Cash Flow Estimation

Capital
Budgeting Prof Anita C

Raman
Discussion: How does a company look out

for investment decision?
• Environmentally sustainable business model..? ➔ GOI Promotional
offer/incentive ➔ international summit➔ future..?
• EXIM/`Trade blocks’ ..`Treaties’
• FDI → Foreign direct investment, FII ➔ foreign institutional investors
• ➔ BRICS …Developing economies/EME
• NITI Ayog ➔ …? Policy annual budget ➔ Economic Survey’ •
Identify gaps..?
• Growth.. ..?
• Disruptor ..? Sector..? Promise
• ➔ related sector acquisition
prof Anita C Raman, IBS Hyd MBA Class 2023
Decisions
• Investment ➔ Long term Machinery/Plant/ L&B ➔ goods/services ➔ Cash
Flows -(Direct expenses (w,R/m & OH) ➔ indirect exp ( Sal, S&D, M) ➔
FE,Tax ➔ profit
• Investment → Short term ➔ working capital ( R/M, inventories/ W/OH)
• Financing ➔ capital structure (Debt/Equity)
• Dividends ➔ how much retain or pay
Decisions
• Investment
• Long term – machinery ➔ produce goods/services ➔ Cash flows (CF)→ Profits •
Short term- working capital ➔ day to day – R/M, labor wages, maintenance, OH
• Financing ➔ sources of finance ➔ debt/equity

• Dividend
Bharti Airtel shares jump nearly 5% after board approves Rs

21,000 crore rights issue
Bharti Airtel Limited’s shares jumped nearly 5

per cent on Monday after the telco’s
approved a plan to raise Rs 21,000 crore by
selling stocks to existing shareholders. The
move to raise capital is aimed at expanding its
network and tackle rising competition in the
sector.
What kind of decision/s is/are this?

Investment ➔ 5G
Financing➔ Rights issue ➔ raising funds existing shareholders..
Decisions..?
• How does companies identify
an
investment opportunity?
• Lupin Chemicals Ltd. has set up
a
project to manufacture
‘RIFAMPICIN’, an anti-TB drug, at an
estimated cost of Rs.8,250 lakh.
Tata Metaliks has set up a new Mini

Blast Furnace with associated systems
for manufacture of foundry grade pig
iron.
How does a company look out for investment

decision? Types of long term Decisions:
• Replacement Projects for Maintaining Business: • Continuity in existing operations/Lines of

Businesses (Tech change over).
• Replacement Projects for Reducing Cost :
• Product becoming obsolete and equipment requires replacement. • Expansion Projects:
• expansion of business operations – geographic
• New Product/Market Development:
• expansion of New product line/ business operations
• R&D or Mandatory Projects:
• Social causes/environmental / changing Customer preferences prof Anita C Raman, IBS Hyd MBA Class 2023
• Mandatory projects • Replacement projects • Expansion projects
• Diversification
projects
• Research and
development projects • Miscellaneous projects
Capital budgeting
• Resources, time, money
• Losses ➔ debt ➔ good will ➔
bankrupt
• Expenses
What makes capital budgeting important?

• Investing huge amt
• Time
• Economic benefits ➔ long term ➔ losses➔
Closure ➔ investors ➔ ??
• Uncertainty – risk ➔ Losses
• Good will hampers
• Survival..?
NATURE OF CAPITAL BUDGETING DECISIONS

• Long Term Implications: Influence the firm’s growth in the long run. •
Outflow of large amount of funds: Huge capital investments •
Irreversible Decisions: revert back unless it is ready to absorb heavy
losses • Complex in nature: large set of formal/informal process •
Impact on the risk of the firm : Long run sustainability or Business risk

capital budgeting process
• has the following four
steps:
• 1. Generation of Ideas:
How does/where does
ideas get generated?
• 2. Analysis of Proposals:
On What basis does
management accept or
reject proposals..?
• 3. Creating the Corporate
Capital Budget.
• 4. Monitoring & Post
Audit:
STEPS INVOLVED IN CAPITAL BUDGETING

DECISIONS
• Identification of potential investment opportunities
• Preliminary screening
• Feasibility study
• Project implementation
• Performance review
Identification of potential investment

opportunities:
• Identify the potential sources for project ideas
• Study the demand and supply position in different industries. • Identify the
industries whose products have demand in the market. • Evaluate the product
profiles of various industries.
• Analyze the trend in imports and exports to identify potential opportunities. •
Analyze indigenously developed technologies as well as imported technologies. •
Study the social and economic trends and consumption patterns among the
domestic as well as foreign population.
• Analyze the possibility of reviving a sick unit
• Identify the possibility of a backward or a forward integration. prof Anita C Raman, IBS Hyd MBA Class
2023
Preliminary Screening:
• Compatibility between the promoter’s financial ability and the

project’s requirement.
• Compatibility of the project with governmental guidelines and
legislations.
• Availability and costs of the input factors.
• Analysis of the size of the market and the share of competitors and
substitute products.
• Analysis about the risk associated with the project. prof Anita C Raman, IBS Hyd MBA Class
2023
Feasibility Study:
• The factors that are considered in feasibility study are:

