Post on 07-Apr-2018
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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:jgnaik52@yahoo.com
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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