Projects: Cash Flow Estimation

-Dr. Tanuj Nandan

tanuj@mnnit.ac.in

Project Valuation using DCF Techniques

Cash Flow Estimation

Discounted Cash Flow Techniques

-Net Present Value (NPV) -Internal Rate of Return (IRR)

Sensitivity Analysis

Dr. Tanuj Nandan, SMS MNNIT Allahabad

Some precursors to DCF valuation

Discounted Cash Flow Techniques are based on three basic concepts: a. Time Value of Money b. Principle of Compounding c. Principle of Discounting The principle of time value is known intuitively to us- a Rupee is worth more today than it will be a year from now.
Dr. Tanuj Nandan, SMS MNNIT Allahabad

Elements of the Cash Flow Stream

Evaluation of projects requires estimates of relevant cash flows. The cash-flows taken into consideration for the purpose are incremental and are computed on a post-tax basis. The cash-flow stream of a conventional project may be considered to comprise three components:
a) Initial Investment b) Operating Cash Flows c) Terminal Cash Flows

Dr. Tanuj Nandan, SMS MNNIT Allahabad

Dr. Tanuj Nandan, SMS MNNIT Allahabad

Time Horizon for Cash Flow Analysis

The time horizon for cash-flow analysis is usually the minimum of the following:
a) b) c) d) Physical Life of the Plant Technological Life of the Plant Product Market Life of the Plant Investment Planning Horizon of the Firm

Dr. Tanuj Nandan, SMS MNNIT Allahabad

Basic Principles of Cash Flow Estimation

The following principles should be borne in mind while estimating the cash flows of a project: a) Separation Principle b) Incremental Principle c) Post-tax Principle d) Consistency Principle

Dr. Tanuj Nandan, SMS MNNIT Allahabad

Separation Principle
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 costs should not be considered because they will be reflected in the cost of capital figure against which the rate of return figure will be evaluated.

Incremental Principle
To ascertain a projects incremental cash flows you have to look at what happens to the cash flows of the firm with the project and without the project
Guidelines Consider all incidental effects Ignore sunk costs Include opportunity costs Examine carefully the allocation of overhead costs Estimate working capital properly

Post-Tax Principle
Cash flows should be measured on a post-tax basis The marginal tax rate of the firm is the relevant rate for estimating the tax liability of the firm

Consistency Principle
Cash flows and discount rates applied to these cash flows must be consistent with respect to the investor group and inflation Investor Group The consistency principle suggests the following match up: Cash flow Cash flow to all investors Cash flow to equity shareholders Discount rate Weighted average cost of capital Cost of equity

Consistency Principle (2)

Cash flows and discount rates applied to these cash flows must be consistent with respect to the investor group and inflation Inflation The consistency principle suggests the following match up: Cash flow Nominal cash flow Real cash flow Discount rate Nominal discount rate Real discount rate

Principle of Compounding
The Principle of Compounding is used to value amounts received more frequently than annually. For example, the value of 8 percent interest receivable semi-annually would be: A=P(1+0.8/2)2 By similarity, an interest of i percent compounded m times a year would be A=P(1+i/m)m
Dr. Tanuj Nandan, SMS MNNIT Allahabad

Principle of Compounding
One other concept that is based on the principle of compounding, and that we will be using is Future Value (FV). It is the value of a cash flow or flows at some date in the future. In simple terms: where compound interest rates are involved, money moved forward in time is compounded, whilst money moved backward in time is discounted.
Dr. Tanuj Nandan, SMS MNNIT Allahabad

Principle of Discounting
The Principle of Discounting is used to determine the value amounts received in future in Present Value (PV) terms. An amount received in future would be worth less than it is worth today, owing to the concept of Time Value. For example, the value of one hundred rupees received a year from now should be discounted to its present value by using an appropriate Discount Factor. Dr. Tanuj Nandan, SMS MNNIT Allahabad

