Estimating Project Cash Flows

Topic 8
Chapter 13

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Identifying Project Cash Flows
C1 C2 Cn
NPV = C0 + + + ... +
(1 + r )1 (1 + r ) 2 (1 + r ) n

◼ After deciding on a good investment decision rule, the next step is to

identify and value the cash flows from the project using the discounted cash
flows techniques (the process of valuing an investment by discounting its
future cash flows).
◼ So, what are the project’s relevant cash flows (相关现金流量)?
1. The cash flows that should be included in a capital budgeting analysis are
those that will only occur (or not occur) if the project is accepted.

❑ With / Without Principle:

CF(project) = CF(corporation)with – CF(corporation)without

2. These cash flows are called incremental cash flows (增量现金流).

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 C1 C2 Cn
Identifying Project Cash Flows NPV = C0 + + + ... +
(1 + r )1 (1 + r ) 2 (1 + r ) n
◼ In Capital Budgeting, cash flows are used, not accounting profits, to
assess the worthiness of a project.
◼ Cash flows are the actual amounts received or paid by the company and
reflect the timing of benefits and costs .
◼ Accounting profits are calculated based on accounting principles.
(i) They do not reflect the actual amounts received or paid.
(ii) They do not reflect actual money in hand.
Therefore they are unreliable measure of the costs (payments) and benefits
(receipts) of a project.
◼ Example:
❑ Credit sales (賒贷銷货)
❑ Depreciation (折舊), non –cash expenses. More explanations on this
later.

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Case Study- Cash is NOT same as profit
E.g. Credit Sales (賒贷銷货)
• For example, many companies recognize /record revenues at the time a
sale is made (credit sales), which is recorded typically before cash can be
used to make investments or to buy goods and services.

• Now contrast the differences in performance under the accounting method

(accrual basis 權責發生制) versus the financial view (cash basis):

Example:
• Assume Good Hope Company records the following transactions over the
month of May 2017.
Goods sold to customers $40,000 50% cash; 50% on one
(Sales) month’s credit (赊帳)
Cost of goods sold (銷貨成本) $15,000 Paid for in cash

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 Case Study- Cash is NOT same as profit
E.g. Credit Sales (賒贷銷货)

Goods sold to customers (Sales) $40,000 50% cash; 50% on one month’s credit

Cost of goods sold $15,000 Paid for in cash

•Assume the business started the month with no cash.

Income Statement • Do all items
(May 2017) from Income
Statement
Accrual basis Cash basis
reflect all cash
collected and
paid?
Sales 40,000 20,000 cash inflow
Less: COGS -15,000 -15,000 cash outflow
• No! Thus, net
income is not
Net Income 25,000 5,000 net cash flow cash.

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Depreciation (折舊) non–cash expenses
Depreciable assets (應折舊資產) are physical objects that
retain their size and shape but lose their economic
usefulness (經濟效用) over time.
Example: Buildings, equipment, truck, etc.

Depreciation is the systematic allocation of

the cost of a depreciable asset to expense.
Depreciation (折舊) non–cash expenses
On 1 July 2023, JJ’s Lawn Care Service
purchased a lawn mower with a useful life
of 5 years for $2,500 cash.
Calculate the yearly depreciation expense and allocate the cost
over the useful life (使用年限) of the lawn mower.

Depreciation
Cost of the asset
expense =
(per period) Estimated useful life

= $2,500 = $500
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 Depreciation (折舊) non –cash expenses
• Depreciation (折舊) is the allocation (分攤) of the cost of an asset to
expense over its estimated life to reflect the wear and tear (損耗) on the
asset as it is used to produce the company’s goods and services.
• Example: A company purchased a truck for $10,000 and the useful life of
the truck is 4 years.

