ESTIMATION OF CASH FLOWS

Principles of Estimating Cash flows

1. Separation Principle
a. Financing decision and Investment decision are different; hence, they
should be evaluated differently.
2. Incremental Principle
a. Consider all incidental cost (Product Cannibalization)
b. Ignore sunk cost (Historical Cost before the project)
c. Include Opportunity cost
d. Ignore Allocated Overheads (Consider Only attributable overheads)
e. Consider Requirement of Working Capital
3. Post-Tax Principle
4. Consistency Principle
Example
Vikas India Ltd. is a leader in manufacturing a wired mouse and now looking for
a project that requires manufacturing Bluetooth mouse. The following
information has been gathered for execution of this project;
1. The project would require an investment outlay of Rs. 50 crores in plant,
machineries and other infrastructure. You can assume that this
investment will be done on immediate basis. The project has been
expected to undertake for next 6 years.
2. Being the product is new in the market, the distributors may expect the
credit. Hence, the project will require an immediate need of Rs. 10
crores as working capital at the start of the project. However, this capital
will be recovered at the end of the project.
3. The production department expects the cost of goods sold as 30% of the
sales.
4. The office and administration cost would remain 3 crores each in the
first three years and 2 crores each in the remaining period.
5. The marketing department expects the sales of the first year as 30 crores
and will grow at a rate of 10% every year.
6. The introduction of the product will lose the product contribution
margin to the extent of Rs. 3 crores from the existing product.
7. The project will be started in the nearby production facility of other
company. Hence, it would require paying rent of Rs. 1 crore every year.
8. The marketing department expects the selling and distribution expenses
as 8% of sales.
9. The company follows the Straight Line Depreciation method to account
the depreciation. The company expect to get Rs. 20 crores as net salvage
value of the project.
10. The working capital is expected to be recovered at par without losing
any value as bad debts.
11. The company will require taking a bank loan of Rs. 25 crores at a rate of
10% p.a.
12. The company expects to earn minimum of 15% after tax on this project.
13. The company is in a tax bracket of 30%.
You are required to prepare an estimation of cash flow and advise the company
on the project.
Summary of Estimating Cash Flow for Bluetooth Mouse
Particulars 0 1 2 3 4 5 6
ICO -50 20
NWC -10 10
Sales 30 33 36.3 39.93 43.92 48.32
COGS (Sales) 30% 30% 30% 30% 30% 30%
Admn. Cost 3 3 3 2 2 2
Loss of Cont. Mar. 3 3 3 3 3 3
Rent 1 1 1 1 1 1
Selling & Dist. (Sales) 8% 8% 8% 8% 8% 8%
Depreciation SLM
Ko (Hurdle Rate) 15%
Tax 30%
Estimation of Cash Flow for Bluetooth Mouse
Particulars 0 1 2 3 4 5 6
Initial Cash Outflow
ICO -50
NWC -10
Operating Cash Flows
Sales 30 33 36.3 39.93 43.92 48.32
- COGS (% Sales) 9 9.9 10.89 11.98 13.17 14.49
- Admn. Cost 3 3 3 2 2 2
- Loss of Con. Mar. 3 3 3 3 3 3
- Rent 1 1 1 1 1 1
- Selling & Dist. Exp. 2.4 2.64 2.90 3.19 3.51 3.86
EBDITA 11.6 13.46 15.51 18.76 21.24 23.97
- Depreciation 5 5 5 5 5 5
EBIT (or EBT) -6.6 8.46 10.51 13.76 16.24 18.97
- Tax@30% 1.98 2.54 3.15 4.13 4.87 5.69
PAT 4.62 5.92 7.36 9.63 11.37 13.26
+ Depreciation 5 5 5 5 5 5
Operating Cash Flows 9.62 10.92 12.36 14.63 16.37 18.26
Terminal Cash Flows
Net Salvage Value 20
Recovery of NWC 10
CFAT -60 9.62 10.92 12.36 14.63 16.37 48.26
Ko (Hurdle Rate) 15%
Calculate;
1. PBP
2. DPBP
3. NPV
4. PI
5. IRR
6. MIRR
7. ARR

