1.

PROJECT CASH FLOWS AND CASH RETURN

For the purpose of economic appraisal, any investment project can be viewed as
a system, within its own boundaries, in and out of which flow various streams of
cash.


CASH FLOWS IN CASH FLOWS OUT


PROJ ECT



We can define CASH RETURN as :

TOTAL CASH FLOW IN - TOTAL CASH FLOW OUT

Since investment projects are likely to be long in duration, it is convenient to
divide the project life into time periods (commonly years) and estimate CASH
FLOWS IN/OUT and CASH RETURN separately for each period :

Money Units (mu)
*

Year In Out Cash Return

0 - - -
1 - - -
2 - - -
3 - - -

etc, for the estimated life of the project.

* often in this module, rather than talk in terms of $, , etc, we will refer to
arbitrary money units, (mu).

It must be stressed at this point (and will frequently be reinforced throughout the
module, that we are dealing here with estimates of the cash flows that we expect
to follow in the future if the project is undertaken. We can rarely be certain of
them. Consequently, the quality of our decision making is highly dependent on
the quality of our estimates.

For a major strategic investment decision such as the building of a new electricity
generating station or the development of a new oil field, we would expect the
CASH RETURN PROFILE to look something like :




5
x
x
x
x
x
x
x
x
x
x
x
x x
x
x
TIME (yrs)
CASH

RETURN

(mu/yr)










At the start, cash flow is predominantly out as plant is purchased and installed.
Thereafter, Cash Flow In in any period is likely to exceed Cash Flow Out. It is
also useful to present this profile on a cumulative basis, from the start of the
project, to illustrate the change over time in overall cash position :

x
x
x
x
x
x
x
x
x
x
x
x
x
A B C D E
TIME (yrs)





CUMULATIVE

CASH

RETURN

(mu)



















In the last diagram, a number of phases can be identified:

A - Development, Design
B - Major Investment Phase
C - Commissioning Start Up Steady Production
D - Steady Production
E - Increasing Costs Obsolescence

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The Main Cash Flow Components :


CASH FLOW IN

Sales Income from product (a)

Grants
+



CASH FLOW OUT

Capital Investment

- fixed capital investment (b)
- working capital investment (c)

Product Cost (d)

- fixed product cost
- variable product cost
Taxes
+


( + very important in practice, but detailed and specific to particular
countries, so beyond the scope of this course.)

Expanding now on items (a), (b), (c) and (d) with some guides to their estimation
:

a) Sales Income

(QUANTITY SOLD) x (SELLING PRICE)

NOTE: contract vs. spot prices

b) Fixed Capital Investment

This is the total cost of the project 'hardware', including site-work, buildings,
equipment, etc (all designed, constructed, installed and commissioned).
A typical breakdown, appropriate to a wide range of process industries, is :

Purchased Equipment (delivered on site) -

Equipment Installation -
Site Clearance, Foundations, Structures -
Buildings -
Pipework (installed) -
Instrumentation and Controls (installed) -
Electrical (installed) -
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Insulation and Paintwork -

Utilities Plant (installed) -
_______
Engineering and Supervision -
Construction Overheads -
Contractor's Fee -
Contingency -
_______
Commissioning Expense -
(Initial Inventory of catalyst, solvents etc) -
_______
Total (Fixed Capital) -
_______

c) Working Capital Investment

In order to illustrate this concept consider a company that expects to use 1200
t/yr of raw material, in a new plant, at a cost of 200 mu/t. Suppose that (in order
to provide a 'cushion' against short term interruptions in supply) they want to
maintain a raw material stock equivalent to one month's supply (100 t).

To build up this stock, in advance of starting operation, the company must spend
(100t) x (200mu/t) =20000 mu, which might otherwise have stayed in the bank
or been used for other purposes.

While the actual material in stock changes over with time; as long as stocks are
maintained at this level, the 20000 mu remains invested in very much the same
way as the money spent in purchasing pumps and heat exchangers. Such an
investment is termed Working Capital.

Note : Do not confuse this Working Capital requirement with the
purchase cost of the raw material, which would be calculated as:

(1200 t/yr) x (200 mu/t) =240000 mu/yr

If the company's sales volume is anticipated as varying over the life of the
project, and a policy of maintaining one month of stock is maintained, then there
will be increases in Working Capital requirement as sales increase and
decreases in Working Capital as sales decrease.

Towards the end of project life (in anticipation of shut-down) stocks will be run
down and all of the Working Capital effectively recovered. (In economic appraisal
calculations, Working Capital is commonly assumed to be completely
recoverable at the end of project life.)

