1 part iv: capital budgeting 4.2. estimation of project cash flows

1

Part IV: CAPITAL BUDGETINGPart IV: CAPITAL BUDGETING

4.2. Estimation of Project Cash Flows

2

4.2.1 Project Cash Flows4.2.1 Project Cash Flows

The effect of taking a project is to change the firm’s overall cash flows today and in the future.

To evaluate a proposed investment, we must consider these changes in the firm’s cash flows and then decide whether or not, they add value to the firm.

The first and most important step, therefore is to decide:

WHICH CASH FLOWS ARE RELEVANT ?

3

Relevant Cash FlowsRelevant Cash Flows

The relevant cash flow for a project is a change in the firm’s overall future cash flow that comes about as a direct consequence of the decision to take that project.

Hence, the relevant cash flow is INCREMENTAL CASH FLOW.

The incremental cash flows for project evaluation consists of any and all changes in the firm’s future cash flows that are a direct consequence of taking the project.

Any cash flow that exists regardless of whether or not a project is undertaken is not relevant.

4

4.2.2 Basic Principles of the 4.2.2 Basic Principles of the Cash Flow Cash Flow EstimationEstimation

1. Stand Alone Principle2. Separation Principle3. Incremental Principle4. Post-Tax Principle5. Consistency Principle.

5

1. Stand Alone Principle1. Stand Alone Principle

• Once we identify the effect of undertaking the proposed project on the firm’s cash flows, we need only focus on the project’s resulting incremental cash flows.

• Once we have determined the incremental cash flows from undertaking a project, we can view that project as a kind of “minifirm” with its own future revenues and costs, its own assets, and, of course, its own cash flows.

• Then compare the cash flows from this minifirm to the cost of acquiring it.

• We will be evaluating the proposed project purely on its own merits, in isolation from any other activities and projects.

6

2. Separation Principle 2. Separation Principle

There are two sides of a project, viz, the investment (or assets) side and the financing side.

Cash flows associated with these sides should be separated.

Suppose a firm is considering a one-year project that requires an investment of Rs 1,000 in fixed assets and working capital at time 0. The project is expected to generate a cash inflow of Rs 1,200 at the end of year 1 and this is the only cash inflow expected from the project. The project will be financed entirely by debt carrying an interest rate of 15 % and maturing after a year. Assume there are no taxes.

7

Separation Principle Separation Principle (contd…)(contd…)

Project

Financing Side Investment Side

Time Cash Flow

0 + 1,000 1 - 1,150

Cost of Capital:15 %

Time Cash Flow

0 - 1,000 1 + 1,200

Rate of Return: 20 %

8


The cost of capital is used as the hurdle rate against which the rate of return on the investment side (which is 20 % in our case) is judged.

While defining the cash flows on the investment side, financing costs should not be considered because, they will be reflected in the cost of capital figure against which the rate of return figure will be evaluated.

Operationally, this means that interest on debt is ignored while computing profits and taxes thereon.

9


If interest is deducted in the process of arriving at profit after tax, an amount equal to Interest (1-tax rate) should be added to PAT.

PBIT (1- T) = (PBT + I) (1-T) = PBT (1-T) + I (1-T) = PAT + I (1-T)

Whether the tax rate is applied directly to the PBIT figure or whether the tax-adjusted interest is added to the PAT figure, we get the same result.

Tax-Adjusted Interest

10

3. Incremental Principle 3. Incremental Principle (4.2.3)(4.2.3)

The cash flow of the project must be measured in incremental terms.

= - Project Cash flow

for the year t

Cash flow for the firm with

the project for

year t

Cash flow for the firm

without the project for the

year t

11

Guidelines to estimate incremental Guidelines to estimate incremental cash flowcash flowa) Consider all Incidental Effects : Take into account the effect on profitability of the

existing activities of the firm because of the complementary or competitive relationship between the project and the existing activities of the firm.

For example: Issue of Product Cannibalization.• The loss of profit resulting from the product cannibalization

may be treated as a negative incremental effect of the new product.

• This may however lead to the possibility of rejecting the new project.

• What if competitor march on the firm by introducing that product ?

