Estimating project cash flows

Chapters 3 to 5 were arithmetic on numbers somebody else supplied. This chapter supplies them, and it is where the real decision is made — a flawless NPV on a fictional forecast is a fiction with a decimal point.

The construction

Start from operating profit and work to cash:

Line
EBIT	Operating profit, before interest and tax
− Tax on EBIT	Tax as if the project were all-equity financed
= NOPAT	Net operating profit after tax
+ Depreciation and amortisation	Added back — never a cash outflow
− Capital expenditure	The actual cash spent on assets
− Increase in working capital	Cash absorbed by receivables and inventory
= Free cash flow

Work the problem:

$\text{NOPAT} = 30 \times (1 - 0.25) = 22.5$ $\text{FCF} = 22.5 + 10 - 12 - 4 = \textbf{₹16.5 crore}$

Why tax is computed before interest

Tax is charged on EBIT, not on profit after interest — even though the real tax bill would be lower if the project were debt-financed.

This is deliberate. Chapter 2 excluded financing from the cash flows because the discount rate handles it, and chapter 9 shows that the WACC includes the tax benefit of debt through an after-tax cost of debt. Charging the tax saving here as well would count it twice.

The rule: cash flows are financing-neutral; the discount rate carries the capital structure.

The depreciation tax shield

Depreciation is not a cash flow, so it is added back. But it reduced taxable profit, and that reduction is cash the company keeps:

$\text{Tax shield} = \text{Depreciation} \times \text{tax rate}$

At 25%, the ₹10 crore of depreciation saves ₹2.5 crore of tax. In the construction above this is already captured — tax was computed on EBIT, which is after depreciation — but it is worth seeing separately, because it explains two things:

Why capital-intensive projects are less tax-punished than they look. The shield is real cash.

Why the depreciation schedule matters to value. Faster tax depreciation pulls the shield forward, and an earlier cash flow is worth more. The accounting depreciation in chapter 8 of the Accounting subject and the tax depreciation can differ, and it is the tax one that belongs here.

Working capital, forgotten and fatal

A growing project absorbs cash into receivables and inventory, as chapter 5 of the Accounting subject showed. It is an investment, not an expense:

• The increase each year is a cash outflow
• It is released at the end of the project, when stock is sold and receivables collected — a cash inflow in the final year

Omitting the release understates the project. Omitting the annual absorption overstates it, usually by more, because it runs for the whole life.

Terminal value

Most projects do not stop cleanly. Three treatments:

Salvage value. For a finite asset, the after-tax proceeds of selling it. Remember the tax: selling above written-down value creates a taxable gain.

Perpetuity. For an ongoing business, $\frac{C}{r-g}$ from chapter 1 of the Quantitative methods subject — with the warning attached there about $g$ approaching $r$.

A terminal multiple. Applying an exit EV/EBITDA. Honest only if the multiple is defensible, and chapter 18 of the Company analysis subject explains why most are not.

Terminal value frequently exceeds half the total. When it does, the valuation is mostly an assumption about the far future dressed as a forecast of the near one, and that should be said out loud rather than buried in a cell.

Real against nominal, and the error it causes

Either discount nominal cash flows (including inflation) at a nominal rate, or real cash flows at a real rate. Both are correct.

Mixing them is not, and the common error is one-directional: forecasting cash flows without inflating them, then discounting at a nominal cost of capital. That understates value systematically, and it is a standard reason good long-lived projects get rejected.

Which input to stress

The problem asks. Of EBIT, depreciation, capex and working capital:

• Depreciation follows from capex and a schedule — close to mechanical.
• Capex is usually quoted by a supplier — reasonably firm, often optimistic on timing.
• Working capital follows from revenue through fairly stable ratios.
• EBIT is volume times price minus cost, and all three are forecasts.

Stress EBIT first, and within it volume before price. It is the input with the widest range and the one every other line depends on.

The point

Free cash flow is NOPAT plus depreciation, less capex and less the increase in working capital — with tax computed on EBIT so that financing stays out of the numerator. Depreciation re-enters through the tax shield, which is real cash and is pulled forward by faster tax schedules. Working capital is an investment released at the end, terminal value often exceeds half the total, and real and nominal must never be mixed.