Estimation of Cash Flows in Capital Budgeting

What is called the Estimation of Cash Flows in Capital Budgeting?

Estimating cash flows in capital budgeting refers to predicting the amount of money a company expects to generate or spend on a project over time. Capital budgeting is the process businesses use to evaluate significant investments or expenses, like building a new factory or launching a new product.

Why do we calculate the estimation of cash flows and what are the benefits?

Estimating cash flows in capital budgeting is crucial for assessing the financial viability of investment projects. Here’s why it is important and the benefits:

1. Project Evaluation: It helps determine if a project is worth pursuing by estimating the future inflows and outflows, showing potential profitability.
2. Risk Assessment: Cash flow estimation allows companies to assess risks by analyzing possible fluctuations in revenue, costs, and external factors.
3. Optimal Resource Allocation: It ensures that resources are allocated efficiently by comparing different projects and selecting the most profitable ones.
4. Decision Making: Provides the basis for making informed investment decisions by evaluating metrics like Net Present Value (NPV) and Internal Rate of Return (IRR).
5. Funding Requirements: Helps determine how much external financing may be needed and when it’s required, supporting better financial planning.
6. Performance Monitoring: By comparing actual cash flows to projections, companies can monitor a project’s financial health and adjust strategies as needed.

These benefits collectively enhance the decision-making process, ensuring better investment choices.

When estimating cash flows, companies look at:

1. Initial Costs: How much money needs to be invested upfront to start the project?
2. Operating Cash Flows: The money the project is expected to generate each year through its operations (like sales revenue minus operating costs).
3. Terminal Cash Flow: Any final cash flows, such as selling off equipment or property when the project ends.

The goal is to calculate all these expected inflows and outflows to determine whether the project will be profitable. Companies use these cash flow estimates to decide if the investment is worth pursuing.

As we already know based on decision criteria, projects are divided into two types: Independent projects and mutually exclusive projects

Independent Projects vs. Mutually Exclusive Projects

• Independent Projects: These are projects that do not affect one another. You can choose to do one, both, or neither, and they won’t interfere with each other. For example, if a company is deciding whether to open a new office in City A or launch a new product, both projects can be pursued independently, meaning the decision on one doesn’t impact the other.

• Mutually Exclusive Projects: These are projects where only one can be selected. Choosing one means you automatically reject the other(s). For instance, if a company needs to choose between purchasing two different types of machines for production, it can only choose one because they serve the same purpose, and buying both would be unnecessary.

When estimating cash flows, we can categorize projects into two additional types based on their purpose or motivation. These are:

• Expansion Projects: Expansion projects are undertaken to grow the business by adding new products and services or increasing current operations’ capacity. These projects are motivated by the desire to increase revenue and market share.

Example: Imagine a company manufacturing sports shoes. An expansion project for this company would be building a new factory to produce a higher quantity of shoes. This project’s motive is to increase the production capacity, allowing the company to sell more products in the market, which will, in turn, generate more revenue.

• Replacement Projects: Replacement projects are carried out when a company needs to replace an existing asset or system with a newer one, usually because the old one is outdated, inefficient, or no longer working well. The motivation here is often cost reduction, efficiency improvement, or maintaining operational capacity.

Example: Suppose the same shoe company has an old manufacturing machine that frequently breaks down and is costly to maintain. A replacement project would involve buying a new, more efficient machine that can produce shoes faster and at a lower cost.

In this blog, I will explain three common formats for estimating the cash flows of a project. Whether the project is an expansion or a replacement project, these formats apply to both.

• Initial Investment Outlay (Money you spend at the beginning)
• Incremental Operating Cash Flows (Money coming in and going out during business operations)
• Terminal Cash Flows (The money you get at the end when you stop)

 Let me explain each of these with a story:

Imagine you are planning to open a lemonade stand. Before starting, you need to think about how much money this project will bring in and how much it will cost you over time. This is exactly what companies do when they think about investing in big projects.

Step-by-Step:

Initial Investment Outlay (Money you spend at the beginning)

This format estimates the initial investment, focusing on calculating the total investment made at the very beginning of a project’s timeline, which is at time zero (t=0). This is when a company invests in a project to get it started. This initial investment is also referred to as an outflow, as it represents an expenditure.

When you first decide to open your lemonade stand, you need to buy things like lemons, sugar, a table, cups, and maybe even an umbrella. This is called the initial investment. You are spending money upfront to get your business started.

Incremental Operating Cash Flows (Money coming in and going out during business operations)

Incremental operating cash flows are the money a business earns or spends from its regular operations after an initial investment is made. They occur over the life of a project, starting after the investment and continuing until the project ends.

