CASH FLOW ILLUSTRATIONS

To show how cash flows are determined bearing in mind the principles
discussed above two illustrations are presented in this section.

Illustration 1 Naveen Enterprises is considering a capital project about

which the following information is available:

The investment outlay on the project will be Rs. 100 million. This consists of
Rs.100 million on plant and machinery and Rs. 20 million on net working
capital. The entire outlay will be incurred at the beginning of the project.

The project will be financed with Rs. 45 million of equity capital, Rs. 5
million oi preference capital, and Rs. 50 million of debt capital. Preference
capital will carry a dividend rate of 15 percent; debt capital will carry an
interest rate of 15 percent.

The life of the project is expected to be 5 years. At the end of 5 years, fixed
assets will fetch a net salvage value of Rs. 30 million whereas net working
capital will be liquidated at its book value.

The project is expected to increase the revenues of the firm by Rs. 120
million per year. The increase in costs on account of the project is expected
to be Rs. 80 million per year (This includes all items of cost other than
depreciation, interest, and tax). The effective tax rate will be 30 per cent.

Plant and machinery will be depreciated at the rate of 15 percent per

year as per the written down value method. Hence, the depreciation
charges will be:

First year : Rs. 12.00 million

Second year : Rs. 10.20 million
Third year : Rs. 8.67 million
Fourth year : Rs. 7.37 million
Fifth year : Rs. 6.26 million

Exhibit 9.2 Project Cash Flows

Years (Rs. In millions)

0 1 2 3 4 5
1 Fixed Assets (80.00) - - - - -
2 Net Working Capital (20.00) - - - - -
3 Revenues - 120 120 120 120 120
Costs (Other than depreciation
4 - 80 80 80 80 80
and interest)
5 Depreciation - 12.00 10.20 8.67 7.37 6.26
6 Profit before Tax - 28.00 29.80 31.33 32.63 33.74
7 Tax - 8.40 8.94 9.40 9.79 10.12
8 Profit after Tax - 19.60 20.86 21.93 22.84 23.62
9 Net Salvage Value - - - - - 30.00
1 Recovery of Net Working
- - - - - 20.00
0 capital
1 (100.0
Initial Investment - - - - -
1 0)
1
Operating cash inflow - 31.60 31.06 30.60 30.21 29.88
2
1
Terminal Flow - - - - - 50.00
3
1 (100.0
Net Cash Flow (11+12+13) 31.60 31.06 30.60 30.21 79.88
4 0)
Book value of investment 100.00 88.00 77.80 69.13 61.76 -

Illustration II India Pharma Ltd is engaged in the manufacture of

pharmaceuticals. The Company was established in 1998 and has registered
a steady growth in sales since then. r:s.ently the company manufactures 16
products and has an annual turnover of Rs. 2,200 million. The company is
considering the manufacture of a new antibiotic preparation, K-cin, for
which the following information has been gathered. .

K-cin is expected to have a product life cycle of five years and thereafter it
would be withdrawn from the market. The sales from this preparation are
expected to be as follows:

Year Sales (Rs in millions)

1 100
2 150
3 200
4 150
5 100

The capital equipment required for manufacturing K-cin is Rs.100 million

and it will be depreciated at the rate of 15 percent per year as per the WDV
method for tax purposes. The expected net salvage value after five years is
Rs. 20 million.

The net working capital requirement for the project is expected to be 20

percent 01 sales. At the end of 5 years, the net working capital is expected
to be liquidated at par, barring an estimated loss of Rs. 5 million on account
of bad debt. The bad debt loss will be a tax-deductible expense.

The accountant of the firm has provided the following cost estimates for K-
cin:
Raw material cost : 30 percent of sales
Variable labour cost : 20 percent of sales
Fixed annual operating and maintenance cost : Rs. 5 million
Overhead allocation (excluding depreciation,
Maintenance and interest) : 10 percent of sales

While the project is charged an overhead allocation, it is not likely to have

any effect on overhead expenses as such.

