3_cash flow estimation

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Estimating Project Costs & Benefits: Basic Principles

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Basic Principles

• In order to evaluate any Investment project, its costs

& benefits have to be estimated. While estimating

the costs and benefits, the following principles have

to be considered.

1. Cash Flow Principle

2. Incremental Principle

3. Consistency Principle

4. Interest exclusion Principle (Separation Principle)

5. Post-tax Principle

Estimating Project Costs & Benefits

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Cash Flow Principle

• Costs & Benefits must be measured in terms of Cash Flows

• Cash Flows are superior than Revenues & Expenses

– Profits are based on Accrual Concept: Revenues are

recognised when they are earned not when cash is

received. Expense is recognised when they become due

& not when paid.

– Expenditure are classified as “Revenue” & “Capital”:

Revenue expenditure is entirely charged, while capital

expenditure is not. They are capitalised & depreciated

over economic life.

• In operational terms: Add back Depreciation & other non-

cash charges which were deducted while computing

Accounting profits, as they do not result in cash outflows.

Cash Flow = PAT + Depreciation & other non-cash charges


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PAT Vs. Cash Flow

Income Statement Cash Flow

Sales Revenue 1,000.0 Inflow 1,000.0

Less: Cost of Sales 640.0 Outflow 640.0

EBDIT 360.0

Less: Depreciation 50.0 Non-Cash

EBIT 310.0

Less: Interest 40.0 Outflow 40.0

PBT 270.0

Less Taxes @35% 94.5 Outflow 94.5

PAT 175.5 Net Cash Flow 225.5

NCF = PAT +Depreciation

225.5 = 175.5 + 50.0Estimating Project Costs & Benefits

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Incremental Principle

• Cash Flows must be measured in Incremental terms -

changes in cash flows due to the proposed project are

relevant.

Project CF = Cash Flow WITH project - Cash Flow WITHOUT project

1. Consider all incidental effects: Project may improve or

reduce the profitability of existing operations.

– Complementary vs. Competitive relationship with

existing products.

2. Ignore Sunk costs: Sunk costs are outlays already

incurred, which cannot be recovered. It is not affected by

acceptance or rejection of the project under consideration.


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Incremental Principle (Contd.)

3. Include Opportunity Costs: If a project requires the use

of some resources already available with the firm the

opportunity cost of such resources should be charged to

the project.

• “Is there any alternative use of the resources if the project

is not undertaken”

• Compare “with or without” and not “before vs. after” Before Take Project After Cash Flow

Before Vs. After

Firm owns Land � Firm Still owns land 0

Before Take Project After Cash Flow

WITH Project

Firm owns Land � Firm Still owns land 0

Before Do Not Take Project After Cash Flow

WITHOUT Project

Firm owns Land � Firm sells land for Rs

10 Lacs

Rs 10 Lacs


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Incremental Principle (Contd.)

4. Question the Allocation of Overheads: Overhead

cost are costs which are indirectly related to a

product.- Administrative, Legal expenses etc.

– Overhead costs are allocated (Spread over) over

various products.

– What matters is the incremental overhead cost

attributable to the project & not allocated

overhead costs.

5. Include Working Capital Requirements: NWC=CA-CL.

Most projects require additional investment in working

capital, which must be recognized in cash flows.

Similarly, on termination of the project, working capital

is released, which must be treated as cash inflow.


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Consistency Principle

• Cash Flows and the discount rates applied to these

cash flows must be consistent with respect to the

investor group and inflation.

� Investor Group: All investors (Equity + Lenders) vs.

Equity only

• CF available to all investors is the CF available after

paying taxes & meeting investment needs of the

project.

= EBIT(1-t)

+ Depreciation & Noncash Charges

- Capital Expenditure

- Changes in Working Capital


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Consistency Principle (Contd.)

• CF available to all Equity is the CF available after

paying taxes, meeting investment needs and fulfilling

debt-related commitments.

= PAT

+ Depreciation & Noncash Charges

- Preference dividend

- Capital Expenditure

- Changes in Working Capital

- Repayment of debt

+ Proceeds from debt issues

- Redemption of Preference Capital

+ Proceeds from Preference issue

� Discount Rate: should be consistent with definition of CF

• CF to All Investors : WACC

• CF to Equity : Cost of Equity


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Consistency Principle (Contd.)

� Inflation:

• Factor in the impact of inflation in the estimates of Cash

Flows: Apply Nominal discount rate

• Estimate future Cash Flows in real terms : Apply Real

discount rate

(1 + r Nominal) = (1+rReal)(1+ inflation rate)


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Interest exclusion Principle

• Cost of Long term debt should be excluded from the

estimation of Cash Flows

• Interest on Long term debt may be reflected by:

– Charging interest on Long term debt from Profit OR

– Discounting the Cash Flows by WACC, which

includes cost of debt as well

• If interest on Long term debt is considered in Cash

Flows and the same is discounted @ WACC, then cost

of debt is being considered twice.

• In operational terms:� Exclude Interest on Long-term debt, or

� If interest on debt has been deducted while calculating

PAT, then Interest *(1-tax rate) should be added back

to PAT.Estimating Project Costs & Benefits

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Interest exclusion Principle (contd.)

Particulars A B

EBDIT 1000 1000

Depreciation 50 50

EBIT 950 950

Interest 100 -

PBT 850 950

Taxes @ 30% 255 285

PAT 595 665

Cash Flow 595+50+100*(1-0.30) = 715 665+50=715

EBIT*(1-tax rate) = (PBT+ Interest) * (1-tax rate)

= PBT*(1-tax rate) + Interest*(1-tax rate)

= PAT + Interest*(1-tax rate)


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Post-tax Principle

• Cash Flows should be measured on Post –tax basis.

• Similarly, cost of Capital should also be on post-tax

basis

• Treatment of Losses:

Case Project Firm Treatment

1 Losses Losses Defer Tax Savings

2 Losses Profits Take tax savings in year of loss

3 Profits Losses Defer taxes until firm makes profits

4 Profits Profits Consider Taxes in each year

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Stand Alone

Losses __ Defer Tax savings until project

makes profits


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Components of Cash Flows

A. Initial Cash Flows:

� Cash flows incurred at the beginning of the project.

� Outlays on Fixed Assets (Cash Outflow)

� Outlays on Net Working Capital (Cash Outflow)

� Sale Proceeds on Old Fixed Assets (Cash Inflow)

B. Operational Cash Flows:

� Cash flows expected during the operational phase

(economic life) of the project.

C. Terminal Cash Flows:

� Cash flows resulting from the liquidation of the project

at the end of its economic life.

� Post-tax salvage value of Fixed Assets (Inflow)

� Post-tax salvage value of Net Working Capital

(Inflow)


3_cash flow estimation

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