## Estimation of Project Cash Flows

Capital budgeting considers only incremental cash flows likely to result from accepting a project. Estimating future cash flows is one of the most important tasks. The following items need careful treatment:

### A. Depreciation (Tax Shield)

Depreciation is a non-cash item and does not directly affect cash flow.
But the tax saving (tax shield) it creates reduces the tax outflow, so that saving is treated as a cash inflow.
In computation: deduct depreciation to get profit before tax → compute tax → then add depreciation back to profit after tax to arrive at cash flow.

### B. Opportunity Cost

The benefit foregone by choosing one investment over an alternative.
Can arise both at the initial outlay and during the project's life.
Included in cash flow estimation.

### C. Sunk Cost

A cash outlay already incurred in the past that cannot be reversed.
Has no impact on the decision → excluded from the analysis.

### D. Working Capital

Initial working capital requirement → treated as cash outflow at the start.
Release of working capital at the end → treated as cash inflow.
No depreciation is charged on working capital.
Additional working capital needed during the life → cash outflow when required; any reduction in working capital → cash inflow.
If nothing is specified about release, assume the full amount is realized at the end of the project.

### E. Additional Capital Investment

Capital investment need not occur only at the beginning; it may be required during the project.
Such investment is treated as a cash outflow at that point in time.

### F. Block of Assets and Depreciation

The tax shield from depreciation is computed per the Income Tax Act, based on the concept of a Block of Assets — a group of assets of the same class.
Tax treatment in the terminal year depends on whether the block consists of one asset or several assets (see worked examples).

### G. Exclusion of Financing Costs Principle

When defining cash flows from long-term funds, financing costs (interest on long-term debt and equity dividends) must be excluded.
These are already captured in the WACC (the discount rate); deducting them again would count the cost of funds twice.
Therefore: interest on long-term debt is ignored in computing profits/taxes, and expected dividends are irrelevant to cash flow analysis.

### H. Post-tax Principle

Tax payments must be properly deducted in deriving cash flows.
Both the cash flows and the discount rate must be on a post-tax basis.

Worked example

### Example 1

Example 1 — Depreciation Tax Shield

X Ltd. has annual turnover ₹30 crore; cash expenses (COGS) ₹25 crore; tax rate 30%; depreciation ₹1.50 crore p.a. Compare cash flow with and without depreciation:

Particulars	No Depreciation (₹ Cr)	Depreciation Charged (₹ Cr)
Total Sales	30.00	30.00
Less: Cost of Goods Sold	(25.00)	(25.00)
	5.00	5.00
Less: Depreciation	–	(1.50)
Profit before tax	5.00	3.50
Less: Tax @ 30%	(1.50)	(1.05)
Profit after Tax	3.50	2.45
Add: Depreciation (non-cash)	–	1.50
Cash Flow	3.50	3.95

Tax shield = ₹1.50 − ₹1.05 = ₹0.45 crore of tax saved. This is the depreciation tax shield, which raises cash flow from 3.50 to 3.95. Depreciation is added back because it is a non-cash expense.

### Example 2

Example 2 — Block of Assets (terminal-year depreciation)

A Ltd. buys machinery for ₹1,00,000; depreciation @ 20% WDV; life 5 years; salvage ₹10,000. WDV at the start of year 5 (after 4 years of depreciation):

	₹
Purchase Price	1,00,000
Less: Dep Yr 1 (20%)	20,000
WDV end Yr 1	80,000
Less: Dep Yr 2	16,000
WDV end Yr 2	64,000
Less: Dep Yr 3	12,800
WDV end Yr 3	51,200
Less: Dep Yr 4	10,240
WDV start Yr 5	40,960

Case 1 — Only asset in the block (block ceases to exist): No depreciation in Yr 5; compute short-term capital loss instead.

	₹
WDV start Yr 5	40,960
Less: Sale value	10,000
Short Term Capital Loss	30,960
Tax Benefit on STCL @ 30%	9,288

Case 2 — More than one asset in the block: Depreciation IS charged in Yr 5 on (WDV − sale value).

	₹
WDV start Yr 5	40,960
Less: Sale value	10,000
WDV	30,960
Depreciation @ 20%	6,192
Tax Benefit on Depreciation @ 30%	1,858

### Example 3

Example 2 (continued) — When sale value (₹50,000) exceeds WDV (₹40,960):

Case 2 (multi-asset block): No depreciation is provided, because WDV ₹40,960 < sale value ₹50,000.

Case 1 (single asset, block ceases): A Short Term Capital Gain arises:

	₹
WDV start Yr 5	40,960
Less: Sale value	50,000
Short Term Capital Gain (STCG)	9,040
Tax outflow on STCG @ 30%	2,712

Note: when sale value exceeds WDV, the result is a taxable gain (cash outflow for tax), not a tax benefit.

⚠️ Common exam mistakes

Including sunk costs in the analysis — they are irrelevant and must be excluded.
Deducting interest on long-term debt or dividends in the cash flows — this double-counts the cost of capital (it's already in WACC).
Forgetting to add back depreciation after computing tax; only the tax shield, not the depreciation expense itself, is a cash item.
Charging depreciation on working capital — none is charged.
Forgetting to treat working capital release as a cash inflow at the end of the project.
In a single-asset block that ceases to exist, charging depreciation in the terminal year instead of computing STCL/STCG.
Mixing post-tax cash flows with a pre-tax discount rate — both must be post-tax.
Treating a sale value above WDV as generating a depreciation tax benefit, when it actually produces a taxable capital gain.

Reference:

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Estimation of Project Cash Flows — Key Considerations

Worked example

⚠️ Common exam mistakes