The manufacture of K-cin would also require some of the common facilities
of the firm. The use of these facilities would call for reduction in the
production of other pharmaceutical preparations of the firm. This would
entail a reduction of Rs. 15 million of contribution margin

The tax rate applicable to the firm is 30 percent.

Based on the above information, the cash flows for the project have been
worked out in Exhibit 9.3. A few points about this exhibit are in order:

The loss of contribution (item 7) is an opportunity cost.

Overhead expenses allocated to the project have been ignored as they do

not represent incremental overhead expenses for the firm as a whole.

It is assumed that the level of net working capital is adjusted at the

beginning 01 the year in relation to the expected sales for the year. For
example, net working capital at the beginning of year 1 (i.e. at the end of
year 0) will be Rs. 20 million that is 20 percent of the expected revenues of
Rs. 100 million for year 1. Likewise, the level of net working capital at the
end of year 1 (i.e. at the beginning of year 21 will be Rs. 30 million that is
20 percent of the expected revenues of Rs.l50 million for year 2.

Exhibit 9.3 Cash Flows for the K-cin Project

Years (Rs. In millions)

0 1 2 3 4 5
(100.0
1 Capital Investment - - - - -
0)
Level of Net working Capital
2 20 30 40 30 20 0
(Ending)
3 Revenues - 100 150 200 150 100
4 Raw Material Cost - 30 45 60 45 30
5 Labour Cost - 20 30 40 40 20
Operating and Maintenance
6 - 5 5 5 5 5
Cost
7 Loss of Contribution - 15 15 15 15 15
8 Depreciation - 15.00 12.75 10.84 9.21 7.83
9 Bad Debt Loss - - - - - 5
1
Profit Before Tax - 15.00 42.25 69.16 45.79 17.17
0
1 (100.0
Tax 4.50 12.68 20.75 13.74 5.15
1 0)
1
Profit After Tax - 10.50 29.58 48.41 32.05 12.02
2
1 Net Salvage Value of
- - - - - 20.00
3 Equipment
1 Recovery of Net Working
- - - - - 15.00
4 capital
1 (100.0
Capital Invetment - - - - -
5 0)
1 Operating Cash Inflow
- 25.50 42.33 59.25 41.26 24.85
6 (12+8+9)
1 - -
Networking capital 20.00 10.00 10.00 -
7 10.00 10.00
1
Terminal Cash inflow (13+14) - - - - - 35
8
1 -
Net Cash flow (15+16-17+18) 15.50 32.33 69.25 51.26 59.85
9 120.00

Illustration III Ojus Enterprises is determining the cash flow for a project
involving replacement of an. old machine by a new machine. The old
machine bought a few years ago has a book value of Rs. 400,000 and it can
be sold to realize a post tax salvage value Rs. 500,000. It has a remaining
life of five years after which its net salvage value is expected to be Rs.
160/000. It is being depreciated annually at a rate of 15 percent under the
written down value method. The net working capital required for the old
machine is Rs. 400,000.

The new machine costs Rs.1,600,000. It is expected to fetch a net salvage

value of Rs.800,000 after 5 years when it will no longer be required the
depreciation rate applicable to it is 15 percent under the written down
value method. The net working capital required for the new machine is
Rs.500,000. The new machine is expected to bring a saving of Rs.257,143
annually in manufacturing costs (other than depreciation). The tax rate
applicable to the firm is 30 percent.

Exhibit 9.4 Cash Flows for a Replacement Project

Years (Rs. In’000)

0 1 2 3 4 5
1 Investment Outlay
a) Cost of New Asset -1600 - - - - -
b) Salvage Value of Old 500 - - - - -
Asset -100 - - - - -
c) Increase in Net working -1200 - - - - -
Capital
 d) Total Net Investment
Operating Inflows Over the
2
Project Life
a) After-Tax Savings in
180.0
Manufacturing cost 180.0 180.0 180.0
0 180.0
b) Depreciation on New 0 0 0
240.0 0
Machine - 204.0 173.4 147.3
0 125.2
c) Depreciation on Old - 0 0 9
600.0 8
Machine - 51.00 43.35 36.85
0 31.32
d) Incremental depreciation - 153.0 130.0 110.5
180.0 93.96
(b+c) - 0 5 4
0 28.19
e) Tax Saving on 45.90 39.02 33.16
54.00
incremental Depreciation -
208.1
f) Net Operating cash inflow 225.9 219.0 213.1
234.0 9
(a+e) 0 2 6
0
3 Terminal Cash Inflow