Choice of an appropriate Discount Factor

The discount factor chosen would have to reflect both, the cost of capital of the firm, as well as the expected inflation rate. Therefore, if cost of capital (generally, WACC) for the firm is 10 percent, and the anticipated inflation rate is 6 percent, the discount factor to be used would be calculated as follows: Discount rate = [(1+0.10) X (1+0.06)] 1 = 1.166 1 = 0.166 or 16.6%
Dr. Tanuj Nandan, SMS MNNIT Allahabad

Calculation of Present Value

The value of a sum received in future in present terms is knows as its present value If an amount of X is received a year from now, its present value would be PV= X/(1+Discount Rate) If X=100 Rs., Discount Rate= 10%, then PV = 100/1.1 = 90.91 Rs Similarly, PV of 100 Rs. received two years hence PV=100/(1.1)2
Dr. Tanuj Nandan, SMS MNNIT Allahabad

Calculation of Present Value

PV of 100 Rs. received n years hence PV=100/(1.1)n PV of 100 Rs. received successively for a period of three years = 100/(1.1)1+100/(1.1)2+100/(1.1)3 This is nothing but the Net Present Value of the stream of payments.

Dr. Tanuj Nandan, SMS MNNIT Allahabad

Net Present Value

The Net Present Value of a stream of future income may thus be defined as:
n

NPV

t=0

CF t ( 1 + k )

where, t = life of the project CFt = Cash flow (net) in period t (assumed to be at the end of the period; includes initial and terminal cash flows) k = Discount rate
Dr. Tanuj Nandan, SMS MNNIT Allahabad

Net Present Value

Cash flows taken into consideration:
Cash Outflows (expenditure) Initial investment to purchase assets Operating costs such as labour and materials Tax payments Project management expenses Any other outflow caused by accepting the project Cash Inflows (income) Revenues from operating the project Any other inflow caused by accepting the project (subsidies, grants, etc.) Eventual scrap value of assets

The net of the inflows and outflows for a particular time period is taken as the cash flow for that period.
IMPORTANT: Depreciation doesMNNIT Allahabad not constitute a cash flow. Dr. Tanuj Nandan, SMS

Net Present Value

Accept-reject criterion for the project: IfNPV > 0, Accept the project NPV = 0, Indifferent NPV < 0, Reject the project

Dr. Tanuj Nandan, SMS MNNIT Allahabad

Net Present Value

An example of project appraisal using NPV: Your company manufactures detergent cakes. It plans to add a new product line- detergent powders by investing money in a new plant that will produce a new variety of detergent soap (powder). Based on your market analysis, the following data is available-

Dr. Tanuj Nandan, SMS MNNIT Allahabad

Net Present Value

Cost of plant, including installation: Rs. 400,000 Useful economic life: 5 years Salvage Value: Nil Capacity: 2,000 Tonnes per year Estimated demand per year: 1,500 Tonnes Estimated sale price per tonne: Rs. 200 Variable costs: 30% of sales revenue Fixed costs per year: Rs. 50,000 in the first year, increasing by Rs. 5,000 each year Discount Rate: 12% (p.a.)
Dr. Tanuj Nandan, SMS MNNIT Allahabad

The project may be viewed thus:

Year 0 Fixed Costs Cash Flows -400,000.00 Year 1 50,000.00 160,000.00 Year 2 55,000.00 155,000.00 Year 3 60,000.00 150,000.00 Year 4 65,000.00 145,000.00 Year 5 70,000.00 140,000.00

Therefore, NPV= - 400,000/(1.12)0 + 160,000/(1.12)1 + 155,000/(1.12)2 + 150,000/(1.12)3 + 145,000/(1.12)4 + 140,000/(1.12)5 = 144,779.11 Rs.
Dr. Tanuj Nandan, SMS MNNIT Allahabad

Dr. Tanuj Nandan, SMS MNNIT Allahabad

Shortcomings of NPV
NPV is sensitive to changes in cash flows, and to discount rates. A change in market conditions, leading to either reduced levels of cash flows or more expensive capital (and hence higher WACC) could lead to a projects NPV becoming less over time. Even projects with negative NPVs may be useful to the firm- in case of strategic advantages or legal requirements.
Dr. Tanuj Nandan, SMS MNNIT Allahabad

Internal Rate of Return

The Internal Rate of Return associated with a stream of future income is the rate of return that equates its net present value to zero. It may thus be defined as:

