Financial Management and Business Data Analytics · Capital Budgeting

How to Estimate Cash Flows in Capital Budgeting

Updated 10 October 2026 · Fact-checked

Estimating cash flows means listing only the extra, after-tax cash a project brings. Split it into three parts: initial outlay (asset cost plus working capital, less sale of old asset), yearly operating cash flow = (Sales − cash costs)(1 − t) + t × depreciation, and terminal cash flow (after-tax salvage plus working capital recovered).

Understand Estimation of Cash Flows

Capital budgeting decisions such as NPV and IRR need one input above all: a correct series of cash flows. If the cash flows are wrong, the best technique still gives a wrong answer. So this topic carries marks in almost every capital budgeting question.

Use incremental cash flows. These are the cash flows that occur only if you accept the project. Compare the firm with the project against the firm without it. Ignore sunk costs (money already spent, such as a feasibility study already paid for). Ignore allocated overheads that do not change. Include opportunity costs, such as rent you give up by using your own building. Ignore interest and dividends, because the discount rate already covers the cost of finance.

Split the project life into three time zones. At time 0 is the initial outlay: cost of the asset, installation, and extra working capital, less any after-tax cash from selling an old asset. During the life are the operating cash flows after tax. At the end is the terminal cash flow: salvage value after tax and recovery of working capital.

Depreciation is not a cash flow. It matters only because it reduces taxable profit, so it saves tax. That saving is the depreciation tax shield = tax rate × depreciation. You deduct depreciation to find tax, then add it back, or you use the shortcut formula given below. Both give the same answer.

Working capital is a cash outflow when it is invested and an inflow when it is released. It is not depreciated and not taxed. Normally you assume the full amount is recovered at the end of the project, unless the question says otherwise.

Key rules to remember

Initial outlay (new project): Initial outlay = Cost of asset + Installation and transport + Increase in net working capital + Other upfront cash costs; Occurs at time 0. Pre-operating costs that are cash costs are included. Do not include interest.
Initial outlay (replacement): Initial outlay = Cost of new asset + Increase in NWC − After-tax proceeds of old asset; After-tax proceeds = Sale price − tax on gain, or Sale price + tax saved on loss.
Tax on sale of an asset: Tax effect = t × (Sale price − Book value); Positive means tax paid on a gain; negative means tax saved on a loss. Apply only if the question states the loss or gain is taxable or adjustable.
Operating cash flow (build-up): OCF = (Sales − Cash costs − Depreciation) × (1 − t) + Depreciation; Equals PAT + Depreciation when there is no interest in the calculation.
Operating cash flow (shortcut): OCF = (Sales − Cash costs) × (1 − t) + t × Depreciation; The second term is the depreciation tax shield. Useful for quick checks.
Incremental OCF (replacement): ΔOCF = (ΔSales − ΔCash costs) × (1 − t) + t × ΔDepreciation; ΔDepreciation = depreciation on new asset − depreciation on old asset.
Terminal cash flow: Terminal cash flow = Salvage value − Tax on salvage + Recovery of NWC; Tax on salvage = t × (Salvage − Book value at end). Added to the last year's OCF.
Straight-line depreciation: Annual depreciation = (Cost − Salvage value) ÷ Life; Use the method the question gives. Depreciable cost includes installation.

How to solve Estimation of Cash Flows questions

Use this order for any cash flow estimation question. Work in a table with years across the top so you can discount easily afterwards.

1Read the question and mark what is incremental. Cross out sunk costs, allocated overheads, interest and dividends. Note opportunity costs to add.
2Compute the initial outlay at year 0: asset cost, installation, extra working capital, minus after-tax proceeds from any old asset.
3Compute annual depreciation on the depreciable cost using the stated method. For a replacement, also find depreciation on the old asset and take the difference.
4Prepare the annual statement: incremental sales less cash costs less depreciation gives profit before tax. Deduct tax at the stated rate. Add back depreciation to get OCF.
5Handle working capital changes in the year they occur. An increase is an outflow, a decrease is an inflow. Release the remaining balance in the last year.
6Compute the terminal cash flow: salvage value, tax on any gain or loss against book value at that time, and working capital recovered. Add it to the last year's OCF.
7Show the net cash flow for each year in one line. Then apply the discount factors (PV tables) and find NPV or the required measure.
8State the decision in one line, for example: NPV is positive, so accept.

