Cash Flows for Investment Analysis

Dr. Janardhan G Naik

M.com, LL.B, AICWA,Ph.D

Cost Accountant and Professor, Head Dept of Accountancy Gogte College of Commerce, Belgaum 590 006 Karnataka State, INDIA Cell : (0091) 9448578089 Email: jgnaik52@yahoo.com

Introduction
Sound investment decisions should be based on the net present value (NPV) rule. While applying the NPV rule remember:
To discount cash flows. The discounting rate could be:
1. The opportunity cost of capital. 2. WAAC i.e. Ko 3. Marginal Cost of Capital

Relevant cash flows

The relevant cash flows to evaluate a project are the incremental cash flows that the project generates for the firm. Incremental cash flows can be defined as the change in the firms future cash flows that are a direct consequence of accepting the project.

Relevant cash flows.

A related, but broader set of costs are the opportunity costs, which are cash flows that could be realized from the best alternative use of the asset(s) that the project will use. These are relevant cash flows in evaluating the project.
For example, if the new project is located in a previously used facility, the firm does not incur costs to purchase the facility but could have sold the facility. This sales price would represent an opportunity cost.

Relevant cash flows

Cash outlays already made (sunk costs) are irrelevant to the decision process as they will be incurred regardless of project acceptance or rejection.
For example, marketing costs used to determine consumer interest in the product generated by the new project are sunk.

Components of Cash Flows

Cash Outflows consist of
Initial investment Additional working capital 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

Components of Cash Flows

Terminal Cash Flows resulting from
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

Initial cash outflows

Initial capital investment i.e. Outflow
Purchase price of new asset. Installation costs necessary to place asset into operation.

Working capital investment

Net working capital = current assets current liabilities. New asset acquisitions usually result in increased levels of working capital (inventory, accounts receivable and accounts payable) to support expanded operations. This increase in working capital (i.e., change in net working capital) is treated as a initial cash outflow.

Operating cash inflows

Operating cash inflows (OCFs) associated with a project can be derived from accounting earnings of the project and represent cash inflows the project is expected to generate. The major difference between accounting earnings and cash inflows is due to depreciation. Depreciation is a non-cash expense, however, it has cash inflow consequences because it influences the firms tax payment.

 Operating cash inflows (OCF) are calculated as follows:

Earnings before Intrest and Taxes (EBIT) for the project are determined, which typically are revenues less all relevant operating expenses including depreciation. Taxes are calculated on these earnings. Depreciation is added back to these operating earnings because it is a non-cash expense.

Project OCF = Project EBIT Taxes + Depreciation

Terminal cash flows

After-tax sale of capital asset
When a depreciable asset is sold, a gain or loss on disposal is calculated based on the book value of the asset at the time of disposal. Taxes are based on this gain or loss. Cash flow from asset sale: Asset Sale price {Capital Gain x tax rate}

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 i.e. Working capital

recouped

Reduction in net working capital requirements after the project termination is recouping of additional working capital. Typically this is just the original working capital investment.

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

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.

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)

Salvage value > Book value:

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

T v d PVDTSn ! v BVn  SVn k  d

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 dividendgrowth model:
NCFn 1  g kg NCFn 1 ! kg

TVn !

Relevant cash flows for replacement projects

Estimating incremental cash flows is relatively straightforward in the case of expansion projects, but not so in the case of replacement projects. With replacement projects, incremental cash flows must be computed by subtracting existing project cash flows from those expected from the new project.

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.

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.

Principles of Cash Flow estimates

1. Differentiate financing cash flows (borrowing type) from investment cash flows (lending type) 2. Incremental principle 3. Post tax principle 4. Consistency principle

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

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 projects 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.

Nominal Vs. Real Rates of Return

Real discount rate = (1+ Nominal discount rate) 1 (1+ Inflation rate) Real Discount Rate (Approx) = Nomial Rate Inflation Rate Nominal discount rate = (1+Real Discount Rate) (1+ Inflation Rate) 1 For a correct analysis, two alternatives are available:
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.

Always remember: Discount nominal cash flows at nominal discount rate; or discount real cash flows at real discount rate.

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 firms 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 firms target capital structure.

Post-tax Incremental Cash Flows Year 0 1 2 40 120 36 12 10 12 6 10 22.5 11.5 3.45 8.05 3 50 160 48 16 10 16 8 10 16.88 35.12 10.54 24.58

(Rs. in million) 4 40 200 60 20 10 20 10 10 5 30 160 48 16 10 16 8 10 6 20 120 36 12 10 12 6 10 80 24 8 10 7

1. Capital equipment (120) 2. Level of working capital 20 30 (ending) 3. Revenues 80 4. Raw material cost 24 5. Variable mfg cost. 8 6. Fixed operating & maint. 10 cost 7. Variable selling expenses 8 8. Incremental overheads 4 9. Loss of contribution 10 10.Bad debt loss 11. Depreciation 30 12. Profit before tax -14 13. Tax -4.2 14. Profit after tax -9.8 15. Net salvage value of capital equipments 16. Recovery of working capital 17. Initial investment (120) 18. Operating cash flow 20.2 (14 + 10+ 11) 19. ( Working capital 20 10 20. Terminal cash flow 21. Net cash flow (17+18-19+20)

8 4 10 4 12.66 9.49 7.12 5.34 57.34 42.51 26.88 6.66 17.20 12.75 8.06 2.00 40.14 29.76 18.82 4.66 25 16

30.55 41.46 52.80 39.25 25.94 14.00 10 10 (10) (10) (10) 41

(140) 10.20 20.55 31.46 62.80 49.25 35.94 55.00

Above Estimated Cash flow

(Now Discounted)
Cash flow from the project: Year 0 1 2 3 Rs million (140) 10.20 20.55 31.46

4 5 6 7 62.80 49.25 35.94 55.00

NPV of the net cash flow stream @ 15% per discount rate = -140 + 10.20 x PVIF(15,1) + 20.55 x PVIF (15,2) + 31.46 x PVIF (15,3) + 62.80 x PVIF (15,4) + 49.25 x PVIF (15,5) + 35.94 x PVIF (15,6) + 55 x PVIF (15,7) = Rs.1.70 million