Cash Flows in Capital Investment Decisions

 Decision Criteria: Will the investment increase firm value?

 Preferred Method: NPV - Considers timing of cash flows and opportunity costs
o Criteria: NPV should be positive
 Only incremental, after-tax cash flows are relevant
o Sunk costs should be ignored - since they are not incremental
o Depreciation & other non-cash expenses are not relevant (should be added back)
o Tax & tax-shield on depreciation is relevant
o Impact on existing business due to substitution, environmental concerns, brand image etc.
should be considered (incremental impact)
o Allocated corporate costs should be ignored (not incremental) unless they are specific to the
project (incremental)
 Financing costs are not deducted from the cash flows, since they are included in the discount rate
(to avoid double-counting).
 The investment choice is considered independent of the project-specific financing decision. The
discount rate will consider opportunity cost of capital for the business, and will be adjusted for
riskiness of the project but will not be affected by how the project is financed.

Modern Pharma
Notes
1. The cash flow in case of Modern Pharma follows the following typical cash flow pattern:

2. While estimating contribution margin, we take into account cannibalization of existing product
since it is an incremental impact.
3. For calculating overheads only 5% of sales, which is specific to project is incremental, hence
relevant.
4. Depreciation is calculated as follows based on written-down-value (WDV) method:
Depn in 1st year = 25% of 120 (Original Cost) = 30
Depn in 2nd year = (1-25%) x 30 = 22.50
 Depn in 3rd year = (1-25%) x 22.50 = 16.875 and so on.
(If Depn had been based on straight-line method (SLM) it would have remained a constant
amount)
5. Depreciation is added back to PBIT x (1-t). Effectively PBIT x (1-t) + Depn = PBDIT (1-t) + Depn x t.
Thus depn has an impact on the operating cash flows only to the extent of its tax shield (Depn x
t).
6. Bad debt in the end reduces the working capital that is recovered. The other cash flow effect of
bad debt is the tax deduction, otherwise it is not a cash expense in the terminal year and must
be added back just like depreciation.
7. We do not reduce interest (or add interest-tax shield) since these effects are considered in the
discount rate, to avoid double counting. The discount rate in this case is 15%.
8. Apart from the intial investment (outflow) which include PPE (120 mn) and Working capital (35
mn), there is also an investment cash flow in the last year corresponding to net salvage value of
equipment and working capital recovery. (Though there is no investment cash flow in interim
years in this problem, in practice there will be some capex and some increase in net working
capital every year.)
9. Salvage value is simply the proceeds from sale of depreciated equipment. Since, there may be a
capital gain (or loss) on equipment sale, the company may pay a capital gains tax. Net salvage
value is Salvage value minus capital gains tax. Since net salvage value is directly given, that is the
final cash flow as reduced by capital gains tax.
10. Working capital recovery will be Rs 35 mn – Rs 4 mn (bad debt).

Calculations:
a)
I. Estimate the operating cash flows
(Rs mn) 1 2 3 4 5 6 7
Sales 80 120 200 200 160 120 80
Raw Mat 24 36 60 60 48 36 24
Mfg Cost 8 12 20 20 16 12 8
Maintenance 10 10 10 10 10 10 10
Loss of Contribn 10 10 10 10 10 10 10
Selling Ex 8 12 20 20 16 12 8
O/H (specific) 4 6 10 10 8 6 4
Depreciation 30.00 22.50 16.88 12.66 9.49 7.12 5.34
Bad Debt 4
Total Expenses 94.00 108.50 146.88 142.66 117.49 93.12 73.34
PBIT -14.00 11.50 53.13 57.34 42.51 26.88 6.66
PBIT x (1-t) -9.80 8.05 37.19 40.14 29.76 18.82 4.66
Add: Depreciation 30 22.50 16.88 12.66 9.49 7.12 5.34
Add: Bad Debt 4
Operating Cash 20.20 30.55 54.06 52.80 39.25 25.94 14.00
Flow

II. Estimate the Investing cash flow, Net cash flow and NPV
 Year Operating Investment Net Cash Discount Net Cash
Cash flow Cash flow flow Factor flow x DF
0 - (125) + (35) (155.00)
1 20.20 20.20 0.8929 18.04
2 30.55 30.55 0.7972 24.35
3 54.06 54.06 0.7118 38.48
4 52.80 52.80 0.6355 33.55
5 39.25 39.25 0.5674 22.27
6 25.94 25.94 0.5066 13.14
7 14.00 25 + 31 70.00 0.4523 31.66
Total PV 181.50

b) NPV = Sum of PV – Initial investment = 181.50 – 155 = Rs 26.50 million

Since NPV is greater than 0, Modern Pharma should invest in manufacturing Floxin.
Payback will occur during the 4th year, when cumulative cash inflows will become equal to initial
investment.