10/30/2022

Estimating Cash Flows

L Ramprasath

Estimating Cash Flows

Cash flows do not come in silver platter. Estimating cash

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

1
 10/30/2022

CF forecasts: How to “spread the numbers”?

Forecasting CFs is a combined effort

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

Which CFs to be considered?

The relevant CFs to be considered consist of any and all
changes in the firm’s future cash flows that are a direct
consequence of taking the project.
Incremental cash flows matter.

2
 10/30/2022

A few basic principles in determining incremental CFs

Sunk costs do not matter

This is a cost we have already paid or have already incurred the
liability to pay
Opportunity costs
A common situation: the firm already owns some of the assets a
proposed project will be using
Opportunity costs matter

Inc CFs Contd…

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

3
 10/30/2022

Net Working capital

An investment in working capital may also be needed in

addition to long-term assets.
Some amount of cash to pay expenses, initial investment in
inventories and account receivables (to cover credit sales).

Post-tax principle

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

4
 10/30/2022

Separation principle

Financing costs can be ignored because they will be reflected

in the cost of capital figure against which the project will be
evaluated.

Example: Projected figures for a capital project

Cost of new machine: 80 mn

Investment in WC: 20 mn
Life of the project: 4 years
Expected revenues: 120 mn per year
Expected Costs: 80 mn per year
Plant and machinery will be depreciated using the straight
line method to zero.
Marginal tax rate: 25%

10

5
 10/30/2022

Example: Projected figures for a capital project

Cost of new machine: 80 mn

Investment in WC: 20 mn
Life of the project: 4 years. At the end of the project, the firm
hopes to sell the machine for 30mn.
Expected revenues: 120 mn per year
Costs (other than depreciation, interest and tax): 80 mn per
year
Plant and machinery will be depreciated using the written
down value method at the depreciation rate of 25%
Marginal tax rate: 25%

Should this project be taken up with a required return of

20%?

11

Cash in - Cash out vs Project CFs

NWC

Sales 500
Costs 310
Profits 190

Beginning of End of year Change

year
Accounts 80 110 +30
receivables
Accounts 50 105 +55
payable
NWC 30 5 -25
12

6
 10/30/2022

Including changes in NWC has the effect of adjusting the

discrepancy between accounting sales and costs and actual
cash receipts and payments

13

Bidding

GT Enterprises has called for bids to supply 140,000 cartons

of machine screws (with particular specifications) per year
over the next five years. You have decided to bid for this
contract.
It will cost you $1,800,000 to install the equipment necessary
to start production; you’ll depreciate this cost straight-line to
zero over the project’s life. You estimate that in five years,
this equipment can be sold off for $150,000.
Your fixed production costs will be $265,000 per year, and
your variable costs should be $8.50 per carton. You also need
an initial investment in NWC of $130,000.

If your tax rate is 35% and you require a 14% return on your
investment, what bid price should you submit?

14

7
 10/30/2022

Which machine?

OA Inc. must choose between two copiers, the XZ40 or the

RH45. Both machines can do the same job but their
investment requirements are different. The XZ40 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?

15

Your firm is considering automating some part of an existing

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?

16