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Financial Management and Strategic Management · Investment Decisions

How to Estimate Cash Flows for Projects in Capital Budgeting

Updated 4 October 2026 · Fact-checked

Estimating project cash flows means listing only the extra cash a project brings to the firm, year by year. Ignore sunk costs and non-cash items. Add back depreciation after tax, include working capital and its recovery, add post-tax salvage, and include opportunity costs.

Understand Estimating Cash Flows for Projects

Capital budgeting decisions run on cash flows, not accounting profit. A project is worth doing only if the extra cash it creates, discounted at the right rate, beats its cost. So the first job is to measure that cash correctly.

Use only incremental cash flows. These are the cash flows that happen if you take the project and do not happen if you reject it. Compare the firm's cash with the project against its cash without it.

Some items are relevant: the initial outlay, extra revenue, extra operating costs, tax on the extra profit, extra working capital, and the sale value of the asset at the end. An opportunity cost is also relevant. If the project uses a machine or land you could otherwise sell or rent out, the cash you give up is a cost of the project. Side effects on other products of the firm count too.

Some items are not relevant. A sunk cost (such as money already spent on a feasibility study) is gone whether or not you accept the project, so ignore it. Allocated general overheads that do not change are ignored. Financing costs such as interest and dividends are left out because the discount rate already covers them. Depreciation is not a cash outflow, but it matters because it reduces tax.

The usual layout has three parts: initial investment at year 0, operating cash flow for each year, and terminal cash flow in the last year (salvage value and release of working capital).

Key rules to remember

Initial outlay (year 0)
Initial outlay = Cost of asset + Installation and transport + Net working capital required (+ opportunity cost of any existing asset used) − Sale proceeds of old asset replaced (adjusted for tax)
Include all cash paid to get the project ready. Do not include sunk costs.
Depreciation
Annual depreciation = (Cost − Salvage value) ÷ Life, for straight line
Use the method the question states. Depreciation is a non-cash charge.
Operating cash flow (PAT method)
CFAT = (Sales − Cash costs − Depreciation) × (1 − t) + Depreciation
Add depreciation back after computing tax. Interest is excluded.
Operating cash flow (shortcut)
CFAT = (Sales − Cash costs) × (1 − t) + Depreciation × t
Same answer as above. Depreciation gives a tax shield of Depreciation × t.
Terminal cash flow
Terminal flow = Salvage value − Tax on gain (or + tax saved on loss) + Recovery of working capital
Tax on salvage depends on the book value and the tax rule given in the question.
Working capital cash flow
Cash flow from working capital = −(Increase in NWC) in the year it rises; +Release of NWC at the end
Only the change in working capital each year is a cash flow.

How to solve Estimating Cash Flows for Projects questions

Use the same layout for every cash flow question. It earns step marks and avoids missing items.

  1. 1Read the question and mark each item as relevant or irrelevant. Strike out sunk costs, interest, and unchanged allocated overheads.
  2. 2Compute the year 0 outflow: asset cost, installation, working capital, and any opportunity cost or old asset sale proceeds.
  3. 3Compute annual depreciation as per the method given.
  4. 4Prepare a table for each year: sales, less cash costs, less depreciation to get profit before tax (PBT), less tax, then profit after tax (PAT).
  5. 5Add back depreciation to PAT to get operating cash flow. Do not deduct interest.
  6. 6Adjust working capital: show the increase as an outflow in the year it occurs and recover it in the final year.
  7. 7Add terminal items in the last year: salvage value net of tax and working capital release.
  8. 8State the net cash flow for each year, then apply discount factors if the question asks for NPV or other criteria.

Quickest way: Shortcut: tax shield layout

When to use it: Use when costs and depreciation are the same every year and the question gives a tax rate.

  1. Compute (Sales − Cash costs) × (1 − t) once and reuse it for each equal year.
  2. Add Depreciation × t as the tax shield.
  3. Put year 0 outflow and terminal inflow on separate lines so you do not miss them.
  4. For MCQs, first remove options that treat sunk cost or interest as a cash flow, or that forget working capital recovery.
  5. In written answers, show the table in rows by year. Show the working notes for depreciation and tax below the table.

Common mistakes in Estimating Cash Flows for Projects

  • Including sunk costs such as a market survey already paid for.

    The cost feels like part of the project because it is linked to it.

    Fix: Ask: does this cash change if I accept or reject? If not, leave it out.

  • Deducting depreciation as a cash outflow, or forgetting to add it back.

    Depreciation appears in the profit statement, so it feels like a cost.

    Fix: Deduct it only to compute tax, then add it back. Or use the shortcut CFAT = (S − C)(1 − t) + Dep × t.

  • Deducting interest from operating cash flows.