• estimates of the project cost,➔ (equipment, WC)
• means of financing the project ➔
• schedules of implementation,
• estimates of costs and benefits associated with the project and the
• estimates of profit associated with the project.
• The final investment decision is taken only after the project is
subjected to a feasibility study.
Implementation:
• preparation of blue prints and designs for project and plant

engineering,
• selection of machinery and equipment, arrangement of project
finance,
• installation of machinery, training the work force, trial run and actual
production.
The implementation of a project is a complicated phase and involves a
lot of time, cost and risk due to the various constraints.
Performance review:
• Deviations : the actual performance Vs planned performance

• Identification of causes for such deviations follow up of necessary
action.
• Performance review helps in analyzing the validity of the
assumptions that were made while selecting the project and provides
guidance in making future investment decisions.
Feasibility Study
• Aspects of Project Appraisal

• The appraisal of a project includes the following types of appraisal:
• Market Appraisal : size of the total market, project’s share
• Technical Appraisal :quality and quantity of raw materials
• Financial Appraisal: risk adjusted return >WACC
• Economic Appraisal: social cost benefit analysis; project is beneficial to the
society
Financial appraisal :Investment

criteria
Investment
criteria
Non-Discounting criteria
Discounting criteria
Benefit cost ratio of return
Internal rate of
return
Payback period
Accounting rate
Net present value
Payback period
Year Project A Project B
0 -100,000 -100,000
1 50,000 20,000
2 30,000 20,000
3 20,000 20,000
4 10,000 40,000
5 10,000 50,000
6 5,000 60,000
• It is the length of time required to recover the

initial on the project.
• The shorter the time, the better.
• This is simple both in concept and application.
• Limitations of payback period

• It does not consider time value of money
• It ignores the cash flows beyond the payback period.
• It is a measure of capital recovery, not profitability
• https://www.investopedia.com/articles/financial-theory/11/corporate-project-valuation
methods.asp
Discounted payback
period • It considers the time value of money
concept.
• Find out the discounted payback for a project which involves an

initial investment of Rs. 10,00,000 and provides an annual cash
inflow of Rs. 400,000 for 4 years. The cost of capital is 12%.
At n = 3 years, PVIFA = 2.402
At n = 4 years, PVIFA = 3.037
Therefore, n = 3.15 years

• Limitations of discounted payback period?
2. Accounting rate of return

ARR
• It is also known as average accounting return or average rate of return.
• It is defined as the average profit after tax or net income divided by
the average book value of investments.
• If a project involves an initial investment of Rs. 500,000 and PAT
generated in 5 years is given below, what will be ARR?
Year PAT
1 100,000
2 150,000
3 50,000
4 0
5 -50,000
2. Accounting rate of return
1.
It is simple to calculate.
It is based on accounting information which is readily

available 2.
It considers returns over the entire life of the project, and therefore, serves as a
3.
measure of profitability, not recovery.
Limitations of ARR
• It does not consider time value of money
• It is based upon accounting profit, not cash flows
• It is internally inconsistent
• The numerator measures the profit after tax which belongs to

only equity shareholders, however, its denominator
represents fixed investment which may include debt as well.
3. Net present value (NPV)

NPV is the sum of the present value of all cash flows – positive as well as
negative.
NPV = PV of all cash inflows – initial investment
Year Cash
0 flows
-10,00,0
00
1 200,000
2 200,000
3 300,000
4 300,000
5 350,000
If NPV is positive, accept the project If NPV is negative, reject the project If NPV is zero, indifferent
= Rs. – 5273 prof Anita C Raman, IBS Hyd MBA Class 2023
Find the NPV for the following Cash flow

invested for different interest rates:
Year CFs (in
0 lakhs)
(25000)
1 6000 9 +5448
2 7000 10 + 4606
3 8000 11 +3799
4 9000 12 +3025
5 10000 13 +2283
18 -1005
20 -2150
discou
(%) 8
Properties of NPV
• NPVs are additive, i.e., the NPV of a package of projects is simply the sum of
NPVs of individual projects in the package.
• The value of a firm can be expressed as sum of the present value of projects in
place (assets in place) as well as the NPV of prospective projects (growth
opportunities)
• When the firm terminates an existing project with a negative NPV, the value of the
firm increases by that amount and vice-versa.
Limitations of NPV
• NPV is expressed in absolute terms rather than relative terms.
• NPV does not take into account the life of the project when mutually
exclusive projects with different lives are being considered. Thus, it is
skewed (biased) towards project with longer life.
4. Benefit cost ratio

