Technical Note on

Identifying Relevant Cash Flows In Capital Budgeting Process

By Jadhav Aditya Mohan

IBS Hyderabad IFHE University, Hyderabad

CONTENTS
TOPIC Introduction Incremental After-Tax Cash Flow Incidental Effects on ICF Effect of Indirect Expenses, Allocated Overheads and Sunk Costs Effect of Financing Costs while Estimating ICF Tax Effect on ICF Effect of Depreciation while Estimating ICF Effect of Salvage Value while Estimating ICF Effect of Changes in Working Capital on Estimation of ICF Value of the Project References Appendix-I: Estimating Relevant Incremental Cash Flows for Single Project Proposal Appendix-II: Estimating Relevant Incremental Cash Flows for Replacement Project Proposal PG. NO. 01 03 03 04 04 04 05 06 07 07 09 10 11

TABLE INDEX Table-1: Difference between Estimation of Cash Flow and Accounting Profit Table-2: Tax Effect while Estimating ICF Table-3: Depreciation Effect on ICF Table-4: Salvage Value and Tax Effect Table-5: Net Working Capital Effect Table-6: Value of the Project 02 05 05 06 07 08

INTRODUCTION The current value of the firm is equal to the present value of all its future cash flows. These future cash flows come from the assets which are already present with the firm or from the future investment opportunities. The funds for investing in these assets and future investment opportunities are raised from the investors in the form of equity and debt financing. These future cash flows are hence discounted at a rate representing the investor's required rate of return and assessment of the uncertainty related to these investments, whenever these cash flows occur over the period of the investment. The objective of the financial manager is to maximize the value of the firm and hence the owner's wealth. This can be achieved by selecting the investment proposals providing the maximum cash inflows and at the same time reducing the cost of capital or the cash outflows that will occur to service the investors providing these funds. The process by which the financial manager achieves these objectives is known as capital budgeting. Capital Budgeting is defined as a many sided activity that includes searching for new and more profitable investment proposals, investigating them to understand their engineering and marketing feasibility and making economic analysis to determine profit potential of various investments. (Bierman & Smidt, 1993) The Capital Budgeting decisions pertain to fixed long term assets which by definition refer to assets which are in operation and yield a return over a period of time longer than one year. These decisions involve potentially large anticipated benefits, relatively high degree of risk and relatively long period of time between initial outlay and anticipated returns. The Capital Budgeting decisions are of three types viz., the accept-reject decision, the mutually exclusive project selection problem and the project selection under the capital rationing situation. (Khan and Jain, 2004) The accept-reject decision arises when all projects are evaluated at par. The projects that are profitable are accepted and all the independent projects leading to loss are rejected. The problem of mutually exclusive project selection arises where the acceptance of one project excludes the other project from being accepted. In such situation, the firm should accept the project which is most profitable. As the firms have limited funds and finance, they cannot accept and implement all the projects which are profitable. Capital rationing refers to a situation in which the firm has more acceptable investment proposals than it can finance and it allocates funds to projects in a manner that maximizes long term returns and cash flows.

Identifying relevant cash flows is the initial and the most important step in the capital budgeting process. The capital budgeting process uses cash flows instead of accounting returns for analysis as cash flows represent the actual cash transactions or economic benefits related to the investment. Cash flow estimation takes the cash into consideration only when the cash really comes or goes out of the system unlike accounting profit where the cost of equipment is spread over the life of equipment and not accounted during its initial purchase or at time of sale. Similarly in cash flow estimation, revenue is recognized when it is generated i.e. when the cash is collected from sale point and expenditure is recognized only when actual cash is paid. Cash flows take into consideration time value of money unlike the accounting process where an expense may be accounted in one time period whereas it may actually occur in a different time period. The difference between cash flows and accounting profits is provided below. Table-1 Difference between Estimation of Cash Flow and Accounting Profit CASH FLOW ESTIMATE Revenues Less Expenses Net Operating Revenues Less Depreciation & Other Non Cash Expenses Earnings before Tax Less Tax @ T% Earnings after Tax Add Depreciation & Other Non Cash Expenses Cash Flow Less Tax @ T% Earnings after Tax (Accounting Profit) Less Depreciation & Other Non Cash Expenses Earnings before Tax Less Expenses Net Operating Revenues ACCOUNTING PROFIT ESTIMATE Revenues

INCREMENTAL AFTER-TAX CASH FLOW (ICF) In the capital budgeting process only the economic gains accruing due to the decisions need to be considered. Hence only the differences in the cash flows due to the decision need to be considered and not the complete cash flows associated with the new project. The incremental cash flows are the additional cash flows (outflows as well as inflows) expected to result from the proposed capital expenditure (Chandra, 2001). The relevant cash flow for analysis is the incremental after-tax cash outflow in the initial investment stage and then the subsequent incremental after-tax cash inflows resulting from the proposed capital expenditure. The incremental cash flow for time t is given as

