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ESTIMATION OF PROJECT CASH FLOWS2IntroductionSound 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.3Cash 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) (1-T) + DEP CAPEX CF = (EBIT)(1-T) + DEP CAPEX = PROFIT + DEP - CAPEXOUTLINE Elements of the Cash Flow Stream Principles of Cash Flow Estimation Cash Flows for a Replacement Project Biases in Cash Flow Estimation5Components of Cash FlowsInitial InvestmentNet Cash FlowsRevenues and ExpensesDepreciation and TaxesChange in Net Working CapitalChange in accounts receivableChange in inventoryChange in accounts payableChange in Capital ExpenditureFree Cash FlowsTerminal cash flowsSalvage ValueSalvage value of the new asset Salvage value of the existing asset now Salvage value of the existing asset at the end of its normal Release of Net Working CapitalNet Working CapitalChange in receivableChange in inventory Change in payable.

Instead of adjusting each item of working capital, we can simply adjust the change in networking capital, viz. the difference between change in current assets (e.g., receivable and inventory) and change in current liabilities (e.g. accounts payable) to profit.Increase in net working capital should be subtracted from and decrease added to after-tax operating profit. Thus, net cash flow: NCF = EBIT (I -T) + DEP NWC (6) Where NWC is net working capital.Free Cash FlowsIn addition to an initial cash outlay, an investment project may require some reinvestment of cash flow (for example, replacement investment) for maintaining its revenue-generating ability during its life. As a consequence, net cash flow will be reduced by cash outflow for additional capital expenditures (CAPEX). Thus, net cash flow equation will be as follow:

NCF = EBIT (1 -T) + DEP -NWC -CAPEXTime Horizon (mimimum of the following)

Physical Life of the Plant Technological Life of the Plant Product Market Life of the Plant Investment Planning Horizon of the FirmBASIC PRINCIPLES OF CASH FLOW ESTIMATION Separation Principle Incremental Principle Post-tax PrincipleSEPARATION PRINCIPLE

Cash flows associated with the investment side and the financing side of the project should be separated.

While defining the cash flows on the investment side, financing costs should not be considered because they will be reflected in the cost of capital figure against which the rate of return figure will be evaluated.INCREMENTAL PRINCIPLETo ascertain a projects incremental cash flows you have to look at what happens to the cash flows of the firm with the project and without the project

Guidelines

Consider all incidental effects Ignore sunk costs Include opportunity costs Question the allocation of overhead costs Estimate working capital properlyPOST-TAX PRINCIPLE

Cash flows should be measured on a post-tax basis

TREATMENT OF LOSSES

14Illustration 1Investment outlay Rs 100 mn, i.e., plant & machinery Rs 80 mn and net working capital Rs 20 mn. The project will be financed by Rs 50 mn of equity capital and Rs 50 mn of debt @ 15% interest rate.Project life 5 years. After tax salvage value of fixed assets after 5 years Rs 30 mn. Net working capital will be liquidated at book value.Expected increase in revenues and costs are Rs 120 mn and Rs 80 mn per year. (Costs are other than depreciation, interest and tax).Tax rate 30%. Depreciation @ 25% as per WDV method.

PROJECT CASH FLOWS

(RS. IN MILLION) 0 1 2 3 4 5

A. FIXED ASSETS (80.00) B. NET WORKING CAPITAL (20.00) C. REVENUES120120120120120 D. COST (OTHER THAN DEPRN AND INT) 80 80 80 80 80 E. DEPRECIATION 20 15 11.25 8.44 6.33 F. PROFIT BEFORE TAX 20 25 28.75 31.56 33.67 G. TAX 6 7.5 8.63 9.47 10.10 H. PROFIT AFTER TAX 14.0 17.5 20.12 22.09 23.57 I. NET SALVAGE VALUE OF FIXED ASSETS 30.00 J. RECOVERY OF NET WORKING CAPITAL 20.00 K. INITIAL OUTLAY(100.00) L. OPERATING CASH FLOW (H+E) 34.0 32.5 31.37 30.53 29.90 M. TERMINAL CASH FLOW (I+J) 50.0 N. NET CASH FLOW (K+L+M)(100.00) 34.0 32.5 31.37 30.53 79.90 RELEVANT CASH FLOWS FOR REPLACEMENT DECISIONS