a) Net Terminal Value of 800.0

New Machine 0
b) Net Terminal Value of Old - - - - 160.0
Machine - - - - 0
c) Recovery of incremental - - - - 100.0
Net Working Capital 0
d) Total Terminal Cash - - - -
Inflow (a+b+c) 740.0
0
-
234.0 225.9 219.0 213.1 948.1
4 Net Cash Flow (1d+2f+3d) 1200.0
0 0 2 6 9
0

Illustration IV Magnum Technologies Limited is evaluating an electronics

project for which the following information has been assembled:

The total outlay on the project is expected to be Rs. 50 million. This consists
of Rs. 30 million of fixed assets and Rs. 20 million of current assets.

The total outlav of Rs. 50 million is proposed to be financed a follows: Rs.15

millions equity. Rs. 20 millions of term loans, Rs. 10 millions of bank finance
{or working capital, and Rs. 5 million of trade credit.

The term loan is repayable in five equal annual installments of Rs. 4 million
each. The first installment will be due at the end of the first year and the
last installment at the end of the fifth year. The levels of bank finance for
working capital and trade credit I ·ill remain at Rs. 10 million and Rs. 5
million till they are paid back or retired at the end of five years.

The interest rates on the term loan and bank finance for working capital will
be 10 percent and 12 per cent respectively.
The expected revenues from the project will be Rs. 60 million per year. The
operating costs, excluding depreciation, will be Rs. 42 million. The
depreciation rate on the fixed sets will be 15 per cent as per the written
down value method.

The net salvage value of fixed assets and current assets at the end of year
5 will be Rs.5 million and Rs. 20 million respectively.

The tax rate applicable to the firm is 30 percent.

Cash Relating to Equity The equity-related cash flow stream reflects the
contributions made benefits accruing to equity shareholders. It may be
divided into three components as follows:

= Initial investment : Equity funds committed to the project

= Operating cash flows : Profit after tax - Preference dividend +
Depreciation + Other non-cash charges
= Liquidation and retirement : Net salvage value of fixed assets
+
Net salvage value of current assets
-
Repayment of term loan
-
Redemption of preference capital
-
Repayment of working capital
advances
-
Retirement of trade credit and other
dues
While the first two components, namely, ‘initial investment’ and ‘operating
cash inflows’ as fairly self-explanatory, the third term, namely, 'liquidation
and retirement cash flows' as a result little explanation. It represents the
net cash flows accruing to equity shareholders t of liquidation of various
assets in the project and retirement/redemption of all other claims.
Remember that equity shareholders have a residual interest in the project
and hence what is left after meeting the claims of all others belongs to
equity shareholders.

Exhibit 9.6 Net Cash Flows Relating to Equity

Years (Rs. In millions)

0 1 2 3 4 5
1 Equity Funds -15.00 - - - - -
2 Revenues - 60.00 60.00 60.00 60.00 60.00
3 Operating Cost - 42.00 42.00 42.00 42.00 42.00
4 Depreciation - 4.50 3.83 3.25 2.76 2.35
Interest on Working Capital
5 - 1.20 1.20 1.20 1.20 1.20
Advance
6 Interest on term loan - 2.00 1.60 1.20 0.80 0.40
7 Profit before Tax - 10.30 11.38 12.35 13.24 14.05
8 Tax - 3.09 3.41 3.70 3.97 4.22
9 Profit after Tax - 7.21 7.96 8.64 9.27 9.84
1
Preference Dividend - - - - - -
0
1 Net Salvage Value of Fixed
- - - - - 5.00
1 Assets
1 Net Salvage Value of Current
- - - - - 20.00
2 Assets
1
Repayment of Term Loans - 4.00 4.00 4.00 4.00 4.00
3
1 Redemption of Preference
- - - - - -
4 Capital
1 Repayment of Short-term Bank
- - - - - -
5 Borrowings
1
Retirement of Trade Creditors - - - - - 5.00
6
1
Initial Investment (1) -15.00 - - - - -
7
1 Operating cash inflows (9-
- 11.71 11.79 11.90 12.03 12.18
8 10+4)
Liquidation and Retirement
1
Cash Flows (11+12-13-14-15- - -4.00 -4.00 -4.00 -4.00 6.00
9
16)
2
Net Cash Flow (17+18+19) -15.00 7.71 7.79 7.90 80.3 18.18
0