• How the loss of sales on account of product cannibalization is treated will depend on whether or not a competitor is likely to introduce a close substitute to the new product that is being considered by the firm.

12

Guidelines (contd….)Guidelines (contd….)

If the firm is operating in an extremely competitive business and is not protected by entry barriers, product cannibalization will occur anyway.

Hence the cost associated with it are not relevant in incremental analysis.

If the firm is sheltered by entry barriers like patent protection or proprietary technology or brand loyalty, the costs of product cannibalization should be incorporated in investment analysis.

13


b) Ignore Sunk Costs

Sunk cost refers to an outlay already incurred in the past or already committed irrevocably.

So it is not affected by the acceptance or rejection of the project under consideration, and hence is irrelevant.

A company is debating whether it should invest in a project. The company has already spent Rs 1 million for preliminary work meant to generate information useful for this decision. Is this 1 million a relevant cost for the proposed project ?

BYGONES ARE BYGONES

14


c) Include Opportunity Cost:

The value of most valuable alternative that is given up if a particular investment is undertaken – Opportunity Cost

This is the cost created for the rest of the firm as a consequence of undertaking the project.

Example:If a project uses resources already available with the firm, there’s a potential for an opportunity cost. Is there any alternative use of the resource is the project is not undertaken ?

TANSTAFFL

“There ain’t no such thing as a

free lunch”

15

Guidelines (contd….)Guidelines (contd….) If a project uses a vacant factory building

owned by the firm, the revenue that can be derived from renting out this building represents the opportunity cost.

If a project uses an equipment which is currently idle, its opportunity cost is its sales price, net of any tax liability.

If a project requires the services of some experienced engineers from an existing division of the firm, the cost that is borne by that division to replace those engineers represents the opportunity cost.

16


What happens when a project uses a resource that has no current alternative use, but some potential alternative use ?Example: Excess Capacity on Some Machine AND Using that excess capacity for a new product

Case I: May exhaust capacity much earlier than otherwise and hence may call for creating new capacity earlier rather than later Opportunity cost = PV of creating capacity earlier – PV or creating capacity later.

Case II: May reduce the output of some products in future.Opportunity Cost = Loss in cash flows that would have otherwise been generated by the sales of those products.

17


d) Question the allocation of Overhead Costs

Overhead Costs: Costs which are indirectly related to a product (or service)

Eg: General Admin Expenses, Managerial Salaries, Legal Expenses, Rent etc.

They are allocated to various products on some basis like labor hrs, machine hrs, prime cost etc.

They are allocated to the new project too. But for the purpose of investment analysis, what

matters is the incremental overhead costs attributable to the project and not the allocated overhead costs.

18


d) Estimate Working Capital Properly

Project will require that the firm invest in net working capital in addition to long-term assets.

Outlays on working capital has to be properly considered while forecasting the project cash flows.

Its is NWC which is relevant The requirement of WC is likely to change over time. WC are not subject to depreciation. Thus the WC at the end of the project life is assumed

to have a salvage value equal to its BV.

19

4. Post-Tax Principle4. Post-Tax Principle

Cash flows should be measured on an after-tax basis

Issues:

1. What tax rate should be used to assess tax liability ?

2. How should losses be treated ?3. What is the effect of non-cash charges ?

20

Relevant Tax RateRelevant Tax Rate

The income from a project typically is marginal.

It is additional to the income generated by the assets of the firm already in place.

Hence,

MARGINAL TAX RATE OF THE FIRM IS THE RELEVANT RATE FOR ESTIMATING TAX

LIABILITY OF THE PROJECT.

21

Treatment of LossesTreatment of Losses

Scenario Project Firm Action1 Incurs Losses Incurs

LossesDefer tax savings

2 Incurs Losses Makes Profit Take tax savings in the year of loss

3 Makes Profit Incurs Losses

Defer taxes until the firm makes profit

4 Makes Profit Makes Profit Consider taxes in the year of profit

Stand Alone Incurs Losses - Defer tax savings until the project makes

profit

22

Effect of Non-cash ChargesEffect of Non-cash Charges

Non-cash charges can have an impact on cash flows if they affect the tax liability.