Cashflowt

Cashflowt withproject Cashflowt withoutproject

ISSUES IN ESTIMATING INCREMENTAL CASH FLOW Various aspects like tax, direct and indirect expenses, financing costs, depreciation, etc. have to be taken into consideration while estimating the incremental cash flow. These aspects have been discussed in detail below. I) Incidental Effects on ICF The changes occurring in the cash flows of the firm and the other projects of the firm which are not directly related to the project under evaluation but which will be occurring due to the acceptance of the concerned project are known as incidental cash flows. Hence while appraising the project; all incidental effects due to the project have to be taken into consideration. Earnings and cash flows for the firm which have been foregone as a result of accepting the project under consideration instead of any other project are known as opportunity costs and should be considered as incidental costs while calculating the ICF for the project. Similarly effect on other projects in terms of changes (positive or negative) in their cash flows must be taken into consideration while estimating ICF. In case, the revenue of the other projects is reducing because of accepting the project under consideration, then the loss must be deducted from the cash flow of the current project to estimate ICF. On the other hand, if the other projects are gaining money due to 3

acceptance of this project, then the additional gains should be added to the cash flows of the current project while estimating ICF. Similarly, increase in variable labor and material expenses should be considered as additional costs while estimating ICF for the project under evaluation. II) Effect of Indirect Expenses, Allocated Overheads and Sunk Costs The fixed indirect expenses and overheads of the firm allocated to the project should not be considered during the estimation of incremental cash flows as they still exist even if the project is rejected. In case, the company has to bear additional fixed overhead expenses due to acceptance of the project, then these additional expenses should be appropriately considered for estimating the ICF wherever required. Costs relating to the project which have been already incurred in the past or are already committed irrevocably are known as Sunk Costs. As these costs cannot be recovered or cancelled irrespective of selection of the project, these costs should not be considered while estimating ICF of the project under evaluation. III) Effect of Financing Costs while Estimating ICF The rate of financing should be considered as the hurdle rate and should be used for discounting the cash flows. Hence the corresponding financing costs or interest should not be considered or deducted from the earnings while computing the project incremental cash flows. The hurdle rate should be same for all comparable projects which are under evaluation and should be equal to the weighted average cost of capital of the firm. IV) Tax Effect on ICF Cash flows have to be considered net of taxes i.e. the tax has to be deducted from the earnings while estimating the cash flows. This is because tax is paid to the government due to which actual cash is flowing out of the firm. As foregone income or losses from the project can be adjusted against the income from other projects of the firm for the current year itself, taxes on the foregone income or losses should be considered as opportunity gains and cash inflow and added to the earnings while computing the incremental cash flows for the project. The tax effect on the incremental cash flows is given in table 2 below.

Table-2 Tax Effect while Estimating ICF Gain Less Tax @ T% Gain after Tax Less Tax @ T% Post-tax Loss Loss

V) Effect of Depreciation while Estimating ICF Depreciation is a non-cash item of cost and hence the cash appropriated to the depreciation cost does not flow out of the firm. On the other hand as depreciation is a tax deductible expense, it should be deducted from the earnings before computing the applicable taxes. This deducted depreciation should be added back to the profit after tax to arrive at the final cash flow. The depreciation effect while estimating cash flow is shown in table-3 below. Table-3 Depreciation Effect on ICF Earnings before Depreciation and Tax Less Depreciation Profit before Tax Less Tax @ T% Profit after Tax Add Depreciation Cash Flow Since depreciation is an operating expense, it should not be considered while computing the initial cash outlay or investment and the terminal cash outlay. The effect of depreciation is already present in the form of the depreciated book value of the asset.

VI) Effect of Salvage Value while Estimating ICF Salvage value of the asset is the value of the asset recovered by selling the asset at the end of its useful life or whenever the asset is sold. The salvage value of an asset is included in two components while estimating the cash flow. The first component is the cash inflow equal to the salvage value occurring due to the sale of the asset. The second component is the opportunity tax gain or loss occurring due to the sale. If the salvage value of the asset is greater than the written down value or the book value of the asset, than the additional gain i.e. the difference between the salvage value and the book value is considered as profit and should be taxed. This tax has to be considered along with the salvage value cash inflow while estimating the ICF. Similarly, if the salvage value is less than the written down value or the book value of the asset, than the difference between the salvage value and the book value is considered as loss and the opportunity tax gain should be calculated and added to the earnings while estimating the incremental cash flows. The salvage value effect is shown in table-4 below. Table-4 Salvage Value and Tax Effect Components of Salvage Value Effect Salvage Value Less Applicable Tax Gain (Loss) on Sale of Asset The Applicable Tax Gain on Profit on Sale of Asset is calculated as Salvage Value Less Book Value Gain (Loss) from Sale Thus Gain (Loss) from Sale x Tax @ T% = Applicable Tax on Gain (Loss) from Sale

