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Project Cash Flow Analysis (Module 4)

Project Cash Flows An Overview Estimates of cash flows are key towards investment evaluation.
Estimating the cash flows is the most difficult aspect of capital budgeting process. In gigantic & complex projects forecasting errors can be quite large. Forecasting cash flows involves numerous variables and multiple participants Capital Outlays: Engineering & Product Development Departments evenue Projections: !ar"eting Department Operating Costs: Production Dept# Cost Accountants# Purchase !anager# Personnel E$ecutives etc% Finance manager coordinate the efforts of various departments and obtain information from them! ensure that the forecasts are based on a set of consistent assumptions! keep the exercise focused on relevant variables and minimi"e the inherent biases in estimation.

Elements o& Cash Flow 'tream

For project evaluation! the relevant cash flows are the incremental a&ter(ta$ cash &lows associated with the project. # conventional project involves cash outflows followed by cash inflows. $hree )asic cash &low components of a conventional project
*nitial *nvestment: A&ter(ta$ cash outlay on capital e$penditure and net wor"ing capital when the project is set up% Operating Cash *n&lows: A&ter(ta$ cash in&lows resulting &rom the operations o& the project during its economic li&e% +erminal Cash *n&low: A&ter(ta$ cash &low resulting &rom the li,uidation o& the project at the end o& its economic li&e%

Cash Flow Components

$erminal +ash Inflow ,perating +ash Inflows '&!&&&


%&!&&& %'!&&& (&!&&& '&!&&& '&!&&& )&!&&& *&!&&& * / ( ) End of 0ear ' -


% . %!'&!&&& Initial Investment

+ime -ori.on &or Cash Flow Analysis

$he time hori"on for cash flow analysis is generally the minimum of the following
1hysical 2ife of the 1lant $echnological 2ife of the 1lant 1roduct 3arket 2ife of the 1lant Investment 1lanning 4ori"on of the Firm

Principles o& Cash Flow Estimation

5eparation 6or E$clusion o& Financing Cost/ 1rinciple Incremental 1rinciple 1ost7$ax 1rinciple +onsistency 6or 0ong(term Funds/ 1rinciple

'eparation Principle
$here are two sides of a project 7 Investment 5ide 6or Asset 'ide8 7 Financing 5ide 5eparation principle suggests that the cash flows associated with these sides should be separated. # firm is considering a % year project requiring an investment of %!&&& in fixed assets and working capital at time &. $he project is expected to generate a single cash inflow of %!*&& at the end of year %. $he project will be financed entirely by debt carrying an interest rate of %'9 p.a. and maturing after % year. $here are no taxes involved within the project.

'eparation Principle
Financing Side $ime & % +ash Flow : %!&&& 7 %!%'& Investment Side $ime & % +ash Flow 7 %!&&& : %!*&&

+ost of +apital %'9

;ate of ;eturn *&9

+ash flows on the investment side of the project do not reflect financing costs 6interest on debt8 in the above example. $he financing costs are included in the cash flows on the financing side and reflected in the cost of capital figure 6i.e. %'9 p.a. in the above example8. $he cost of capital is used as the hurdle rate against which the rate of return on the investment side 6i.e. *&9 in the above example8 is evaluated. +he separation principle that while de&ining the cash &lows on the investment side# &inancing costs should not )e considered )ecause they will )e re&lected in the cost o& capital &igure against which rate o& return &igure will )e evaluated%

*ncremental Principle
#ccording to this principle! cash flows of a project must be measured in incremental terms. $he question to be answered is what happens to the cash &lows o& the &irm with the project and without the project. $he difference between the above two will reflect the incremental cash flows attributable to the project.
for the firm with the project for year <t= > +F for Project CF+F t = the firm without the project for year <t= CF 1 Cash Flows

*ncremental Principle
In estimating the incremental cash flows of a project! the following considerations must be adhered to
+onsider #ll Incidental Effects Ignore 5unk +osts Include ,pportunity +osts ?uestion the #llocation of ,verhead +osts Ensure 1roper Estimation of @et Aorking +apital

2 e& te$t &or details

Post +a$ Principle

+ash flows of a project should always be measured on an after7tax basis. Firms should always use after7tax cash flows along with the after7tax discount rate. $he important issues in assessing the impact of taxes on a project are
3hat ta$ rate should )e used to assess ta$ lia)ility% -ow should losses )e treated% 3hat is the e&&ect o& non(cash charges%

Post +a$ Principle

+a$ ates Average +a$ ate 4A+ /: $otal tax burden as a proportion of the total income of the business. !arginal +a$ ate 4!+ /: $ax rate applicable to the income at margin i.e. the next rupee of income. 3$; is higher than #$; because tax rates are progressive.

