1. ESTIMATING RELEVANT CASH FLOWS
CHAPTER 6
ESTIMATING RELEVANT CASH FLOWS

2. Chapter outline Introduction Difference between profit and cash flow
Estimating relevant cash flows
Components of project cash flows
Calculation of the initial investment
Calculation of the operating cash flows
Calculation of the terminal cash flow
Capital gains tax
Conclusion

3. Learning outcomes By the end of this chapter, you should be able to:
justify why cash flows, not profits, are relevant to capital budgeting decisions
explain how tax considerations and depreciation for tax purposes affect capital budgeting decisions
calculate the initial investment associated with a proposed capital expenditure
determine the relevant operating cash flows associated with a proposed capital expenditure
calculate the terminal cash flow associated with a proposed capital expenditure.

4. Introduction
Investing large sums of money in a project with expectation of generating future cash flows that will be sufficient to warrant the initial investment
Before managers acquire new capital assets, they need to be sure investment will yield positive NPV
Process of evaluating projects: main focus of capital budgeting
Need to focus on calculating cash flows
Required to evaluate capital investments to determine if they contribute to shareholder wealth maximisation  

5. Difference between profit and cash flows
When investigating financial feasibility:
Focus is placed only on cash flow of project, and not profit
Reason: profit represents accounting item calculated based on accounting guidelines
Profit does not necessarily represent cash flow
Another distinction between profit and cash flow:
Profits calculated for certain period of time
Cash flows determined on specific point in time (when cash is physically received or spent)

6. Estimating relevant cash flows
Cash flow that leads to change in business’ overall future cash flows, direct consequence of accepting a project
Incremental cash flows
Evaluation of expansion activities
Focus placed on cash flows associated with new project
Evaluation of replacement activities
Comparison between current cash flow, and cash flow after replacement took place

7. Estimating relevant cash flows
Sunk costs
Unrecoverable past costs
Excluded when determining a project’s incremental contribution to overall cash flow of the business
Opportunity costs
Value of most valuable alternative given up if investment is undertaken
Should be included as part of relevant cost
Finance costs
Already included in company’s cost of capital, excluded
Inflation and tax
After-tax cash flows
Company tax, capital gains tax

8. Components of cash flows
Initial investment
Operating cash flow
Terminal cash flow

9. Calculating the initial investment
Total up-front costs
Cost of investment
Shipping and installation costs
Training costs
Any change in net working capital
Calculated on an after-tax basis
Distinction between replacement and expansion projects

10. Initial investment for an expansion project
Relevant cash flow determined by considering additional cash flows that will result from new project

11. Initial investment for a replacement project
Not sufficient to focus only on cash flows associated with new assets
Also need to consider what effect removal of existing asset has on company’s cash flows

12. Example 6.4

13. Calculating the operating cash flows
After initial investment is made, series of cash flows usually generated over project lifetime
Major objective is to identify projects in which cash flows will be generated to justify initial investment
Capital investment represents investment in fixed assets for operating activities
Utilising asset will generate cash flow

14. Calculating the operating cash flows
Operating cash flows for expansion project
Operating cash flows for replacement project
Incremental after-tax cash flows shows replacement asset cuts costs or provides higher income

15. Calculating the terminal cash flow
Cash flows that relate only to final year of project lifetime
Three common categories:
Estimated salvage value
Shut-down costs
Recovery of the investment in net working capital provided for at beginning of project lifetime as part of initial investment

16. Capital gains tax
Provision for capital gains tax not necessary when assets are sold at prices less than their original cost prices
Is possible, however, that an asset can be sold at price in excess of not only its book value, but also in excess of its original purchase price
In such a situation, transaction will also be exposed to capital gains tax

17. Example 6.8

18. Conclusion
The focus should be placed on cash flows, and not profit, when capital projects are appraised.
Sunk costs and additional financial costs should not be included when determining a project’s relevant cash flows.
In contrast, opportunity costs, inflation and taxes should be included when estimating a project’s relevant cash flows.

19. Conclusion (cont.)
Although the procedure differs slightly when estimating cash flows for an expansion project and a replacement project, projects consists of three types of cash flows, namely an initial investment, operating cash flows during the life of the project and a terminal cash flow.
In those cases where assets are sold for more than their original cost price, the resulting capital gain will be taxable.