CHAPTER 9

PROJECT CASH FLOWS

OUTLINE

   Elements of the cash flow stream

   Principles of cash flow estimation

   Cash flow illustrations

   Cash flows for a replacement project

   Viewing a project from different perspectives

   How financial institutions and Planning Commission define cash

flows

Biases in cash flow estimation

Elements of the Cash Flow Stream

• Initial Investment

• Operating Cash Inflows

• Terminal Cash Inflow

Time Horizon

• Physical Life of the Plant

• Technological Life of the Plant

• Product Market Life of the Plant

• Investment Planning Horizon of the Firm

Basic Principles of Cash Flow

Estimation

• Separation Principle

• Incremental Principle

• Post-tax Principle

• Consistency Principle

Separation Principle

Cash flows associated with the investment side and the financing Cash flows associated with the investment side and the financing

side of the project should be separated.side of the project should be separated.

While defining the cash flows on the investment side, financing While defining the cash flows on the investment side, financing

costs should not be considered because they will be reflected in the 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 cost of capital figure against which the rate of return figure will be

evaluated.evaluated.

Incremental Principle

To ascertain a project’s incremental cash flows you have to look at

what happens to the cash flows of the firm with the project and without

the project.

Guidelines

• Consider all incidental effects

• Ignore sunk costs

• Include opportunity costs

• Question the allocation of overhead costs

• Estimate working capital properly

Post-Tax Principle

Cash flows should be measured on a post-tax basisCash flows should be measured on a post-tax basis

The marginal tax rate of the firm is the relevant rate for The marginal tax rate of the firm is the relevant rate for estimating the tax liability of the firm.estimating the tax liability of the firm.

Treatment of Losses

Scenario Project Firm Action 1 Incurs losses Incurs losses Defer tax savings 2 Incurs losses Makes profits Take tax savings in

the year of loss 3 Makes profits Incurs losses Defer taxes until

the firm makes profits

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

Stand Incurs losses - Defer tax saving alone until the project

makes profits

Deferred Tax Liability (Asset) and MAT-1 Taxable income, determined according to IT regulations is generally different Taxable income, determined according to IT regulations is generally different

from accounting profit, determined according to generally accepted accounting from accounting profit, determined according to generally accepted accounting principles (GAAP).principles (GAAP).

The difference between the two may be permanent or temporary. A permanent The difference between the two may be permanent or temporary. A permanent difference is caused by an item which is included for calculating either taxable difference is caused by an item which is included for calculating either taxable income or accounting profit, but not both.income or accounting profit, but not both.

A temporary difference (also called timing difference) is caused by an item which A temporary difference (also called timing difference) is caused by an item which is included for calculating both taxable income and accounting profit, but in is included for calculating both taxable income and accounting profit, but in different periods.different periods.

Deferred tax liability (or asset) arises because of the temporary differences Deferred tax liability (or asset) arises because of the temporary differences between taxable income and accounting. A deferred tax liability (asset) is between taxable income and accounting. A deferred tax liability (asset) is recognised when the charge in financial statements is less (more) than the amount recognised when the charge in financial statements is less (more) than the amount allowed for tax purposes.allowed for tax purposes.

A deferred tax charge in the profit and loss account in a particular year does not A deferred tax charge in the profit and loss account in a particular year does not mean that there is a tax outflow in that year; likewise, a deferred tax benefit in the mean that there is a tax outflow in that year; likewise, a deferred tax benefit in the profit and loss account in a particular year does not mean that there is a tax profit and loss account in a particular year does not mean that there is a tax benefit in that year.benefit in that year.

Deferred Tax Liability (Asset) and MAT-2 Under the Income Tax Act, if a company has paid MAT, the difference between Under the Income Tax Act, if a company has paid MAT, the difference between

MAT and the income tax payable on the total income otherwise, called MAT MAT and the income tax payable on the total income otherwise, called MAT credit entitlement, can be availed of for seven years. This means, for example, if credit entitlement, can be availed of for seven years. This means, for example, if a company has a MAT credit entitlement of Rs. 10 million in year 1 and it has a a company has a MAT credit entitlement of Rs. 10 million in year 1 and it has a tax liability of Rs. 20 million in year 2, it will get a MAT credit of Rs. 10 million tax liability of Rs. 20 million in year 2, it will get a MAT credit of Rs. 10 million in year 2, thereby effectively reducing its tax outgo in a year 2 by Rs. 10 million.in year 2, thereby effectively reducing its tax outgo in a year 2 by Rs. 10 million.