So, once your lemonade stand is set up, every day you will sell lemonade and make money. But you also have to keep buying more lemons and sugar. The difference between what you earn from sales and what you spend on ingredients is your operating cash flow. This will keep happening every day that you run your stand.

Terminal Cash Flows (The money you get at the end when you stop)

At some point, maybe after the summer ends, you decide to close your lemonade stand. You might sell your umbrella or table to someone else. This is called the terminal cash flow, the money you get when you stop the business and sell off any leftover assets. This type of cash flow might occur at any time in the future.

Explanation and calculation of each format of estimating the cash flows

Format for estimating the initial cash investment in a project

The format for estimating the initial cashflow looks like this,

Cost of new assets

(+) Capitalized expenditure (transportation cost, installation costs, and pre-testing costs)

(+/-) Increased/decreased in net working capital

(-) Net proceeds from the sale of old assets (if the investment is a replacement decision)

(+)Tax savings due to the sale of old asset (if the investment is a replacement decision)

=Total Initial cash investment

To be noted: This format provides a general idea, but it is not fixed. The calculation for estimating the initial cash flow will ultimately depend on the specific nature of the project.

In the blog “Estimation of Initial Investment in Capital Budgeting” I’ve discussed the whole process and calculation of estimating the total initial cash investment in a project.

Format for estimating the operating cash flows in a project

The format for estimating the operating cash flows looks like this,

In the blog “Estimation of Operating Cash Flows in Capital Budgeting” I’ve discussed the whole process and calculation of estimating the overall operating cash flows from a project and also explained the whole process of tax adjustment into the cash flow under salvage value.

Coming to the last format that is terminal cash flows.

What is called the terminal cash flow of a project?

Terminal cash flows refer to the final inflows and outflows a company experiences at the end of a project’s life. They typically include the salvage value of an asset, recovery of working capital, and any associated tax effects. These terminal cash flows are vital because they can significantly affect the total return on investment (ROI).

Components of Terminal Cash Flow:

• Salvage Value: This is the estimated resale value of the asset at the end of its useful life. If the asset is sold for more than its book value, a gain is realized, and taxes are paid on this gain. If sold at a loss, a tax deduction can occur.

• Recovery of Working Capital: Any investment in working capital made during the project’s life (inventory, receivables) may be recovered at the project’s end. This is a cash inflow.

• Tax Implications: The tax impact on the salvage value must be considered. Gains from selling the asset above book value are taxable, while losses may provide tax relief.

Adjusting Terminal Cash Flows with Operating Cash Flows

At the end of a project, the terminal cash flow is adjusted with the final operating cash flow. The operating cash flows are the net benefits from the project over time, and the terminal cash flow is the final inflow or outflow that occurs when the project ends.

How to Adjust:

1. Add the Salvage Value to the Final Year’s Net Cash Benefits.
2. Adjust for Tax Impacts:
   • If the salvage value exceeds the book value: Deduct taxes on the gain from the salvage.
   • If the salvage value equals the book value: No taxes are applied.
   • If the salvage value is less than the book value: Adjust for tax savings due to the loss.

Let me clear this up with an example:

Let’s say you run a manufacturing business that decides to invest in machinery for a project. You purchase a machine for $50,000. Over the next five years, it generates operating cash flows and is depreciated to a book value of $10,000. At the end of its life, the machine is sold for $15,000.

Steps:

• Operating Cash Flows: Assume the machine generates $200,000 in operating cash inflows over the project’s five years. After accounting for depreciation and taxes, the net cash benefits (NCB) total $160,000.

• Salvage Value: At the end of year 5, the machine is sold for $15,000, creating a taxable gain of $5,000 (15,000 sale price – 10,000 book value).

• Tax Impact: Let’s assume a 20% tax rate on the gain. The tax on the salvage value is $1,000 ($5,000 * 20%).

• Adjusted Salvage Value: After deducting the tax, the adjusted salvage value is $14,000 ($15,000 – $1,000).

You will input this salvage value of $14,000 in the operating cash flows format. I hope you are being able to connect the dots. If you are still not clear, go above and check the format of operating cash flows, I hope you’ll understand.

For more clear knowledge, you can read the blog “Estimation of operating cash flows in Capital Budgeting” I also explained the adjustment of tax here as well.

Overall, the purpose of this blog was to explain the whole process of estimating the cash flows in capital budgeting.

If you still need any more clarification regarding any part feel free to comment below.