J ust as raw material stocks contribute to Working Capital requirement, so to do
in-process (i.e. partly processed) stock and product stock.


To summarise, we can define Working Capital Investment as :

assets committed to meeting short-term operating needs

and build up our estimate as :

Value of : Raw Material Stock -
In-Process Stock -
Product Stock -

Credit extended to customers, (less credit
received from suppliers) -

Available Cash (for wages, supplies, etc) -
_______

Total (Working Capital) -
_______


Despite these complications of short-term Working Capital fluctuations, for
preliminary project appraisal it is usual to estimate Working Capital, very
approximately, as perhaps:

10-30% of fixed capital, or
2 - 4 months sales income.


Stock levels, and hence Working Capital requirements, tend to be high for
high value speciality products, particularly if a large number of batch
processing steps requiring substantial stocks of intermediates are involved.
(This tendency is to some extent being counteracted by current
manufacturing management philosophies such as 'Materials Requirement
Planning' and 'J ust In Time' production.)

For some products there may be a significant seasonal fluctuation in stock
holding requirements, which may need to be taken into account in the more
detailed evaluations.

d) Product Cost

These are the continuing costs associated with the purchase of raw material,
operation of the production unit, distribution of the product and day-to-day
running of the business.

A useful classification appropriate to many industry situations is :

Product Cost = Operating Cost + Company Overhead
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OPERATING COST

Raw Materials :

Feedstocks (income from by-products is sometimes considered as a negative item)

Process Materials

Utilities : Fuel
Electricity
Steam
Cooling Water
Waste Treatment

Selling Expense : Product Formulation and Packaging
Product Storage
Product Distribution

Operating Labour : Shift Operators
Shift Supervision
Day Labour
Labour Overheads
Maintenance : Maintenance Labour
Maintenance Supervision
Maintenance Materials

Plant Overhead : Factory/Plant Management and Administration
Staff Facilities
Quality Control Lab
Insurance
Rates (or other local taxes)
Royalties

COMPANY OVERHEAD

Executive Functions
Central Technical Services (e.g. R&D, Engineering)
Financial
Legal
Marketing



This classification is based according to where the costs are incurred :

Operating Cost - at plant level
Company Overhead - at central organisation
level

Remember that in preparing Product Cost estimates for use in project
evaluation, we must do so on an INCREMENTAL basis (i.e. we need to ask
which cost items are changed by the project and if so what will be the difference
between before and after values). For small tactical investment decisions, the
effect on Company Overhead is almost certainly negligibly small, but for a major
strategic investment decision, such as the development of a new product range,
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then significant increases in Central Organisation expense are likely to be
involved.

An alternative (and very useful) classification depends on the variation of Product
Cost with production level.

To a reasonable approximation, Product Cost varies with output
according to :

FIXED
COST
VARIABLE
COST




PRODUCT
COST

(mu/yr)









OUTPUT (pu/yr)


d1) Fixed Product Cost

Fixed Product Costs are those items of Product Cost which do not vary
with production level. (In the short to medium-term at least, even if
nothing is produced, they must still be met.)

d2) Variable Product Cost

These are costs that change approximately in direct proportion to
throughput. (i.e. double the throughput, double the variable cost.)


Some cost components, notably energy costs, might have both a fixed and
variable component. Maintenance costs might not be absolutely fixed as they
might increase as plant was pushed to very high throughputs.

In spite of these reservations, the FIXED +VARIABLE PRODUCT COST model
is still an adequate approximation, and certainly useful in the analysis of
investment projects.

Product Cost Estimation

This section provides guidelines on Product Cost Estimation for economic
appraisal purposes.

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Raw Materials :

Cost (mu/yr) =Usage (t/yr) x Price (mu/t)

The price is best obtained from supplier quotations.

Most bulk raw materials are supplied through longer term contracts and
may involve substantial quantity discounts. These contract prices will
generally be lower than the 'spot' prices, but in conditions of over-
capacity, the 'spot' prices may be very low as suppliers try to 'dump' their
excess product at costs marginally exceeding their variable production
costs.

Prices are normally quoted Free on Board, 'FOB', at the supplier's plant
rather than at the point of use, so all transportation charges must be
added to get the effective price to the project.

Remember that your extra demand (if substantial) may influence the
market price of the material.

Process Materials :

Prices are subject to the same considerations as for raw materials. Water
for direct use in a process may be of a substantially higher quality and
price than water required for cooling.