Quickest way: Shortcut OCF with the tax shield

When to use it: Use when the same sales, costs and depreciation repeat every year, or when you need to check your table in the last minutes.

Compute annual cash profit before tax: Sales − Cash costs.
Multiply by (1 − t) to get after-tax cash profit.
Add t × Depreciation to get OCF. Depreciation itself is never added in full in this method.
Compute the year 0 outlay and the terminal items separately.
Put terminal items in the last year only. Use the annuity factor for the OCF and the single-year factor for the terminal cash flow.
Cross-check one year with the PAT + Depreciation method if time allows.

Common mistakes in Estimation of Cash Flows

Treating depreciation as a cash outflow, or adding it back after not deducting it.
Students mix the build-up method with the shortcut method.
Fix: Choose one method. Build-up: deduct depreciation for tax, then add it back in full. Shortcut: never deduct it, only add t × Depreciation.
Including interest on the loan in the cash flows.
The problem gives a loan, so students feel the interest must be used.
Fix: Financing costs are captured in the discount rate. Leave interest out of project cash flows unless the question clearly asks otherwise.
Forgetting to recover working capital at the end, or counting it at year 1 instead of year 0.
Working capital is not a fixed asset, so it slips out of mind.
Fix: Show working capital as an outflow when invested and an inflow in the final year. Tick it on your checklist for both ends.
Including sunk costs, such as a market survey already paid, or ignoring an opportunity cost.
Students include every figure given in the question.
Fix: Ask: does this cash flow change only if we accept the project? If not, leave it out. If the project uses a resource that could earn money elsewhere, include that lost amount.
Wrong tax on sale of an old asset: using the sale price instead of the gain or loss against book value.
Students tax the whole proceeds.
Fix: Tax effect = t × (Sale price − Book value). A loss gives a tax saving, so it increases the inflow.
Using the full depreciation of the new asset in a replacement decision.
Students forget the old asset would have kept depreciating.
Fix: Use incremental depreciation = new − old for the tax shield.

Worked examples

Example 1

Sunrise Packaging Ltd is considering a new machine costing ₹40,00,000, with installation of ₹2,00,000. It needs working capital of ₹3,00,000 at the start, recovered at the end of year 5. Incremental annual sales are ₹30,00,000 and cash operating costs are ₹18,00,000. Life is 5 years. Salvage value at the end is ₹6,00,000. Depreciation is straight-line on cost including installation, down to the salvage value. Tax rate is 25%. Cost of capital is 10%. Present value factors at 10%: years 1 to 5 annuity 3.7908; year 5 single 0.6209. Find the cash flows and NPV.

Show the solution

Initial outlay = 40,00,000 + 2,00,000 + 3,00,000 = ₹45,00,000.
Depreciation = (42,00,000 − 6,00,000) ÷ 5 = ₹7,20,000 a year.
Cash profit = 30,00,000 − 18,00,000 = ₹12,00,000. Profit before tax = 12,00,000 − 7,20,000 = ₹4,80,000. Tax at 25% = ₹1,20,000. Profit after tax = ₹3,60,000.
OCF = 3,60,000 + 7,20,000 = ₹10,80,000 a year. Check: 12,00,000 × 0.75 + 0.25 × 7,20,000 = 9,00,000 + 1,80,000 = 10,80,000.
Book value at end of year 5 = 42,00,000 − 36,00,000 = ₹6,00,000, which equals salvage value, so no tax on sale.
Terminal cash flow = 6,00,000 + 3,00,000 = ₹9,00,000, received in year 5 along with that year's OCF.
PV of OCF = 10,80,000 × 3.7908 = ₹40,94,064.
PV of terminal cash flow = 9,00,000 × 0.6209 = ₹5,58,810.
Total PV of inflows = ₹46,52,874. NPV = 46,52,874 − 45,00,000 = ₹1,52,874.

