642Cash Flow Estimation

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Project Cash Flow Estimation

Financial Management


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Project Cash Estimation

Significance of Cash Flows and CashFlow Estimation

The concept of relevant versusirrelevant cash flows

Points to watch in estimating cash flows

How to estimate project operating cashflows?

How to estimate project total cash flows?


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Cash Flows

To be consistent with wealth maximizationprinciple, an evaluation of a project must bebased on cash flows and not on accountingprofits

To be able to use NPV technique or any othertechnique of capital budgeting analysissuccessfully and accurately, we must have

an unbiased estimate of the expected future cash flowsof the project

including time to completion and estimate initialinvestment/cost

extremely important and most difficult task


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Projects have failed or succeeded due to

incorrect or correct estimates of the cash

flows of the project.

If cash flow estimates are incorrect, it

doesnt matter which technique we use, the

project is doomed to fail


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Relevant versus Irrelevant

Cash Flows

The results of an acceptance of a project is to

change the cash flows of a firm.

Cash flows of a firm that change because of theproject are called relevant cash flows;

Any cash flows that does not change irrespective

of the acceptance/rejection of the project is

irrelevant to decision making and should not be

considered.


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Points of Consider

Sunk Costs

Opportunity Costs

Project Externalities

Change in Net Working Capital


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Sunk Costs

Sunk CostsA cost that has already been

incurred and cannot be recovered

irrespective of the decision to accept orreject the project.

R&D, Market Research, Consultants Fees

Is it relevant or irrelevant?


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Opportunity Costs

Opportunity Costs--The cash flow foregone byusing your resources in a particular way.

Resources have multiple uses

You can use them in one way to the exclusion ofother uses and this gives rise to opportunity costs

By using your own building for your business,

you forego the rent that you could have earned byrenting it to some one else.

Is it relevant or irrelevant to decision making?


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Project Externalities

Project Externalities--the effect of a newproject (positive or negative) on an existing

project or division of a firm.For instance, introduction of a new model

of a car on other existing models producedby the same firm.

Is it relevant or irrelevant to decisionmaking?


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Net Working Capital

Change in Net Working Capital--Networking capital is defined as current assetsminus current liabilities.

Investment in working capital is a cashoutflow during the year in whichinvestment takes place

Any investment in working capital is acash inflow during the last year of theproject and must be treated accordingly


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Estimating Project Cash Flows

Total Cash Flows of a Project in year t,

where t ranges from year 0 to year n.

= Project Operating Cash Flows for thatparticular yearchange in Net Working

Capitalinitial investment

There is no project operating cash flows foryear 0


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Estimating Project Operating

Cash Flows

Cash flows from operations for any year

Estimated Sales Revenue *****

Total Costs ***** Variable Costs ***

Fixed Costs

per year ***

Depreciation ***

Sales Revenue minus Total Costs = Earnings Before Interest and Taxes(EBIT)

Deduct Taxes from EBIT ***

Net Income ***


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Operating Cash Flows = Net Income +

Depreciation OR

Operating Cash Flows= EBITTaxes +

Depreciation

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642Cash Flow Estimation