4 Analysing Project Cash Flow

ANALYZING PROJECT CASH
FLOW
(INCOME APPROACH VALUATION)
I.K. GUNARTA
CAPITAL BUDGETING
Capital Budgeting: The process of planning

for purchases of long-term assets.
For example: Our firm must decide whether to

purchase a new plastic molding machine for
$127,000. How do we decide?
• Will the machine be profitable?
• Will our firm earn a high rate of return on the
investment?
The relevant project information follows:

▪ The cost of the new machine is $127,000.
▪ Installation will cost $20,000.
▪ $4,000 in net working capital will be needed at
the time of installation.
▪ The project will increase revenues by $85,000 per
year, but operating costs will increase by 35% of
the revenue increase.
▪ Simplified straight line depreciation is used.
▪ Class life (economic life) is 5 years, and the firm
is planning to keep the project for 5 years.
▪ Salvage value at the end of year 5 will be $50,000.
▪ 14% cost of capital; 34% marginal tax rate.
Capital Budgeting Steps
1) Evaluate Cash Flows
Look at all incremental cash flows
occurring as a result of the project.
▪ Initial outlay
▪ Differential Cash Flows over the life
of the project (also referred to as
annual cash flows).
▪ Terminal Cash Flows
0 1 2 3 4 5 6 ... n
Initial
outlay
0 1 2 3 4 5 6 ... n
Initial
outlay
0 1 2 3 4 5 6 ... n
Annual Cash Flows

Initial Terminal
outlay Cash flow
0 1 2 3 4 5 6 ... n
Annual Cash Flows

2) Evaluate the Risk of the Project

▪ We’ll get to this in the next chapter.
▪ For now, we’ll assume that the risk of the
project is the same as the risk of the
overall firm.
▪ If we do this, we can use the firm’s cost of
capital as the discount rate for capital
investment projects.
3) Accept or Reject the Project

Step 1: Evaluate Cash Flows
a) Initial Outlay: What is the cash flow at
“time 0?”
(Purchase price of the asset)

+ (shipping and installation costs)
(Depreciable asset)
+ (Investment in working capital)
+ After-tax proceeds from sale of old asset
Net Initial Outlay
“time 0?”
(127,000)
+ (shipping and installation costs)
(Depreciable asset)
Net Initial Outlay
“time 0?”
(127,000)
+ ( 20,000)
(Depreciable asset)
Net Initial Outlay
“time 0?”
(127,000)
+ ( 20,000)
(147,000)
Net Initial Outlay
“time 0?”
(127,000)
+ (20,000)
(147,000)
+ (4,000)
Net Initial Outlay
“time 0?”
(127,000)
+ (20,000)
(147,000)
+ (4,000)
+ 0
Net Initial Outlay
▪ a) Initial Outlay: What is the cash flow at
“time 0?”
(127,000) Purchase price of asset

+ (20,000) Shipping and installation
(147,000) Depreciable asset
+ (4,000) Net working capital
+ 0 Proceeds from sale of old asset
($151,000) Net initial outlay
“time 0?”
(127,000) Purchase price of asset

+ (20,000) Shipping and installation
(147,000) Depreciable asset
+ (4,000) Net working capital
+ 0 Proceeds from sale of old asset
($151,000) Net initial outlay
b) Annual Cash Flows: What
incremental cash flows occur over the
life of the project?
For Each Year, Calculate:
Incremental revenue
- Incremental costs
- Depreciation on project
Incremental earnings before taxes
- Tax on incremental EBT
Incremental earnings after taxes
+ Depreciation reversal
Annual Cash Flow
For Years 1 - 5:
Incremental revenue
- Incremental costs
Annual Cash Flow
For Years 1 - 5:
85,000
- Incremental costs
Annual Cash Flow
For Years 1 - 5:
85,000
(29,750)
Annual Cash Flow
For Years 1 - 5:
85,000
(29,750)
(29,400)
Annual Cash Flow
For Years 1 - 5:
85,000
(29,750)
(29,400)
25,850
Annual Cash Flow
For Years 1 - 5:
85,000
(29,750)
(29,400)
25,850
(8,789)
Annual Cash Flow
For Years 1 - 5:
85,000
(29,750)
(29,400)
25,850
(8,789)
17,061
Annual Cash Flow
For Years 1 - 5:
85,000
(29,750)
(29,400)
25,850
(8,789)
17,061
29,400
Annual Cash Flow
For Years 1 - 5:
85,000 Revenue
(29,750) Costs
(29,400) Depreciation
25,850 EBT
(8,789) Taxes
17,061 EAT
29,400 Depreciation reversal
46,461 = Annual Cash Flow
c) Terminal Cash Flow: What is the cash

flow at the end of the project’s life?
Salvage value
+/- Tax effects of capital gain/loss
+ Recapture of net working capital
Terminal Cash Flow

50,000 Salvage value

+/- Tax effects of capital gain/loss
+ Recapture of net working capital
Terminal Cash Flow
Tax Effects of Sale of Asset:
▪ Salvage value = $50,000.
▪ Book value = depreciable asset - total
amount depreciated.
▪ Book value = $147,000 - $147,000
= $0.
▪ Capital gain = SV - BV
= 50,000 - 0 = $50,000.
▪ Tax payment = 50,000 x .34 = ($17,000).


(17,000) Tax on capital gain
Recapture of NWC
Terminal Cash Flow


4,000 Recapture of NWC
Terminal Cash Flow


4,000 Recapture of NWC
37,000 Terminal Cash Flow
Project NPV:
▪ CF(0) = -151,000.
▪ CF(1 - 4) = 46,461.
▪ CF(5) = 46,461 + 37,000 = 83,461.
▪ Discount rate = 14%.
▪ NPV = $27,721.
▪ We would accept the project.
Capital Rationing
▪ Suppose that you have evaluated

five capital investment projects
for your company.
▪ Suppose that the VP of Finance
has given you a limited capital
budget.
▪ How do you decide which
projects to select?

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ANALYZING PROJECT CASH

Capital Budgeting: The process of planning

For example: Our firm must decide whether to

The relevant project information follows:

Annual Cash Flows

Annual Cash Flows

2) Evaluate the Risk of the Project

3) Accept or Reject the Project

(Purchase price of the asset)

(127,000) Purchase price of asset

(127,000) Purchase price of asset

c) Terminal Cash Flow: What is the cash

c) Terminal Cash Flow: What is the cash

50,000 Salvage value

c) Terminal Cash Flow: What is the cash

50,000 Salvage value

c) Terminal Cash Flow: What is the cash

50,000 Salvage value

c) Terminal Cash Flow: What is the cash

50,000 Salvage value

▪ Suppose that you have evaluated

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