Cash Flows Relating to Long-term Funds: As dicussed earlier in this

chapter, the cash flow stream relating to long-term found consists of three
components as follows:

Initial investment : Long-term funds invested in the project. This

is equal to: fixed assets + working capital
margin

Operating cash inflow : Profit after tax

+
Depreciation
+
Other non-cash charges
+
Interest on long-term borrowings (1-tax rate)
Terminal cash flow : Net salvage value of fixed assets
+
Net recovery of working capital margin

Exhibit 9.7 Net Cash Relating to Long-Term Found

Years (Rs. In millions)

0 1 2 3 4 5
1 Fixed Assets -30.00 - - - - -
2 Working Capital Margin -5.00 - - - - -
3 Revenues - 60 60 60 60 60
4 Operating Costs - 42 42 42 42 42
5 Depreciation - 4.50 3.83 3.25 2.76 2.35
Interest on Working Capital
6 - 1.20 1.20 1.20 1.20 1.20
Advance
7 Interest on Term Loan - 2.00 1.60 1.20 0.80 0.40
8 Profit before tax - 10.30 11.38 12.35 13.24 14.05
9 Tax - 3.09 3.41 3.70 3.97 4.22
1
Profit after Tax - 7.21 7.96 8.64 9.27 9.84
0
1
Net Salvage Value of Fix Assets - - - - - 5.00
1
1 Net Recovery of Working
- - - - - 5.00
2 capital Margin
1
Initial Investment(1+2) -35.00 - - - - -
3
1 Operating cash inflow
- 8.99 8.36 8.36 7.80 6.84
4 10+5+7(1-T)
1
Terminal Flow (11+12) - - - - - 10.00
5
1
Net Cash Flow (13+14+15) -35.00 8.99 8.36 7.80 7.29 16.84
6

Cash Flows Relating to Total Resources: The cash flow stream relating
to total resources consists of three components as follows:

Initial investment : All the resources committed to the project.

This is simply the total outlay on the project
consisting of fixed assets plus gross working
capital.

Operating cash inflow : Profit after tax

+
Depreciation
 +
Other non-cash charges
+
Interest on long-term borrowings (1-tax rate)
+
Interest on short-term borrowings (1-tax rate)

Terminal cash flow : Net salvage value of fixed assets

+
Net salvage value of Current assets

Exhibit 9.8 Net Cash Flows Relating to Total Resources

Years (Rs. In millions)

0 1 2 3 4 5
1 Total Resources -50.00 - - - - -
2 Revenues - 60 60 60 60 60
3 Operating Costs - 42 42 42 42 42
4 Depreciation - 4.50 3.83 3.25 2.76 2.35
Interest on Working Capital
5 - 1.20 1.20 1.20 1.20 1.20
Advance
6 Interest on Term Loan - 2.00 1.60 1.20 0.80 0.40
7 Profit before tax - 10.30 11.38 12.35 13.24 14.05
8 Tax - 3.09 3.41 3.70 3.97 4.22
9 Profit after Tax - 7.21 7.96 8.64 9.27 9.84
1
Net Salvage Value of Fix Assets - - - - - 5.00
0
1 Net Salvage Value of Current
- - - - - 20.00
1 Assets
1
Initial Investment (1) -50.00 - - - - -
2
1 Operating cash inflow
- 13.95 13.75 13.58 13.43 13.30
3 [9+4+6(1-T)+5(1-T)]
1
Terminal Flow (10+11) - - - - - 25.00
4
1
Net Cash Flow (12+13+14) -50.00 13.95 13.75 13.58 13.43 38.30
5

PROBLEMS

Futura Limited is considering a capital project about which the following

information is available.
The investment outlay on the project will be Rs 200 million. This consists of
Rs 150 million on the plant and machinery and Rs 50 million on net working
capital. The entire outlay will be incurred in the beginning.