VII) Effect of Changes in Working Capital on Estimation of ICF Working capital is the difference between current assets and current liabilities. It is the part of current assets which is being financed using long-term sources of finance as the current liabilities are unable to finance it. This financing of current assets by long-term sources of finance is known as Working Capital Financing (Brealey & Myers, 2006). Any increase in working capital of the firm occurring due to the acceptance of the new project should be appropriated to the project and considered as a cash outflow in the estimation of initial cash outlay. This additional or net working capital will be recovered back by the firm at the end of the projects life in the terminal cash flow. Working capital being the part of the current assets is never depreciated over the period of the project and the working capital is completely recovered at the end of the project's life. In case, the net working capital requirement reduces with the new project, it is to be considered as cash inflow while estimating initial cash outlay. This inflow is offset in the form of cash outflows at the end of project's life. Any increase in net working capital for a period is to be considered as cash outflow or expense for the period and any decrease in net working capital is considered as cash inflow or income for the period. Table-5 Net Working Capital Effect (New Inventory Level) - (Old Inventory Level) = Add (New Receivables) - (Old Receivables) Less (New Payables) - (Old Payables) = Net Payables = Net Receivables Net Inventory

Net Working Capital for the Project

VALUE OF THE PROJECT Any project is valued using three categories of cash flows viz., Initial cash flows occurring at the start of the project, the Operating Cash flows or the income generated during the operation of the project and the terminal cash flows occurring when the project is closed, dismantled and salvaged off. The above rules and effects are taken into

consideration while computing each of these cash flows wherever applicable. The value of the project is estimated according to the process given in table-6 below. Table-6 Value of the Project Operating Cash Flows Add Terminal Cash Flows Less Initial Cash Flows Value of the Project

The process for estimating the relevant cash flows for a Single Project Proposal is provided in Appendix-I. The process for estimating the relevant cash flows for a Replacement Project Proposal is provided in Appendix-II.

REFERENCES Bierman, Harold Jr. and Seymour Smidt (1993). The Capital Budgeting Decision: Economic Analysis of Investment Projects, Edition VIII, Upper Saddle River, Prentice Hall Inc. ISBN-0-02-309943-7, pp.591. Brealey, Richard A. and Stewart C. Myers (2006). Principles of Corporate Finance, Edition VII, New Delhi, Tata McGraw-Hill Publishing Company Ltd. ISBN-0-07052908-6, pp.1071. Chandra, Prasanna (2001). Financial Management: Theory and Practice, Edition V, New Delhi, Tata McGraw-Hill Publishing Company Ltd. ISBN-0-07-044501-X. pp.1123. Khan, M. Y. and P. K. Jain (2004). Financial Management: Text, Problems and Cases, Edition IV, New Delhi, Tata McGraw-Hill Publishing Company Ltd. ISBN0-058340-4. pp.1264.

Appendix-I

Estimating Relevant Incremental Cash Flows for Single Project Proposal

INITIAL CASH OUTLAY Cost of New Project Add Installation Cost of Plant and Equipment Add (Less) Working Capital Requirement Initial Cash Outlay CASH INFLOWS FOR PERIOD OF OPERATION Revenues Less Operating Cost Net Operating Revenues Less Depreciation Earnings before Tax Less Tax @ T% Earnings after Tax Add Depreciation Cash Flow After Tax FOR THE LAST OPERATING YEAR Cash Flow After Tax Add Salvage Value (Post tax) Add (Less) Recovery of Working Capital Cash Flow for Last Year

10

Appendix-II

Determining Relevant Incremental Cash Flows for Replacement Project Proposal

INITIAL CASH-FLOWS Cost of New Asset Add Net Working Capital Required for the New Asset Add Installation Cost Less Salvage Value Realized from Old Asset Less Net Working Capital Recovered by Selling the Old Asset Less Opportunity Tax Gain (Loss) occurring due to the Replacement Initial Cash Flow or Cash Outlay

TERMINAL CASH FLOW

Salvage Value of New Asset Add Recovery of Net Working Capital Required for the New Asset Add Opportunity Tax Gain (Loss) due to Sale of New Asset Less Salvage Value Realized from Old Asset had it Not Been Replaced Less Net Working Capital Recovered from the old asset Less Opportunity Tax Gain (Loss) due to Sale of Old Asset had it Not Been Replaced Terminal Cash Flow or Cash Outlay

11

OPERATING CASH-FLOWS

CASH FLOWS FOR PERIOD OF OPERATION Operating Cash Inflows from the new asset Less Operating Cash Inflows from the old asset had it not been replaced CASH FLOW FOR THE PERIOD (For New Asset as well as Old Asset) Revenues Less Operating Cost Add (Less) Changes in Working Capital for the Year Net Operating Revenues Less Depreciation Earnings before Tax Less Tax @ T% Earnings after Tax Add Depreciation Operating Cash Flow After Tax

12