-10,000 -2,500 -2,500 -2,500 -2,500

0 1 2 3 4

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 Determining Project’s
Incremental Cash Flows
[i.e. C0, C1, C2, C3………. Cn]

C1 C2 Cn
NPV = C0 + + + ... +
(1 + r )1
(1 + r ) 2
(1 + r ) n

(SECTION 13.1)

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 In determining incremental cash flows, the
following principles must be applied:
i) Sunk costs (沉沒成本) are cash flows that have already occurred or been
committed.
=> Examples: Fee for a feasibility study (可行性研究) of the project.
Past Research & Development expenditures (研究和開發研发费用).
=> These costs are there whether the project is accepted or not and
therefore irrelevant; should NOT be included!
ii) Opportunity Costs (機會成本) are cash flows that are lost because of
accepting the current project.
=> Example: Building a plant on a piece of land owned by the firm
creates an opportunity cost equals the current market price of
the land (NOT the previous purchase cost) because the firm lost
the chance to sell the land on current market price.
=> These are incremental cash flows; should be included!

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iii) Side Effects are the effects (positive or negative) that the
acceptance of a project may have on the cash flows to other
business activities of the firm.

(1) A negative effect is called cannibalization when a new

project takes away sales from an existing product.
=> Example: Coca Cola introduces another diet version of
Coke.
=> Erosions are often very difficult to quantify, but they
should be considered!
(2) A positive effect is called synergistic effect when new
projects may add sales to the existing line (such as adding
a coffee store to an existing retail store).

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iv) Overhead costs (i.e. general operating costs) that are due to
the project should be included. DO NOT, however, include
allocation of overhead costs that will be incurred with or
without the project (e.g. the salary of the CEO).

v) Include only after-tax cash flows:

cash flows expected to result from the proposed project must
be measured on an after-tax basis, because the firm will not
have the use of any cash flows until it has satisfied the
government’s tax claims.
After-tax
basis

C1 C2 Cn
NPV = C0 + + + ... +
(1 + r )1 (1 + r ) 2 (1 + r ) n

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vi) Financing Costs are reflected in the project’s
required rate of return, NOT in the cash flows from the
project C C C
NPV = C0 + 1
+ 2
+ ... + n
(1 + r ) 1
(1 + r ) 2
(1 + r ) n
◼ The cost of financing of an investment is certainly a relevant
cost when deciding to accept or not.
◼ If a project is analyzed using the NPV rule, the project’s
expected cash flow stream is discounted at the project’s cost
of capital. That is, the cost of financing the project is
already considered in the cost of capital.
◼ To avoid double counting, DO NOT include the cash flows
associated with interest payments or principal on debt,
dividends or other financing costs in computing the project’s
incremental cash outflows.
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 Relevant cash flow - summary??
Principles determine incremental cash flows

Relevant
incremental CF?
Sunk costs – costs that have incurred in the past
Opportunity costs – costs of lost options
Side effects
Positive side effects – benefits to other projects
Negative side effects – costs to other projects
Financing costs – interest, dividends

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CALCULATING A PROJECT’S
CASH FLOWS

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Cash Flow Calculations -
This framework is based on the cash flows timeline of the project:
◼ Three components of cash flows of a project:
1) the total investment costs upfront 前期;
2) the annual operating cash flows over the project’s life, and
(a) after-tax operating cash income
(b) tax savings from depreciation
3) the terminal cash flows.
0 1 2 3 4

Initial OCF1 OCF2 OCF3 OCF

investment +
cost Terminal CFs
(after-tax salvage value)
+ +
Δ NWC (Δ NWC)

CF0 CF1 CF2 CF3 CF4

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(1) Total Investment Costs Upfront 前期
(Initial Cash Outlay 開支)
◼ The total investments cost upfront are the immediate cash
outflows necessary to purchase the assets (e.g. land,
equipment, building) and put it in operating order at the
beginning of the project, n = 0 (today).

◼ This includes:
(a) initial investment cost like purchase cost of assets,
set-up cost, installation, shipping/freight, training
cost and
(b) increased working-capital requirements (Δ NWC) .

