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Chapter 2: Cash Flow Models For Planning: Without This New Investment
Chapter 2: Cash Flow Models For Planning: Without This New Investment
Chapter 2: Cash Flow Models For Planning: Without This New Investment
Introduction
What is cash flow? Is it the total amount of cash flowing into the company
during a period? Is it the total amount of cash flowing out of the company
during a period? Is it the net of the cash inflows and outflows for a period?
Well, there is no specific definition of cash flow—and that’s probably why there
is so much confusion regarding the measurement of cash flow.
Cash flow is essentially the movement of money into and out of your business;
it's the cycle of cash inflows and cash outflows that determine your business'
solvency. Cash flow analysis is the study of the cycle of your business' cash
inflows and outflows, with the purpose of maintaining an adequate cash flow
for your business, and to provide the basis for cash flow management.
A firm invests only to increase the value of their ownership interest. A firm will
have cash flows in the future from its past investment decisions. When it
invests in new assets, it expects the future cash flows to be greater than
without this new investment.
To evaluate an investment, we’ll have to look at how it will change the future
cash flows of the firm, and, hence, the value of the firm. The change in a firm’s
value as a result of a new investment is the difference between its benefits and
its costs:
Project’s change in the value of the firm = Project’s benefits − Project’s costs
A more useful way of evaluating the change in the value is the breakdown of
the project’s cash flows into two components:
1. The present value of the cash flows from the project’s operating activities
(revenues minus operating expenses), referred to as the project’s operating
cash flows (OCF); and
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2. The present value of the investment cash flows, which are the
expenditures needed to acquire the project’s assets and any cash flows from
disposing the project’s assets. Or,
Asset Acquisition
In acquiring any asset, there are three types of cash flows to consider:
1. Cost of the asset,
2. Set-up expenditures, including shipping and installation; and
3. Any tax credit.
The tax credit may be an investment tax credit or a special credit—such as a
credit for a pollution control device—depending on the prevailing tax law.
Cash flow associated with acquiring an asset is:
Cash flow from acquiring assets = Cost + Set-up expenditures - Tax credit
Suppose the firm buys equipment that costs $100,000 and it costs $10,000 to
install it. If the firm is eligible for a 10% tax credit on this equipment (that is,
10% of the total cost of buying and installing the equipment) the change in the
firm’s cash flow from acquiring the asset of $99,000 is as follows:
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Cash flow from acquiring assets = $100,000 + $10,000 – 0.10($100,000 +
$10,000) = $100,000 + $10,000 – $11,000 = $99,000
The cash outflow is $99,000 when this asset is acquired: $110,000 out to buy
and install the equipment and $11,000 in from the reduction in taxes.
Asset Disposition
At the end of the useful life of an asset, the firm may be able to sell it or may
have to pay someone to haul it away. If the firm is making a decision that
involves replacing an existing asset, the cash flow from disposing of the old
asset must be figured in since it is a cash flow relevant to the acquisition of the
new asset.
If the firm disposes of an asset, whether at the end of its useful life or when it
is replaced, two types of cash flows must be considered:
1. What you receive or pay in disposing of the asset; and
2. any tax consequences resulting from the disposal
Cash flow from disposing assets = Proceeds or payment from disposing
assets – Taxes from disposing assets
The proceeds are what you expect to sell the asset for if you can get someone to
buy it. If the firm must pay for the disposal of the asset, this cost is a cash
outflow. The tax consequences are a bit more complicated. Taxes depend on:
1. The expected sales price,
2. The book value of the asset for tax purposes at the time of
disposition, and
3. The tax rate at the time of disposal.
If a firm sells the asset for more than its book value but less than its original
cost, the difference between the sales price and the book value for tax purposes
(called the tax basis) is a gain, taxable at ordinary tax rates. If a firm sells the
asset for more than its original cost, then the gain is broken into two parts:
1. Capital gain: the difference between the sales price and the original cost; and
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2. Recapture of depreciation: the difference between the original cost and the
tax basis.
The capital gain is the benefit from the appreciation in the value of the asset
and may be taxed at special rates, depending on the tax law at the time of sale.
The recapture of depreciation represents the amount by which the firm has
over depreciated the asset during its life. This means that more depreciation
has been deducted from income (reducing taxes) than necessary to reflect the
usage of the asset. The recapture portion is taxed at the ordinary tax rates,
since the excess depreciation taken all these years has reduced taxable income.
If a firm sells an asset for less than its book value, the result is a capital loss.