It is also known as profitability index
PVB is the present value of benefits and I is the initial investment

4 50,000
Year Cash
0 flows - NBCR = BCR – 1 = 1.145 – 1 = 0.145
100,000
1 25,000 BCR NBCR Rule
2 40,000
3 40,000
>0
Cost of capital is 12% Reject
<0 >1<1=1 Indifferent
=0 Accept
Benefit cost ratio

• Since this criteria measures the NPV per rupee of outlay, it can
easily discriminate between large and small investments, and
hence is preferable over NPV.
• Under unconstrained conditions, the BCR criterion will accept

and reject the same projects as NPV.
• When the capital budget is limited in the current period, the

BCR may rank the projects correctly in the order of decreasing
efficient use of capital.
Internal Rate of Return (IRR)

• to estimate the profitability of are reinvested at the same
potential investments. rate.
• annual rate of growth an The decision rules used in the IRR
investment is expected to method are as follows:
generate.
1.The project’s internal rate of return
• IRR is that discount rate at must exceed a project’s weighted
which the NPV of the project is average cost of capital (WACC);
equal to zero. otherwise, the project should be
rejected.
• In other words, it is the discount 2.If several independent projects
rate which equates the present meet the rule above, all of them
value of future cash flows with should be accepted. In case of
the initial investment. several mutually exclusive projects,
the project with the highest IRR must
• assumes that all cash flows be accepted.
received from an investment
1 2 N 1 2 N
NPV = CF0 +CF +CF + … +CF = 0 (1 + IRR) (1 + IRR) (1 + IRR)

5. Internal rate of return (IRR)
• If a firm is planning to invest has an Initial outlay of
Rs.1,00,000 and is likely to have the following cash
inflows for next four years, find its IRR
Year Cash
0 flows -
100,000
1 30,000
2 30,000
3 40,000
4 45,000
NPV
45,000
0
15.37% Discount rate
At 15%, PV = 100,801
0
At 16%, PV = 98,636
IRR = 15.37%
Year Cash
Consider the following project The
0 flows -
IRR equation for this project is
160,000
1 10,00,000
2 -10,00,000
The simple computation tells us that this equation has two roots, viz., 1.25 and 5.00
It means, the IRR corresponding to these roots will be 25% and 400%, i.e., the
NPV is zero at two discount rates
The multiple internal rates of return problem
flows.
NPV
occur when at least one future cash inflow of a
project is followed by cash outflow.
In other words, there is at least one negative Discount rate
value after a positive one, or the signs of cash 25% 400%
flows change more than once. In this case, we
say that the project has non-normal cash
https://www.youtube.com/watch?v=ZTLA7eirx-w prof
Anita C Raman, IBS Hyd MBA Class 2023
NPV vs IRR
• Do the NPV and IRR lead to identical decisions?
• Only when 2 conditions are met

• The cash flows must be conventional
• Projects must be independent
• What are the limitations of IRR?
• When the cash flows are not conventional
Modified internal rate of return (MIRR)

• Assumptions:
• MIRR assumes that
positive cash flows
are reinvested at the
firm's cost of
capital
• Initial outlays are financed at the firm's
financing cost
A project entails an initial investment of
$1,000, and offers cash returns of $400,
$500, and $300 at the end of years one, two
and three respectively. The company’s cost of
capital is 10%.
Source: accaglobal.com
Modified internal rate of return (MIRR)

1. Calculate the present value of all the cash outflows (PVC), using the cost of
capital. 2. Calculate the terminal value (TV) of all the cash inflows expected from the
project 3. Compute MIRR using the formula as below
Consider the project as shown below, and find the MIRR if the cost of capital is 15%
Year 0 1 2 3 4 5 6
Cash flows -120 -80 20 60 80 100 120
Evaluation
1. MIRR is superior to IRR in that it assumes the project cash flows are
reinvested at the cost of capital whereas IRR assumes the cash flows are
reinvested at project’s own IRR
2. Problems of multiple IRRs do not arise with the use of MIRR

3. If two mutually exclusive projects are of the same size, NPV and
MIRR leads to the sane decision, irrespective of variations in their life
4. If two mutually exclusive projects are of different sizes, NPV is

preferable.
Cash flow vs profit

• Accrual concept
• Other non-cash charges – accounting

rules • Time value of money
Basic elements
• Initial investment (cash
outflow) • Net Operating cash
inflows • Terminal cash inflows
Basic
principles •
Separation principle •
Incremental principle •
Post-tax principle
• Consistency principle
Separation principle
Project
Financing side Investment side
Rate of return = 20%
Cost of capital = 15%