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(1) Finding the total investment costs ??
(a) An Example on Initial Investment cost
Perfect Surfing Ltd. is considering setting up a new surfboard
manufacturing plant. The company bought a piece of land five years ago
for $150m in anticipation of this project. The current market value of the
piece of land is $250m. The company will build the plant on this land,
and it will cost $15m to do so. What is the relevant cash flow to use for
the initial investment for the project?
◼ __ ________ is a sunk cost and is irrelevant.
◼ __ _________ is an opportunity cost and is relevant, since the
land could be sold for this amount.
◼ _ __________________ are initial cash outlays (支出) to
get the project going.
◼ Initial Investment costs = ____________________

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(1) Finding the total investment costs
(b) Changes in Net Working Capital (are part of incremental CFout)
The Balance Sheet (Topic 1)
Total Value of Assets Total Value of Liabilities
and Shareholders' Equity

Net
Working Current Liabilities
Current Assets Capital

Long Term Debt

Fixed Assets

1. Tangible
2. Intangible Shareholder Equity

Assets = Liabilities + Shareholders’ equity

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(1) Finding the total investment costs
(b) Changes in Net Working Capital (are part of incremental CFout)
◼ Normally a new project will require that the firm invest in net working
capital (營運資金) in addition to long-term assets.

◼ Net working capital (NWC) is the amount by which a firm’s current

assets exceed its current liabilities.
= Current assets (流動資產) – Current liabilities (流動負債)
= (Accounts receivable + Inventory + cash) – (Accounts
payable)
◼ Accounts receivable (debtors) 應收帳款 - amounts owed to the company
by customers as a result the company sold goods or provided services on
credit (赊帳).
◼ Accounts payable (creditor) 應付帳款 - amounts owed to suppliers for
the purchases of inventory on credit.

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(1) Finding the total investment costs
(b) Changes in Net Working Capital (are part of incremental CFout)
◼ This additional working capital is a cash outflow at the beginning of a project’s life.

◼ At the end of the project’s life, NWC will return to its original level as inventories
are sold, receivables are collected, and bills are paid. In any event, the recovery of
NWC is a one-off cash inflow at the end of the project’s life.

◼ Additional working capital may be required in other years of the project.

◼ Net Working Capital (NWC)

= Current assets – Current liabilities

◼ Δ NWC
= Δ Current assets – Δ Current liabilities
= (Δ AR + Δ Inventory + Δ cash) – Δ AP

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Example on NWC
ABC Ltd. is considering a 5-year project which will require
additional inventory of $134,000 and will also increase accounts
payable by $37,000 as suppliers are willing to finance part of
these purchases. Accounts receivable are currently $100,000 and
are expected to increase by 8 percent if this project is accepted.
What is the initial project cash flow related to net working
capital?
◼In terms of CF,

NWC(t=0) = Δ Current assets – Δ Current liabilities

= (Δ Inventory + Δ AR) – Δ AP
= [$134,000 + ($100,000) x 8%] - $37,000
= $105,000 (cash outflow)

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(2) Finding the annual operating cash flows (OCF)

◼ Pro Forma or Projected Financial Statements and

Cash Flow (预計財务報表)
◼ (a) After-tax operating cash income
◼ (b) Tax savings from depreciation

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(2) Finding the annual operating cash flows (OCF)
The first thing we need when we begin evaluating a proposed investment is a
set of pro forma, or projected financial statement to estimate expected future
cash flows of a project.
Projected Income Statement (預計收益表)

Sales (50,000 units at $4.00/unit) $200,000

Cost of goods sold (銷售成本) 125,000

Gross profit (毛利) $ 75,000

Operating expenses 12,000
Depreciation** 折舊 ($90,000/3); (non cash expense) 30,000
Earnings before interest and taxes (EBIT) $ 33,000
Taxes (34%) 11,220
Net Income $ 21,780

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 Calculating Operating Cash Flows -
(a) After-tax operating cash income (OCI)

❑ Cash flows that result from day-to-day activities

❑ **Not including depreciation, interest (e.g.
bond interest; financing cost)

OCI = EBIT + Depreciation (non-cash expense) - Tax

= 33,000 + 30,000 – (63,000 x 34%) = $41,580 or
= (33,000 + 30,000) x (1 – tax rate)

Note: Include only after-tax cash flows:

cash flows expected to result from the proposed project must be measured
on an after-tax basis, because the firm will not have the use of any cash
flows until it has satisfied the government’s tax claims.

