Cash Flow Analysis for Project Evaluation
Construction of Cash Flows
Cash flows are a crucial aspect of project analysis, as they represent the financial viability of the project. Cash flow analysis allows us to measure the profitability of an investment by systematizing all the financial aspects, including:
- Initial investment
- Investments during operation
- Revenues and expenditures for operation
- Salvage value of the project
- Recovery of working capital
Main Uses of Cash Flow Analysis:
- Measure the profitability of the project
- Measure the return on equity
- Measure the company’s ability to repay loans obtained for financing
The preparation of cash flow differs based on the type of company (new company vs. a company in operation).
Elements of Cash Flow:
Initial Expenditure Funds:
This refers to the total initial investment required for project implementation, including working capital outflow at time zero.
Revenues and Operating Expenses:
These are all the actual cash inflows and outflows.
- Income = Total Sales
- Expenses = Total Cost of Sales (Cost of Goods Sold)
Timing of Revenues and Expenditures:
Cash flow is time-sensitive. Time zero marks all expenditures before project implementation. For instance, when replacing a machine, the sale of old equipment is considered income, while the purchase of new machinery is an expense.
Scrap or Salvage Value of the Project:
When projecting cash flows, the salvage value of the project should be estimated. The simplest method is using the book value of the assets (less accurate). A more complex and efficient method is determining the present value of future net benefits, considering the cost of the project in operation.
Tax on Profits:
To determine tax expenditure, non-cash expenses like depreciation of fixed assets, amortization of intangible assets, and the book value of assets sold are analyzed.
Depreciation (Not a Cash Outflow):
Depreciation does not involve a cash outlay. It is an accounting measure to reduce tax expenses. Assets are depreciated at the same rate each year (straight-line method).
Classification of Costs:
Cost of Construction:
- Direct Costs: All expenses directly related to the production process (e.g., cost of manufacture, raw materials, and direct labor).
- Indirect Costs: All indirect labor costs (e.g., energy, water, communications).
Operating Expenses:
- Selling & General (SG&A) Expenses: Salaries, social insurance, gratuities, transportation, storage, etc.
- General and Administrative Expenses: Labor costs, rent, office supplies, office equipment, taxes, etc.
Financial Expenses:
Interest on borrowings to finance the company.
Structure of a Cash Flow:
| + | Tax Revenue |
| – Tax Expenditure | |
| – Non-Cash Expenses | |
| = | Income Before Tax |
| – Tax | |
| = | Income After Tax |
| + | Non-Cash Expenses |
| – Expenses Not Subject to Tax | |
| + | Tax Benefits |
| = | Cash Flow |
Income (sale of goods) and expenses pertaining to taxes (manufacturing cost) impact the company’s accounting profit.
Non-cash expenses reduce the tax burden but are not cash outflows (e.g., depreciation, amortization, asset book value). They are subtracted and then added back to account for their tax benefit.
Expenses not subject to taxes are investments that do not affect the company’s accounting wealth upon purchase (e.g., asset changes). These are zero for investments in land, physical works, and machinery.
Tax benefits include the value of waste recovery and working capital recovery.
Cash Flow of the Investor:
This section analyzes the effect of financing and debt repayment. It includes interest on the loan, loan repayment, and other financing costs.
| Value Share | Loan | Interest | Balance |
|---|
The share value is subtracted from the interest to determine the loan amount. The loan is then deducted from the balance to calculate the remaining debt.
Another way to finance a project is through leasing, which allows a company to use an asset without upfront payment.
Project Cash Flows for Businesses in Operation:
Projects for businesses already in operation include:
- Expansion
- Internalization (Outsourcing)
Two Ways to Evaluate Cash Flows:
- Projecting inflows and outflows separately.
- Projecting the incremental flow of revenues and expenses.
EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization):
EBITDA is a financial indicator used to analyze and compare profitability across companies and industries. It is based on projected cash flows and is widely used by investors and corporations.
EBITDA measures a company’s financial performance by eliminating the effects of tax and financing structure. It does not represent the net cash flow but serves as a profitability indicator that reflects a firm’s ability to generate profits.
“Debt and unpaid obligations are commitments that a company must address, regardless of the alternatives available at any given time.”
Criteria and Evaluation of Projects:
Fundamentals of Financial Mathematics:
Financial mathematics considers the time value of money. When evaluating a project, the smallest current consumption and the amount of cash flows over time should be considered. The recovery should include the required reward.
Net Present Value (NPV):
NPV calculates the present value of future cash flows, discounted at a specific rate. A project is accepted if the NPV is greater than zero, rejected if it is less than zero, and may be accepted if it is equal to zero (depending on the minimum required rate of return).
Internal Rate of Return (IRR):
IRR is the discount rate at which the NPV of a project is zero. It represents the highest rate an investor could pay without losing money, assuming all funds are financed and the loan is repaid with the investment’s cash inflows.
NPV vs. IRR:
While both methods provide insights into a project’s profitability, they may lead to different conclusions, especially when dealing with unconventional cash flows or mutually exclusive projects.
Payback Period:
The payback period determines the time required to recover the initial investment. This result is compared to the company’s acceptable timeframe. However, this method does not consider subsequent profits, the cost of liquidity, or the time value of money.
Effects of Inflation on Project Evaluation:
When evaluating a project, it is crucial to use real cash flows (adjusted for inflation) rather than nominal values. Inflation erodes the purchasing power of cash and receivables, impacting the project’s profitability.