CF /
t

t=0 (1+IRR)

t=0 where, n = life of the project CFt = Cash flow (net) in period t (assumed to be at the end of the period; includes initial and terminal cash flows) IRR = Internal Rate of Return
Dr. Tanuj Nandan, SMS MNNIT Allahabad

Internal Rate of Return

We may use the same example as in NPV A discount rate of 12% yielded a positive NPV We therefore need a higher rate of discounting This method uses hit and trial We try to locate two successive rates of return, one which yields a positive NPV, and the next that yields a negative NPV

Dr. Tanuj Nandan, SMS MNNIT Allahabad

Internal Rate of Return

We find that When r= 26%, NPV= 1,214 When r= 27%, NPV=-6,574 Interpolating, we find that k = 26%+ {(1214-0)/(1214- (-6574))} = 26%+1214/6695 = 26+0.1558 = 26.1558
Dr. Tanuj Nandan, SMS MNNIT Allahabad

Internal Rate of Return

Accept-reject criterion for the project: IfIRR > WACC, Accept the project IRR = WACC, Indifferent IRR < WACC, Reject the project

Dr. Tanuj Nandan, SMS MNNIT Allahabad

Scenario Analysis
What does Scenario Analysis do? It shows how changes in a variable such as unit sales affect NPV or IRR. Each variable is fixed except one. This one variable is changed to analyse the effect on NPV or IRR. Answers what if questions, e.g. What if sales decline by 30%?
Dr. Tanuj Nandan, SMS MNNIT Allahabad

Scenario Analysis
For example, Let us consider three alternate outcomes to the detergent powder example:
Probability Best Case Base Case Worst Case (Optimistic) (Most Likely) (Pessimistic) 0.20 0.60 0.20 Sales Volume (Tonnes) 1,750.00 1,500.00 1,250.00 Sales Price (Rs/ Tonne) 200.00 200.00 200.00

Dr. Tanuj Nandan, SMS MNNIT Allahabad

Based upon the above, we get the following results:

Scenario Best Case (Optimistic) Base Case (Most Likely) Worst Case (Pessimistic) E(NPV) (NPV) CV(NPV) = {(NPV)/E(NPV)}
Dr. Tanuj Nandan, SMS MNNIT Allahabad

Probability NPV 0.20 0.60 0.20

270,946 144,779 18,612 144,779 79,795 0.55

Scenario Analysis
What does Scenario Analysis do? It shows how changes in a variable such as unit sales affect NPV or IRR. Each variable is fixed except one. This one variable is changed to analyse the effect on NPV or IRR. Answers what if questions, e.g. What if sales decline by 30%?
Dr. Tanuj Nandan, SMS MNNIT Allahabad

Shortcomings of Scenario Analysis

It only considers a few possible outcomes. It assumes that inputs are perfectly correlated; all bad values occur together and all good values occur together. These shortcomings may be resolved by Simulation Analysis

Dr. Tanuj Nandan, SMS MNNIT Allahabad

Simulation Analysis
Simulation Analysis is a computerized version of scenario analysis which uses continuous probability distributions.
Computer selects values for each variable based on given probability distributions. NPV and IRR are calculated. Process is repeated many times (1,000 or more). End result: Probability distribution of NPV and IRR based on sample of simulated values. Generally shown graphically.
Dr. Tanuj Nandan, SMS MNNIT Allahabad

Simulation Analysis
Let us return to the detergent powder example.
We will assume that UNIT SALES are normally distributed, withMean= 1,500 Tonnes Standard Deviation = 125 Tonnes Further, we assume that the UNIT PRICE has a triangular distributionLower Bound =160 Rs/Tonne Most Likely = 200 Rs/Tonne Upper Bound = 240 Rs/Tonne

Dr. Tanuj Nandan, SMS MNNIT Allahabad

Simulation Analysis- The Process

The process of Simulation Analysis involves picking a random variable for unit sales and sale price. These values are then substituted in the spreadsheet and NPV is computed. The process is repeated many times (1000, in this case), and the input variables (units and price) and the output (NPV) are saved.

