10. Analysis of Project Cash Flows

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Financial Management I

10. Analysis of Project Cash Flows

Dr. Suresh

[email protected]

Phone: 40434399, 25783850


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Course Content - Syllabus

*Book reference

Sr Title ICMR Ch. PC Ch. IMP Ch.

1 Introduction to Financial Management 1* 1 12 Overview of Financial Markets 2* 2 -3 Sources of Long-Term Finance 10* 17 20, 214 Raising Long-term Finance - 18* 20, 21, 235 Introduction to Risk and Return 4* 8, 9 4, 56 Time Value of Money 3* 6 27 Valuation of Securities 5* 7 38 Cost of Capital 11* 14 99 Basics of Capital ExpenditureDecisions 18* 11 8

10 Analysis of Project Cash Flows - 12* 10, 11

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Analysis of Project Cash Flows

Reference Books

1. Financial Management, Prasanna Chandra, 7th Edition,

Chapter 12

2. Financial Management, I. M. Pandey, 9th Edition,

Chapter 10, 11


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SyllabusAnalysis of Project Cash Flows

1. Cash Flow Estimation

2. Identifying the Relevant Cash Flows

3. Cash Flow Analysis

4. Replacement, cash Flow Estimation Bias

5. Evaluating Projects with Unequal Life

6. Adjusting Cash Flow for Inflation


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Introduction: Analysis of Project Cash Flows

It is an analysis of invest inflows and cash inflows.

It is most important and most difficult step in capital

budgeting. Important because of project viability

decisions and difficult because of forecasting error. For

example, Alaska pipeline project, initial cost estimatewas about $700 million, however final cost was about $7

billion.

Year 0 1 2 3 4 5 6 7 8

150 10 15 30 50 50 40 30 20Initial Operating Cash Inflows

Investment 50Terminal

Cash Flow


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1. Cash Flow Estimation

Following principles are followed while estimating the cashflows of a project

Separation Principle

Incremental Principle

Post-tax Principle

Consistency Principle


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1. Cash Flow Estimation: Separation Principle

Separation Principle

There are two sides of a project viz. investment side (orasset side) and financing side. Cash flows associated with

these sides should be separated.

For example, a firm is considering a one-year project

that requires an investment of Rs. 1,000 in fixed assets

and working capital at time 0. The project is expected to

generate a cash inflow of Rs. 1200 at the end of year 1.

This is the only cash inflow expected from the project.

Project is financed by debt carrying an interest rate of

15% maturing after 1 year.


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0 + 1,000 0 - 1,000

1 - 1,150 1 + 1,200

Cost of capital: 15% Cost of return: 20%

Note that the cash flows on investment side do not show

cost of financing (interest in our example). Financingcosts are included in the cash flows on the financing side,

which reflects in cost of capital. Cost of capital is used as

a hurdle rate against which rate of return on investment

side is judged.

Project

Investment SideFinancing Side

Cash FlowTime TimeCash Flow


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Important point to be noted that the cash flows oninvestment side should not include financing costs,

because they will be reflected in the cost of capital

against which the rate of return will be evaluated.

Operationally, this means that interest on debt is ignored

while computing profits and taxes thereon. Alternatively,

if interest is deducted in the process of arriving at profitafter tax, an amount equal to interest(1-tax rate)

should be added to profit after tax. Note that


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Profit before interest and tax (1tax rate)= (Profit before tax + interest) (1tax rate)

= (Profit before tax) (1-tax rate)+ interest(1-tax rate)

= Profit after tax + interest(1-tax rate)

Thus, whether the tax rate is applied directly to the

Profit before interest and tax or whether tax-adjusted

interest, which is simply Interest(1-tax rate) is added to

the profit after tax, we get the same result.


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1. Cash Flow Estimation: Incremental Principle

Incremental Principle

Cash flow of a project must be measured in incrementalterms. To find a projects incremental cash flows, you

have to look at what happens to the cash flows of the

firm with the project and without the project. Thedifference between the two reflects the incremental cash

flows attributable to the project. That is

Project cash flow for year t = Cash flow for the firm with

the project for year tCash flow for the firm without

the project for year t


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While estimating the incremental cash flows of a project,following guidelines must be used.