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(2) Finding the annual operating cash flows (OCF)

(b) Tax savings from depreciation

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Depreciation matters because it has indirect cash flow impact

Depreciation itself is a non-cash expense; consequently, it is only relevant

because it reduces the tax payment.

With Without
depreciation depreciation
Earnings before taxes and depreciation (75,000 -12,000) 63,000 63,000
Depreciation 30,000 -
Earnings before interest and taxes (EBIT) 33,000 63,000
Taxes (34%) 11,220 21,420
Net Income 21,780 41,580

◼Depreciation tax shield / savings = 21,420 – 11,220 = $10,200

❑ Or = Depreciation x Tax rate = 30,000 x 34% = $10,200
❑ yearly tax savings that result from depreciation deduction
❑ Treat as cash inflow
❑ Effect on cash flow is + Without depreciation need to pay more tax

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(2) Finding the annual operating cash flows (OCF)

◼ (a) After-tax operating cash income 41,580

◼ (b) Tax savings from depreciation 10,200
After-tax annual operating cash flows $51,780

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(3) Finding the Terminal Cash Flows
◼ Terminal cash flows are the cash flows resulting from
termination of a project at the end of its project life.

◼ In the final year of a project, the assets acquired during the life
of the project may be sold and the working capital that has
been invested may be recovered.

◼ They represent the

❑ (a) after-tax salvage value (殘值) of assets and

❑ (b) recovery of working capital that occur in the final year

of the project.

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 (3) Finding the Terminal Cash Flows
(a) After-tax Salvage Value 殘值(Incremental CFs)
Common Terms about an asset
◼ Book value / remaining book value (賬面價值):
Asset Cost -– Accumulated Depreciation (累計折舊)

◼Depreciation (折舊) is the allocation (分攤) of the cost of an asset to expense over its
estimated life to reflect the wear and tear (損耗) on the asset as it is used to produce the
company’s goods and services.
◼Depreciation (at full cost) = Asset cost / Useful life

◼ Accumulated depreciation means the total depreciation taken to date.

◼Useful life: how long the company expects to receive benefits from the asset before
disposing of it.

◼Salvage value (resale price) (殘值) : the amount the company expects to receive from
selling the asset at the end of its useful life.

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 Calculating Gain/(Loss) on sale of Assets
• Assume that a machine costing $10,000, had accumulated
depreciation of $8,000 and book value of $2,000 (10,000 - $8,000) at
the time it was sold for $3,000 cash.
• Determine the gain or loss on sale of this machine.

 Book Value (BV) = Asset Cost – Accumulated Depreciation

 Selling Price – BV = Gain or Loss on sale of assets

Cost of machine $ 10,000 If Cash > Book Value, record a gain.

If Cash < Book Value, record a loss.
Accumulated depreciation (8,000)
If Cash = Book Value, no gain or loss.
Book value at time of sale 2,000
Cash received 3,000
Gain on sale of machine $ 1,000

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 (3) Finding the Terminal Cash Flows
(a) After-tax Salvage (殘值)
(Incremental CFs)
◼ The proceeds from sale (i.e. resale price) of the
assets, often called “salvage value,”
◼ If the salvage value is different from the book value
of the asset, then there is a tax effect.
Step 1: Remaining Book value = Asset cost – Accumulated depreciation**
(**Accumulated depreciation累計折舊 means the total depreciation taken to
date) Gain →tax
◼ Step 2: After-tax cash flow from asset sale (salvage value) * payment

