Estimating Project Cash Flows

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Estimating Project Cash Flows
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Back to the principles of corporate finance

• Investment principle Invest in projects that
  yield a return greater than the minimum
  acceptable hurdle rate
• Returns should be measured based on cash flows
  generated by each project and the timing of these
  cash flows, and should also consider both
  positive and negative side effects of the project

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Basic principles of estimating project cash flows

• Use cash flows rather than earnings in your
  analysis the firm is interested in what free
  cash can be generated by a project, which differs
  from accounting earnings
• Use incremental cash flows, meaning cash flows
  that occur as a consequence of the decision to
  proceed with the project not total cash flows for
  the firm
• Adjust cash flows for the time value of money

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Which cash flows are relevant when evaluating a
project?

• The relevant cash flows include the change in the
  firms total cash flows that come as a direct
  consequence of the decision to take the project
• We call these the incremental cash flows of the
  project
• Any cash flow to the firm that takes place
  whether we take the project or not are not
  relevant to our analysis
• Incremental cash flow cash flow with project
  cash flow without project

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Why can we focus only on incremental cash flows?

• We can assume that each project undertaken by a
  firm is a stand alone project
• Once we identify the projects incremental cash
  flows, we can evaluate a project based on its own
  merits
• This is known as the stand-alone principle

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Determining incremental cash flows

• Forget about sunk costs
• Include opportunity costs
• Include all indirect effects from the project
• Recognize investments in net working capital
• Beware of allocated overhead costs
• Separate investment and financing decisions

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Sunk costs must be excluded from a projects cash
flows

• A sunk cost is a cost that the firm has already
  incurred or has incurred the liability to pay
• These costs remain the same whether or not we
  accept the project
• Based on an incremental cash flow analysis, these
  costs are irrelevant and should not be included
  in the analysis
• Examples RD in pharmaceuticals, hiring of a
  consultant to evaluate a project

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Projects may use firm resources that have
opportunity costs

• Example A firm considers using land that it
  already owns to build a manufacturing plant
• The opportunity cost of the land, the value of
  the forgone alternative use for the land, must be
  included in the costs of the project
• At the minimum, we must include the current
  market value of the asset if it were sold

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Indirect effects from a project

• Specific projects may have side benefits or costs
  (or both), meaning that they affect cash flows of
  other projects
• Example Intel introduces a new processor VW
  introduces the Phaeton model United decides to
  offer service between C-U and Chicago
• To determine incremental cash flows, we must
  determine all side effects from a project and
  adjust cash flows accordingly
• In this case, we must also consider the
  possibility that sales lost due to the
  introduction of a new product might be lost
  anyway due to competition

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Include investments in net working capital

• Projects require investments in net working
  capital, both at the beginning and during the
  life of the project
• Investments in net working capital involve cash
  flows that must be taken into consideration
• Working capital is recovered at the end of a
  project and this constitutes a cash inflow

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Overhead costs and project financing

• If a project generates extra overhead costs, then
  these must be included in the analysis
• We must not include accounting charges for
  overhead costs as incremental costs of a project
  if these costs must be paid by the firm
  nevertheless
• Example Costs associated with the firms
  headquarters
• We do not include any financing costs, such as
  interest paid, dividends or principal repaid, in
  the estimation of incremental cash flows
  (separate investment from financing decision)

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Components of project cash flows

• A projects cash flows are composed of
• Cash flow from operations
• Cash flow from investments in NWC
• Cash flow from investments in plant and equipment

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A projects net operating cash flows

• Cash inflow from sales
• Cost of goods sold
• Selling, general, administrative and other
  expenses
• Depreciation
• Taxable income
• Tax payable
• Net income
• Depreciation
• Net operating cash flow

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• Another approach to calculate net operating cash
  flows is to separate cash flows from non cash
  flows as follows
• Cash inflow from sales
• Cost of goods sold
• Selling, general, administrative and other
  expenses
• Net cash income
• Depreciation
• Taxable income
• Tax payable
• Net operating cash flow

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• A third approach is to identify the tax shield
  of allowable depreciation
• Cash inflow from sales
• Cost of goods sold
• Selling, general, administrative and other
  expenses
• Net cash income
• Tax on net cash income
• Net after-tax cash income
• Tax shield of allowable depreciation
  (Depreciation ? tax rate)
• Net operating cash flow

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Depreciation and project cash flows

• Depreciation is a non-cash expense and, thus, is
  added back to net income to determine a projects
  cash flows
• Depreciation is relevant because it impacts the
  firms tax bill
• Corporations keep two sets of books
• They use accelerated depreciation on the IRS
  books in order to maximize the benefits of the
  tax shield from depreciation
• They use straight-line depreciation to determine
  earnings reported to shareholders in order to
  show a better performance

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A projects NWC requirements

• Changes in NWC as a result of a project are
  relevant to the projects analysis
• Examples Building up inventory of raw materials
  or finished products selling on credit, thus,
  increasing A/R purchasing materials on credit,
  thus, increasing A/P
• An increase in NWC is like an investment, meaning
  a cash outflow decreases in NWC imply a cash
  inflow
• Project cash flows are measured by the changes,
  not the levels, in NWC in each period

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• Investments in NWC usually rise and fall with the
  volume of sales
• Investments in NWC are reversible, meaning that
  they are liquidated and generate a cash inflow at
  the end of the projects life
• However, changes in accrued wages or accrued
  taxes should not be included in changes in NWC
  because they arise naturally as the business
  invests in working capital

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Cash flows from capital expenditures

• Capital expenditures are not treated as
  accounting expenditures, but they do cause cash
  outflows
• Two types of capital expenditures
• New (or growth) capital expenditures designed to
  create new assets and future growth (e.g.
  purchasing a new machine)
• Maintenance capital expenditures designed to
  maintain existing assets, which increase with the
  life of the project (e.g. maintenance costs of
  the machine)
• Both expenditures reduce cash flows

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Calculating a projects free cash flows

• A projects cash flows are equal to
• Cash flows from operations Cash flows from
  Investments in NWC Cash flows from capital
  expenditures

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Example 1 Estimating cash flows from a new
business

• You are interested in setting up a software
  development business. You will need to acquire
  computer hardware costing 100,000. The lifetime
  of this hardware is five years and will be
  depreciated using straight-line depreciation. In
  addition, you will have to rent an office for
  50,000 per year, hire five specialists at a
  total cost of 50,000 per year, and incur
  marketing and selling costs of 100,000 per year.
  You expect to price the software you produce at
  100 per unit and sell 6,000 in the first year.
  After that, you expect the number of units sold
  to increase by 10 each year. The actual cost of
  materials used to produce each unit is 20. The
  project requires an initial investment in NWC of
  40,000 and you will need to maintain working
  capital at 10 of revenues during the life of the
  project. The tax rate is at 40. Estimate the
  annual cash flows from this project.