Income from a project typically is marginal. 3$; of the firm is the relevant rate for estimating the tax liability of the project.

A+ vs !+
Taxable Income of Project B I@; -'!&&&
Income Sla s (in I!") Hp to .!''& .!''% > (&!-'& #bove (&!-'& #a$ "ate A%%lica le %& 9 %' 9 *'9

Tax Payable by Project .!''& x &.%& B I@; .'' 6(&!-'& > .!''&8 x &.%' B I@; (!)-' 6-'!&&& > (&!-'&8 x &.*' B I@; /!'/..'& ATR B C6.'' : (!)-' : /!'/..'&8D-'!&&&E x %&& B %F.. 9 MTR B *' 9 6G #$;8

Post +a$ Principle

+reatment o& 0osses

Firm as well as the project can incur losses. Following are the possible scenarios.
Scenario % * ( ) 5tand #lone Project Incurs 2osses Incurs 2osses 3akes 1rofits 3akes 1rofits Incurs 2osses Firm Incurs 2osses 3akes 1rofits Incurs 2osses 3akes 1rofits 7 Action Iefer tax savings $ake tax savings in the year of loss Iefer taxes until the firm makes profits +onsider taxes in the year of profit Iefer tax savings until the project makes profits

Post +a$ Principle

E&&ect o& 5on(Cash Charges

@on cash charges can have an impact on cash flows if they a&&ect the ta$ lia)ility. e%g% Depreciation $ax Jenefit of Iepreciation
Iepreciation x 3$;

Aritten Iown Kalue 6AIK8 method of depreciation allowed for tax purposes as per Income $ax #ct in India. Iepreciation +harge
IE1t B JKt(6r B JK&6%7r8t(6r IE1 B Iep +harge! JK B Jook Kalue! r B ;ate of

Post +a$ Principle

&e'erred #a$ (ia ility +a$a)le *ncome 4+*/ generally different from Accounting Pro&it 4AP/.

Iifference may be Permanent or +emporary. Permanent Di&&erence: +aused by an item which is included for calculating either $I or #1! but not )oth. +emporary Di&&erence: +aused by an item which is included for calculating )oth $I and #1! but in di&&erent time periods. Ieferred tax liability 6or asset8 arises because of temporary differences between $I and #1. # deferred tax liability 6asset8 is recogni"ed when the charge in the financial statements is less 6more8 than the amount allowed for tax purposes.

7oo" 8alue o& Asset 1 *5 6#99#999

)ear % * ( ) ' . / F %&
Total !e"

&e% * +,- (S(M) %!&&!&&& > 10,000 B F&!&&& F&!&&& > 10,000 B /&!&&& /&!&&& > 10,000 B .&!&&& .&!&&& > 10,000 B -&!&&& -&!&&& > 10,000 B '&!&&& '&!&&& > 10,000 B )&!&&& )&!&&& > 10,000 B (&!&&& (&!&&& > 10,000 B *&!&&& *&!&&& > 10,000 B %&!&&& %&!&&& > 10,000 B & I#R 1,00,000

&e% * +,- (.&/) %!&&!&&& > 10,000 B F&!&&& F&!&&& > 9,000 B /%!&&& /%!&&& > 8,100 B .*!F&& .*!F&& > 7,290 B -'!-%& -'!-%& > 6,561 B 'F!&)F 'F!&)F > 5,905 B '(!%)) '(!%)) > 5,31 B ).!/(& ).!/(& > ,783 B )(!&). )(!&). > ,305 B (/!.)* (/!.)* > 3,87 B ()!/-/ I#R 65,132

