Cash Flows

 

ESTIMATIO ESTIMA TION N OF OF PROJECT CASH FLOWS

 

Introduction ‡ Sound investment decisions should be based on the net present value (NPV ) rule. NPV  r o b l e m t o b e r e s o l v e d i n a p p l y i n g t h e ‡ P rule:

 ± What should be discounted? In theory, the answer is obvious: We sho should always discount cash flows. Wrihnactiprlaet,e tshheouolpdpb flo ouwld s? bIn  ± p oe rtuunsietd y tcoosdtisoco f ucnatpictaasl hsh e

used as th the e dis isccount rate.

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Cash Flows Versus Profit ‡ Cash flow is not the same thing as profit, at least, for two reasons:  ±

profit, as measured by an accountant, is based on accrual  concept. First ,

Second , for computing profit, expenditures are arbitrarily  ± divided into revenue and capital expenditures. CF = (REV (REV  EXP  DEP) DEP) (1(1-T) T) + DEP DEP  CAPE CAPEX X CF = (EBIT)(1-T) (EBIT)(1-T) + DEP  CAPEX = PROFI PROFIT T + DEP DEP - CAPEX CAPEX

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OUTLINE



Elements of  the Cash Flow Stream



Principles of  Cash Flow Estimation 



Cash Flows for a Replacement Project



Biases in Cash Flow Estimation

 

Componen omponents ts of Cash Flows ‡ Initial Investment ‡ Net Cash Flows  ± Revenues and Expenses  ± Depreciation and Ta Taxes xes Working Capital  ± Change ±inCNet hange in accounts receivable  ± Change in inventory  ± Change in accounts payable

 ± Change in Capital Expenditure  ± Free Cash Flows

‡ Terminal cash flows  ± Salvage Value  ± Salvage value of the new asset  ± Salvage value of the existing asset now  ± Salvage value of the existing asset at the end of its normal

 ± Release of Net Working Capital

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Net Working Capital ‡ Change in receivable ‡ Change in inventory ‡ Change in payable.

 

‡ Instead of adjusting each item of working capital, we can simply adjust the change in networking capital, viz. the difference be betw twe een ch cha ange in cu curr rre ent as asssets (e (e.g .g., ., receiv iva able and an d in inve vent ntory ory) and chan ang ge in current liabilitie iess (e.g .g.. accounts payable) to pr prof ofit it.. ‡ Increase in net working capital should be subtracted from and decrease added to after-tax operating profit .

‡ Thus, net cash flo low: w: ‡ ‡

NCF = EBIT (I -T) + DEP  NWC Where NWC is net net worki orking ng capi capittal al..

(6)

 

Free Cash Flows ‡ In addition to an initial cash outla lay y, an investme men nt project may require some reinvestment of cash flow (for example, replacement in inv vestment) for maintaining its revenuegenerating ability during its life. As a consequence, net cash flow will be reduced by cash outflow for additional capital expe xpendi nditur tures es (CAPEX). Thus, net cash flow equation will be as follow:

‡ NCF = EBIT (1 -T) + DEP -NWC -CAPEX

 

BASIC PRINCIPLES OF CASH FLOW ESTIMATION ESTIMATION



Separation Principle



Incremental Principle



Post-tax Principle

 

SEPARA SEP ARATION TION PRINC PRINCIPLE IPLE  Cash flows associated with the investment side and the financing side of the project should be separated.

 While defining the cash flows on the investment side, financing financi ng costs should not be considere considered d because because they will be reflect reflected ed in the cost of capital figure against against which the rate of return figure will be evaluated.

 

INCREMENTAL INCREMENT AL PRINCIPLE PRI NCIPLE To ascertain a projects incremental cash flows you have to look loo k at what happ happen enss to the cash flows flows of the firm with the the project and without the project Guidelines 

Consider all incidental effects



Ignore sunk costs



Include opportunity costs



Question the allocation of  overhead costs



Estimate working capital properly

 

POST-T POST -TAX AX PRINCIPL PRINCIPLE E



Cash flows should be measured on a post-tax basis

 

Illustration 1 ‡ Investment outlay Rs 100 mn, i.e., plant & machinery Rs 80 mn and net working capital Rs 20 mn. ‡ The project will be financed by Rs 50 mn of equity 5

5%

capital and Rs 0 mn of debt @ 1 inter in teres estt ra rate. te. roject life 5 years. After tax salvage value of fixed ‡ P assets asse ts aft fter er 5 years Rs 30 mn. Net working capital will be liquidated at book value. ‡ Expected increase in revenues and costs are Rs 120 mn and Rs 80 mn per year. (Costs are other than depr de prec ecia iatio tion, n, in inte terres estt and and ta taxx). ‡ Tax rate 30%. Depreciation @ 25% as per WDV method.

