Financial Management

Estimation
of
Estimation of Cash Flow
Significance of Cash Flows and Cash Flow
Estimation
Show the conceptual difference between profit
and cash flow.
Incremental Cash Flows
Discuss the approach for calculating incremental
cash flows.
Highlight the interaction between financing and
investment decisions.
Significance of Cash Flows
To be consistent with wealth maximization
principle, an evaluation of a project must be
based on cash flows and not on accounting
profits
To be able to use NPV technique or any other
technique of capital budgeting analysis
successfully and accurately, we must have
an unbiased estimate of the expected future cash flows
of the project
including time to completion and estimate initial
investment/cost
extremely important and most difficult task
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.
Cash Flows Vs. Profit
CF (REV EXP DEP) DEP CAPEX
CF Profit DEP CAPEX
= +
= +
Incremental Cash Flows
Every investment involves a comparison of
alternatives:
When the incremental cash flows for an investment
are calculated by comparing with a hypothetical zero-
cash-flow project, we call them absolute cash flows.
The incremental cash flows found out by comparison
between two real alternatives can be called relative
cash flows.
The principle of incremental cash flows
assumes greater importance in the case of
replacement decisions.
Points of Consider
Sunk Costs
Opportunity Costs
Project Externalities
Change in Net Working Capital
Sunk Costs
Sunk CostsA cost that has already been
incurred and cannot be recovered
irrespective of the decision to accept or
reject the project.
R&D, Market Research, Consultants Fees
Is it relevant or irrelevant?
Opportunity Costs
Opportunity Costs--The cash flow foregone by
using your resources in a particular way.
Resources have multiple uses
You can use them in one way to the exclusion of
other uses and this gives rise to opportunity costs
By using your own building for your business,
you forego the rent that you could have earned by
renting it to some one else.
Is it relevant or irrelevant to decision making?
Project Externalities
Project Externalities--the effect of a new
project (positive or negative) on an existing
project or division of a firm.
For instance, introduction of a new model
of a car on other existing models produced
by the same firm.
Is it relevant or irrelevant to decision
making?
Net Working Capital
Change in Net Working Capital--Net
working capital is defined as current assets
minus current liabilities.
Investment in working capital is a cash
outflow during the year in which
investment takes place
Any investment in working capital is a
cash inflow during the last year of the
project and must be treated accordingly
Components of Cash Flows
Initial 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
Contd..
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 its
normal
Tax effect of salvage value
Release of Net Working Capital
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-line or
the written-down value basis.
For the tax purposes, depreciation is
computed on the written down value
(WDV) of the block of assets.
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 of depreciation
tax shield lost on (SV BV)
)
PVDTS BV SV
n n n
T d
k d
v

= v

+
|
Terminal Value for a New
Business
The terminal value included the salvage value of the asset
and the release of the working capital.
Managers make assumption of horizon period because
detailed calculations for a long period become quite
intricate. The financial analysis of such projects should
incorporate an estimate of the value of cash flows after
the horizon period without involving detailed
calculations.
A simple method of estimating the terminal value at the
end of the horizon period is to employ the following
formula, which is a variation of the dividendgrowth
model:
)
1
NCF 1
NCF
TV
n
n
n
g
k g k g
+
+
= =

Cash Flow Estimates for
Replacement Decisions
The initial investment of the new machine
will be reduced by the cash proceeds from
the sale of the existing machine:
The annual cash flows are found on
incremental basis.
The incremental cash proceeds from
salvage value is considered.
Additional Aspects of
Incremental Cash Flow Analysis
Allocated Overheads
Opportunity Costs of Resources
Incidental Effects
Contingent costs
Cannibalisation
Revenue enhancement
Sunk Costs
Tax Incentives
Investment allowance Until
Investment deposit scheme
Other tax incentives
Investment Decisions Under
Inflation
Executives generally estimate cash flows assuming unit costs and
selling price prevailing in year zero to remain unchanged. They argue
that if there is inflation, prices can be increased to cover increasing
costs; therefore, the impact on the projects profitability would be the
same if they assume rate of inflation to be zero.
This line of argument, although seems to be convincing, is fallacious
for two reasons.
First, the discount rate used for discounting cash flows is generally
expressed in nominal terms. It would be inappropriate and inconsistent
to use a nominal rate to discount constant cash flows.
Second, selling prices and costs show different degrees of
responsiveness to inflation:
The depreciation tax shield remains unaffected by inflation since
depreciation is allowed on the book value of an asset, irrespective of its
replacement or market price, for tax purposes.
Normal Vs. Real Rates of Return
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 discount
rate; or discount real cash flows at real discount rate.
Financing Effects in Investment
Evaluation
According to the conventional capital budgeting approach
cash flows should not be adjusted for the financing
effects.
The adjustment for the financing effect is made in the
discount rate. The firms weighted average cost of capital
(WACC) is used as the discount rate.
It is important to note that this approach of adjusting for
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 in the firms
target capital structure.