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Determining Cash Flows for Investment Analysis

Chapter Objectives

Show the conceptual difference between

profit and cash flow. Discuss the approach for calculating incremental cash flows. Highlight the interaction between financing and investment decisions.

By Akash Saxena

Introduction

Sound investment decisions should be based

on the net present value (NPV) rule. Problem to be resolved in applying the NPV rule:

What should be discounted? In theory, the answer is obvious: We should always discount cash flows. What rate should be used to discount cash flows? In principle, the opportunity cost of capital should be used as the discount rate.

By Akash Saxena

**Cash Flows Versus Profit
**

Cash flow is not the same thing as profit, at

**least, for two reasons:
**

First, profit, as measured by an accountant, is based on accrual concept. Second, for computing profit, expenditures are arbitrarily divided into revenue and capital expenditures.

CF ! (REV EXP DEP) DEP CAPEX CF ! Profit DEP CAPEX

By Akash Saxena

**Incremental Cash Flows
**

Every investment involves a comparison of

alternatives:

When the incremental cash flows for an investment are calculated by comparing with a hypothetical zero-cash-flow project, we call them absolute cash flows. The incremental cash flows found out by comparison between two real alternatives can be called relative cash flows.

The principle of incremental cash flows

**assumes greater importance in the case of replacement decisions.
**

By Akash Saxena

**Components of Cash Flows
**

Initial Investment Net Cash Flows Revenues and Expenses Depreciation and Taxes Change in Net Working Capital

Change in accounts receivable Change in inventory Change in accounts payable

**Change in Capital Expenditure Free Cash Flows
**

By Akash Saxena

**Components of Cash Flows
**

Terminal Cash Flows Salvage Value

Salvage value of the new asset Salvage value of the existing asset now Salvage value of the existing asset at the end of its normal Tax effect of salvage value

Release of Net Working Capital

By Akash Saxena

**Depreciation for Tax Purposes
**

Two most popular methods of charging

depreciation are:

Straight-line Diminishing balance or written-down value (WDV) methods.

For reporting to the shareholders, companies

in India could charge depreciation either on the straight-line or the written-down value basis. For the tax purposes, depreciation is computed on the written down value (WDV) of the block of assets.

By Akash Saxena

**Salvage Value and Tax Effects
**

As per the current tax rules in India, the after-tax

salvage value should be calculated as follows:

Book value > Salvage value:

After-tax salvage value = Salvage value + PV of depreciation tax shield on (BV ± SV) After-tax salvage value = Salvage value ± PV of depreciation tax shield lost on (SV BV)

Salvage value > Book value:

«T v d » PVDTSn ! ¬ ¼ v BVn SVn k d ½

By Akash Saxena

**Terminal Value for a New Business
**

The terminal value included the salvage value of the

asset and the release of the working capital. Managers make assumption of horizon period because detailed calculations for a long period become quite intricate. The financial analysis of such projects should incorporate an estimate of the value of cash flows after the horizon period without involving detailed calculations. A simple method of estimating the terminal value at the end of the horizon period is to employ the following formula, which is a variation of the dividend²growth model:

TVn ! NCFn 1 g
kg NCFn 1 ! kg

By Akash Saxena

**Cash Flow Estimates for Replacement Decisions
**

The initial investment of the new machine will

be reduced by the cash proceeds from the sale of the existing machine: The annual cash flows are found on incremental basis. The incremental cash proceeds from salvage value is considered.

By Akash Saxena

**Additional Aspects of Incremental Cash Flow Analysis
**

Allocated Overheads Opportunity Costs of Resources Incidental Effects Contingent costs Cannibalisation Revenue enhancement Sunk Costs Tax Incentives Investment allowance Until Investment deposit scheme Other tax incentives

By Akash Saxena

**Investment Decisions Under Inflation
**

Executives generally estimate cash flows assuming unit costs

and selling price prevailing in year zero to remain unchanged. They argue that if there is inflation, prices can be increased to cover increasing costs; therefore, the impact on the project¶s profitability would be the same if they assume rate of inflation to be zero. This line of argument, although seems to be convincing, is fallacious for two reasons.

First, the discount rate used for discounting cash flows is generally expressed in nominal terms. It would be inappropriate and inconsistent to use a nominal rate to discount constant cash flows. Second, selling prices and costs show different degrees of responsiveness to inflation:

The depreciation tax shield remains unaffected by inflation since depreciation is allowed on the book value of an asset, irrespective of its replacement or market price, for tax purposes.

By Akash Saxena

**Nominal Vs. Real Rates of Return
**

For a correct analysis, two

alternatives are available:

ominaldiscount rate = (1 + eal discount rate)(1+ inflation rate) 1

Always remember: Discount

**nominal cash flows at nominal discount rate; or discount real cash flows at real discount rate.
**

By Akash Saxena

¡

either the cash flows should be converted into nominal terms and then discounted at the nominal required rate of return, or the discount rate should be converted into real terms and used to discount the real cash flows.

**Financing Effects in Investment Evaluation
**

According to the conventional capital budgeting

approach cash flows should not be adjusted for the financing effects. The adjustment for the financing effect is made in the discount rate. The firm¶s weighted average cost of capital (WACC) is used as the discount rate. It is important to note that this approach of adjusting for the finance effect is based on the assumptions that:

The investment project has the same risk as the firm. The investment project does not cause any change in the firm¶s target capital structure.

By Akash Saxena

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