Project Cash Flow Estimation

1. Project Cash Flow Estimation Financial Management

2. Project Cash Estimation • Significance of Cash Flows and Cash Flow Estimation • The concept of “relevant” versus “irrelevant” cash flows • Points to watch in estimating cash flows • How to estimate project operating cash flows? • How to estimate project total cash flows?

3. Cash Flows • To be consistent with wealth maximization principle, an evaluation of a project must be based on cash flows and not on accounting profits • To be able to use NPV technique or any other technique of capital budgeting analysis successfully and accurately, we must have • an unbiased estimate of the expected future cash flows of the project • including time to completion and estimate initial investment/cost • extremely important and most difficult task

4. 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 doesn’t matter which technique we use, the project is doomed to fail

5. “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 the project 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.

6. Points of Consider • Sunk Costs • Opportunity Costs • Project Externalities • Change in Net Working Capital

7. Sunk Costs • Sunk Costs—A cost that has already been incurred and cannot be recovered irrespective of the decision to accept or reject the project. • R&D, Market Research, Consultant’s Fees • Is it relevant or irrelevant?

8. Opportunity Costs • Opportunity Costs--The cash flow foregone by using your resources in a particular way. • Resources have multiple uses • You can use them in one way to the exclusion of other 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 by renting it to some one else. • Is it relevant or irrelevant to decision making?

9. Project Externalities • Project Externalities--the effect of a new project (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 produced by the same firm. • Is it relevant or irrelevant to decision making?

10. Net Working Capital • Change in Net Working Capital--Net working capital is defined as current assets minus current liabilities. • Investment in working capital is a cash outflow during the year in which investment takes place • Any investment in working capital is a cash inflow during the last year of the project and must be treated accordingly

11. 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 that particular year – change in Net Working Capital – initial investment There is no project operating cash flows for year 0

12. 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 ***

13. Operating Cash Flows = Net Income + Depreciation OR • Operating Cash Flows= EBIT – Taxes + Depreciation