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    Cash Flows forInvestment Analysis

    Dr. Janardhan G NaikM.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:[email protected]

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    Introduction

    Sound investment decisions should bebased 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

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    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

    acceptingthe project.

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    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 arerelevant 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 pricewould represent an opportunity cost.

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    Relevant cash flows

    Cash outlays already made (sunk costs)

    are irrelevant to the decision process as

    they will be incurred regardless of projectacceptance or rejection. For example, marketing costs used to determine

    consumer interest in the product generated by the

    new project are sunk.

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    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

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    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

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    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.

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    Operating cash inflows

    Operating cash inflows (OCFs) associated with a projectcan be derived from accounting earnings of the projectand represent cash inflows the project is expected togenerate.

    The major difference between accounting earnings andcash inflows is due to depreciation.

    Depreciation is a non-cash expense, however, it has

    cash inflow consequences because it influences thefirms tax payment.

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    Operating cash inflows (OCF) are

    calculated as follows: Earnings before Intrest and Taxes (EBIT) for the

    project are determined, which typically arerevenues less all relevant operating expenses

    including depreciation. Taxes are calculated on these earnings.

    Depreciation is added back to these operatingearnings because it is a non-cash expense.

    Project OCF = Project EBIT Taxes +Depreciation

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    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}

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    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 itsnormal

    Tax effect of salvage value

    Release of Net Working Capital i.e. Working capitalrecouped

    Reduction in net working capital requirements after theproject termination is recouping of additional workingcapital.

    Typically this is just the original working capitalinvestment.

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    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

    !

    !

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    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-lineor the written-down value basis.

    For the tax purposes, depreciation iscomputed on the written down value

    (WDV) of the block of assets.

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    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 ofdepreciation tax shield lost on (SV BV)

    PVDTS BV SVn n nT d

    k d

    v ! v

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    Terminal Value for a New Business

    The terminal value included the salvage value of theasset and the release of the working capital.

    Managers make assumption of horizon period becausedetailed calculations for a long period become quiteintricate. The financial analysis of such projects should

    incorporate an estimate of the value of cash flows afterthe horizon period without involving detailedcalculations.

    A simple method of estimating the terminal value at theend of the horizon period is to employ the following

    formula, which is a variation of the dividendgrowthmodel:

    1

    NCF 1 NCFTV

    n nn

    g

    k g k g

    ! !

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    Relevant cash flows for

    replacement projects Estimating incremental cash flows is relatively

    straightforward in the case ofexpansion

    projects, but not so in the case ofreplacementprojects.

    With replacement projects, incremental cash

    flows must be computed by subtracting existingproject cash flows from those expected from the

    new project.

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    Cash Flow Estimates for

    R

    eplacement Decisions The initial investment of the new

    machine will be reduced by the cash

    proceeds from the sale of the existingmachine:

    The annual cash flows are found on

    incremental basis.

    The incremental cash proceeds from

    salvage value is considered.

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    Incremental Cash Flows

    Every investment involves a comparisonof alternatives: When the incremental cash flows for an

    investment are calculated by comparing with ahypothetical zero-cash-flow project, we callthem absolute cash flows.

    The incremental cash flows found out by

    comparison between two realalternatives canbe called relative cash flows.

    The principle of incremental cash flowsassumes greater importance in the case

    ofreplacement decisions.

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    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

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    Additional Aspects of

    Incremental Cash Flow Analysis Allocated Overheads

    Opportunity Costs of Resources

    Incidental Effects Contingent costs Cannibalisation

    Revenue enhancement

    S

    unk Costs Tax Incentives Investment allowance Until

    Investment depositscheme

    Other tax incentives

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    Investment Decisions Under

    Inflation Executives generally estimate cash flows assuming

    unit costs and selling price prevailing in year zero toremain unchanged. They argue that if there isinflation, prices can be increased to cover increasing

    costs; therefore, the impact on the projectsprofitability would be the same if they assume rate ofinflation to be zero.

    This line of argument, although seems to beconvincing, is fallacious for two reasons. First, the discount rate used for discounting cash flows is generally

    expressed in nominalterms. It would be inappropriate andinconsistent to use a nominal rate to discount constant cash flows.

    Second, selling prices and costs show different degrees ofresponsiveness to inflation:

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

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    Nominal Vs. Real Rates ofReturn

    Real discount rate = (1+ Nominal discount rate) 1(1+ Inflation rate)

    Real DiscountRate (Approx) = NomialRate Inflation Rate

    Nominal discount rate = (1+Real DiscountRate) (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 discountrate; or discount real cash flows at real discount rate.

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    Financing Effects in Investment Evaluation

    According to the conventional capital budgetingapproach cash flows should not be adjusted for thefinancing effects.

    The adjustment for the financing effect is made in thediscount rate. The firms weighted average cost ofcapital (WACC) is used as the discount rate.

    It is important to note that this approach of adjustingfor 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 inthe firms target capital structure.

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    Post-tax Incremental Cash Flows (Rs. in million)

    Year 0 1 2 3 4 5 6 7

    1. Capital equipment (120)2. Level of working capital 20 30 40 50 40 30 20

    (ending)3. Revenues 80 120 160 200 160 120 804. Raw material cost 24 36 48 60 48 36 245. Variable mfg cost. 8 12 16 20 16 12 86. Fixed operating & maint. 10 10 10 10 10 10 10

    cost7. Variable selling expenses 8 12 16 20 16 12 88. Incremental overheads 4 6 8 10 8 6 49. Loss of contribution 10 10 10 10 10 10 1010.Bad debt loss 4

    11. Depreciation 30 22.5 16.88 12.66 9.49 7.12 5.3412. Profit before tax -14 11.5 35.12 57.34 42.51 26.88 6.6613. Tax -4.2 3.45 10.54 17.20 12.75 8.06 2.0014. Profit after tax -9.8 8.05 24.58 40.14 29.76 18.82 4.6615. Net salvage value of

    capital equipments 2516. Recovery of working 16

    capital17. Initial investment (120)

    18. Operating cash flow 20.2 30.55 41.46 52.80 39.25 25.94 14.00(14 + 10+ 11)

    19.( Working capital 20 10 10 10 (10) (10) (10)20. Terminal cash flow 41

    21. Net cash flow (140) 10.20 20.55 31.46 62.80 49.25 35.94 55.00(17+18-19+20)

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    Above Estimated Cash flow(Now Discounted)

    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

    Cash flow from the project:

    Year 0 1 2 3 4 5 6 7

    Rs million (140) 10.20 20.55 31.46 62.80 49.25 35.94 55.00