Dr. Tanuj Nandan, SMS MNNIT Allahabad

Frequency 80 100 120 140 160 20 40 60 0 -160000 -120000 -80000 -40000 0 40000 80000 120000 160000 Bin 200000 240000 280000 320000 360000 400000 440000 480000 520000 More Frequency

Histogram

Simulation Analysis- The Result

Dr. Tanuj Nandan, SMS MNNIT Allahabad

Dr. Tanuj Nandan, SMS MNNIT Allahabad

Simulation Analysis- The Result

Unit Sales Price (Rs/Tonne) 201 23 Unit Sales (Tonnes) 1474 203 NPV (Rs.) 135,644 132,979 INR 470,303 (INR 151,936) 0.98 INR 128,453 836 83.6%

Mean Standard Deviation Max Min CV (NPV) Median Number of Positive NPVs Prob (NPV>0)

Dr. Tanuj Nandan, SMS MNNIT Allahabad

Advantages
Reflects the probability distributions of each input. Shows range of NPVs, the expected NPV, NPV, and CVNPV. Gives an intuitive graph of the risk situation.

Dr. Tanuj Nandan, SMS MNNIT Allahabad

Limitations
Difficult to specify probability distributions and correlations. If inputs are bad, output will be bad: Garbage in, garbage out. Sensitivity, scenario, and simulation analyses do not provide a decision rule. They do not indicate whether a projects expected return is sufficient to compensate for its risk.
Dr. Tanuj Nandan, SMS MNNIT Allahabad

How to interpret these results

CV obtained from Scenario Analysis = 0.55 CV obtained from Simulation Analysis = 0.98 Generally, a CV of over 0.4 is considered high-risk. Going by the risk-return tradeoff, the discount rate will have to be adjusted suitably.

Dr. Tanuj Nandan, SMS MNNIT Allahabad

The risk-return tradeoff

Expected Return

RFR

Risk
Dr. Tanuj Nandan, SMS MNNIT Allahabad

With an 8% risk-adjustment, will the project still be acceptable?

Adjusting the discount rate (k) to reflect the higher levels of risk, we go back to the original k kadj=k+8% = 20% This implies that we have added about 67% to k to adjust for risk. This yields an NPV of 53,967 Rupees Hence, the project remains acceptable even after accounting for higher risk
Dr. Tanuj Nandan, SMS MNNIT Allahabad

A simple cash flow illustration

Magnum Technologies Ltd. is considering an electronics project about which the following information is available: The investment outlay in the project will be Rs. 50 million, comprised of Rs. 30 million on fixed assets, and Rs. 20 million on current assets. The project will be financed with Rs. 15 million of equity capital, Rs. 20 million of term loans, and Rs. 10 million of bank finance for working capital, and Rs. 5 million of trade credit.

A simple cash flow illustration (2)

The term loan is repayable in five equal installments of Rs. 4 million each. The levels of bank finance for working capital and trade credit will remain at Rs. 10 million till they are paid back or retired at the end of 5 years. The interest rates on term loan and bank finance for working capital will be 15 percent and 18 percent, respectively. The expected revenues from the project will be Rs. 60 million per year. The operating costs, excluding depreciation, will be Rs. 42 million. The depreciation rate on fixed assets will be 331/3 percent on WDV basis.

A simple cash flow illustration (3)

The net salvage value of fixed assets and current assets at the end of year 5 will be Rs. 5 million and Rs. 20 million respectively. The tax rate applicable to the firm is 50 percent.

Net Cash Flows Relating to Equity

Years 0 1. Equity Funds 2. Revenues 3. Operating Costs 4. Depreciation 5. Interest on Working Capital Advance 6. Interest on Term Loan 7. Profit Before Tax 8. Tax 9. Profit After Tax 10. Preference Dividend 11. Net Salvage Value of Fixed Assets 12. Net Salvage Value of Current Assets 13. Repayment of Term Loans 14. Redemption of preference capital 15. Repayment of short-term bank borrowings 16. Retirement of Trade Creditors (15.00) 1 60.0 42.0 10.0 1.80 3.00 3.20 1.60 1.60 4.00 2 60.0 42.0 6.67 1.80 2.40 7.13 3.57 3.56 4.00 (Rs. In Million) 3 60.0 42.0 4.44 1.80 1.80 9.96 4.98 4.98 4.00 4 60.0 42.0 2.96 1.80 1.20 12.04 6.02 6.02 4.00 5 60.0 42.0 1.98 1.80 0.60 13.62 6.81 6.81 5.00 20.00 4.00 10.00 5.00

