Estimating Project Costs & Benefits:

Basic Principles

1
 Basic Principles
• In order to evaluate any Investment project, its costs &
benefits have to be estimated.
• While estimating the costs and benefits, the following
principles have to be considered:
1. Cash Flow Principle
2. Incremental Principle
3. Consistency Principle
4. Interest exclusion Principle (Separation Principle)
5. Post-tax Principle

Estimating Project Costs & Benefits 2

 Cash Flow Principle
• Costs & Benefits must be measured in terms of Cash Flows

 Profits are based on Accrual Concept:

 Revenues are recognized when they are earned not when cash is received.
 Expenses are recognized when they become due & not when paid.

 Expenditure are classified as ‘Revenue’ & ‘Capital’:

 Revenue expenditure is entirely charged
 Capital expenditure is capitalized & depreciated over economic life.

• Cash Flows are superior than Revenues & Expenses

• In operational terms: Add back Depreciation & other non-cash
charges, which were deducted while computing Accounting
profits, as they do not result in cash outflows.
Cash Flow = PAT + Depreciation & other non-cash charges

Estimating Project Costs & Benefits 3

 PAT Vs. Cash Flow
Income Statement Cash Flow
Sales Revenue 1,000.0 Inflow 1,000.0
Less: Cost of Sales 640.0 Outflow 640.0
EBDIT 360.0
Less: Depreciation 50.0 Non-Cash
EBIT 310.0
Less: Interest 40.0 Outflow 40.0
PBT 270.0
Less Taxes @35% 94.5 Outflow 94.5
PAT 175.5 Net Cash Flow 225.5
Cash Flow = PAT + Depreciation
Estimating Project Costs & Benefits
225.5 = 175.5 + 50.0
4
 Incremental Principle
• Cash Flows must be measured in Incremental terms -changes in
cash flows due to the proposed project are relevant.

Project CF = CF of FIRM WITH project - CF of FIRM WITHOUT project

1. Consider all incidental effects: Project may improve or reduce the

profitability of existing operations. Complementary vs.
Competitive relationships with existing products need to be
analyzed.
 Product cannibalization
• In a Highly Competitive scenario, product cannibalization
will occur anyway, hence no need to factor in.
• In businesses with entry barriers, such impact need to be
factored in. (present value of lost post-tax profits)
 Synergies with existing businesses
 Consider sales forecasts today plus after-sales cash flows also
Estimating Project Costs & Benefits
5
 Incremental Principle
2. Ignore Sunk costs: Sunk costs are expenditure already incurred
on the project, prior to project analysis which cannot be
recovered.
– It is not affected by acceptance or rejection of the project
under consideration.
• Cost of Test Marketing, prior to conducting full-blown
investment analysis.
• R & D costs.
• Cost of Old machine in a replacement decision.

Estimating Project Costs & Benefits

6
 Incremental Principle (Contd.)

3. Include Opportunity Costs: If a project uses resources already

available with the firm, the opportunity cost of such resources
should be charged to the project.
• “Is there any alternative use of the resources if the project is not
undertaken ? ”
• Compare “with vs. without” and not “before vs. after”
Scenario A: Resources have current alternative uses:

 Analyze the alternative uses and factor in the opportunity costs:

– Resources may be rented  Lost rental income
– Resources may be sold  sale price net of taxes & lost depreciation tax
shield
– Resources may be used elsewhere in the firm cost of replacing
Scenario B: Resources have no current alternative use, but the firm
has to forgo the alternative uses in the future. E.g.. Excess
Capacity
Estimating Project Costs & Benefits 7
 Incremental Principle (Contd.)

4. Question the Allocation of Overheads: Overhead cost are costs

which are indirectly related to a product (Administrative, Legal
expenses etc.) which are Spread over (allocated) over units
produced.
• What matters is the incremental overhead cost attributable to
the project & not allocated overhead costs.
5. Include Working Capital Requirements: NWC=CA-CL.
• Besides the initial investment in Plant & Equipment, projects also
require additional investment in working capital, which must be
recognized in cash flows.
• Requirement of NWC is likely to change over time, which must
also be factored in.
• On project termination, working capital is released, which must
be treated as cash inflow.
6. Consider Salvage value
Estimating Project Costs & Benefits
MRI @ Max Health 8
 Interest exclusion Principle
• Cost of Long term debt should be excluded from the estimation
of Cash Flows
• Interest on Long term debt may be reflected by:
– Charging interest on Long term debt from Profit OR
– Discounting the Cash Flows by WACC, which includes cost of
debt as well
• If interest on Long term debt is considered in Cash Flows which
are then discounted @ WACC, then cost of debt is being
considered twice.
• In operational terms:
 Exclude Interest on Long-term debt, or
 If interest on debt has been deducted while calculating PAT, then
Interest *(1-tax rate) should be added back to PAT.

