12/3/2020

Cash flows do not come in silver platter. Estimating cash

flows is probably the most difficult part of cap budgeting.
Estimating Cash Flows However there are a few simple principles that will make our
life easier in doing this.
L Ramprasath

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CF forecasts: How to “spread the numbers”? Net Working capital

While considering net value added, Cash flows matter—not

accounting earnings
An investment in working capital may also be needed in
We need to go from accounting numbers to cash flows. addition to long-term assets.
Some amount of cash to pay expenses, initial investment in
Forecasting CFs is a combined effort inventories and account receivables.
Outlays given by engg and product develop divisions
Revenue projections by Marketing
Operating costs by production people, cost accountants,
purchase managers etc.

Role of FM

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A few basic principles in determining incremental CFs

Which CFs to be considered? Sunk costs do not matter

The relevant CFs to be considered consist of any and all This is a cost we have already paid or have already incurred the
changes in the firm’s future cash flows that are a direct liability to pay
consequence of taking the project. Opportunity costs
Incremental cash flows matter. A common situation: the firm already owns some of the assets a
proposed project will be using
Opportunity costs matter

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Inc CFs Contd… Post-tax principle

Last but not the least: In addition to the direct CFs, let us not
forget the incidental effects.
Side effects matter.
Erosion is a “bad” thing. If our new product causes existing
customers to demand less of our current products, we need to
recognize that.
If, however, synergies result that create increased demand of
existing products, we also need to recognize that.
Environment plays a deciding role
Taxes are cash outflows.
So we will look at incremental after-tax cash flows only
Some choices in terms of tax rates
Avg tax rate: Total tax / Total income
Marginal: Tax rate applicable to the next rupee of income
Income from a project typically is marginal – in addition to
the income already generated by the firm.
Use the marginal tax rate for estimating the tax liabilities of
the project

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Separation principle

Financing costs can be ignored because they will be reflected Depreciation – WDV
in the cost of capital figure against which the project will be
evaluated.

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Example: Projected figures for a capital project

Cost of new machine: 80 mn

Investment in WC: 20 mn NWC
Life of the project: 4 years. At the end of the project, the firm
hopes to sell the machine for 30mn. Sales 500
Expected revenues: 120 mn per year Costs 310
Costs (other than depreciation, interest and tax): 80 mn per Net income 190
year
Plant and machinery will be depreciated using the written Beginning of End of year Change
year
down value method at the depreciation rate of 25%
Accounts 880 910 +30
Marginal tax rate: 25% receivables
Accounts 550 605 +55
Should this project be taken up with a required return of payable
20%? NWC 330 305 -25
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Your firm is considering automating some part of an existing Using our toolbox to find the bidding price
production process. The necessary equipment costs $60,000
to buy and install. The automation will save $22,000 per year
(before taxes) for the next four years by reducing labour and
material costs.
Assume the equipment will be worth $20,000 in four years
and WDV at the rate of 25% will be used to compute tax
liabilities.
If the tax rate is 25% and the hurdle rate is 10%,
should you automate?

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Which machine? Try this

OA Inc. must choose between two copiers, the XX40 or the Problems 8, 12, 25 and 36
RH45. The XX40 costs $900 and will last for three years. The
copier will require a real aftertax cost of $120 per year after
all relevant expenses.
The RH45 on the other hand costs $1400 and will last five
years. The real aftertax cost for the RH45 will be $95 per
year.
The inflation rate is expected to be 5% per year and the
nominal discount rate is 14%.
Which copier should the company choose?

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