The most important of such non-cash charges is depreciation.

The tax benefit of depreciation is:

Depreciation x Marginal Tax Rate

23

5. Consistency Principle5. Consistency Principle

Cash flows and the discount rates applied to these cash flows must be consistent with respect to the investor group and inflation.

Investors’ Group: The cash flow of a project may be estimated from

the point of view of all investors (equity shareholders as well as lenders) or from the point of view of just equity shareholders.

24

Consistency Principle Consistency Principle (contd…)(contd…)

The cash flow of a project from the point of view of all investors is the cash flow available to all investors after paying taxes and meeting investing needs of the project, if any.

Cash flows to all investors = PBIT (1-T) + Depreciation - Capital Expenditure - Change in NWC

25


The cash flow of a project from the point of view of equity shareholders is the cash flow available to equity shareholders after paying taxes, meeting investment needs, and fulfilling debt-related commitments.

Cash flows to equity shareholders = PBIT (1-T)+ Depreciation- Preference Dividend - Capital Expenditures- Change in NWC- Repayment of Debt+ Proceeds from debt issues- Redemption of preference capital+ Proceeds from preference issue

26


The discount rate must also be consistent with the definition of cash flow

Cash Flow Discount RateTo all investors Weighted Average Cost of

CapitalCash flow to equity Cost of Equity

27


Inflation:

Either incorporate expected inflation in the estimates of future cash flows and apply a nominal discount rate to the same.

Or estimate future cash flows in real terms and apply a real discount rate to the same

Nominal Cash flowt = Real Cash flow (1+ Expected inflation rate)t

Nominal Discount rate = (1+ Real discount rate)(1+Expected inflation rate) - 1

28

Elements of the Cash Flow Elements of the Cash Flow StreamStream

The cash flow stream of a conventional project – a project which involves cash outflows followed by cash inflows – comprises of three basic components:

1. Initial Investment – After tax cash outlay2. Operating Cash Inflows – After tax cash inflows

resulting from the operations of the project during its economic life

3. Terminal Cash Flow- After tax cash flow resulting from the liquidation of the project at the end of its economic life.

29

4.2.4: Pro-Forma Financial 4.2.4: Pro-Forma Financial Statements and Project Cash FlowsStatements and Project Cash FlowsIllustration:Illustration: Suppose we think we can sell 50,000 units of a new product per

year at a price of $ 4 per can. It costs us about $ 2.50 per can to make the product, and a new

product such as this one typically has only a 3 year life We require 20 % return on new products. Fixed costs for the project, including such things as rent on the

production facility, will run $ 12,000 per year. We will need to invest a total of $ 90,000 in manufacturing

equipment. This $ 90,000 will be depreciated over the 3 year life of the

project. The cost of removing the equipment will roughly equal its actual

value in 3 years, so it will be essentially worthless on a market value basis as well.

The project will require an initial $ 20,000 investment in net working capital, and the tax rate is 34 %.

30

Illustration (contd…)Illustration (contd…)

Projected Income Statement

Sales (50,000 units at $ 4/ unit)

$ 200,000

Variable costs ($ 2.50/ unit) 125,000

$ 75,000

Fixed costs 12,000

Depreciation ($ 90,000/ 3) 30,000

EBIT $ 33,000

Taxes (34 %) 11,220

Net income $ 21,780

Notice that we have not deducted any interest expenses

31


Projected Capital Requirements

Year

0 1 2 3

NWC 20,000 20,000 20,000 20,000

Net fixed assets 90,000 60,000 30,000 0

Total Investment 110,000 80,000 50,000 20,000

32


Project Cash Flow = Project Operating Cash Flow

– Change in net working capital – Project capital spending

Project Operating Cash flow = EBIT + Depreciation – Taxes

EBIT 33,000

Depreciation + 30,000

Taxes @ 34 % - 11,220

Operating Cash Flow

$ 51, 780

33


Projected Total Cash Flows

Year

0 1 2 3

Operating Cash Flow

51,780 51,780 51,780

Changes in NWC - 20,000 + 20,000

Capital Spending - 90,000

Total Project Cash Flow

- 110,000 51,780 51,780 71,780

34


NPV of the project is positive, and creates over $ 10,000 in value and should be accepted.