Estimating Project Costs & Benefits 9

 Interest exclusion Principle (contd.)

Particulars A B
EBDIT 1000 1000
Depreciation 50 50
EBIT 950 950
Interest 100 -
PBT 850 950
Taxes @ 30% 255 285
PAT 595 665
Cash Flow 595+50+100*(1-0.30) = 715 665+50=715
EBIT*(1-tax rate) = (PBT+ Interest) * (1-tax rate)
= PBT*(1-tax rate) + Interest*(1-tax rate)
= PAT + Interest*(1-tax rate)
Estimating Project Costs & Benefits 10
 Post-tax Principle
• Cash Flows should be measured on after–tax basis.
• Similarly, the hurdle rate (minimum required rate of return)
should also be on post-tax basis.
• Consider the marginal rate of tax (not average)
• Treatment of Losses:

Case Project Firm Treatment

1 Profits Profits Consider Taxes in the year of profit
2 Losses Profits Take tax savings in year of loss
3 Profits Losses Defer taxes until firm makes profits
4 Losses Losses Defer Tax Savings
5 Losses __ Defer Tax savings until project makes
(Stand Alone)
profits

Estimating Project Costs & Benefits 11

 Post-tax Principle

Estimating Project Costs & Benefits 12

 Consistency Principle
• Cash Flows and the discount rates applied to these cash flows
must be consistent with respect to:
– investor group and
– inflation.
 Investor Group: Cash Flows may be estimated from the point of
view of: (a) All investors - Equity & Debt Holders,
(b) Equity shareholders only
• CFs available to all investors (CF to the Firm) are pre-debt, after-
tax CFs available to all investors after meeting re-investment needs
of the project.(Free Cash Flow to Firm or FCFF or Unlevered FCF)
= EBIT(1-t) or PAT + interest on LT Debt*(1-t)
+ Depreciation & Noncash Charges
+ Salvage Value of FA/NWC
- Capital Expenditure
- Changes
Estimating Project Costs & Benefits in Working Capital 13
 Consistency Principle (Contd.)

• CF available to Equity: CF available after paying taxes, meeting

re-investment needs and fulfilling debt-related commitments.
(Free Cash Flow to Equity or FCFE)
= PAT
+ Depreciation & Noncash Charges
+ Salvage Value of FA/NWC
- Capital Expenditure
- Changes in Working Capital
- Preference dividend
- Repayment of debt
+ Proceeds from debt issues
- Redemption of Preference Capital
+ Proceeds from Preference issue
• Discount Rate: should be consistent with definition of CF
• CF to All Investors (FCFF) : WACC
• CF to Equity (FCFE)
Estimating Project Costs & Benefits
: Cost of Equity
14
 Consistency Principle (Contd.)

 Inflation:

Two choices:

• If you factor in the impact of inflation in the estimates of Cash

Flows, then apply Nominal discount rate.

• If you estimate future Cash Flows in real terms, then apply Real
discount rate.

(1 + r Nominal) = (1+rReal)(1+ inflation rate)

rReal = {(1 + r Nominal) / (1+ inflation rate)} - 1

Estimating Project Costs & Benefits 15

 Components of Cash Flows
A. Initial Cash Flow:
 Cash flows incurred at the beginning of the project.
 Outlays on Fixed Assets (Cash Outflow)
 Outlays on Net Working Capital (Cash Outflow)
 Sale Proceeds on Old Fixed Assets (Cash Inflow)

B. Operational Cash Flow:

 Cash flows expected during the operational phase (economic
life) of the project.

C. Terminal Cash Flow:

 Cash flows resulting from the liquidation of the project at the
end of its economic life.
 Post-tax salvage value of Fixed Assets (Inflow)
 Post-tax salvage value of Net Working Capital (Inflow)
Estimating Project Costs & Benefits 16
 Components of Cash Flows
Year 0 Year 1 Year 2 Year 3 ……. Year n-1 Year n

Initial
Cash Flow

Operating Operating Operating ……... Operating Operating

Cash Flow Cash Flow Cash Flow Cash Flow Cash Flow

Terminal
Cash Flow

Net Cash Net Cash Net Cash Net Cash ……. Net Cash Net Cash
Flow Flow Flow Flow Flow Flow

