1. PROF. HARNESH MAKHIJA Project Cash Flows

2. Content Elements of cash flow streams Principles of cash flow estimation Cash flow illustrations Cash flow for replacement project Viewing a project from different prespectives

3. Elements of cash flows 1. Initial Investment: Cash Outlay on capital expenditure and net working capital 2. Operating cash inflows: The operating cash inflows are the cash inflows resulting from the operations of the project during its economic life. 3. Terminal cash inflow: Is the cash flow resulting from the liquidation of the project at the end of its economic life.

4. Basic Principles of Cash Flow Estimation Separation Principle Incremental Principle Post-tax Principle Consistency Principle

5. Separation Principle Cash flows associated with the investment side and the financing side of the project should be separated. Cash flows associated with the investment side and the financing side of the project should be separated. While defining the cash flows on the investment side, financing costs should not be considered because they will be reflected in the cost of capital figure against which the rate of return figure will be evaluated. While defining the cash flows on the investment side, financing costs should not be considered because they will be reflected in the cost of capital figure against which the rate of return figure will be evaluated.

6. Example Project Financing Side Investment Side Time Cash Flow 0 +1000 1 -1150 Time Cash Flow 0 -1000 1 +1200 Cost of capital 15%Rate of return 20%

7. Incremental Principle To ascertain a project’s incremental cash flows you have to look at what happens to the cash flows of the firm with the project and without the project. Guidelines 1. Consider all incidental effects 2. Ignore Sunk cost 3. Include opportunity cost

8. Consider all incidental effects The project may enhance the profitability of some of the existing activities of the firm, or it may detract from the profitability of some of the existing activities of firm. How should product cannibalization the erosion in the sales of the firm’s existing products on account of a new product introduction be handled?

9. Ignore Sunk Cost A sunk cost refers to an outlay already incurred in the past or already committed irrevocably. So, it is not affected by the acceptance or rejection of the project under consideration

10. Include Opportunity Costs If a project uses resources already available with firm, there is a potential for an opportunity cost- this is the cost created for the rest of the firm as a consequence of undertaking project. Is there any alternative use of the resources if the project is not undertaken. Resources may be rented out Resources may be sold Resources may require elsewhere in the firm.

11. Post Tax Principle Income from project typically is marginal. Income from project typically is marginal. Cash flows should be measured on a post-tax basis. Cash flows should be measured on a post-tax basis. The marginal tax rate of the firm is the relevant rate for estimating the tax liability of the firm. The marginal tax rate of the firm is the relevant rate for estimating the tax liability of the firm.

12. Consistency Principle Cash flows and discount rates applied to these cash flows must be consistent with respect to the investor group and inflation Investor Group The consistency principle suggests the following match up: Cash flow Discount rate Cash flow to all investors Weighted average cost of capital Cash flow to equity Cost of equity shareholders

13. Cash Flows Relating to Equity The equity-related cash flow stream reflects the contributions made and benefits receivable by equity shareholders. It may be divided into three components as follows : Initial investment : Equity funds committed to the project Operating cash flows : Profit after tax – Preference dividend + Depreciation + Other non-cash charges Liquidation and retirement cash flow (Terminal cash flow) : Net salvage value of fixed assets + Net salvage value of current assets - Repayment of term loans - Redemption of preference capital - Repayment of working capital advances – Retirement of trade credit and other dues

14. Cash Flows Relating to Long-term Funds As discussed earlier in this chapter, the cash flow stream relating to long-term funds consists of three components as follows : Initial investment : Long-term funds invested in the project. This is equal to: fixed assets + working capital margin Operating cash inflow : Profit after tax +Depreciation+ Other non-cash charges + Interest on long-term borrowings (1-tax rate) Terminal cash flow : Net salvage value of fixed assets + Net recovery of working capital margin

15. Cash Flows Relating to Total Funds The cash flow stream relating to total funds consists of three components as follows: Initial investment : All the funds committed to the project. This is simply the total outlay on the project consisting of fixed assets as well as current assets (gross) Operating cash inflow : Profit after tax +Depreciation+ Other non-cash charges + Interest on long-term borrowings (1-tax rate) + Interest on short-term borrowings (1-tax rate) Terminal cash flow : Net salvage value of fixed assets + Net salvage value of current assets