Consider All Incidental Effects: These include some

enhancements and some detract effects on profitability.

All these effects must be taken into account.

Ignore Sunk Costs: A sunk cost refers to an outlay already

incurred in the past or already committed irrevocably.

Include Opportunity Costs: Opportunity cost is the valueof the next best alternative forgone. If a project uses

resources already available with the firm, there is a

potential for an opportunity cost.

C i i i i


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Question the Allocation of Overhead Costs: Costs whichare only indirectly related to a project or service are

referred to as overhead costs. They include general

administrative expenses, managerial salaries, legal

expenses, rent and so on.

Estimate Working Capital Properly: Working capital (or

more precisely, net working capital) is defined as

(current assets, loans and advances)(current liabilitiesand provisions). Outlays on working capital have to be

properly considered while project cash flows. Working

capital changes over time.

1 C h Fl E i i P P i i l


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1. Cash Flow Estimation: Post-tax Principle

Post-tax Principle

Cash flows should be measured on an after tax basis.

Average tax rate is the total tax as a proportion of the

total income of the business. The marginal tax rate is the

tax rate applicable to the income at margin i.e. the next

rupee of income. The marginal tax rate is higher than the

average tax rate because of various tax incentives.

1 C h Fl E i i C i P i i l


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1. Cash Flow Estimation: Consistency Principle

Consistency Principle

Cash flows and the discount rates applied to these cashflows must be consistent with respect to the investor

group and inflation. Investor groups are of equity

shareholders and lenders.In dealing with inflation, you have two choices. You can

use expected inflation in the estimates of future cash

flows and apply a nominal discount rate to the same.

Else, you can estimate the future cash flows in real terms

and apply a real discount rate to the same.

2 Id if i h R l C h Fl


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Projects have following components of cash flows

Initial investment

Annual net cash flows

Terminal cash flows

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Initial investment

This is the net cash outlay in the period in which an asset

is purchased. A major element of the initial investment is

gross outlay or original value (OV) of the asset.



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Annual net cash flows

An investment is expected to generate annual cash flows

from operations after an initial cash outlay has been

made. Cash flows should always be estimated on an

after-tax basis.



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Terminal cash flows

Last or the terminal year of an investment may have

additional cash flows or salvage value.

Salvage value is defined as the market price of an

investment at the time of its sale. The cash proceeds net

of taxes from the sale of the assets will be treated as cash

inflow in the terminal (last) year.

4 R l t C h Fl E ti ti Bi


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4. Replacement, Cash Flow Estimation Bias

Cash flows for new projects or expansion projects is

relatively easy. In such cases, the initial investment,

operating cash inflows and terminal cash flows are the

after-tax cash flows associated with the proposed project.

Estimating the cash flows for a replacement project issomewhat complicated because you have to determine

the incremental cash outflows and inflows in relation to

the existing project.Biases in cash flow estimation

As the cash flows have to be forecasted far into the

future, errors occur in estimation. Biases may lead to

over stating or under stating of true project profitability.

5 E l ti P j t ith U l Lif


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The choice between projects with different lives should be

made by evaluating them for equal periods of time.Example

A firm has to choose between two projects X and Y

which have different lives.

0 1 2 3 4 NPV, 10%

X 120 30 30 30 40 215.1

Y 60 40 40 - - 129.42

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Cash Flows

Correct procedure to compare NPVs of the projects for equal

periods of time.

0 1 2 3 4 NPV, 10%

Y1 60 40 40 0 0 129.42

Y2 0 0 60 40 40 106.96

Y = Y1 + Y2 60 40 100 40 40 236.38

X 120 30 30 30 30 215.10

6 Adj ti C h Fl f I fl ti


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6. Adjusting Cash Flow for Inflation

A common problem which complicates the investment

decision making is inflation. The rule is to be consistentin treating inflation in the cash flows and the discount

rate.

Inflation is a fact of life all over the world. Because thecash flows of a project occur over a long period of time, a

firm should be concerned about the inflation on the

projects profitability. Capital budgeting results will be

biased if the inflation is not correctly factored in the

analysis.

Nominal rate = (1 + real rate) x (1 + inflation rate) -1

Documents

10. Analysis of Project Cash Flows