 

PROJECT CASH FLOWS (RS. IN MILLION) 0

1

2

3

4

120

12 0

120

12 0

D. COST (OTHER THAN DEPRN AND INT) E. DEPRECIATION

80 20

80 15

80 11.25

80 8.44

80 6.33

F. PROFIT BEFORE TAX

20

25

28.75

31.56

33.67

7.5

8.63

9 . 47

10 .10

17.5

20 .12

2 2. 09

23.57

A. FIXED ASSETS

(80.00)

B. NET WORKING CAPITAL

(20.00)

C. REVENUES

G. TAX

6

H. PROFIT AFTER TAX

1 4. 0

5

120

I. NET SALVAGE VALUE OF FIXED ASSETS

30.00

J. RECOVERY OF NET WORKING CAPITAL

20.00

K. INITIAL OUTLAY

(100.00)

L. OPERATING CASH FLOW (H+E)

34.0

32.5

31 .37

30.53

M. TERMINAL CASH FLOW (I+J) N. NET CASH FLOW (K+L+M)

29.90 50.0

(1 0 0. 00 )

34.0

32.5

31 .37

30.53

79.90

 

RELEVANT CASH FLOWS FOR REPLACEMENT DECISIONS INITIAL INVESTMENT

=

INITIAL INVESTT TO TO ACQ UIRE UIRE NEW ASSET

=

OPERATING CASH INFLOWS =

OPERATING CASH INFLOWS FROM NEW ASSET AFTER-T AFTERTAX CASH

TERMINAL CASH FLOW

FLOWS FROM TERMINATION OF NEW ASSET

THE ADVANTA ADVANTAGE OF SELLING THE OLD M/C .. HAS BEEN CONSIDERED .. THE DISADV ..  TOO SHOULD BE CONSIDERED

-

INFLOWS FROM LIQ UID UIDN .. OLD ASSET

-

OPERATING CASH

-

INFLOWS FROM OLD ASSET,HAD IT NOT BEEN REPLACED

FLOWS FROM TERMN OF OLD ASSET, HAD IT NOT BEEN REPLACED

 

‡ Suppose you own a plot of land that presently has a market value of Rs 1 mn. If you keep it for a year, it is expected to fetch you Rs 1.2 mn. You come across another plot of land that will cost you Rs 1.5 mn now. If you buy this land you hope to sell it for Rs 2 mn a year hence. ‡ Should you replace the existing plot? Assume no taxes and no operating cash flows.

 

Cash flows for the replacement

decision

ostt - Aft After er ttax ax sa salv lvag age e ‡ Initial investment = Cos value of the old plot. Rs 1.5 mn  1 mn = Rs 0.5 mn. ‡ Operating cash flow = 0

‡ Terminal flow = After tax salvage value from the new plot   After tax salvage value of the old plot had it been retained. = Rs 2 mn  Rs 1. 1.2 2 mn = R Rss 0 0.8 .8 mn

 

‡ Thus, the relevant cash flow stream of this replacement proposal is: replacement Cash flow ‡ Year 0 1

-Rs 5,00,000 Rs 8,00,000

If you dont subtract theget salvage value value of the tcash he existing a year from now, you the following flow plot stream for the replacement proposal: Year Cash flow 0 - Rs 5,00,000 1 Rs 20,00,000 This is erroneous because it considers the advantage fr from om selling the plot today but overlooks the disadvantage expected a year from now now..