The life of the project is expected to be 7 years. At the end of 7 years, fixed
assets will fetch a net salvage value of Rs 48 million whereas net working
capital will be liquidated at its book value.

The project is expected to increase the revenues of the firm by Rs 250

million per year. The increase in costs on account of the project is expected
to be Rs 100 million per year (This includes all items of cost other than
depreciation, interest, and tax). The tax rate is 30 percent.

Plant and machinery will be depreciated at the rate of 25 percent per year
as per the written down method.
(a) Estimate the post-tax cash flows of the project.
(b) Calculate the IRR of the project.

Modern Pharma is considering the manufacture of a new drug, Floxin, for

which the following information has been gathered:

Floxin is expected to have a product life cycle of seven years and after that
it would be withdrawn from the market. The sales from this drug are
expected to be as follows:

Year 1 2 3 4 5 6 7
Sales (Rs in million) 80 120 160 200 160 120 80

The capital equipment required for manufacturing Floxin is Rs 120 million

and it will be depreciated at the rate of 25 percent per year as per the WDV
method for tax purposes. The expected net salvage value after seven years
is Rs 25 million.

The working capital requirement for the project is expected to be 25

percent of sales. Working capital level is adjusted at the beginning of the
year in relation to the expected sales for the year. At the end of 7 years,
working capital is expected to be liquidated at par, barring an estimated
loss of Rs 4 million on account of bad debts which, of course, will be a tax -
deductible expense.

The accountant of the firm has provided the following estimates for the cost
of Floxin:

Raw material cost : 30 percent of sales

Variable manufacturing cost
Fixed annual operating and
maintenance costs
Variable selling expenses
Overhead allocation
: 10 percent of sales
: Rs 10 million
: 10 percent of sales
: 10 percent of sales
(excluding depreciation,
maintenance, and interest)

The incremental overheads attributable to the new product are, however,

expected to be only 5 percent of sales.

The manufacture of Floxin will cut into the sales of an existing product
thereby reducing its contribution margin by Rs 10 million per year.

The tax rate for the firm is 30 percent.

(a) Estimate the post-tax incremental cash flows for the project to
manufacture Floxin.
(b) What is the NPV of the project if the cost of capital is 15 percent?

Teja International is determining the cash flows for a project involving

replacement of an old machine by a new machine. The old machine bought
a few years ago has a book value of Rs 800,000 and it can be sold to realise
a post-tax salvage value of Rs 900,000. It has a remaining life of five years
after which its net salvage value is expected to be Rs 200,000. It is being
depreciated annually at a rate of 25 percent under the WDV method.

The new machine costs Rs 3,000,000. It is expected to fetch a net salvage

value of Rs 1,500,000 after five years. The depreciation rate applicable to it
is 25 percent under the WDV method. The new machine is expected to
bring a saving of Rs 650,000 annually in manufacturing costs (other than
depreciation). The incremental working capital associated with this machine
is Rs 500,000. The tax rate applicable to the firm is 30 percent.
(a) Estimate the cash flow associated with the replacement project.
(b) What is the NPV of the replacement project if the cost of capital is 14
percent?

A machine costs Rs 100,000 and is subject to a depreciation rate of 25

percent under the WDV method. What is the present value of the tax
savings on account of depreciation for a period of 5 years if the tax rate is
40 percent and the discount rate is 15 percent?

Mahima Enterprises is considering replacing an old machine by a new

machine. The old machine bought a few years ago has a book value of Rs
90,000 and it can be sold for Rs 90,000. It has a remaining life of five years
after which its net salvage value is expected to be Rs 10,000. It is being
depreciated annually at the rate of 20 percent as per the WDV method.

