Cash flow projections and the application of techniques to estimate cashflows

Welcome to the Core of Project Appraisal!

Hi there! Welcome to one of the most practical and important chapters in your CB1 journey. In the previous chapters, you might have learned about different ways to value a business or a project. But how do we get the numbers that go into those calculations? That is exactly what we are going to cover today.

Estimating cash flows is like being a detective. You need to look at a project and decide which pieces of money moving in and out actually "count." Get this right, and your Net Present Value (NPV) calculations will be solid. Get it wrong, and you might recommend a project that actually loses money!

Don't worry if this seems a bit technical at first. We will break it down step-by-step, using simple logic and real-world examples.

1. The Fundamental Golden Rule: The Incremental Principle

The most important thing to remember is the Incremental Principle. When evaluating a project, we only care about the change in cash flows that happens specifically because we took on the project.

Ask yourself: "If I don't do this project, does this cash flow still happen?"
- If the answer is Yes, ignore it.
- If the answer is No, include it.

Sunk Costs (The "Let It Go" Costs)

A Sunk Cost is money that has already been spent and cannot be recovered, regardless of whether the project goes ahead.
Example: You spent \$10,000 last year on a feasibility study to see if a new juice bar would work. Whether you open the juice bar today or not, that \$10,000 is gone.
Common Mistake: Students often try to include sunk costs to "recoup" them. In CB1, we ignore them! We only look forward, never backward.

Opportunity Costs (The "Road Not Taken")

An Opportunity Cost is the value of the next best alternative that you give up to do this project. Even if no physical cash leaves your pocket today, it is a real cost.
Example: If you use a warehouse you already own for a new project, you can't rent it out to someone else. The lost rent is a cash outflow for the project.

Side Effects and Externalities

Sometimes a new project affects your existing business. This is often called Cannibalization or Erosion.
Example: If Apple releases a new iPhone, sales of the older iPhone might drop. We must subtract those lost sales from the new project’s cash flows.

Quick Summary: Only include Incremental flows. Ignore Sunk Costs. Include Opportunity Costs and Side Effects.

2. Dealing with Inflation

Inflation is the general increase in prices over time. In CB1, you must be very careful to be consistent. There are two ways to handle this:

1. Nominal Approach: Use "Nominal Cash Flows" (the actual dollars you expect to see in the future, including inflation) and discount them using a "Nominal Discount Rate."
2. Real Approach: Use "Real Cash Flows" (expressed in today's purchasing power) and discount them using a "Real Discount Rate."

The Golden Rule of Consistency: Never mix and match!
- Nominal Flows + Nominal Rate = Correct.
- Real Flows + Real Rate = Correct.
- Nominal Flows + Real Rate = Disaster!

The Fisher Equation

You can convert between real and nominal rates using this formula:
\( (1 + i) = (1 + r) \times (1 + h) \)
Where:
\( i \) = nominal interest rate
\( r \) = real interest rate
\( h \) = expected inflation rate

Memory Aid: Think of Nominal as "Name only" (the number on the bill) and Real as "Real power" (what it can actually buy).

3. Taxation and Capital Allowances

Tax is a real cash outflow. However, the government often gives businesses a "discount" on their taxes to encourage investment in equipment. This is done through Capital Allowances (sometimes called Tax-allowed Depreciation).

The Tax Shield

Depreciation itself is not a cash flow (it's just an accounting entry). However, because depreciation reduces your taxable profit, you pay less tax. This saving is called a Tax Shield.

The cash flow effect of a capital allowance is:
\( Tax\ Saving = Capital\ Allowance \times Tax\ Rate \)

Tax Timing

In many exam questions, tax is not paid in the same year the profit is earned. It is often paid one year later.
Example: If a project earns profit in Year 1, the tax cash outflow might occur in Year 2. Always read the question carefully to see if tax is paid "in the same year" or "in arrears."

Key Takeaway: Depreciation is NOT a cash flow, but the Tax Saving resulting from it IS a cash flow.

4. Working Capital

When you start a project, you often need to tie up money in Working Capital (like buying inventory or having cash in the till). This is a cash outflow at the start of the project.

As the project grows, you might need more working capital (an additional outflow). At the end of the project, you usually recover all that working capital (a cash inflow), as you sell off the last of the stock and collect your final payments.

Quick Review Box: Working Capital Tips
- Initial investment = Outflow (Year 0).
- Increase in working capital = Outflow.
- Decrease in working capital = Inflow.
- Recovery at the end = Inflow (usually in the final year).

5. Step-by-Step: How to Estimate Project Cash Flows

When you face a complex problem, follow these steps to stay organized:

1. Identify the Initial Investment: This includes the cost of the asset, delivery, and setup, plus any initial working capital.
2. Forecast Operating Cash Flows:
- Calculate Revenues (Price x Volume).
- Subtract Operating Costs (Variable and Fixed).
- Note: Do NOT subtract interest payments here! Interest is handled by the discount rate.
3. Calculate Tax: Apply the tax rate to the operating profit, making sure to subtract capital allowances first to find the taxable amount.
4. Identify Terminal Cash Flows: At the end of the project, add back any scrap value (salvage value) of the equipment and the recovery of working capital.

6. Common Mistakes to Avoid

Don't worry if this seems tricky at first, many students make these mistakes! Just keep an eye out for them:

- Including Interest Payments: In project appraisal, we use the discount rate (like WACC) to account for the cost of financing. If you subtract interest payments as a cash flow AND use a discount rate, you are double-counting the cost of money.
- Forgetting the Terminal Value: Many students forget to "clean up" at the end of the project by adding back the scrap value and working capital recovery.
- Miscalculating the Tax Shield: Remember that you only get the tax saving on the allowable depreciation, not the total cost of the asset all at once (unless it's a 100% first-year allowance).

Final Summary

- Cash flows must be incremental.
- Sunk costs are ignored; Opportunity costs are included.
- Be consistent with Inflation (Nominal vs. Real).
- Working capital is invested at the start and recovered at the end.
- Tax is a cash flow, and Capital Allowances provide a Tax Shield.

You’ve got this! Practice setting up these cash flows in a table format (Year 0, Year 1, Year 2...) to keep your work clear and easy to follow.