In this case, the asset’s value has decreased by more than the amount taken
for depreciation for tax purposes. A capital loss is given special tax treatment:
If there are capital gains in the same tax year as the capital loss, they are
combined, so that the capital loss reduces the taxes paid on capital
gains, and
If there are no capital gains to offset against the capital loss, the capital
loss is used to reduce ordinary taxable income.
The benefit from a loss on the sale of an asset is the amount by which taxes
are reduced. The reduction in taxable income is referred to as a tax shield,
since the loss shields some income from taxation.
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research, engineering analyses, operations research, analysis of our
competitors and our managerial experience.
Change in Revenues: the revenues from the new project are really only the
additional revenues the revenues from the new project minus the revenue we
could have earned from renting the building. So, when a firm undertakes a new
project, the financial managers want to know how it changes the firm’s total
revenues, not merely the new product’s revenues.
Change in Expenses: When a firm takes on a new project, the costs associated
with it will change the firm’s expenses. If the investment changes the sales of
an existing product, the decision maker must estimate the change in unit
sales. Based on that estimate, the estimate of the additional costs of producing
the additional number of units is derived by consulting with production
management. In addition, an estimate of how the product’s inventory may
change when production and sales of the product change is also needed.
Change in Taxes
Taxes figure into the operating cash flows in two ways. First, if revenues and
expenses change, taxable income and therefore, taxes change. That means we
need to estimate the change in taxable income resulting from the changes in
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revenues and expenses resulting from a new project to determine the effect of
taxes on the firm. Second, the deduction for depreciation reduces taxes.
Depreciation itself is not a cash flow, but depreciation reduces the taxes that
must be paid, shielding income from taxation. The tax shield from depreciation
is like a cash inflow.
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If the investment makes the firm’s production facilities more efficient, it may be
able to reduce the level of inventory. Because of an increase in the level of
transactions, the firm may want to keep more cash and inventory on hand. As
the level of operations increase, the effect of any fluctuations in demand for
goods and services may increase, requiring the firm to keep additional cash
and inventory “just in case.” The firm may also increase working capital as a
precaution because if there is greater variability of cash and inventory, a
greater safety cushion will be needed. On the other hand, if a project enables
the firm to be more efficient or lowers costs, it may lower its investment in
cash, marketable securities, or inventory, releasing funds for investment
elsewhere.
There are many ways of compiling the component cash flow changes to arrive
at the change in operating cash flow. We will start by first calculating taxable
income, making adjustments for changes in taxes, non cash expenses, and net
working capital to arrive at operating cash flow.
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Principles of cash flow estimation
Cash flows of a project have to be estimated for a time horizon. The time
horizon is the minimum of physical life of the plant, technological life of the
plant, or the product market life. There are a number of principles of cash flow
estimation. These are:
1. Separation principle,
2. Incremental principle.
3. Post-tax principle and
4. Consistency principle,
The separation principle holds that the project cash flows can be divided in
two types named as financing side and investment side. On the other hand, the
consistency principle says some kind consistency is necessary to be
maintained between the flow of cash in a project and the rates of discount that
are applicable on the cash flows. At the same time, there is the post-tax
principle that holds that the forecast of cash flows for any project should be
done through the after-tax method.
1. Separation principle
The Separation Principle is used to bring out the project cash flows of a
particular project. It is an important part of capital budgeting. Before starting a
new project, it is very important to estimate properly the inflow and outflow of
cash. There are several methods that are used to bring out the exact figure of
the project cash flow and Separation Principle is one of those methods.
The Separation Principle treats the cash flow in a different way. At first, the
project is divided in two parts. The first part deals with the investment side and
the later part is related to the financing side. To get proper picture of the
project cash flow, the cash flow is separated according to its relation with the
investment of financing side. There are several unique features of Separation
Principle. One of these features is that the cash flow related to the investment
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side of the project never considers the cost of financing. On the other hand,
these charges of financing are considered while the cash flow calculations
related to the financing side are done.
2. Incremental Principle
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expenditures that are done for the preliminary work related to the project,
unrecoverable in any case.
Overhead Cost: All the costs that are not related directly with a service
but have indirect influences are considered as overhead charges. There are
the legal and administrative expenses, rentals and many more. Whenever
a company takes a new project, these costs are assigned.
Working Capital: Proper estimation is essential and should be considered
at the time when the budget for the project's profit potential is prepared.
N.B: under incremental principle: In an existing company, the cash flows are to
be estimated by evaluating the cash flows of the company with the project and
without the project. The difference will be incremental cash flows related to the
project.
