Identifying Relevant Cash Flows

In Capital Budgeting Process

A Technical Note
by
Aditya Mohan Jadhav1

1
Professor, Department of Accounting, Economics and Finance, T. A. Pai Management Institute, Manipal, Karnataka – 576104.
Project Cash-flows Aditya Mohan Jadhav

Identifying Relevant Cash-flows in Capital Budgeting Process

A. 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 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 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
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Project Cash-flows Aditya Mohan Jadhav

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 ACCOUNTING PROFIT ESTIMATE

Revenues Revenues
Less Less
Expenses Expenses
Net Operating Revenues Net Operating Revenues
Less Less
Depreciation & other Non-cash Depreciation & other non-cash
expenses expenses
Earnings before Tax Earnings before Tax
Less Less
Tax @ T% Tax @ T%
Earnings after Tax Earnings after Tax
Add (Accounting Profit)
Depreciation & other Non-cash
expenses
Cash Flow

B. 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

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Project Cash-flows Aditya Mohan Jadhav

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 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 labour 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
must 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.

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Project Cash-flows Aditya Mohan Jadhav

IV) Tax Effect on ICF

Cash flows must 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 flows 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 tax
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

Market Value of Asset

Less
Book Value of Asset Depreciation of Asset Sold =
Foregone Depreciation
Gain (loss)
Tax Effect to be considered in Tax loss due to foregone
cash-flow = depreciation = Depreciation
Gain (loss) x Tax Rate Foregone x Tax rate

Cash-flow (Net)
Cash-flow from selling the asset at Market Value + Tax Gain (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.
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
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Project Cash-flows Aditya Mohan Jadhav

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 must be deducted 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 salvage value 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) on profit from 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

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Project Cash-flows Aditya Mohan Jadhav

VII) Effect of Changes in Working Capital on Estimation of ICF

Working capital is estimated as 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 project’s 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) = Net Inventory

Add
(New Receivables) - (Old Receivables) = Net Receivables
Less
(New Payables) - (Old Payables) = Net Payables

Net Working Capital for the Project

OR

(Current Assets with project) – = Net Current Assets

(Current Assets without project)
Less
(Current Liabilities with project) – = Net Current Liabilities
(Current Liabilities without project)

Net Working Capital for the Project

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Project Cash-flows Aditya Mohan Jadhav

C. 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-0-07-052908-6, 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. ISBN-0-058340-4. pp.1264.

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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 & other non-cash expenses
Earnings before Interest & Tax
Less
Tax @ T%
Net Operating Earnings after Tax
Add
Depreciation
Less
Additional Working Capital Requirement
Less
Additional Capital Expenditure
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

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Project Cash-flows Aditya Mohan Jadhav

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

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Project Cash-flows Aditya Mohan Jadhav

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
Less
Additional Working Capital Requirement
Less
Additional Capital Expenditure
Operating Cash Flow After Tax

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