Net Cash Flows Relating to Equity

Years 0 1. Equity Funds 2. Revenues 3. Operating Costs 4. Depreciation 5. Interest on Working Capital Advance 6. Interest on Term Loan 7. Profit Before Tax 8. Tax 9. Profit After Tax 10. Preference Dividend 11. Net Salvage Value of Fixed Assets 12. Net Salvage Value of Current Assets 13. Repayment of Term Loans 14. Redemption of preference capital 15. Repayment of short-term bank borrowings 16. Retirement of Trade Creditors (15.00) 1 60.0 42.0 10.0 1.80 3.00 3.20 1.60 1.60 4.00 2 60.0 42.0 6.67 1.80 2.40 7.13 3.57 3.56 4.00 (Rs. In Million) 3 60.0 42.0 4.44 1.80 1.80 9.96 4.98 4.98 4.00 4 60.0 42.0 2.96 1.80 1.20 12.04 6.02 6.02 4.00 5 60.0 42.0 1.98 1.80 0.60 13.62 6.81 6.81 5.00 20.00 4.00 10.00 5.00

Net Cash Flows Relating to Equity (2)

Years 0 17. Initial Investment (1) 18. Operating Cash Inflows (9-10+4) 19. Liquidation & retirement cash flows (11+12-13-14-15-16) 20. Net cash flows (17+18+19) (15.00) (15.00) 1 11.60 (4.00) 7.60 2 10.23 (4.00) 6.23 (Rs. In Million) 3 9.42 (4.00) 5.42 4 8.98 (4.00) 4.98 5 8.79 6.00 14.79

A simple cash flow illustration

Naveen Enterprises is considering a capital project about which the following information is available: The investment outlay in the project will be Rs. 100 million, comprised of Rs. 80 million on plant & machinery, and Rs. 20 million on net working capital. The project will be financed with Rs. 45 million of equity capital, Rs. 5 million of preference capital, and Rs. 50 million of debt capital. Preference capital will carry a dividend rate of 15 percent; debt capital will carry an interest rate of 15 percent.
Dr. Tanuj Nandan, SMS MNNIT Allahabad

A simple cash flow illustration (2)

The life of the project is expected to be 5 years. At the end of 5 years, fixed assets will fetch a net salvage value of Rs. 30 million whereas net working capital will be liquidated at its book value. The project is expected to increase the revenues of the firm by Rs. 120 million per year. The increase in costs on account of the project is expected to be Rs. 80 million per year. The effective tax rate will be 30 percent. Plant and machinery will be depreciated at the rate of 25 percent per year on WDM method.
Dr. Tanuj Nandan, SMS MNNIT Allahabad

Cash Flow Illustration

Ojus Enterprises is determining the cash flow for a project involving replacement of an old machine by a new machine. The old machine has a book value of Rs. 400,000 It can be sold to realize Rs. 500,000 It has a remaining life of 5 years, after which it can be sold at Rs. 160,000 Machinery is depreciated @ 25% pa on WDV Working capital required for the old machine is Rs. 400,000
Dr. Tanuj Nandan, SMS MNNIT Allahabad

Cash Flow Illustration (contd.)

The new machine costs Rs. 1,600,000 It is expected to fetch a net salvage value of Rs. 800,000 after 5 years, after which it will no longer be required. Working capital required for the new machine is Rs. 500,000 The new machine is expected to bring a saving of Rs. 300,000 annually in manufacturing costs Tax rate applicable to the firm is 40% Estimate incremental, after-tax cash flows associated with the replacement project.
Dr. Tanuj Nandan, SMS MNNIT Allahabad

Dr. Tanuj Nandan, SMS MNNIT Allahabad