1 Time 1
Time Cash flow +1000 Cash flow – 1000
0 0
–1150 +1200
Incremental principle
• The cash flows of a project must be measured in incremental terms.
That is, cash flows of the firm with the project minus the cash flows
of the firm without the project.
• Always ignore sunk costs

• Include the opportunity cost
• Estimate working capital properly
Post-tax principle
• Cash flows must be considered purely on post-tax basis.
• Non-cash charges can have an impact on cash flows if they affect tax
liability.
Consistency principle
The cash flows may be estimated from the point of view of all investors
(shareholders and lenders) or from the point of view of just equity
shareholders.
Cash flows to all investors =PBIT (1 – tax rate)

+ Depreciation and other non-cash charges
– Increase in net working capital
– Capital expenditure
The discount rate used for cash flow to all investors must be the weighted
average cost of capital while it must be the cost of equity for cash flow to
just equity shareholders
Estimation of Cashflow principles

• important principles underlying measurement of costs and benefits :
• All costs and benefits must be measured in terms of cash flows.
• All cash flows must be defined in post-tax terms.
• The net cash flows are defined from the point of view of the suppliers of long-term funds.
• Interest on long-term loans must not be included for determining the net cash flows, since the post-tax cost of
long-term funds obviously includes the post-tax cost of long-term debt. Therefore, if interest on long-term
debt is considered, there will be an error of double-counting.
• The cash flows must be measured in incremental terms.
Some implications
• If the proposed project has a beneficial or detrimental impact on the other product lines of the firm, then such
impact must be quantified.
• Sunk costs must be ignored.
• Opportunity costs associated with the utilization of the resources available with the firm must be considered.
• The share of the existing overhead costs which is to be borne by the end product(s) of the proposed project
must be ignored.

Cash Flow Estimation

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Capital

Budgeting Prof Anita C

Discussion: How does a company look out

prof Anita C Raman, IBS Hyd MBA Class 2023

• Financing ➔ sources of finance ➔ debt/equity

prof Anita C Raman, IBS Hyd MBA Class 2023

Bharti Airtel shares jump nearly 5% after board approves Rs

Bharti Airtel Limited’s shares jumped nearly 5

What kind of decision/s is/are this?

Tata Metaliks has set up a new Mini

How does a company look out for investment

• Replacement Projects for Maintaining Business: • Continuity in existing operations/Lines of

• Mandatory projects • Replacement projects • Expansion projects

prof Anita C Raman, IBS Hyd MBA Class 2023

What makes capital budgeting important?

prof Anita C Raman, IBS Hyd MBA Class 2023

NATURE OF CAPITAL BUDGETING DECISIONS

prof Anita C Raman, IBS Hyd MBA Class 2023

STEPS INVOLVED IN CAPITAL BUDGETING

Identification of potential investment

• Compatibility between the promoter’s financial ability and the

• The factors that are considered in feasibility study are:

prof Anita C Raman, IBS Hyd MBA Class 2023

• preparation of blue prints and designs for project and plant

prof Anita C Raman, IBS Hyd MBA Class 2023

• Deviations : the actual performance Vs planned performance

prof Anita C Raman, IBS Hyd MBA Class 2023

• Aspects of Project Appraisal

prof Anita C Raman, IBS Hyd MBA Class 2023

Financial appraisal :Investment

prof Anita C Raman, IBS Hyd MBA Class 2023

• It is the length of time required to recover the

• The shorter the time, the better.

• This is simple both in concept and application.

• Limitations of payback period

• Find out the discounted payback for a project which involves an

At n = 3 years, PVIFA = 2.402

At n = 4 years, PVIFA = 3.037

Therefore, n = 3.15 years

2. Accounting rate of return

prof Anita C Raman, IBS Hyd MBA Class 2023

2. Accounting rate of return

It is based on accounting information which is readily

prof Anita C Raman, IBS Hyd MBA Class 2023

• It is based upon accounting profit, not cash flows

• The numerator measures the profit after tax which belongs to

prof Anita C Raman, IBS Hyd MBA Class 2023

3. Net present value (NPV)

NPV = PV of all cash inflows – initial investment

Find the NPV for the following Cash flow

prof Anita C Raman, IBS Hyd MBA Class 2023

prof Anita C Raman, IBS Hyd MBA Class 2023

4. Benefit cost ratio

PVB is the present value of benefits and I is the initial investment

1 25,000 BCR NBCR Rule

prof Anita C Raman, IBS Hyd MBA Class 2023

Benefit cost ratio

• Under unconstrained conditions, the BCR criterion will accept

• When the capital budget is limited in the current period, the

prof Anita C Raman, IBS Hyd MBA Class 2023

Internal Rate of Return (IRR)

prof Anita C Raman, IBS Hyd MBA Class 2023