    Students copy the profit statement format.

    Fix: Leave out financing costs. The cost of capital in the discount rate covers them.

  • Ignoring working capital or not recovering it at the end.

    It is often given as a side note in the question.

    Fix: Show it as an outflow at the start (or when it rises) and as an inflow in the final year, unless the question says otherwise.

  • Ignoring the opportunity cost of an existing asset or land the project uses.

    No fresh payment is made, so it looks free.

    Fix: Include the cash the firm gives up, after tax, as an outflow in year 0.

  • Treating salvage value as fully taxable or fully tax free without checking the question.

    Students apply a fixed rule from memory.

    Fix: Compare salvage with the book value and follow the tax treatment stated in the question. State your assumption.

Worked examples

Example 1

A company plans to buy a machine for ₹10,00,000. Life is 5 years. Salvage value at the end is ₹1,00,000. Depreciation is straight line on cost less salvage value. Annual sales increase by ₹8,00,000 and annual cash operating costs by ₹3,00,000. Tax rate is 30%. Ignore working capital and tax on salvage value. A market study costing ₹50,000 was paid last year. Compute the year-wise net cash flows.

Show the solution
  1. The ₹50,000 study is a sunk cost. Ignore it.
  2. Depreciation = (10,00,000 − 1,00,000) ÷ 5 = ₹1,80,000 per year.
  3. Profit before tax = 8,00,000 − 3,00,000 − 1,80,000 = ₹3,20,000.
  4. Tax at 30% = ₹96,000. PAT = 3,20,000 − 96,000 = ₹2,24,000.
  5. Operating cash flow = 2,24,000 + 1,80,000 = ₹4,04,000 per year.
  6. Check with the shortcut: 5,00,000 × 0.70 + 1,80,000 × 0.30 = 3,50,000 + 54,000 = ₹4,04,000.
  7. Year 5 also receives salvage value of ₹1,00,000, so year 5 flow = 4,04,000 + 1,00,000 = ₹5,04,000.

Answer: Year 0: −₹10,00,000. Years 1 to 4: ₹4,04,000 each. Year 5: ₹5,04,000.

Example 2

A firm is evaluating a project that needs a machine costing ₹20,00,000 and net working capital of ₹3,00,000 at the start. Life is 4 years with no salvage value. Depreciation is ₹5,00,000 a year. Annual sales are ₹16,00,000 and annual cash costs are ₹7,00,000. Tax rate is 25%. Working capital is recovered in full at the end of year 4. Find the net cash flows.

Show the solution
  1. Year 0 outflow = 20,00,000 + 3,00,000 = ₹23,00,000.
  2. Profit before tax = 16,00,000 − 7,00,000 − 5,00,000 = ₹4,00,000.
  3. Tax at 25% = ₹1,00,000. PAT = ₹3,00,000.
  4. Operating cash flow = 3,00,000 + 5,00,000 = ₹8,00,000 each year.
  5. Check: 9,00,000 × 0.75 + 5,00,000 × 0.25 = 6,75,000 + 1,25,000 = ₹8,00,000.
  6. Year 4 also gets working capital release of ₹3,00,000, so year 4 flow = 8,00,000 + 3,00,000 = ₹11,00,000.

Answer: Year 0: −₹23,00,000. Years 1 to 3: ₹8,00,000 each. Year 4: ₹11,00,000.

Exam tips

  • Always write a working note for depreciation and tax. Step marks are given even if the final figure is wrong.
  • Read the question for words like already spent, allocated, or interest. These usually signal items to exclude.
  • Check for working capital and salvage value in the last line of the question. They are easy to miss.
  • When the question gives a sale of an old asset, check if tax on gain or loss must be adjusted before putting it in year 0.
  • In MCQs, test each option against the rule: incremental, after tax, non-cash items added back, financing costs excluded.

Practice questions from Investment Decisions

Estimating Cash Flows for Projects in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Estimating Cash Flows for Projects: frequently asked questions

Why is depreciation added back in cash flow calculations?

Depreciation is a non-cash expense, so no money leaves the firm. You deduct it first only to find the correct tax, then add it back. The real benefit is the tax saved, which equals depreciation × tax rate.

What is the difference between sunk cost and opportunity cost?

A sunk cost is already spent and cannot change with the decision, so you ignore it. An opportunity cost is cash or benefit you give up by using a resource in the project, so you include it.

Should interest be included in project cash flows?

No. Interest and other financing costs are left out of cash flows. The discount rate, usually the cost of capital, already takes care of the cost of funds.

How is working capital treated in capital budgeting?

Treat the required increase in net working capital as an outflow when it is needed. Treat its release as an inflow at the end of the project life, unless the question states otherwise.