Return on this investment obviously exceeds 20 % (because NPV is positive at 20 %)

We can find out that IRR works out to be 25.8 % > 20 %

Payback period is about 2.1 years ( ? ) ARR comes out to be 33.51 % ( 21,780 / 65,000)

10,648 $20.1

780,71

20.1

780,51

20.1

780,51000,110NPV

32

35

Cash flows for a replacement Cash flows for a replacement projectproject

Initial Investment

Cost of the new assets

+ NWC required for

the new assets

After tax Salvage Value realized from

the old assets+

NWC required for the old assets

= -

Operating Cash FlowOperating Cash

inflows from the newassets

Operating Cashinflows from the old

assets

= -

Terminal Cash FlowAfter tax SV of the

new assets +

Recovery of NWCAssociated with new

assets

After tax SV of the old assets

+Recovery of NWC

Associated with oldassets

=

-

36

Illustration 1 – Cash Illustration 1 – Cash EnterprisesEnterprises

Cash 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 80 million on the 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 of preference capital, and Rs 50 million of debt capital. Preference capital will carry a dividend rate of 15 %; debt capital will carry an interest rate of 15 %.

37

Cash Enterprises (contd…)Cash Enterprises (contd…)

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 costs other than depreciation, interest and tax). The effective tax rate will be 30 %.

38

Cash Enterprises (contd…)Cash Enterprises (contd…)

Plant and machinery will be depreciated at the rate of 25 % per year as per the written down value method. Hence, the depreciation charges will be:

First year : Rs 20.00 millionSecond year : Rs 15.00 millionThird year : Rs 11.25 millionFourth year : Rs 8.44 millionFifth year : Rs 6.33 million

39

Illustration 2 – Pharma Illustration 2 – Pharma LimitedLimited

Pharma Ltd is engaged in the manufacture of pharmaceuticals. The company was established in 1991 and has registered a steady growth in sales since then. Presently, the company manufactures 16 products and has an annual turnover of Rs 2200 million. The company is considering the manufacture of a new antibiotic preparation, K-cin, for which the following information has been gathered.

40

Pharma Limited (contd…)Pharma Limited (contd…)

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 (in million Rs)1 1002 1503 2004 1505 100

41


The capital equipment required for manufacturing K-cin is Rs 100 million and it will be depreciated at the rate of 25 % per year as per the WDV method for tax purposes. The expected net salvage value after 5 years is Rs 20 million.

The working capital requirement for the project is expected to be 20 % of sales. At the end of 5 years, 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.

42


The accountant of the firm has provided the following cost estimates for K-cin:

Raw material cost : 30 % of sales

Variable labor cost : 20 % of sales

Fixed annual operating and maintenance cost : Rs 5 million

Overhead allocation (excluding depreciation,

Maintenance and interest ) : 10 % of sales

While the project is charged on an overhead allocation, it is not likely to have any effect on overhead expenses as such

43


The manufacturer 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 40 %.

44

Illustration 3 (Ojus Illustration 3 (Ojus Enterprises)Enterprises)

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 of Rs 500, 000. It has a remaining life of 5 years after which its net salvage value is expected to be Rs 160,000. It is being depreciated annually at a rate of 25 % under the WDV method. The working capital required for the old machine is Rs 400,000.

45

Ojus Enterprises (contd…)Ojus Enterprises (contd…)

The new machine costs Rs 1,600,000. It is expected to fetch a net salvage of Rs 800,000 after 5 years when it will no longer be required. The depreciation rate applicable to it is 25 % 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 300,000 annually in manufacturing costs (other than depreciation). The tax rate applicable to the firm is 40 %.

46

Ojus Enterprises (contd…)Ojus Enterprises (contd…)

1 part iv: capital budgeting 4.2. estimation of project cash flows

Documents

firms cash flows

relevant cash flows

incremental cash flows

firms future cash flows

time cash flow

firms overall cash flows

cash flow estimation

proposed project