Post +a$ Principle

!inimum Alternative +a$ 4!A+/ In case of companies! if the income7tax payable on the total income computed under the Income $ax #ct is less than 69 percent o& its )oo" pro&it! the tax payable for the relevant previous year is deemed to be 69 percent o& the )oo" pro&it. !A+ Credit Entitlement If a company has paid 3#$! the difference between 3#$ and the income tax payable on the total income otherwise! can be availed of for seven years. Post +a$ cash &lows o& a project 1rofit #fter $ax 61#$8 : Iepreciation & #morti"ation : Ieferred tax
charge > 3#$ credit entitlement

Consistency Principle
Cash &lows and the discount rates applied to these cash flows must )e consistent with respect to the investor group and in&lation. $he project cash flow may be estimated from the point of view of #ll Investors 6Equity owners : 2enders8 Equity 5hareholders

Consistency Principle
$he cash flow of a project from the view point of all investors is the cash flow available to all investors a&ter paying ta$es and meeting project reinvestment needs. +ash flows to all investors B 1JI$ 6% 7 tax rate8 : Iepreciation and @on7cash +harges 7 +apital Expenditure 7 +hange in @et Aorking +apital
2 P7*+ 1 Pro&it 7e&ore *nterest and +a$

Consistency Principle
+ash flows from all investors point of view *nitial *nvestment B $otal outlay invested in the project Operating cash in&lows B 1#$ : Iepreciation : ,ther non7cash charges : Interest on long7term borrowings 6%7tax rate8 : Interest on short7term borrowings 6%7tax rate8 +erminal cash &lows B @et salvage value of fixed assets : @et salvage value of current assets
6 e&er E$hi)it :%; &rom te$t )oo"# <uestion on Pg% :%6=/

Consistency Principle
$he cash flow of a project from the point of view of equity shareholders is the cash flow available to equity holders a&ter paying ta$es! meeting investment needs and &ul&illing de)t(related commitments% +ash flow to Equity Investors B
charges 7 7 7 7 : 7 : 1rofit after Interest and $ax 61#I$8 : Iepreciation and other non7cash 1reference Iividend +apital Expenditure +hange in @et Aorking +apital ;epayment of Iebt 1roceeds from Iebt Issues ;edemption of 1reference +apital 1roceeds from 1reference +apital

Consistency Principle
+ash Flows from E,uity *nvestors point of view *nitial *nvestment B Equity funds invested in the project

Operating cash &lows B 1#$ > 1reference Iividend : Iepreciation : ,ther @on7cash +harges +erminal>0i,uidation & etirement cash &lows @et salvage value of assets 7 ;epayment of term loans 7 ;edemption of preference capital 7 ;epayment of working capital advances 7 ;epayment of trade credit
6 e&er E$hi)it :%= &rom te$t )oo"# <uestion on Pg :%6=/

Consistency Principle
$he Iiscount ;ate must be consistent with the definition of cash flow
Cash Flow +ash flow to all investors +ash flow to equity holders &iscount "ate Aeighted #verage +ost of +apital 6A#++8 +ost of Equity 6i.e. ;ate of Equity Iividend8

In capital budgeting! project cash flows are generally analy"ed from all investors point o& view! and 3ACC o& the &irm is applied to them towards discounting.

Consistency Principle
$owards dealing with Inflation in project cash flow estimation following options are available
Incorporating e$pected in&lation in the estimates of future cash flows and applying a nominal discount rate to same. Estimating the future cash flows in real 4in&lation adjusted/ terms and applying a real discount rate to the same.

@ominal +Ft B ;eal +Ft 6% : Expected Inflation ;ate8t @ominal Iiscount ;ate B 6% : ;eal Iiscount ;ate8 6% : Expected Inflation

Consistency Principle
Following match up is recommended
Cash Flow @ominal +ash Flow ;eal +ash Flow &iscount "ate @ominal Iiscount ;ate ;eal Iiscount ;ate

In capital budgeting! general trend is to estimate nominal project cash flows and use nominal discount rate towards discounting them.