Utilities :

Prices for various forms of energy as purchased from the energy supply
companies are fairly widely published, but internally generated services,
where applicable, may be substantially cheaper.

Selling Expense :

The significance of these items depends very much on the type of
product.

Operating Labour :

Labour costs are more a function of tasks to be performed rather than the
amount of product being produced. They are virtually fixed costs for a
particular plant and are only weakly dependent on plant size.

Manning levels are largely dictated by start-up, shut-down and
emergency conditions. Estimation techniques suggested in older books
are unlikely to apply well to modern automated plant.


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For 24 hour, 7 day manning, 4-5 shift crews are required. So 5 people
may be required to cover each identified operating or supervisory
function.

Maintenance :

For estimation purposes, this is often taken as a percentage of Fixed
Capital Investment (5-15%.) The percentage taken should take account
of corrosive conditions, materials of construction and plant complexity.

In estimating, perhaps allow for increasing maintenance costs as the
plant ages.

Maintenance costs may be 'semi-variable' in nature as the likelihood of
breakdown may be higher as the plant is pushed to its limit of capacity.

Plant and Company Overheads :

While the cost items covered so far can generally be directly and
unambiguously related to a particular project, this is not so easily done
with 'overhead' costs.
These should only be included in an economic appraisal to the extent that they would
actually be changed by adopting the project.

Developing a Cash Return Profile

This section started with a definition of Cash Return. Earlier we saw how Cash
Return and Cumulative Cash Return Profiles might look for a major project. The
section finishes with a worked example, showing how cash flow estimates may
be brought together to provide such a Cash Return Profile.

The following data has been assembled for a proposed process plant, with a
capacity of 20000 units/yr, which would start production during Year 2010 and is
expected to operate for 9 years:
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Fixed Capital Investment : 2.5 million

Fixed Capital Phasing : Year % of Fixed Capital
Investment

2008 20
2009 70
2010 10

Scrap Value : 0.3 million (during 2019)

Decommissioning Costs : 0.5 million (during 2019)

Working Capital : (mainly product stock and extended credit)

Working Capital requirement in any year is estimated at 3 months of the
sales value for that year (i.e. 25% of sales income).

Assume totally recoverable at the end of project.

Production Phasing :

Year % of Capacity units/yr

2011 50 10000
2012 80 16000
2013-2018 100 20000
2019 90 18000

Product Cost :

Fixed 0.65 million /yr
Variable 150 /unit

Selling Price : 250 /unit


This data can be assembled into the following tabular calculation of the Cash
Return and Cumulative Cash Return Profiles: (You are strongly advised to
study this example in detail and to try the corresponding tutorial example.
It is essential that you understand these examples, before progressing to
later work.)
Cash Flows:

Year 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019
Production units/year 10000 16000 20000 20000 20000 20000 20000 20000 18000 TOTALS
Fixed
Capital 000s 500 1750 250 200 2700
Working
Capital 0 0 0 25 75 250 0 0 0 0 000s 6 3 0 -1250 0
Sales
Income 000s 0 0 0 2500 4000 5000 5000 5000 5000 5000 5000 4500 41000
Product
Cost 000s 2150 3050 3650 3650 3650 3650 3650 3650 3350 30450
Cash
Return 000s -500 -1750 -250 -275 575 1100 1350 1350 1350 1350 1350 2200 7850
Cumulativ
e Cash
Return 000s -500 -2250 -2500 -2775 -2200 -1100 250 1600 2950 4300 5650 7850

Explanatory Notes :

1) The '200' at the end of the Fixed Capital row is the difference between the Decommissioning Costs and the Scrap Value.
2) Product Cost for each year is obtained as: (Production x Variable Cost per unit) +Fixed Cost/yr
3) The Working Capital requirement for 2011 will be 25% of the Sales Income for that year (0.25 x 2500 =625). Since operation is
just starting, all of this represents new investment. In 2012, 25% of Sales Income is 1000, but 625 of this has been built up
already, making the fresh investment in stocks etc, (1000-625) =375.
Note that the Working Capital column sums to zero, reflecting our assumption that it is totally recoverable.

General Points:
1) A tabular presentation like this helps avoid calculation errors. Work in thousands or millions if appropriate.
2) The discretisation of the project life into one year blocks is clearly an approximation to reality. (Justifiable however when we
consider that these cash flows are all estimates, with often a high degree of uncertainty.) Provided we adopt a consistent
approach when comparing alternatives, we should not worry unduly about the exact timing of relatively minor items such as
scrap value and working capital.
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