Note 1: Calculation of Depreciation

SLM Depreciation = (C - SV)/n  (50 – 20) / 6  5 Crores per Year
SLM Depreciation
Year Op. Bal. Depre. Cl. Bal.
1 50 5 45
2 45 5 40
3 40 5 35
4 35 5 30
5 30 5 25
6 25 5 20
Practice Example
Naveen Enterprises is considering a capital project about which the following
information is available;
1. The investment outlay on the project will be Rs. 100 million. This consists of Rs.
80 million on plant and machinery and Rs. 20 million on net working capital. The
entire outlay will be incurred at the beginning of the project.
2. 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 costs
15%, debt capital will carry an interest rate of 15%.
3. The company has a beta of 1.23, Risk-free rate and market risk premium is 5%
and 7% respectively.
4. 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.
5. The project is expected 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 (This includes all items of cost other than depreciation, interest
and tax). The effect tax rate will be 30%.
6. Plant and machinery will be depreciated at the rate of 25% per year as per
written down value method.
You are required to evaluate the project and comment on the feasibility of this project.
 Modern Pharma (Discussed Section A)
Particulars 0 1 2 3 4 5 6 7
ICO -120 25
WDV Depre. 25%
WC Requirement 20 30 40 50 40 30 20 0
Incre. WC Investments -20 -10 -10 -10 10 10 10 20
Bad Debts 4
Sales 80 120 160 200 160 120 80
RM Cost (%Sales) 30% 30% 30% 30% 30% 30% 30%
Variable Mfg. Cost (%Sales) 10% 10% 10% 10% 10% 10% 10%
Fixed Cost 10 10 10 10 10 10 10
Variable Selling Exp. 10% 10% 10% 10% 10% 10% 10%
Incre. O/H Cost 5% 5% 5% 5% 5% 5% 5%
Loss of Contr. Marg. 10 10 10 10 10 10 10
Tax Rate 30%
Ko 15%
 Estimation of Cash flows
Particulars 0 1 2 3 4 5 6 7
Initial Cash Flows
ICO -120
Incre. WC Investments -20 -10 -10 -10 10 10 10 20
Operating Cash Flows
Sales 80 120 160 200 160 120 80
- RM Cost 24 36 48 60 48 36 24
- Variable Mfg. Cost 8 12 16 20 16 12 8
- Variable Selling Exp. 8 12 16 20 16 12 8
- Incre. O/H Cost 4 6 8 10 8 6 4
Contribution 36 54 72 90 72 54 36
- Fixed Cost 10 10 10 10 10 10 10
- Loss of Contr. Marg. 10 10 10 10 10 10 10
- Bad Debts Losses 4
EBDITA 16 34 52 70 52 34 12
- WDV Depreciation (1*) 30 22.5 16.87 12.66 9.49 7.12 5.34
EBIT ( or EBT) -14 11.5 35.13 57.34 42.51 26.88 6.66
- Taxes @30% -4.2 3.45 10.53 17.2 12.75 8.06 1.99
PAT -9.8 8.05 24.60 40.14 29.76 18.82 4.67
+ WDV Depreciation (1*) 30 22.5 16.87 12.66 9.49 7.12 5.34
Operating Cash Flows 20.2 30.55 41.47 52.8 39.25 25.94 10.01
Terminal Cash Flows
Net Salvage Value 25
Net Cash Flows After Tax -140 10.2 20.55 31.47 62.8 49.25 35.94 55.01
Ko 15%
Calculate;
8. PBP
9. DPBP
10. NPV
11. PI
12. IRR
13. MIRR
14. ARR

*Note 1: Calculation of WDV Deprecation @25%

Year Op. Bal. WDV Depre. @25% Cl. Bal.
1 120 30 90
2 90 22.5 67.5
3 67.5 16.87 50.63
4 50.63 12.66 37.9
5 37.9 9.49 28.48
6 28.48 7.12 21.36
7 21.36 5.34 16.02
 Modern Pharma (Discussed Section B)
Particulars 0 1 2 3 4 5 6 7
ICO -120 25
Depre. Method 25% WDV
WC Required 20 30 40 50 40 30 20 0
WC Investment -20 -10 -10 -10 10 10 10 20
Bad Debt Loss -4

Sales 80 120 160 200 160 120 80

RM Cost (% Sales) 30% 30% 30% 30% 30% 30% 30%
Var. Mfg. Cost (% Sales) 10% 10% 10% 10% 10% 10% 10%
Fixed Cost 10 10 10 10 10 10 10
Var. Selling Exp. (% Sales) 10% 10% 10% 10% 10% 10% 10%
O/H Allocation 5% 5% 5% 5% 5% 5% 5%
Loss of Cont. Marg. 10 10 10 10 10 10 10
Tax Rate 30%
Ko 15%
 Estimation of Cash flows
Particulars 0 1 2 3 4 5 6 7
Initial Cash Outlay
ICO -120
Incre. WC Investment -20 -10 -10 -10 10 10 10 20
Operating Cash Flows
Sales 80 120 160 200 160 120 80
- RM Cost 24 36 48 60 48 36 24
- Var. Mfg. Cost 8 12 16 20 16 12 8
- Var. Selling Exp. 8 12 16 20 16 12 8
Contribution 40 60 80 100 80 60 40
- Fixed Cost 10 10 10 10 10 10 10
- O/H Allocation (Inc.) 4 6 8 10 8 6 4
- Loss of Cont. Marg. 10 10 10 10 10 10 10
- Bad Debts -- -- -- -- -- -- 4
EBDITA 16 34 52 70 52 34 12
- Depreciation (WDV) 30 22.5 16.88 12.66 9.49 7.12 5.31
EBT -14 11.5 35.12 57.34 42.5 26.8 6.69
- Tax@ 30% -4.2 3.45 10.54 17.2 12.75 8.06 2.01
PAT -9.8 8.05 24.58 40.14 29.76 18.82 4.68
+ Depreciation (WDV) 30 22.5 16.88 12.66 9.49 7.12 5.31
Operating Cash Flows 20.2 30.55 41.46 52.8 39.25 25.94 9.99
Terminal Cash Flows
Net Salvage Value 25
Net Cash Flows After Tax -140 10.2 20.55 31.46 62.8 49.25 35.94 54.99
Ko 15%
NPV +1.70
Calculate;
1. PBP
2. DPBP
3. NPV
4. PI
5. IRR
6. MIRR
7. ARR

Note 1: Calculation of Depreciation as per WDV Method

Year Op. Bal. Depre. @25% Cl. Bal.
1 120 30 90
2 90 22.5 67.5
3 67.5 16.88 50.62
4 50.62 12.66 37.94
5 37.94 9.49 28.41
6 28.41 7.12 21.24
7 21.24 5.31 15.93