Post Tax Principle is one of the basic principles of cash flow estimation. This
is used to bring out the project cash flows with accuracy. After tax calculations
are suggested by the Post Tax Principle for the project cash flow.There are
some businesses that generally neglect the payment of tax while measuring the
cash flow of a project. Next, these businesses try to cover the fault by using the
discount rate. These discount rates are very hard to adjust and thus the after-
tax rate of discount and after-tax cash flows are used jointly.
There are some important issues that are related to the Post Tax Principle and
its application. These issues are the following:
Tax Rate: There are two different tax rates termed as the average tax rate
and the marginal tax rate. The average tax rate is considered as the entire
tax as a proposal of the overall earning from the business. On the other
hand, the marginal tax rate represents those taxes that are imposed on
the earnings at margin.
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The tax rates are often found as progressive and because of this, the
average tax rates are always lower than the marginal tax rate. The firms
run some particular projects and the income from these projects are
considered as marginal because this income is a kind of additional income
as the existing assets of the firm are the main source of income. Because
of this, the payable taxes on the project are estimated through the
marginal tax rate, as it is the most appropriate rate to do that.
Handling the Losses: The post tax principle holds that there remains
possibility of losses for both the firm as well as the particular project.
There are several ways of minimizing these losses. In certain situations,
the tax saving is postponed until the firm or the particular project makes
profit.
Non-Cash Charges: The post tax principle also holds that whenever the
tax liabilities are affected by the non-cash charges, the project cash flow
estimation will be affected. Depreciation is one of these non-cash charges.
N.B: under post tax principle: Tax impact on the cash flow is considered and
after tax cash flows are estimated.
4. Consistency Principle
Consistency Principle is one of the four major principles that are used for
estimating the project cash flows. According to this principle, consistency in
the cash flows is very necessary. At the same time, consistency in the
applicable discount rates on the cash flows should also be maintained. There
are two important factors that are related to the Consistency Principle. These
two are the investor group and the inflation.
Investor Group: The Consistency Principle holds that while estimating the
project cash flow, it is also important to consider the investor's opinion or view.
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There are different types of investors in a firm like the lenders or the
stockholders and so on. Again, if it is not possible to consider every kind of
investors' view, then the stockholder's view regarding the cash flow may be
considered.
According to the investor's standpoint, the project cash flow denotes that
amount of cash that is provided to the investors. The payable taxes must be
deducted from this amount and if there is any need for investment in the
ongoing project then that amount should also be deducted from the amount
allotted for the investors.
At the same time, if the stockholders standpoint is regarded then the project
cash flow is that amount that is offered to the stockholders. This amount
should not include any kind of payable tax or any such amount that is
necessary to invest in the particular project. Again, before offering any money
to the stockholders, the firm is required to clear all the debts.
Now, the next important factor is the consistency of the discount rate that is to
be applied on the project cash flow. There are two types of discount rate known
as the weighted average cost of capital and cost of equity.
Inflation: In case of inflation, there are two ways of estimating the project cash
flow of a particular project. The first option is to merge a likely inflation in the
project cash flow estimates. After this, a nominal discount rate is applied on
the amount. Another way of handling the inflation factor is to calculate the
project cash flows of the future in real terms with real discount rates.
N.B: under consistency principle: The inflation expectation built into estimation of
revenues and costs and cost of capital have to be consistent or same.
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Sunk costs
Working capital
Opportunity costs
Product cannibalization
(c) Cash flows should be estimated consistently
Similarly, the capital outlays associated with a new product are generally
obtained from the engineering and product development staffs, while operating
costs are estimated by cost accountants, production experts, personnel
specialists, purchasing agents, and so forth.
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decision at hand. Analysts often make errors in estimating cash flows, but two
cardinal rules can help you minimize mistakes:
1. Capital budgeting decisions must be based on cash flows, not accounting
income.
2. Only incremental cash flows are relevant.
Many things can lead to differences between net cash flows and net income.
First, depreciation is not a cash outlay, but it is deducted when net income is
calculated. Second, net income is based on the depreciation rate the firm’s
accountants decide to use, not necessarily on the depreciation rate allowed by
the IRS, and it is the IRS rate that determines cash flows. Moreover, if a project
requires an addition to working capital, this directly affects cash flows but not
net income. Other factors also differentiate net income from cash flow, but the
important thing to keep in mind is this: For capital budgeting purposes, the
project’s cash flows, not its accounting income, is the key item.
In theory, capital budgeting analyses should deal with cash flows exactly when
they occur; hence, daily cash flows theoretically would be better than annual
flows. However, it would be costly to estimate and analyze daily cash flows, and
they would probably be no more accurate than annual estimates because we
simply cannot accurately forecast at a daily level out 10 years or so into the
future. Therefore, we generally assume that all cash flows occur at the end of
the year.