= Resale price – Tax Rate (Resale price – remaining book value)

* A one-off cash inflow to the firm at the end of the project

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(3) Finding the Terminal Cash Flows
(a) After-tax Salvage (Incremental CFs)
❑ If the proceeds from the sale (i.e. resale price) are expected to exceed book
value, a tax payment shown as an outflow (deduction from sale proceeds)
will occur. Gain on sale → tax
payment (outflow)
= Resale price – Tax Rate (Resale price $3,000 – remaining book value $2,000)

❑ When the proceeds from the sale are less than book value, a tax rebate
shown as a cash inflow (addition to sale proceeds) will result.
Loss on sale → tax
rebate (inflow)
= Resale price – Tax Rate (Resale price $4,000 – remaining book value $5,000)

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 (3) Finding the Terminal Cash Flows
(a) Example: Depreciation and After-tax Salvage Q1??

◼ You purchase equipment for $120,000. At the end of year 3, you believe that the
salvage value of the equipment is $20,000. The company’s tax rate is 40%.
Assumed the useful life of the equipment is 6 years.

◼ Q1. What is the depreciation expense each year under straight-line

depreciation method? (Depreciation at full cost)
Depreciation = ??

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 (3) Finding the Terminal Cash Flows
(a) Example: Depreciation and After-tax Salvage Q2??
◼ You purchase equipment for $120,000. At the end of year 3, you believe that the
salvage value of the equipment is $20,000. The company’s tax rate is 40%.
Assumed the useful life of the equipment is 6 years.

Q2. What is the after-tax salvage value in year 3?

Remaining book value in year 36 = ??

❑ After-tax salvage value = ??

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(3) Finding the Terminal Cash Flows
(b) Changes in Net Working Capital (are part of incremental CFin)
◼ At the end of the project’s life, NWC will return to its original level
as inventories are sold, receivables are collected, and bills are paid.
In any event, the recovery of NWC is a one-off cash inflow at the
end of the project’s life.

◼ Example: $20,000 additional working capital as initial investment

was fully recovered at the final year of the project which is year 3.

0 1 2 3

-20,000 +20,000

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Put it all together - Projected Total Cash Flows
Year

0 1 2 3

(1) Investment -$120,000

Costs
After tax operating
Cash Income
(2) After-tax operating ($41,580) + Tax $51,780 $51,780 $51,783(a)0
cash flows Saving from
Depreciation
($10,200)
(3a) After-tax salvage Salvage Value
cash flows ($20,000) + Tax 36,000
Rebate (16,000)
(3b) Changes in NWC -$20,000 20,000

Total Project -$140,000 $51,780 $51,780 $107,780

Cash Flows

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Projected Total Cash Flows(cont’d) ??

◼ What is the NPV of the project with discount rate of 20%?

Year 0 1 2 3
Total Project CF -$140,000 $51,780 $51,780 $107,780

107,780
◼ NPV = 1,481.02

Accept or Reject the project? Why? because NPV > 0.

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(3) Finding the Terminal Cash Flows??
(a) Example: After-tax Salvage value for land (no depreciation charged to land)

◼ Land has unlimited useful life, therefore no depreciation charged.

Gain on sale of land is considered as a capital gain.
◼ You purchase a piece of land at $5m for a project today. The project will
be last for 6 years. The land is expected to sell at $8 million at the end of
the project. The capital gain tax (資本利得稅) is 10%. The discount rate
is 15%.
◼ Q1. What is the gain on sale of land (i.e. after-tax salvage value)?
◼ After-tax salvage value at year 6 = ??:
Resale price – Tax Rate (Resale price – remaining book value)

◼ Q2. What is the today value (PV) of the gain on sale of land = ??:
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Readings and Exercises: Chapter 13

Readings:
◼Textbook: Brigham Chapter 13

◼(section 13.2b, 13.2c, 13.2d, and those sections

related to the lecture notes)

Exercises:
Supplementary Exercises: Ex 8 (hard copies)

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END

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