Estimating Project Costs & Benefits 17

 Estimating Cash Flows -recap
1. Cash Flow Principle:
 Cash Flow = PAT + Depreciation & other non-cash charges
2. Incremental Principle:
 Project CF = CF of FIRM WITH project - CF of FIRM WITHOUT project
 Consider all incidental effects
 Ignore Sunk costs
 Include Opportunity Costs
 Question the Allocation of Overheads
 Include Working Capital Requirements
 Consider Salvage value
3. Consistency Principle:
 CF to All Investors (FCFF)  WACC
 CF to Equity (FCFE)  Cost of Equity
 CF are on real terms  discount rate should be on real terms basis.
4. Interest exclusion Principle: (Separation Principle)
 EBIT (1-tax rate) OR PAT + Interest(1-tax rate)
5. Post-tax Principle
Estimating Project Costs & Benefits 18
 Estimating Cash Flows
Reliance Enterprises is considering a new investment project of Rs. 70
Mn comprising of Rs.60 Mn. on Plant & Equipment and Rs.10 Mn. on
net working capital. The project will be financed by Equity capital
(Rs.40 Mn.) and Long-term debt @ 13.5% (Rs.30 Mn). The expected
life of the project is 5 years at the end of which the plant and
equipment would fetch a salvage value of Rs. 20 Mn while the
liquidation value of working capital will be equal to Rs.10 Mn.(its book
value). The project will increase the revenues of the firm by Rs.85 Mn.
per year and also increase the expenses by Rs.40 Mn. per year. (other
than depreciation, interest on Long-Term loans & taxes). Plant and
equipment will be depreciated at the rate of 25% per year on WDV
basis. The marginal tax rate will be 30 per cent.
Estimate the cash flows for the proposed project.

Estimating Project Costs & Benefits 19

 Estimating Cash Flows

Estimating Project Costs & Benefits 20

 Estimating Cash Flows

Estimating Project Costs & Benefits 21

 Replacement project
Allied Limited is considering replacement one of its existing machines
with a new machine. The new machine will cost Rs.1,60,000/- and
would have a useful life of 5 years. It will generate annual cash
revenues of Rs.2,50,000/- and incur annual cash expenses of
Rs.1,30,000/-.Estimated salvage value of the new machine is
Rs.8,000/-. The existing machine has a book value of Rs.40,000/- and
can be sold for Rs.20,000/- today. It is good for the next 5 years and
is estimated to generate annual cash revenues of Rs.2,00,000/- and
to involve annual cash expenses of Rs.1,40,000/-. If sold after 5
years, the salvage value of the existing machine can be expected to
be Rs.2,000/-.The tax rate is 35% and the machine depreciate @ 25 %
on written-down value basis.

If the company’s hurdle rate is 10 per cent, should the company

replace the existing machine?
Estimating Project Costs & Benefits 22
Replacement project

23
Replacement project

24
 Lemon Juice Project (Modern Foods)
The Board of Directors of Modern Foods Limited is considering a proposal for a
lemon juice project. The lemon juice would be produced in an unused building
adjacent to the main plant of the company. The building is owned by the firm, is
fully depreciated, however, it can be rented out for an annual rent of Rs. 1 Mn. The
outlay on the project is expected to be Rs. 25 Mn., out of which Rs. 15 Mn. would
be on Plant and Machinery, and the balance Rs. 10 Mn. on Gross working capital.
The proposed project would be finance by Equity of Rs.10 Mn., Term Loan of Rs. 8
Mn., Working Capital finance for Rs. 5 Mn., and the balance Rs. 2 Mn. from Trade
Credit. The term loan is repayable in 8 equal semi-annual installments of Rs. 1 Mn.
each, the first installment being due after 18 months. The term loan carries interest
@ 15% pa. The level of working capital finance and trade credit will remain at Rs. 5
Mn. and Rs. 2 Mn. respectively, till they are paid back or retired at the end of 5
years, which is the expected life of the project. The rate of interest on Working
capital loan would be 14% pa. The lemon juice project is expected to generate
revenue of Rs. 30 Mn. a year, while the operating costs (excluding depreciation and
interest, & taxes) are expected to be Rs. 20 Mn. a year. The depreciation rate on
fixed assets will be 25% as per WDV method. The net salvage value of the fixed
assets at the end of 5 years is expected to be Rs. 5 Mn. Recovery of working capital
at the end of 5 years is expected at its book value. The income tax rate is 30%.
Estimating Project Costs & Benefits
Estimate the FCFF and FCFE. 25
 Lemon Juice Project (Modern Foods)

Estimating Project Costs & Benefits 26

 Lemon Juice Project (Modern Foods)

Estimating Project Costs & Benefits 27

 Lemon Juice Project (Modern Foods)

