional problems.

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Essentials in cash flow identification

• Principle of the stand-alone project– View the proposed project as a kind of ‘mini-firm’

including its incidental or synergistic effects.

• Indirect or synergistic effects– The rationale for the incorporation of these indirect

effects has its base in the opportunity cost principle

– Example page 15

• Opportunity cost principle– The opportunity cost is the value of the most valuable

alternative that is given up if the proposed investment project is undertaken. Example 2.1 & Example 2.2 P.16

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Essentials in cash flow identification

• Sunk costs– A sunk cost is an amount spent in the past in relation to

the project, but which cannot now be recovered or offset by the current decision.

– They should not be included in the cash flows.– Lockheed Example P.17– Chemtron Corporation P.17

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Essentials in cash flow identification

• Overhead costs– In the project evaluation, the issue is the identification

of incremental overhead costs not allocate them to the production units.

– Only the incremental cash flows resulting from changes in overhead expenses should be included in evaluating a project proposal.

– If the expenses are already being incurred, a proportion should not be allocated to the new project.

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Essentials in cash flow identification

• Treatment of working capital– Increases in working capital requirements are

considered cash outflows even though they do not leave the firm.

– When the project terminates, any working capital recovered is treated as a cash inflow

– The flows of working capital must be treated as capital flows and not operational flows.

• Treatment of depreciation– In project evaluation, what is relevant is not the

accounting depreciation but the tax allowable depreciation.

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Essentials in cash flow identification

• Tax payable– Tax payable is a cash outflow.– Corporate tax is calculated as a percentage of taxable

income. – The rate of corporate tax is usually a fixed rate for every

dollar of taxable income.

• After-tax cash flows– If the project generates tax liabilities, then the tax

payable is relevant to the project, and must be accounted for as a cash outflow

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Essentials in cash flow identification

• Investment allowance– …

• Financing flows– Interest charges or any other financing costs such as

dividends or loan repayments are not deducted in arriving at cash flows, because we are interested in the cash flow generated by the assets of the project

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Essentials in cash flow identification

• Within-year timing of cash flows– The standard practice in capital budgeting is to

assume that capital expenditures occur at the beginning of the year and all other cash flows occur at the end of the year.

– Flows which would normally occur at the start of any year will be timed as occurring at the end of the immediately preceding year

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Essentials in cash flow identification

• Inflation and consistent treatment of cash flows and discount rates– To deal with inflation appropriately, the project

analysis must recognize expected inflation in the forecast of future cash flows and use a discount rate that reflects investors’ expectations of future inflation.

– Consistency in the discounted cash flow analysis requires that if a project’s cash flows are in nominal terms, they should be discounted by nominal discount rates, and if a project’s cash flows are in real terms they must be discounted by real discount rates. Real and nominal quantities should not be mixed.

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What To Discount

Estimate Cash Flows on an Incremental BasisDo not confuse average with incremental payoffsInclude all incidental effectsDo not forget working capital requirementsInclude opportunity costs Forget sunk costsBeware of allocated overhead costsTreat inflation consistently

Points to “Watch Out For”

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The Meaning of RELEVANT Cash Flows.

A relevant cash flow is one which will change as a direct result of the decision about a project.

A relevant cash flow is one which will occur in the future. A cash flow incurred in the past is irrelevant. It is sunk.

A relevant cash flow is the difference in the firm’s cash flows with the project, and without the project.

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Cash Flows: A Rose By Any Other Name Is Just as Sweet.

• Relevant cash flows are also known as:-Marginal cash flows.

Incremental cash flows.

Changing cash flows.

Project cash flows.

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Project Cash Flows: Yes and No.

• YES:- these are relevant cash flows -

Incremental future sales revenue. Incremental future production costs. Incremental initial outlay.

Incremental future salvage value.

Incremental working capital outlay.

Incremental future taxes.

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Project Cash Flows: Yes and No.

• NO:- these are not relevant cash flows -

Changed future depreciation.

Reallocated overhead costs.

Adjusted future accounting profit.

The cost of unused idle capacity.

Outlays incurred in the past.

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Cash Flows and Depreciation: Always A Problem.

• Depreciation is NOT a cash flow.Depreciation is simply the accounting amortization of an initial capital cost.Depreciation amounts are only accounting journal entries.

Depreciation is measured in project analysis only because it reduces taxes.

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Other Cash Flow Issues.

• Tax payable: if the project changes tax liabilities, those changed taxes are a flow of the project.

Investment allowance: if a taxing authority offers this ‘extra depreciation’ concession, then its tax savings are included.

Financing flows: interest paid on debt, and dividends paid on equity, are NOT cash flows of the project.

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Other Cash Flow Issues.

• In property investment, ‘property’ cash flows may be distinguished from ‘equity’ cash flows.

In project analysis, cash inflows are timed as at the end of a year, and capital outlays are timed as at the start of a year.

Forecast inflated cash flows must be discounted at the nominal discount rate, not the real discount rate.

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Using Cash Flows All relevant project cash flows are set out in a table.

The cash flow table usually reads across in End Of Years, starting at EOY 0 (now) and ending at the project’s last year.The cash flow table usually reads down in cash flow elements, resulting in a Net Annual Cash Flow. This flow will have a positive or negative sign.

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Project Cash Flows: Summary

• Only future, incremental, cash flows are Relevant.

Relevant Cash Flows are entered into a yearly cash flow table.

Net Annual Cash Flows are discounted to give the project’s Net Present Value.

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Example 2.3. The Delta Project

• This example illustrates the calculation of after-tax cash flows for an asset expansion project.

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Example 2.3. The Delta Project

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