PM Unit III - Project Cash Flows

Prepared By
Ghaith Al Darmaki
gm.al.darmaki@gmail.com
MBA for Engineering Business Managers
Manchester Business School

 Introduction
 Elements of The Cash Flow Stream
 Basic Principles of Cash Flow Estimation
 Separation principle
 Incremental principle
 Post-tax principle and
 Consistency principle.
 Long Term Funds Principle

Project Management - Unit III Prepared By: Ghaith Al Darmaki 2

 Estimating cash flows – the investment outlays and
the cash inflows after the project is commissioned –
is the most important, but also the most difficult
step in capital budgeting.

 Estimating cash flows process involves many people
and numerous variables  Errors in forecasting.


Elements of The Cash
Flow Stream

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Flow Stream
 A project which involves cash outflows followed by cash
inflows comprises of three basic components. They are,
 Initial investment: Initial investment is the after-tax
cash outlay on capital expenditure and net working
capital when the project is set up.
 Operating cash inflows: The operating cash inflows
are the after-tax cash inflows resulting from the
operations of the project during its economic life.
 Terminal cash inflow: The terminal cash inflow is the
after-tax cash flow resulting from the liquidation of the
project at the end of its economic life.


Flow Stream

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Basic Principles of Cash
Flow Estimation

 The following principles should be followed while
estimating the cash flows of a project:
 Post-tax principle


Flow Estimation
Incremental principle:
 The cash flow of a project must be measured in
incremental terms.
 To ascertain a project’s incremental cash flow
one has to look at what happens to the cash
flows of the firm with the project and without
the project.
 The difference between the two reflects the
incremental cash flows attributable to the
project. (Cash flow for the firm - (Cash flow for the firm
(Project cash
flow for the
=
with the project for without the project
year t) the year t) for the year t)


Flow Estimation
 In estimating the incremental cash flows of a
project, the following guidelines must be borne in
mind:
 Consider all incidental effects.
 Ignore sunk costs.
 Include opportunity costs.
 Question the allocation of overhead costs.
 Estimate working capital properly


Flow Estimation
 Consider all incidental effects: In addition to
the direct cash flows of the project, all its
incidental effects on the rest of the firm must
be considered. The project may enhance the
profitability of some of the existing activities of
the firm because it has a complimentary
relationship with the; or it may detract from the
profitability of some of the existing activities of
the firm because it has a competitive relationship
with them-all these effects must be taken into
account.


Flow Estimation
Example of incidental effects

A company X introduce a new car model which caused a
decrease in the sale of another model.
 Decreased CF per year on other lines would be a
cost to this project.
 This is an incidental effect to the project.
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Flow Estimation
 Ignore sunk costs:
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.
 example, a company is debating whether it should invest
in a project. The company has already spent R.O. 10,000
for preliminary work meant to generate information
useful for this decision. This R.O. 10,000 represents a
sunk cost as it cannot be recovered irrespective of
whether the project is accepted or not.


Flow Estimation
Example of sunk costs

You plan to produce a new car model using a
technology you bought last year at 50,000 OMR.

 Should this 50,000 OMR cost from the previous year be
included in the analysis?

 No, this cost is a sunk cost and should not be
considered. e
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Flow Estimation
 Include opportunity costs:
 If a project uses resources already available with
the firm, there is a potential for an opportunity
cost.
 The opportunity cost of a resource is the
benefit that can be derived from it by
putting it to its best alternative use.
 For example, if a project uses a vacant factory
building owned by the firm, the revenue that can
be derived from renting out this building
represents the opportunity cost.


Flow Estimation
 Question the allocation of overhead costs:
 Costs which are only indirectly related to a
product (or service) are referred to as overhead
costs.
 They include items like general administrative
expenses, managerial salaries, legal expenses,
rent and so on.
 When a new project is proposed, a portion of
the overhead costs of the firm is usually
allocated to it.


Flow Estimation
 Estimate working capital properly: Outlays on working
capital have to be properly considered while forecasting the
project cash flows. In this context the following points must
be noted:
 Working capital is defined as “Current Assets – Current
Liabilities”
 The requirement of working capital is likely to change
over time as the output of the project changes.
 Working capital is renewed periodically and hence is not
subject to depreciation. Therefore, the working capital
at the end of the project life is assumed to have a salvage
value equal to its book value.


Flow Estimation



Flow Estimation
Separation principle
 There are two sides of a project:
 The investment (or asset) side
 The financing side
 The cash flows associated with these sides should be
separated.


Flow Estimation
 Example:
Suppose a firm is considering a one-year project that
requires an investment of R.O. 1000 in fixed assets and
working capital at time 0. The project is expected to
generate a cash inflow of R.O. 1200 at the end of year 1 (this
is the only cash flow expected from the project). The project
will be financed entirely by debt carrying an interest rate of
15 percent and maturing after 1 year. Assume there are no
taxes.


Flow Estimation
 Example:


Flow Estimation
 Example (continue ..)
 The cash flows on the investment side of the project
includes the rate of return of 20% and do not reflect the
financing costs of 15% (interest in our example).
 The cash flows on the financing side of the project includes
the financing cost of 15% (interest in our example) and do
not reflect on the rate of return of 20%.
 The important point is that while estimating the cash flows
on the investment side do not consider financing costs like
interest or dividend.


Flow Estimation



Flow Estimation
Post-tax principle
 Cash flow should be measured on an after-tax
basis.
 This is used to bring out the project cash flows
with accuracy.
Consistency principle
 Once you adopt an accounting principle or
method, you should continue to follow it
consistently in future accounting periods.
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Cash flows relating to long
term funds
 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 (this represents
the portion of current assets supported by long-term
funds)
 Operating cash inflow:
Profit after tax + Depreciation + Other noncash charges
+ Interest on long-term borrowings (1-tax rate)
 Terminal cash flow:
Net salvage value of fixed assets + Net recovery of
working capital margin

term funds
 Illustration:
Magnum Technologies Limited is evaluating an electronics project for which the following
information has been assembled. Prepare a net cash flow statement relating to long-
term funds:
 The total outlay on the project is expected to be R.O. 50 million. This consists of
R.O. 30 million of fixed assets and R.O. 20 million of current assets.
 The total outlay of R.O. 50 million is proposed to be financed as follows: R.O. 15
million of equity, R.O. 20 million of term loans, R.O. 10 million of bank finance for
working capital and R.O. 5 million of trade credit.
 The term loan is repayable in five equal installments of R.O. 4 million each. The first
installment will be due at the end of the first year and the last installment at the end
of the fifth year. The levels of bank finance for working capital and trade credit will
remain at R.O. 10 million and R.O. 5 million till they are paid back or retired at the
end of five years.
 The interest rates on the term loan and bank finance for working capital will be 15
percent and 18 percent respectively.
 The expected revenues from the project will be R.O. 60 million per year. The
operating costs, excluding depreciation, will be R.O. 42 million. The depreciation
rate on the fixed assets will be 33 and 1/3 percent as per the written down value
method.
 The net salvage value of fixed assets and current assets at the end of year 5 will be
R.O. 5 million and R.O. 20 million respectively.
 The tax rate applicable to the firm is 50 percent.

term funds

 Initial investment= Fixed assets + working capital
margin

 Operating cash inflow = Profit after tax +
Depreciation + Other noncash charges + Interest on
long-term borrowings (1-tax rate)

 Terminal cash flow = Net salvage value of fixed assets
+ Net recovery of working capital margin


term funds
Microsoft Excel
Worksheet


THANK YOU


PM Unit III - Project Cash Flows

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PM Unit III - Project Cash Flows