Corporate Accounting and Financial Management · Capital Budgeting

Estimating Cash Flows for Projects in Capital Budgeting

Updated 11 October 2026 · Fact-checked

Estimating project cash flows means finding only the incremental, after-tax cash that a project adds. You split it into three parts: initial outlay (cost, installation, extra working capital), yearly operating cash flow (PAT plus depreciation, or EBIT(1 − t) plus depreciation), and terminal cash flow (salvage value after tax plus working capital recovered).

Understand Estimating Cash Flows for Projects

Capital budgeting decides whether a project is worth doing. Before you can apply NPV or IRR, you need the right cash flows. Most marks in this topic are won or lost here, not in the discounting.

Use incremental cash flows: the cash the company has with the project minus the cash it would have without it. Count only cash, not accounting profit. Ignore sunk costs (money already spent, such as a past feasibility study) because they do not change with the decision. Include opportunity costs (for example, rent forgone on a building you already own). Ignore interest and financing costs in the cash flows, because the discount rate already covers the cost of funds. Include externalities such as lost sales on an existing product.

The cash flows fall in three stages. The initial outlay at Year 0 is the cost of the asset, transport and installation, plus extra working capital, minus the after-tax sale value of any old asset replaced. Operating cash flows arise each year: after-tax operating profit plus non-cash charges. Terminal cash flows arise in the last year: salvage value (after tax) and the recovery of working capital.

Depreciation is not a cash outflow, but it reduces taxable profit. So it saves tax. This is the depreciation tax shield = depreciation × tax rate. You add back depreciation to profit, because it was deducted only on paper, and the tax saving stays in your pocket.

Working capital is a cash outlay. It is paid out at the start (or when sales grow) and released at the end. It is not depreciated and not taxed on recovery.

Key rules to remember

Initial outlay: Initial outlay = Cost of new asset + Installation and freight + Increase in net working capital − After-tax proceeds from sale of old asset; If the old asset is sold at a loss or gain against book value, adjust the tax effect on that loss or gain.
Annual operating cash flow (profit method): CFAT = (Sales − Operating costs excluding depreciation − Depreciation) × (1 − t) + Depreciation; Operating costs exclude interest. Here t is the tax rate.
Annual operating cash flow (shield method): CFAT = (Sales − Cash operating costs) × (1 − t) + Depreciation × t; Gives the same answer as the profit method. Handy for speed.
Depreciation tax shield: Tax shield = Depreciation × t; Applies only if the firm has enough taxable profit to absorb the depreciation.
Straight-line depreciation: Depreciation = (Cost − Salvage value) ÷ Life; Use the method given in the question.
After-tax salvage value: After-tax salvage = Sale price − t × (Sale price − Book value); If sale price is below book value, the loss reduces tax and so adds to cash.
Terminal cash flow: Terminal CF = After-tax salvage value + Working capital released; Add this to the final-year operating cash flow.
Incremental cash flow for replacement: Incremental CFAT = CFAT of new asset − CFAT of old asset; Compare yearly, including the change in depreciation.

How to solve Estimating Cash Flows for Projects questions

Follow the same order for every cash flow question. Lay it out as a Year 0 to Year n table so the examiner can follow your marks.

1List what is given: cost, installation, life, salvage, tax rate, depreciation method, working capital, and old asset details.
2Remove irrelevant items: sunk costs, interest, and allocated overheads that do not change. Add opportunity costs and lost sales.
3Compute Year 0 outlay: asset cost plus installation plus working capital, less after-tax proceeds of any old asset.
4Compute annual depreciation using the method stated. For replacement, work out depreciation on both assets and take the difference.
5Compute yearly profit before tax (savings or sales less cash costs less depreciation), deduct tax, and add back depreciation to get CFAT.
6Compute terminal cash flow: after-tax salvage plus working capital recovered. Add it to the last year.
7Show a clear table of net cash flows for Years 0 to n.
8Use these flows for the required NPV, IRR or payback, and write a one-line conclusion.

Quickest way: Shield method with a Year-wise table

When to use it: Use it when depreciation is constant each year and you have limited time.

Compute Year 0 outlay first and write it as a negative number.
Compute (Sales − Cash costs) × (1 − t) once. This is the after-tax operating cash.
Compute Depreciation × t once. Add it to get the annual CFAT.
If every year is equal, treat CFAT as an annuity and use the annuity factor.
Add working capital release and after-tax salvage only to the last year.