Estimating Project Costs & Benefits 28

 Lemon Juice Project (Modern Foods)

Estimating Project Costs & Benefits 29

 Lemon Juice Project (Modern Foods)

Estimating Project Costs & Benefits 30

 Attempt
In Practice 9.5 of Damodaran (Page 272)

Correction in problem : Delete point # 4

Estimating Project Costs & Benefits 31

 Coffee Shop at Crosswords (Project Synergies)
Crosswords, a chain of bookstores, is considering to add a coffee shop
which is expected to be an attractive destination for the customers.
The initial investment in equipment required for setting up the coffee
shop shall be Rs. 3,00,000/- . Such investment has an expected useful
life of 5 years and shall depreciate on SLM basis to nil salvage value
by the end of 5th year. Revenues from the coffee shop are expected
to be Rs. 1,20,000/- in the first year, which shall increase by 10% a
year for the next 4 years. Cost of material required to run the coffee
shop is expected to be 30% of the revenue generated each year.
Employee cost shall be Rs. 50,000/- in the first year and shall increase
by 5% each year thereafter. The coffee shop shall also be required to
maintain inventory estimated at 5% of the revenues, such investment
to be made at the beginning of each year. Assume a tax rate of 40% .
Based on the above information, prepare the estimated cash flows for
the coffee shop and evaluate the coffee shop project, if the hurdle
rate is 15%.
Estimating Project Costs & Benefits 32
 Coffee Shop at Crosswords (Project Synergies)

Estimating Project Costs & Benefits 33

 Coffee Shop at Crosswords (Project Synergies)
Next, consider that the coffee shop shall increase the revenues of
Crosswords, the book store, by Rs.8,00,000/- in the first year, which
shall grow @ 10% a year for the next 4 years. Assuming a 10% pre-tax
operating margin on revenue.
Should the Coffee Shop project be undertaken up now?

Estimating Project Costs & Benefits 34

 Big Bazar (Project Cannibalization)
Big Bazar is considering to open a new store which shall require an
initial investment of Rs. 20 Mn. The expected life of the store is 10
years during which it shall depreciated on SLM and shall have a
salvage value of Rs. 7.50 Mn at the end of 10th year. The store shall
generate revenues of Rs. 40 Mn. in year 1 which shall increase by 5%
each year. The pre-tax operating margin (before depreciation) shall be
10%. Working capital shall be 8% of the revenues and such investment
to be made at the beginning of each year. It will borrow Rs. 5 Mn @
5.80% and shall repay the loan in 10 equal yearly instalments. Assume
a tax rate of 35%. The post-tax hurdle rate is 9.78%.

If 25% of the sales of the proposed store comes from another Big
Bazar store in the city, should the project be accepted.

Estimating Project Costs & Benefits 35

 Big Bazar (Project Cannibalization)

Estimating Project Costs & Benefits 36

 Big Bazar (Project Cannibalization)

Estimating Project Costs & Benefits 37

 Big Bazar (Project Cannibalization)

 1 1 
5=x - 10 
 0.058 0.058(1.058) 
5
x= = 0.67
7.4303
Estimating Project Costs & Benefits 38
 Big Bazar (Project Cannibalization)

Estimating Project Costs & Benefits 39

 Online Store (Opportunity Costs)
Crosswords, a bookstore chain, is considering to invest in online book ordering
service, which will be staffed by two full-time employees. The initial investment to
start the service shall be Rs. 1 Mn. which has an expected useful life of 4 years
during which it would be depreciated on SLM basis to nil salvage value. The
revenues from the online business is expected to be Rs. 1.50 Mn in the first year and
is expected to increase by 20% in year 2 and 10% for the next two years. The salaries
shall be Rs. 1,50,000 in year 1 and grow 10% a year for the next 3years. Cost of
books is assumed to be 60% of the revenues each year. Working capital including
inventory of books required to be maintained would be 10% of revenues each year,
such investment to be made at the beginning of each year. Assume a tax rate of
40% for the business.
Based on the above information, prepare the estimated cash flows for the online
business and evaluate it assuming the hurdle rate as 15%.
Besides the two full-time employees required for the online business, the workload
to the General Manager of the company would increase hence would have to be
compensated additionally. He would be given a incentive of Rs. 100,000/- a year
which shall grow @ 5% a year thereafter.
How will this impact the viability of the proposed project.
Estimating Project Costs & Benefits 40
 Online Store (Opportunity Costs)

Estimating Project Costs & Benefits 41

 Online Store (Opportunity Costs)

Estimating Project Costs & Benefits 42

 Online Store (Opportunity Costs)

Estimating Project Costs & Benefits 43