Cash Flows for Investment Analysis

• Sound investment decisions should be

based on the net present value (NPV) rule.
• Problem to be resolved in applying the
NPV rule:
– What should be discounted? In theory, the
answer is obvious: We should always discount
cash flows.
– What rate should be used to discount cash flows?
In principle, the opportunity cost of capital should
be used as the discount rate.
 Cash Flows Versus Profit
• Cash flow is not the same thing as profit,
at least, for two reasons:
– First, profit, as measured by an accountant, is
based on accrual concept.
– Second, for computing profit, expenditures are
arbitrarily divided into revenue and capital
expenditures.
CF  (REV  EXP  DEP)  DEP  CAPEX
CF  Profit  DEP  CAPEX
 Incremental Cash Flows
• Every investment involves a comparison of
alternatives:
– When the incremental cash flows for an investment are
calculated by comparing with a hypothetical zero-cash-flow
project, we call them absolute cash flows.
– The incremental cash flows found out by comparison
between two real alternatives can be called relative cash
flows.
• The principle of incremental cash flows assumes
greater importance in the case of replacement
decisions.
 Example
• A firm wants to replace an old equipment,
capable of generating Rs.2,000; Rs.1,500 &
Rs.500 during next 3 years. It has a B.V. of
Rs.5,000 & M.V. of Rs.3,000.
• Firm is considering a new equipment of
Rs.10,000, capable of generating cash flows of
Rs.8,000, Rs.7,000 & Rs.4,500 in next 3 years.
• Both old & new equipments are assumed to
have 0 resale value after 3 years.
• It is further assumed that taxes do not exist
(Depreciation becomes irrelevant if taxes do not
exist).
Computation of incremental cash
flows: Replacement Decision
Cash flows(Rs.)
Year 0 1 2 3
Cash flows of new (10,000) 8,000 7,000 4,500
Equipment
Less, Cash flows (3,000) 2,000 1,000 500
Of old Equipment
Incremental cash (7,000) 6,000 6,000 4,000
Flows (old – new)
What will happen if both the old & new equipments have the resale
value of Rs.500 & Rs.2,500 respectively?
Net cash inflow will be Rs.2,000 as the firm will forgo the
opportunity of realising Rs.500 from the sale of old one, if the
firm goes for the new one.
 Components of Cash Flows
1. Initial Cash Outflow.
• A typical investment will have three components
of cash flows:
• 1. Initial cash outflow,
• 2. Annual net cash flows,
• 3. Terminal cash flows.

• 1. Initial cash outflow: refers to gross

investments for purchase of assets(+)
expenditure for making machines operational(+)
opportunity cost of the asset.
 Components of Cash Flows…..
2. Annual Net Cash flows
• 2. Annual Net Cash flows: recognizes
cash flows on after tax basis.
• Since depreciation plays a crucial role for
computation of tax (depreciation tax
shield) it has to be treated twice in
computation of cash flows:
• NCF = REV –EXP –DEP – TAX +DEP
• = EBIT –TAX + DEP
• = EBIT(1-T) + DEP
 Components of Cash Flows…..
2. Annual Net Cash flows….contd..
• Increase in Net Working Capital: Investment in
fixed assets leads to an increase in the amount
of current assets required for enhancing the
level of production – simultaneous increase in
current liabilities. It has to be subtracted from
after tax operating profit.
• NCF = EBIT (1-T) + DEP – Increase in NWC
• Reinvestment of additional capital: for
maintaining revenue generating ability of the
fixed asset.
• Free Cash Flow = NCF = EBIT(1-T)+DEP –
Increase in NWC -CAPEX
 Components of Cash Flows…..
3. Terminal Cash Flows
3. Terminal Cash Flows:
• represents salvage or scrap value.
• Takes place when life of project comes to an end – tn
period.
• Salvage value is estimated on the basis of cost of asset
& accumulated depreciation or sale value of used asset.
• Amount of clean-up & removal expenses, if any, is
subtracted from this amount.
• Moreover, some amount of net working capital is
released as a result of cessation of the operation. This
amount is added to the salvage value.