Common mistakes in Estimating Cash Flows for Projects

Treating depreciation as a cash outflow, or forgetting to add it back
Students deduct depreciation to get profit and then stop there.
Fix: After computing PAT, always add depreciation back. Or use the shield method: after-tax cash profit plus depreciation × t.
Including interest in the cash flows
Interest appears in the question and looks like a cost.
Fix: Leave out interest and financing costs. The cost of capital used as the discount rate covers them.
Including sunk costs such as a past survey fee
The cost looks like part of the project.
Fix: Ask whether the cash changes if the project is accepted. If not, ignore it.
Forgetting to recover working capital at the end
Students remember to invest it in Year 0 but not release it.
Fix: Add the full working capital to the final year as an inflow, with no tax on it.
Ignoring tax on the sale of an old or terminal asset
Salvage value is treated as plain cash received.
Fix: Compare sale price with book value. Tax any gain and give credit for any loss at the tax rate, unless the question says otherwise.
Using total cash flows instead of incremental ones in a replacement decision
Old asset figures are mixed with new asset figures.
Fix: Work out the difference in savings and in depreciation between the new and old asset, then tax it.

Worked examples

Example 1

A company plans to buy a machine costing ₹10,00,000 with installation of ₹2,00,000. Life is 4 years, salvage value is nil, and depreciation is straight-line. It needs extra working capital of ₹1,00,000, recovered at the end of Year 4. Annual sales are ₹12,00,000 and cash operating costs are ₹6,00,000. Tax rate is 30%. Find the net cash flows for each year.

Show the solution

Depreciable cost = ₹10,00,000 + ₹2,00,000 = ₹12,00,000.
Annual depreciation = ₹12,00,000 ÷ 4 = ₹3,00,000.
Year 0 outlay = ₹12,00,000 + ₹1,00,000 working capital = ₹13,00,000.
Profit before tax = ₹12,00,000 − ₹6,00,000 − ₹3,00,000 = ₹3,00,000.
Tax at 30% = ₹90,000, so PAT = ₹2,10,000.
CFAT = PAT + depreciation = ₹2,10,000 + ₹3,00,000 = ₹5,10,000.
Check by shield method: (₹6,00,000 × 0.70) + (₹3,00,000 × 0.30) = ₹4,20,000 + ₹90,000 = ₹5,10,000.
Year 4 also has working capital recovery of ₹1,00,000, so Year 4 flow = ₹6,10,000.

Answer: Year 0: −₹13,00,000; Years 1 to 3: ₹5,10,000 each; Year 4: ₹6,10,000.

Example 2

A firm is considering replacing an old machine with a new one. The old machine has book value ₹2,00,000, remaining life 5 years, and can be sold now for ₹2,50,000. Depreciation on it is ₹40,000 a year. The new machine costs ₹8,00,000, has a 5-year life, nil salvage and depreciation of ₹1,60,000 a year. The new machine will save cash operating costs of ₹2,50,000 a year. Tax rate is 30%. Find the initial outlay and the incremental annual cash flow after tax.

Show the solution

Gain on sale of old machine = ₹2,50,000 − ₹2,00,000 = ₹50,000.
Tax on the gain = 30% × ₹50,000 = ₹15,000.
After-tax proceeds from old machine = ₹2,50,000 − ₹15,000 = ₹2,35,000.
Initial outlay = ₹8,00,000 − ₹2,35,000 = ₹5,65,000.
Incremental depreciation = ₹1,60,000 − ₹40,000 = ₹1,20,000.
Incremental profit before tax = ₹2,50,000 − ₹1,20,000 = ₹1,30,000.
Tax at 30% = ₹39,000, so incremental PAT = ₹91,000.
Incremental CFAT = ₹91,000 + ₹1,20,000 = ₹2,11,000.
Check: (₹2,50,000 × 0.70) + (₹1,20,000 × 0.30) = ₹1,75,000 + ₹36,000 = ₹2,11,000.

Answer: Initial outlay is ₹5,65,000. Incremental annual cash flow after tax is ₹2,11,000 for each of 5 years.

Exam tips

Draw a Year 0 to Year n table and show each component. ICSI answers earn marks for method even if arithmetic slips.
State your assumptions in one line, for example that interest is ignored and working capital is fully recovered.
Read the question for the depreciation method and tax treatment of the sale of assets before you start.
Do a quick shield-method check on one year to catch errors in the profit method.
End with the decision rule after computing NPV or payback, so the answer is complete.

Practice questions from Capital Budgeting

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 do we ignore interest when estimating project cash flows?

The discount rate (cost of capital) already reflects the cost of funds. If you deduct interest in the cash flows as well, you count the financing cost twice and understate the project's value.

What is the depreciation tax shield?

It is the tax saved because depreciation reduces taxable profit. You calculate it as depreciation × tax rate. It is a real cash saving even though depreciation itself is not a cash outflow.

How is working capital treated in capital budgeting?

Treat extra working capital as an outflow when it is needed, usually Year 0. Treat its recovery as an inflow in the final year. It is not depreciated and is normally not taxed on recovery.

What is a sunk cost and why is it ignored?

A sunk cost is money already spent that cannot be recovered whatever you decide. It does not change with acceptance or rejection of the project, so it is not an incremental cash flow.