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DETERMINING CASH FLOWS FORINVESTMENT ANALYSIS

CHAPTE

R 10

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LEARNING OBJECTIVES

Show the conceptual difference between profit and

cash flow

Discuss the approach for calculating incremental

cash flows

Explain the treatment of inflation in capital

budgeting

Highlight the interaction between financing andinvestment decisions

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INTRODUCTION

Sound investment decisions should be based on thenet present value (NPV) rule.

Problems to be resolved in applying the NPV rule What should be discounted? In theory, the answer is:

We should always discount cash flows.

What rate should be used to discount cash flows? In

principle, the opportunity cost of capital should beused as the discount rate.

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CASH FLOWS VERSUS

PROFIT

Cash flow is not the same thing as profit, at least, fortwo reasons.

First, profit, as measured by an accountant, is based on accrualconcept.

Second, for computing profit, expenditures are arbitrarily dividedinto revenue and capital expenditures.

CAPEXDEPProfitCF

CAPEXDEP)DEPEXPREV(CF

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INCREMENTAL CASH FLOWS

Every investment involves a comparison of alternatives:

When the incremental cash flows for an investment arecalculated by comparing with a hypothetical zero-cash-flow

project, we call them absolute cash flows.

The incremental cash flows found out by comparisonbetween two real alternatives can be called relative cashflows.

The principle of incremental cash flows assumes greaterimportance in the case ofreplacement decisions.

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Example

Suppose a firm is considering replacing an equipment at bookvalue of Rs. 5000 and market value of Rs. 3000. New

equipment will require an initial cash outlay of Rs 10,000, and

is estimated to generate cash flows of Rs 8,000, Rs 7,000 and Rs

4,500 for the next 3 years. The book value of old machine is a sunk cost. Market value is

opportunity cost.

Thus, on an incremental basis the net cash outflow of new

equipment is: Rs 10,000 Rs 3,000 = Rs 7,000.Also, The differences of the cash flows of new equipment over

the cash flows of old equipment are incremental cash flows.

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COMPONENTS OF CASH

FLOWS

Initial Investment

Net Cash Flows

Depreciation and Taxes

Net Working Capital

Change in accounts receivable

Change in inventory Change in accounts payable

Free Cash F lows

Terminal Cash Flows

Salvage Value

Salvage value of the new asset

Salvage value of the exi sting asset now

Salvage value of the exi sting asset at the end of its normal

Tax eff ect of salvage value

Release of Net Working Capi tal

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Initial InvestmentInitial investment is the net cash outlay in the period

in which an asset is purchased.

A major element of the initial investment is gross

outlay or original value (OV) of the asset, whichcomprises of its cost (including accessories and spare

parts) and freight and installation charges.

Original value is included in the existing block of

assets for computing annual depreciation.

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Example of Initial Investment9

Wattle Extract Project: InitialInvestment

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Net Cash Flows

Consist of annual cash flows occurring from the operation of

an investment, but it is also be affected by changes in net

working capital and capital expenditures during the life of the

investment.

The computation of the after-tax cash flows requires a careful

treatment of non-cash expense items such as depreciation.Depreciation, calculated as per the income tax rules influences

cash flows indirectly by way of depreciation tax shield.

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Net cash flow Revenues Expenses Taxes

NCF REV EXP TAX

= - -

= - -

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Calculation of 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 couldcharge depreciation either on the straight-line or the written-down value basis.

No choice of depreciation method and rates for the taxpurposes is available to companies in India.

Depreciation is computed on the written down value of theblock of assets and rates are specified.

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Free Cash Flows

It is the cash flow available to service both lenders

and shareholders, who have provided, respectively,

debt and equity, funds to finance the firms

investments.It is this cash flow, which should be discounted to

find out an investments NPV.

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Terminal Cash Flow: Salvage

Value

Salvage value is a terminal cash flow.

Salvage value may be defined as the market price

of an investment at the time of its sale.

No immediate tax liability (or tax savings) arises on

the sale of an asset because the value of the asset

sold is adjusted in the depreciable base of assets.

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Effects of Salvage Value

Salvage value of the new asset: It will increase cash inflow

in the terminal (last) period of the new investment.

Salvage value of the existing asset now: It will reduce theinitial cash outlay of the new asset.

