Projecting Cash Flows

Net cash flow from a project is the difference between cash receipts and cash expenditures over the life of a project. Some general guidelines must be followed in estimating cash flows.

1.       Cash flows must be measured on an incremental basis. That is, the cash flow from a project should be measured by the difference between the stream of the firm's cash flows with and without the project. Any increase in the expenditure or reduction in the receipts of other divisions of the firm resulting from the adoption of a given project must be considered.

2.       Cash flows must be estimated on an after tax basis, using the firm's marginal tax rate.

3.       As a non-cash expense, depreciation affects the firm's cash flow only through its effect on taxes.

Suppose a firm considers addition of a new product line, which will cost Rs 1 million. The marketing division expects the life of the project to be 5 years. Incremental sales revenues are estimated to be Re 1 million during the first year of operation and to rise by 10 per cent per year until the fifth year, when the product will be replaced.

The production department projects that the incremental variable costs of producing the product will be 50 per cent of incremental sales revenue and that the firm would incur additional fixed costs of Rs 150,000 per year. The finance department anticipates a marginal tax rate of 40 per cent for the firm. The finance department of the firm would use the straight line depreciation method so that the annual depreciation charge would be Rs 200,000 per year for five years.

The salvage value of the initial equipment is estimated to be Rs 250,000, and the firm expects to recover Rs 100,000 of its working capital at the end of the fifth year.

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