 

Depreciation Base ‡ In a replacement decision, the depreciation base of a new asset will be equal to:

‡

Cost of new equipment

‡ ‡

+Written down value of old equipment

-Salvage value of old equipment

 

Illustration 2 ‡ ABC company purchased a machine three years ago at a cost of  ‡ ‡ ‡ ‡ ‡ ‡

Rs10,000. The machine had a life of 8 years at the time of its purchase. It is being depreciated at 15% on decl declin inin ing g bala balanc nce. e. The company is thinking of replacing it with a new machine costing Rs20 Rs 20,0 ,000 00 with with an expec xpectted 5 year ear lif life. The Th e prof profit it bef before ore depr eprecia eciattion ion is esti estima matted to incr incre eas ase e by Rs4, Rs4,44 445 a year. Assume that the old and new machines will be now depreciated at 25% on decli eclin ning ing balan alance ce for tax purpose poses. s. The salvage value of the new machine is anticipated as Rs500 after 5 years.

‡ The market value of the old machine today is Rs11,500. It is ‡ ‡

estima esti mate ted d to ha hav ve zero ero salv salvag age e val alue ue after fter 5 years. The income tax may be assumed as 55%. The companys ys after tax cost of capital is 12 percent. Should the new machine be bought?

 

‡

The book value of the old machine today is Rs6,141 as shown below:

Year

Depreciation (15%)

Book-value

0

-

(balance) 10,000

1

1,500

8,500

2

1,275

7,225

3

1,084

6,141

 

‡

The total proceeds from the sale of the old machines Rs11, 500. Since a new machine (cost Rs20,000) is being acquired in the block to which the old machine belonged, the depreciation base will be as follows: follows:

‡

=Cost of new machine + Book value of old machine  Salvage value of old machine

‡

=20,000 + 6,141   11,500 = 14,641

‡

Net Cash Outlay

‡

Cost of new machine

‡

Less: Total sale proceeds of old machine

‡ ‡

Rs20,000 11,500

 _____________ Rs8,500

 

‡

Toda day y whe hen n th the e repl plac acem eme ent is be beiing con onssid ider ere ed the boo ook k val alue ue of th the e old old mac achi hine ne is Rs6,141, whic hich will be taken as the basis for calcul ula ating de dep preciation at new rate (viz (viz.. 25%). Th The e di diff ffer eren enti tial al de depr prec ecia iati tion on is ca calc lcul ulat ated ed as follo ollow ws:

Year

DEP on old

DEP on New

(BV=Rs6141)

(DEP base Rs14,641)

Differential depreciation Rs8,500

1

1,535

3,660

2,125

2

1,151

2,745

1,594

3

863

2,059

1,195

4

648

1,544

896

5

486

1,158

672

 

Calculation of Net Cash Inflow

Year

Profit before depreciation

 After tax profit

Differential Depreciation

Tax shield on depreciation

Net cash inflow

1

4,445

2,000

2,125

1,169

3,169

2

4,445

2,000

1,594

877

2,877

3 4

4,445 4,445

2,000 2,000

1,195 896

657 493

2,657 2,493

5

4,445

2,000

672

370

2,370

Salvage value

500

 

Calculation of NPV

Year

Cash inflows

PVF12%

PV

1

3,169

0.893

2,830

2

2,877

0.797

2,293

3

2,657

0.712

1,892

4

2,493

0.636

1,585

5

2,870

0.567

1,627  _______  Total PV of inflow

10,227

Less: Net cash outlay 8.500 NPV

 _______  1,727

 

BIASES IN CASH FLOW ESTIMATION ESTIMATION  OVERSTATEMENT

 INTENTIONAL OVERSTATEMENT  LACK OF EXPERIENCE  CAPITAL RATIONING  UNDERSTATEMENT  SALVAGE VALUES ARE UNDER-ESTIMATED  INTANGIBLE BENEFITS ARE IGNORED  VALUE OF FUTURE OPTIONS IS IGNORED

 

SUMMING UP  The cash flow stream of a project comprises of three components : initial investment, operating cash inflows, and terminal cash inflow principles should be foll followed owed while  The following principles estimating estim ating the cash flows of a proj project ect : separation separation principle, incremental principle, post-tax principle, and consistency principle

 Adequate care should be taken to guard against certain biases bias es which which may may lead lead to over over-statement or understatement of true project profitability