Salvage value of the existing asset at the end of its normal

life:It will reduce the cash flow of the new investment of inthe period in which the existing asset is sold.

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Release of Net Working

CapitalBesides salvage value, terminal cost flows will also

include the release of net working capital.

It is reasonable to assume that funds initially tied

up in net working capital at the time the investmentwas undertaken would be released in the last year

when the investment is terminated.

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DEPRECIATION FOR

TAX PURPOSES

Two most popular methods of charging depreciation are:

1. Straight-line and diminishing balance

2. Written-down value (WDV) methods

In India, depreciation is allowed as deduction every year on the

written-down value basis in respect of fixed assets as per the rates

prescribed in the Income Tax rules.

Depreciation is computed on the written down value of the blockof assets.

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Depreciation base

In the case of block of assets, the written down value iscalculated as follows:

The aggregate of the written down value of all assets in the

block at the beginning of the year

Plus the actual cost of any asset in the block acquired duringthe year

Minus the proceeds from the sale of any asset in the block

during the year

Thus, in a replacement decision, the depreciation base of a new

asset will be equal to: Cost of new equipment + Written down

value of old equipment Salvage value of old equipment

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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 ofdepreciation tax shield on (BV SV)

Salvage value > Book value:

After-tax salvage value = Salvage value - PV of depreciation

tax shield lost on (SV

BV)

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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 detailedcalculations for a long period become quite intricate. Thefinancial analysis of such projects should incorporate anestimate of the value of cash flows after the horizon periodwithout involving detailed calculations.

A simple method of estimating the terminal value at the end ofthe horizon period is to employ the following formula, which isa variation of the dividend growth model

gk

NCF

gk

g1NCFTV 1nnn

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Terminal Value of New

Business / New Products

New businesses have the potential of generating revenues and

cash flows much beyond the assumed period of analysis,

which is referred to as horizon period.

A simple method of estimating the terminal value at the end of

the horizon period is:

whereNCFn+1 is the projects net cash flow one year after thehorizon period, kis the opportunity cost of capital (discount rate)

andgis the expected growth in the projects net cash flows.

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( )1

NCF 1 NCFTV

n nn

g

k g k g

++

= =

- -

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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 incrementalbasis.

The incremental cash proceeds from salvage value

is considered.

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Additional Aspects of

Incremental Cash Flow Analysis

Allocated Overheads

Opportunity Costs of Resources

Incidental Effects

Contingent costs

Cannibalisation Revenue enhancement

Sunk Costs

Tax Incentives

I nvestment allowanceUntil I nvestment deposit scheme

Other tax incenti ves

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Investment Decisions Under

Inflation Executives generally estimate cash flows assuming unit costs and

selling price prevailing in year zero to remain unchanged. Theyargue that if there is inflation, prices can be increased to coverincreasing costs; therefore, the impact on the projects profitabilitywould be the same if they assume rate of inflation to be zero.

This line of argument, although seems to be convincing, isfallacious for two reasons.

First, the discount rate used for discounting cash flows is generallyexpressed in nominalterms. It would be inappropriate and inconsistentto 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 ofits replacement or market price, for tax purposes.

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Nominal VS. Real Rates of

Return For a correct analysis, two alternatives are available:

either the cash flows should be converted into nominal terms and thendiscounted at the nominal required rate of return, or

the discount rate should be converted into real terms and used to discount thereal cash flows

Important: Discount nominal cash f lows at nominal discount rate; ordiscount real cash f lows at real discount rate.

Example: If a firm expects a 10 per cent real rate of return from aninvestment project under consideration and the expected inflation rate is 7

per cent, the nominal required rate of return on the project would be:

(1.10)(1.07) 1 1.177 1 0.177 or 17.7%k= - = - =

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It would be inconsistent to discount the real cash flows of the project

by thenominal discount rate. For example, in case of following cash

flows discounting with 14% nominal rate of real cash flows returns

negative NPV:

The cash flows should be discounted with real discount rate as follows:

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1.141 0.0654

1.07K= - =

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Financing effects in Investment

Evaluation

According to the conventional capital budgeting approachcash 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) isused as the discount rate.

It is important to note that this approach of adjusting for thefinance 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 targetcapital structure.

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