The new machine costs Rs 400,000. It is expected to fetch a net salvage

value of Rs 25,000 after 5 years. It will be depreciated annually at the rate
of 25 percent as per the WDV method. Investment in working capital will
not change with the new machine. The tax rate for the firm is 35 percent.
Estimate the cash flow associated with the replacement proposal, assuming
that other costs remain unchanged.
Supreme Industries is evaluating a project for which the following
information has been assembled:

(a) The total outlay of the project is expected to be Rs 450 million. This
consists of Rs 250 million of fixed assets and Rs 200 million of gross current
assets.

(b) The proposed scheme of financing is as follows: Rs 100 million of equity,

Rs 200 million of term loans, Rs 100 million of working capital advances,
and Rs 50 million of trade credit.

(c) The term loan is repayable in 10 equal semi-annual installments of Rs 20

million each. The first installment will be due after 18 months. The interest
rate on the term loan will be 15 percent.

(d) The levels of working capital advance and trade credit will remain at Rs
100 million and Rs 50 million respectively till they are paid back or retired
at the end of 6 years. The working capital advance will carry an interest
rate of 18 percent.

(e) The expected revenues for the project will be Rs 500 million per year.
The operating costs (excluding depreciation and interest) are expected to
be Rs 320 million per year. The depreciation rate on the fixed assets will be
331/3 percent as per the written down value method.
(f) The net salvage value of fixed assets and current assets, at the end of
year 6 (the project life is expected to be 6 years) will be Rs 80 million and
Rs 200 million respectively.

(g) The tax rate applicable to the firm is 50 percent.

Define the cash flows from the point of view of (i) equity funds, (ii) long-
term funds, and (iii) total funds.

MINICASE

Metaland is a major manufacturer of light commercial vehicles. It has a very

strong R&D centre which has developed very successful models in the last
fifteen years. However, two models developed by it in the last few years
have not done well and were prematurely withdrawn from the market.

The engineers at its R&D centre have recently developed a prototype for a
new light commercial vehicle that would have a capacity of four tons.

After a lengthy discussion, the board of directors of Metaland decided to

carefully evaluate the financial worthwhileness of manufacturing this model
which they have labelled Meta 4.

You have been recently hired as the executive assistant to Vijay Mathur,
Managing Director of Metaland. Vijay Mathur has entrusted you with the
task of evaluating the project.
Meta 4 would be produced in the existing factory which has enough space
for one more product. Meta 4 will require plant and machinery that will cost
Rs 400 million. You can assume that the outlay on plant and machinery will
be incurred over a period of one year. For the sake of simplicity assume
that 50 percent will be incurred right in the beginning and the balance 50
percent will be incurred at the end of year 1. The plant will commence
operation after one year

Meta 4 project will require Rs 200 million toward gross working capital. You
can assume that the gross working capital investment will occur at the end
of year 1.

The proposed scheme of financing is as follows: Rs 200 million of equity, Rs

200 million of term loan, Rs 100 million of working capital advance, and Rs
100 million of trade credit. Equity will come right in the beginning by way of
retained earnings. Term loan and working capital advance will be raised at
the end of year 1.

The term loan is repayable in 8 equal semi-annual installments of Rs 25

million each. The first installment will be due after 18 months of raising the
term loan. The interest rate on the term loan will be 14 percent.

The levels of working capital advance and trade credit will remain at Rs 100
million each, till they are paid back or retired at the end of 5 years, after
the project commences, which is the expected life of the project. Working
capital advance will carry an interest rate of 12 percent.

Meta 4 project is expected to generate a revenue of Rs 750 million per

year. The operating costs (excluding depreciation and taxes) are expected
to be Rs 525 million per year.

For tax purposes, the depreciation rate on fixed assets will be 25 percent as
per the written down value method. Assume that there is no other tax
benefit. ]

The net salvage value of plant and machinery is expected to be Rs 100

million at the end of the project life. Recovery of working capital will be at
book value.

The income tax rate is expected to be 30 percent.

Vijay Mathur wants you to estimate the cash flows from three different
points of view'
(a) Cash flows from the point of all investors (which is also called the
explicit cost find point of view).
(b) Cash flows from the point of equity investors.
(c) Cash flows as defined by financial institutions.