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THE ADVANTAGE OF SELLING THE OLD M/C .. HAS BEEN CONSIDERED .. THE DISADV .. TOO SHOULD BE CONSIDEREDINITIAL INVESTMENTOPERATING CASH INFLOWSTERMINAL CASH FLOWINITIAL INVESTT TO ACQUIRE NEW ASSETOPERATING CASH INFLOWS FROM NEW ASSETAFTER-TAX CASH FLOWS FROM TERMINATION OF NEW ASSETINFLOWS FROM LIQUIDN .. OLD ASSETOPERATING CASH INFLOWS FROM OLD ASSET,HAD IT NOT BEEN REPLACEDFLOWS FROM TERMN OF OLD ASSET, HAD IT NOT BEEN REPLACEDSuppose you own a plot of land that presently has a market value of Rs 1 mn. If you keep it for a year, it is expected to fetch you Rs 1.2 mn. You come across another plot of land that will cost you Rs 1.5 mn now. If you buy this land you hope to sell it for Rs 2 mn a year hence. Should you replace the existing plot? Assume no taxes and no operating cash flows. Cash flows for the replacement decisionInitial investment = Cost - After tax salvage value of the old plot. Rs 1.5 mn 1 mn = Rs 0.5 mn.Operating cash flow = 0Terminal flow = After tax salvage value from the new plot After tax salvage value of the old plot had it been retained. = Rs 2 mn Rs 1.2 mn = Rs 0.8 mn Thus, the relevant cash flow stream of this replacement proposal is: Year Cash flow 0 -Rs 5,00,000 1 Rs 8,00,000If you dont subtract the salvage value of the existing plot a year from now, you get the following cash flow stream for the replacement proposal: Year Cash flow 0 - Rs 5,00,000 1 Rs 20,00,000This is erroneous because it considers the advantage from selling the plot today but overlooks the disadvantage expected a year from now.

Illustration 2 Project: Installation of a computer systemEstimated costs and benefits:Cost of computer and accessories Rs 1.5 mnOperation and maintenance Rs 0.25 mn p.a.Savings in clerical cost Rs 0.6 mn p.a.Savings in space cost Rs 0.1 mn p.a. Life 5 years depreciation 33.33% WDV. After 5 years, disposed of at book value.Tax rate 50%.

Illustration 3Proposal: To replace one machine.Existing machine was bought two years ago for Rs 1 mn. Depreciated @ 33.33% p.a. Sale value now = book value now.Remaining life 5 years. Disposal value then = book value then.New machine cost Rs 1.6 mn. Dep rate of 33.33%. Salvage value after 5 years = book value then. Increase in revenues with new machine is Rs 2,00,000 and reduce operating costs by Rs 1,50,000 per year. Tax rate 50%.Depreciation BaseIn a replacement decision, the depreciation base of a new asset will be equal to: Cost of new equipment +Written down value of old equipment -Salvage value of old equipmentBIASES IN CASH FLOW ESTIMATION

OVERSTATEMENT INTENTIONAL OVERSTATEMENT LACK OF EXPERIENCE CAPITAL RATIONING

UNDERSTATEMENT SALVAGE VALUES ARE UNDER-ESTIMATED INTANGIBLE BENEFITS ARE IGNORED VALUE OF FUTURE OPTIONS IS IGNORED

SUMMING UP

The cash flow stream of a project comprises of three components : initial investment, operating cash inflows, and terminal cash inflow

The following principles should be followed while estimating the cash flows of a project : separation principle, incremental principle, post-tax principle, and consistency principle

Adequate care should be taken to guard against certain biases which may lead to over-statement or under- statement of true project profitability SCENARIOPROJECT FIRM

ACTION

1

INCURS LOSSESINCURS LOSSESDEFER TAX SAVINGS 2

INCURS LOSSESMAKES PROFITSTAKE TAX SAVINGS IN

THE YEAR OF LOSS

3

MAKES PROFITSINCURS LOSSESDEFER TAXES UNTIL THE FIRM MAKES PROFITS 4

MAKES PROFITSMAKES PROFITSCONSIDER TAXES IN

THE YEAR OF PROFIT

STAND INCURS LOSSES

-

DEFER TAX SAVING ALONEUNTIL THE PROJECT MAKES PROFITSSCENARIOPROJECT FIRM

ACTION

1

INCURS LOSSESINCURS LOSSESDEFER TAX SAVINGS 2

INCURS LOSSESMAKES PROFITSTAKE TAX SAVINGS IN

THE YEAR OF LOSS

3

MAKES PROFITSINCURS LOSSESDEFER TAXES UNTIL THE FIRM MAKES PROFITS 4

MAKES PROFITSMAKES PROFITSCONSIDER TAXES IN

THE YEAR OF PROFIT

STAND INCURS LOSSES

-

DEFER TAX SAVING ALONEUNTIL THE PROJECT MAKES PROFITSSCENARIOPROJECT FIRM

ACTION

1

INCURS LOSSESINCURS LOSSESDEFER TAX SAVINGS 2

INCURS LOSSESMAKES PROFITSTAKE TAX SAVINGS IN

THE YEAR OF LOSS

3

MAKES PROFITSINCURS LOSSESDEFER TAXES UNTIL THE FIRM MAKES PROFITS 4

MAKES PROFITSMAKES PROFITSCONSIDER TAXES IN

THE YEAR OF PROFIT

STAND INCURS LOSSES

-

DEFER TAX SAVING ALONEUNTIL THE PROJECT MAKES PROFITS