Answer: Initial outlay ₹45,00,000; OCF ₹10,80,000 for years 1 to 5; terminal cash flow ₹9,00,000 in year 5. NPV = ₹1,52,874 (positive), so accept the project.

Example 2

Bharat Textiles Ltd plans to replace an old machine. The old machine has a book value of ₹4,00,000, remaining life of 5 years, straight-line depreciation with nil salvage value, and can be sold now for ₹1,50,000. The new machine costs ₹10,00,000, has a 5-year life, straight-line depreciation with nil salvage value, and will save cash operating costs of ₹2,50,000 a year. It needs an extra ₹50,000 of working capital, recovered at the end of year 5. Tax rate is 30%, and any loss on sale of the old machine can be set off against other profits. Cost of capital is 12%. Present value factors at 12%: years 1 to 5 annuity 3.6048; year 5 single 0.5674. Find the initial outlay, incremental cash flows and NPV.

Show the solution

Loss on old machine = 4,00,000 − 1,50,000 = ₹2,50,000. Tax saved = 30% × 2,50,000 = ₹75,000.
After-tax proceeds from old machine = 1,50,000 + 75,000 = ₹2,25,000.
Initial outlay = 10,00,000 + 50,000 − 2,25,000 = ₹8,25,000.
Depreciation on new = 10,00,000 ÷ 5 = ₹2,00,000. Depreciation on old = 4,00,000 ÷ 5 = ₹80,000. Incremental depreciation = ₹1,20,000.
ΔOCF = 2,50,000 × (1 − 0.30) + 0.30 × 1,20,000 = 1,75,000 + 36,000 = ₹2,11,000 a year.
Terminal cash flow: salvage is nil for both machines and book values are nil, so only working capital of ₹50,000 is recovered in year 5.
PV of ΔOCF = 2,11,000 × 3.6048 = ₹7,60,613 (rounded).
PV of working capital recovered = 50,000 × 0.5674 = ₹28,370.
Total PV of inflows = ₹7,88,983. NPV = 7,88,983 − 8,25,000 = −₹36,017.

Answer: Initial outlay ₹8,25,000; incremental OCF ₹2,11,000 for 5 years; ₹50,000 extra in year 5. NPV = −₹36,017 (negative), so the replacement should not be done on these figures.

Exam tips

Draw a year-wise table with rows for outlay, sales, costs, depreciation, tax, OCF, working capital and salvage. Step marks are given for each row.
Write the assumption you make, such as 'working capital fully recovered at end' or 'loss on sale can be set off'. A stated assumption protects marks.
In MCQs, check whether the answer needs the initial outlay, the yearly OCF or the terminal cash flow. The wrong option is often the correct number for another part.
Check that interest, sunk costs and allocated overheads are left out. Many questions plant these figures deliberately.
Keep each year's net cash flow on one line before discounting. If the question gives PV factors, use them as given and do not recompute.

Practice questions from Capital Budgeting

Estimation of Cash Flows in other exams

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

Estimation of Cash Flows: frequently asked questions

Why do we add back depreciation if it is not a cash flow?

We deduct depreciation only to find the correct tax. Since it is non-cash, we add it back to get the real cash flow. The net benefit of depreciation is the tax it saves, which equals the tax rate × depreciation.

Should interest be included in project cash flows?

No. The discount rate already reflects the cost of funds. Including interest in the cash flows would count the cost of finance twice.

What is a sunk cost and how do I treat it?

A sunk cost is money already spent that cannot be recovered whatever you decide, such as a survey fee already paid. Leave it out because it is not incremental to the decision.

How is working capital treated in capital budgeting?

The extra working capital is an outflow when the project starts, or when it increases. It is not depreciated. Unless told otherwise, it is recovered as an inflow in the final year.

How is the tax on the sale of an old asset calculated?

Compare the sale price with the book value. If the sale price is higher, tax is paid on the gain. If it is lower, the loss saves tax when the question allows set-off. Use tax rate × (sale price − book value).