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Note, though, for projects with highly predictable cash flows, it might be useful
to assume that cash flows occur at midyear (or even quarterly or monthly); but
for most purposes, we assume end-of-year flows.
Incremental Cash Flows is the difference between the cash flows of the firm
with the investment project and the cash flows of the firm without the
investment project both over the same period of time is referred to as the
project’s incremental cash flows.
Incremental cash flows are flows that will occur if and only if some specific
event occurs. In capital budgeting, the event is the firm’s acceptance of a
project and the project’s incremental cash flows are ones that occur as a result
of this decision. Cash flows such as investments in buildings, equipment, and
working capital needed for the project are obviously incremental, as are sales
revenues and operating costs associated with the project.
3. Replacement Projects
Two types of projects can be distinguished: expansion projects, where the firm
makes an investment, such as a new Home Depot store, and replacement
projects, where the firm replaces existing assets, generally to reduce costs.
Replacement analysis is complicated by the fact that almost all of the cash
flows are incremental, found by subtracting the new cost numbers from the old
numbers.
4. Sunk Costs
A sunk cost is an outlay that was incurred in the past and cannot be recovered
in the future regardless of whether the project under consideration is accepted.
In capital budgeting, we are concerned with future incremental cash flows we
want to know if the new investment will produce enough incremental cash flow
to justify the incremental investment. Because sunk costs were incurred in the
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past and cannot be recovered regardless of whether the project is accepted or
rejected, they are not relevant in the capital budgeting analysis.
Another issue relates to opportunity costs associated with assets the firm
already owns.
6. Externalities
Another potential problem involves externalities, which are defined as the
effects of a project on other parts of the firm or the environment. The three
types of externalities negative within-firm externalities, positive within-firm
externalities, and environmental externalities.
Estimating cash flows for capital projects is perhaps the most difficult part of
the investment screening and selection process. With regard to the process of
capital budgeting, most firms use some type of post completion auditing, yet
few firms have well developed, sophisticated systems for evaluating ongoing
projects.
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Implicit in cash flow forecasts are judgments pertaining to:
Competitors’ reactions to the investment.
Changes in the tax code.
The costs of materials and labor.
The time it takes to get the project underway
What is cash flow? Is it the total amount of cash flowing into the company
during a period? Is it the total amount of cash flowing out of the company
during a period? Is it the net of the cash inflows and outflows for a period?
Well, there is no specific definition of cash flow and that’s probably why there
is so much confusion regarding the measurement of cash flow. Ideally, the
analyst needs a measure of the company’s operating performance that is
comparable among companies something other than net income.
A simple, yet crude method of calculating cash flow requires simply adding
noncash expenses (e.g., depreciation and amortization) to the reported net
income amount to arrive at cash flow.
Estimated cash flow = Net income + depreciation and amortization
The problem with this measure is that it ignores the many other sources and
uses of cash during the period. Consider the sale of goods for credit. This
transaction generates sales for the period. Sales and the accompanying cost of
goods sold are reflected in the period’s net income and the estimated cash flow
amount. However, until the account receivable is collected, there is no cash
from this transaction. If collection does not occur until the next period, there is
a misalignment of the income and cash flow arising from this transaction.
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Therefore, the simple estimated cash flow ignores some cash flows that, for
many companies, are significant.
Additionally, EBITDA does not consider interest and taxes, which may also be
substantial cash outflows for some companies. These two rough estimates of
cash flows are used in practice not only for their simplicity, but because they
experienced widespread use prior to the disclosure of more detailed information
in the statement of cash flows. Currently, the measures of cash flow are wide-
ranging, including the simplistic cash flows measures, measures developed
from the statement of cash flows, and measures that seek to capture the
theoretical concept of “free cash flow.”
[
Cash flows without any adjustment may be misleading because they do not
reflect the cash outflows that are necessary for the future existence of a firm.
An alternative measure, free cash flow, was developed by Michael Jensen in his
theoretical analysis of agency costs and corporate Takeovers.
In theory, free cash flow is the cash flow left over after the company funds all
positive net present value projects. Positive net present value projects are
those projects (i.e., capital investments) for which the present value of expected
future cash flows exceeds the present value of project outlays, all discounted at
the cost of capital. In other words, free cash flow is the cash flow of the firm,
less capital expenditures necessary to stay in business (i.e., replacing facilities
as necessary) and grow at the expected rate (which requires increases in
working capital).
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