Hi everyone, so far we have learned how to apply capital budgeting techniques to calculate NPV, IRR, and the payback period. However, we still have a very important task left in a project valuation, which is estimating cash flows from the project. Overall, project cash flow analysis is very similar to firm-level cash flow analysis. So you could use your knowledge of the free cash flow analysis for the firm, mostly. But there also exists some unique features of a project cash flow analysis. In this lecture, we'll explore the project cash flow principles before we start evaluating a project using Excel. Topics of this lecture includes stand-alone principle, incremental cash flow principle, salvage value, sunk cost, opportunity cost, and side effects. First of all when analyzing a project, we should follow the stand-alone principle. It suggests that each project should be analyzed in isolation from the firm. In other words, we should treat a project as if it is a small independent company. Hence, just like a firm has its own financial statements, a project should also have its own financial statements. Using the financial statements, we can identify the project level assets, revenues, and costs. The second principle is called the incremental cash flow principle. It means we have to use only incremental cash flows related to the project. Incremental cash flow is the one that only occurs as a consequence of the decision. To determine whether you'll include a cash flow in your analysis, you can ask the following question. Will this cash flow occur only if we accept the project? If the answer is yes, you include the cash flow, otherwise you don't. Next, in the project analysis we need to deal with the salvage value of assets. For fixed assets the salvage value is the estimated resale value at the end of the project's life. The concept of salvage value is somewhat similar to terminal value in a firm valuation in a sense that they would occur at the end of the estimation period. If you believe that your fixed assets in the project, such as machines and equipment, will have positive resale value, you need to include it in the analysis. In many cases actual resale value can be different from the book salvage value at the end of the project's life. Then we have a taxation when calculating the cash inflow from salvage. We'll examine how to deal with it later in this module. Salvage value also includes the salvaged net working capital investments. We know that networking capital or the change in networking capital, more precisely, is one of most important components of a cash flow. When analyzing net working capital at the project level, we could argue that once the project is over, the net working capital invested in or tied to the project is returned to the company. That should be considered as a cash inflow from the project at the end. A sunk cost is a cost that has already been incurred and cannot be recovered. Following the incremental cash flow principle, we do not consider sunk costs in a project analysis. A sunk cost is the cost in the past and has nothing to do with our decision on whether to undertake the project. Here is an example of a sunk cost. If you are considering a project of manufacturing and selling invisible cars, but you have already spent $500,000 in prototype testing. The cost should not be considered in your analysis because it had been incurred in the past anyway. Another type of cost to mention here is the opportunity cost. It's defined as the value from the most valuable alternative that has to be given up if the project is taken. An opportunity cost usually arises when a project uses resources that have been already owned by the firm. Because giving up the alternative is a consequence of taking the project you're analyzing. Based on the incremental cash flow principle, we should include the opportunity cost in the analysis. In this example you might think that the land is free in this project, but it is not. The land, alternatively, could be sold for $1 million if the project is not undertaken. We should include this opportunity cost in our analysis. Finally, when you start a new project in your company, the new project could have either positive or negative side effects to existing projects. A positive side effect is called a synergy. Examples of a negative side effect are erosion and cannibalism. The incremental cash flow principle would suggest that side costs should be also considered in a project analysis.
