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CHAPTER 10

CASH FLOWS FOR INVESTMENT ANALYSIS

Q1. Distinguish between profits and cash flows. Why are cash flows important in
investment decisions?
A1 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 conceptrevenue
(sales) is recognised when it is earned, rather than when cash is received, and
expense is recognised when it is incurred rather than when cash is paid.
Second, for computing profit, expenditures are arbitrarily divided into revenue
and capital expenditures. Revenue expenditures are entirely charged to profits
while capital expenditures are not. Capital expenditures are capitalised as assets
(investments), and depreciated over their economic life. Only annual depreciation
is charged to profit. Depreciation (DEP) is an accounting entry and does not
involve any cash flow. Thus, the measurement of profit excludes some cash flows
such as capital expenditures and includes some non-cash items such as
depreciation.
Investment decisions require information about cash flows. It is the inflow and
outflow of cash, which matters in practice. It is cash, which a firm can invest, or
pay to creditors to discharge its obligations, or distribute to shareholders as
dividends. Cash flow is a simple and objectively defined concept. It is simply the
difference between rupees received and rupees paid out.

Q2. What are incremental cash flows? Briefly explain the effects of the following on
the calculation of incremental cash flows: (a) sunk costs, (b) allocated overheads,
and (c) opportunity costs.
A2 Every investment involves a comparison of alternatives. The minimum
investment opportunity, which a company will always have, will be either to
invest or not to invest in a project. 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 are found out by subtracting (algebraically) cash
flows of Project 1 from that of Project 2 (or vice versa). Such 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.
Sunk costs are cash outlays incurred in the past. They are the results of past
decisions, and cannot be changed by future decisions. Since they do not influence
future decisions, they are irrelevant costs. They are unavoidable and irrecoverable
historical costs; they should simply be ignored in the investment analysis.
Since the general overheads will be incurred whether or not the new projects are
undertaken, those allocated overheads should be ignored in computing the net
cash flows of an investment. However, some of the overheads may increase

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because of the new project; these should be charged to the project. The
incremental cash flow rule indicates that only incremental overheads are relevant.
Opportunity costs are the expected benefits, which the company would have
derived from those resources if they were not committed to the proposed project.
It is important to note that the alternative use rule is a corollary of the incremental
cash flow rule.

Q3. A company has just tested the market for a new product. The test indicates that
the product may capture about 40 percent of the market share. It is also expected
that 25 percent of the new products share will be at the cost of an existing
product. The new product can be manufactured in the existing facilities, which
could also be used to meet the expected increase in one of the companys existing
products. The companys financial analyst argues that she would include the test
costs in the new products cash flows since they were incurred for testing the new
product, but would exclude the lost contribution on an existing product and the
value of the existing facilities to be used for the manufacture of the new product
because no out-of-pocket cost is incurred. Do you agree with the analyst? Why or
why not?
A3 No, test costs have already been incurred (whether project is undertaken or not,
they will not be influenced); they are sunk costs and hence, cannot be included in
the new products cash flows. Lost contribution on an existing product and the
value of the existing facilities to be used for the manufacture of the new product is
the opportunity cost and should be included in evaluating the new project.

Q4 How should depreciation be treated in capital budgeting? Do the depreciation


methods affect the cash flows differently? How?
A4 The computation of the after-tax cash flows requires a careful treatment of non-
cash expense items such as depreciation. Depreciation is an allocation of cost of
an asset. It involves an accounting entry and does not require any cash outflow;
the cash outflow occurred when the assets was acquired.
Depreciation, calculated as per the income tax rules, is a deductible expense for
computing taxes. In itself, it has no direct impact on cash flows, but it indirectly
influences cash flow since it reduces the firms tax liability. Cash outflow for
taxes saved is in fact an inflow of cash. The saving resulting from depreciation is
called depreciation tax shield.
Depreciation tax shield = Tax rate Depreciation
DTS = T DEP
In India, for tax purpose written down value method of depreciation is allowed.
Hence, other methods will have no effect on cash flows.
Q5 In an interview with the chief executive of a motorcycle manufacturing company,
he commented: We present our capital budgeting numbers in real terms.
Therefore, we have got to anticipate the inflation rate. Discuss the chief
executives comment.
A5 The NPV rule gives correct answer to choose an investment under inflation if it is
treated consistently in cash flows and discount rate. The manufacturing company
should discount real cash flows at the real discount rate. The discount rate, being

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the cost of capital, is market determined and is always in nominal terms. Hence,
the company should determine the inflation rate to convert nominal cost of capital
into real cost of capita. The following equation gives the relationship between
nominal and real cost of capital:
Norminal discount rate = (1 + real discount rate)(1 + inflation rate) - 1
1 + nominal discount rate
Real discount rate = -1
1 + inflation rate

Q6. The chairman of a rubber company stated, We dont adjust our capital budgeting
calculations for inflation because the price and costs of the product increase by
the same rate. Comment.
A6 What the chairman is implying is that they use real cash flows in making capital
decisions. If the real cash flows have been correctly identified and these cash
flows are discounted at real cost of capital, then the rubber company is using a
correct procedure. However, because of non-cash items like depreciation and
different inflation rates for items of revenues and expenses, it is difficult to use
real cash flow approach. It is more convenient to use nominal cash flows and
nominal discount rate in such cases.

Q7. Illustrate the distinction between real and nominal rates of return. Is this
distinction important in capital budgeting decisions? Why?
A7 The nominal discount rate is a combination of the real rate (say, K) and the
expected inflation rate (let us call it, ). This relationship, long ago recognised in
the economic theory, is called the Fishers effect. It may be stated as follows:
Nominal discount rate = (1 + real discount rate)(1 + inflation rate) - 1

k = (1 + K )(1 + a) - 1
In practice, it is customary to add the real rate and the expected inflation rate to
obtain the nominal required rate of return: k = K + a.
Yes, the distinction is important in capital budgeting decisions. The NPV rule
gives correct answer to choose an investment under inflation if it is treated
consistently in cash flows and discount rate. The discount rate is a market-
determined rate and therefore, includes the expected inflation rate. It is thus
generally stated in nominal terms. The cash flows should also be stated in nominal
terms to obtain an unbiased NPV. Alternatively, the real cash flows can be
discounted at the real discount rate to calculate unbiased NPV.

Q8. Why should investment decisions be separated from financing decisions?


Illustrate your answer.
A8 The firms weighted average cost of capital is used in evaluating investment
projects under two conditions: (1) the risk of project is the same as that of the
firm; (2) the target capital structure is same for the firm and all projects and
remains constant over years. WACC incorporates the financing effect. Hence
cash flows do not consider the financing effects. These cash flows are known as
free cash flows; they are available to service both debt and equity.