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Project Cash Flows


No adjustment is required for expected salvage value. ... working capital investments need to be salvaged at the end of the project life. ... – PowerPoint PPT presentation

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Title: Project Cash Flows

Project Cash Flows
  • 04/25/07
  • Ch. 9

Investment decision revisited
  • Acceptable projects are those that yield a return
    greater than the minimum acceptable hurdle rate
    with adjustments for project riskiness.
  • We know now how to calculate the acceptable
    hurdle rate (cost of capital) and make
    project-specific adjustments.
  • To enable us to calculate a projects return
    and thus allow us to evaluate the project, the
    next step is to calculate project cash flows.

Project cash flows estimation
  • Estimating project cash flows requires
  • Estimating project revenues
  • Allocating appropriate expenses
  • Converting these projections into incremental
    cash flows
  • We need to understand the differences between
  • Accounting earnings and cash flows, and
  • cash flows and incremental cash flows.

Accounting earnings vs. cash flows
  • Accrual accounting requires the recognition of
    expenses during the period in which the related
    revenue is recognized. Cash flows may not
  • Capital expenditures are treated as if generated
    over multiple periods and expensed (depreciation
    or amortization) rather than subtracted from
    revenues when the occur.
  • Because of accrual accounting and capital
    expenditure accounting, accounting earnings can
    differ significantly from cash flows.

Accounting earnings vs. cash flows
  • To go from accounting earnings (EBIT) to cash
    flows, we must adjust for
  • Non-cash expenses, such as depreciation and
  • Capital expenditures, and
  • working capital investment

Refresher on depreciation methods
  • Broadly speaking, depreciation methods can be
    classified as straight line or accelerated
  • Straight line depreciation - capital expense is
    spread evenly over time,
  • Accelerated depreciation - capital expense is
    depreciated more in earlier years and less in
    later years.

Refresher on depreciation methods
  • Annual depreciation expense using
  • Straight line
  • (Original asset value salvage value) / number
    of years to be depreciated
  • Depreciation for tax purposes is determined by
    using the modified accelerated cost recovery
    system (MACRS).
  • Under the basic MACRS procedures, the depreciable
    value of an asset is its full cost, including
    outlays for installation.
  • No adjustment is required for expected salvage
  • For tax purposes, the depreciable life of an
    asset is determined by its MACRS recovery
    predetermined period and is based on the type of

The depreciation tax benefit
  • While depreciation reduces taxable income and
    taxes, it does not reduce the cash flows.
  • The benefit of depreciation is therefore the tax
    benefit. In general, the tax benefit from
    depreciation can be written as
  • Tax Benefit Depreciation Tax Rate

Working capital investment
  • Intuitively, money invested in inventory or in
    accounts receivable cannot be used elsewhere. It,
    thus, represents a drain on cash flows
  • To the degree that some of these investments can
    be financed using suppliers credit (accounts
    payable) the cash flow drain is reduced.
  • Investments in working capital are thus cash
  • Any increase in working capital reduces cash
    flows in that year
  • Any decrease in working capital increases cash
    flows in that year
  • To provide closure, working capital investments
    need to be salvaged at the end of the project

Cash flows vs. incremental cash flows
  • The appropriate cash flows to consider in
    evaluating whether a project makes a firm more
    valuable is the incremental cash flows generated
    by the project.
  • This can differ from total cash flows for three
  • Sunk costs
  • Opportunity costs
  • Allocated costs that the firm would incur even if
    the project was not accepted.

Sunk costs
  • Any expenditure that has already been incurred,
    and cannot be recovered (even if a project is
    rejected) is called a sunk cost
  • When analyzing a project, sunk costs should not
    be considered since they are not incremental
  • By this definition, market testing expenses and
    RD expenses are both likely to be sunk costs
    before the projects that are based upon them are

Opportunity costs
  • Opportunity costs are cash flows that could be
    realized from the best alternative use of the
  • When analyzing a project, opportunity costs
    should be considered since they represent cash
    flows that the firm would have generated if the
    project is not accepted, but are lost if the
    project is accepted.

Allocated costs
  • Firms allocate costs to individual projects from
    a centralized pool (such as general and
    administrative expenses) based upon some
    characteristic of the project (sales is a common
  • For large firms, these allocated costs can result
    in the rejection of projects
  • To the degree that these costs are not
    incremental (and would exist anyway), this makes
    the firm worse off.
  • Thus, it is only the incremental component of
    allocated costs that should show up in project

Project revenue estimation process
  • Experience and History If a firm has invested in
    similar projects in the past, it can use this
    experience to estimate revenues and earnings on
    the project being analyzed.
  • Market Testing If the investment is in a new
    market or business, you can use market testing to
    get a sense of the size of the market and
    potential profitability.
  • Ex., Home Depot Expo Stores
  • Scenario Analysis If the investment can be
    affected be a few external factors, the revenues
    and earnings can be analyzed across a series of
    scenarios and the expected values used in the

Scenario analysis
  • Scenario analysis is made up of four components
  • Factors that determine the success of the project
  • Analysis should focus on two or three of the most
    critical factors
  • Number of scenarios to be considered
  • Three scenarios for each factor (best, average
    and worst-case) tend to most useful
  • Estimation of project revenues and/or expenses
    under each scenario
  • Assigning probabilities to each scenario

From forecasts to operating income (EBIT)
  • Calculate/estimate the appropriate expenses
    associated with the estimated revenues
  • Separate projected expenses into operating and
    capital expenses.
  • Operating expenses are designed to generate
    benefits in the current period, while capital
    expenses generate benefits over multiple periods
  • Depreciate or amortize the capital expenses over
  • Allocate fixed expenses that cannot be traced to
    specific projects.

From forecasts to operating income (EBIT)
  • Operating income (EBIT) measures the income
    earned on all the capital invested in a project
    and is calculated as
  • EBITRev Cost of Goods Sold SGA Expenses
    Other allocated expenses - Depr.Amort.

From accounting income to cash flows
  • To get from EBIT to cash flows
  • add back non-cash expenses (like depreciation and
  • subtract out cash outflows which are not expensed
    (such as capital expenditures)
  • Include investment in working capital.
  • Cash flow to firm EBIT(1-t) Depr.Amort.
    Chg in WC Cap Exp.

Chapter 9 sections NOT covered
  • An argument for time weighted cash flows
  • We do not calculate the intermediate steps that
    the text takes, for example, calculating cash
    flows for the project, then the incremental cash
    flows. We go directly from the (incremental)
    operating income to the incremental cash flows
    for the project.