Given the non-cash nature of deferred tax charge (or benefit) and MAT credit Given the non-cash nature of deferred tax charge (or benefit) and MAT credit entitlement, the post-tax cash flow is derived from profit after tax as follows:entitlement, the post-tax cash flow is derived from profit after tax as follows:

+ + - + + -

Remember that depreciation and amortisation and deferred tax charge are debits to Remember that depreciation and amortisation and deferred tax charge are debits to the profit and loss account without any corresponding cash outflow in the year. the profit and loss account without any corresponding cash outflow in the year. And, MAT credit entitlement is a credit to the profit and loss account without any And, MAT credit entitlement is a credit to the profit and loss account without any corresponding cash inflow in the year.corresponding cash inflow in the year.

Depreciation and amortisation

MAT credit entitlement

Deferred tax charge

Profit after tax

Consistency Principle

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

Investor Group

The consistency principle suggests the following match up:

Cash flow Discount rate

• Cash flow to all investors • Weighted average cost of capital• Cash flow to equity • Cost of equity shareholders

Inflation

The consistency principle suggests the following match up:

Cash flow Discount rate

Nominal cash flow Nominal discount rate Real cash flow Real discount rate

Project Cash Flows

(RS. IN MILLION)

0 1 2 3 4 5

A. FIXED ASSETS (80.00)

B. NET WORKING CAPITAL (20.00)

C. REVENUES 120 120 120 120 120

D. COST (OTHER THAN DEPR’N AND INT) 80 80 80 80 80

E. DEPRECIATION 20 15 11.25 8.44 6.33

F. PROFIT BEFORE TAX 20 25 28.75 31.56 33.67

G. TAX 6 7.5 8.63 9.47 10.10

H. PROFIT AFTER TAX 14.0 17.5 20.12 22.09 23.57

I. NET SALVAGE VALUE OF FIXED ASSETS 30.00

J. RECOVERY OF NET WORKING CAPITAL 20.00

K. INITIAL OUTLAY (100.00)

L. OPERATING CASH FLOW (H+E) 34.0 32.5 31.37 30.53 29.90

M. TERMINAL CASH FLOW (I+J) 50.0

N. NET CASH FLOW (K+L+M) (100.00) 34.0 32.5 31.37 30.53 79.90

BOOK VALUE OF INVESTMENT 100 80 65 53.75 45.31

Relevant Cash Flows for Replacement Projects

= -

= -

= -

The advantage of selling the old m/c.. has been considered.. The disadv.. too should be considered

Initial Investment

Operating Cash Inflows

Terminal Cash Flow

Initial Invest’t to acquire New Asset

Operating Cash Inflows From New

Asset

After-tax Cash Flows from Termination of

new Asset

After Tax Cash Inflows from

Liquid’n .. Old Asset

Operating Cash Inflows from Old

Asset

After-tax Cash Flows from Term’n of old

Asset

Cash Flows for the Replacement Project RS. IN ‘000

YEAR

0 1 2 3 4 5

I. INVESTMENT OUTLAY 1. COST OF NEW ASSET (1600) 2. SALVAGE VALUE OF OLD ASSET

500

3. INCREASE IN NET WORKING CAPITAL

(100)

4. TOTAL NET INVESTMENT (1 -2+3)

(1200)

II. OPERATING INFLOWS OVER THE PROJECT LIFE

5. AFTER - TAX SAVINGS IN MANUFACTURING COSTS

180 180 180 180 180

6. DEPRECIATION ON NEW MACHINE

400 300 225 168.8 126.6

7. DEPRECIA TION ON OLD MACHINE

100 75 56.3 42.2 31.6

8. INCREMENTAL DEPRECIATION (6 -7)

300 225 168.7 126.6 95

9. TAX SAVINGS ON INCREMENTAL DEPRECIATION ( 0.4 X 8)

120 90 67.5 50.6 38

10. NET OPERATING CASH INFLOW (5+9)

300 270 247.5 230.6 218

III. TERMINAL CASH INFLOW

11. NET TERMINAL VALUE

OF NEW MACHINE 800

12. NET TERMINAL VALUE OF OLD MACHINE

160

13. RECOVERY OF INCREMENTAL NET WORKING CAPITAL

100

14. TOTAL TERMINAL CASH INF LOW( 11 - 12+ 13)

740

IV. NET CASH FLOWS (4+10+14)

(1200) 30 270 247.5 230.6 958

Viewing a Project from other Perspectives

Now, a project can be viewed from four distinct points of view.

·   Equity point of view.·   Long-term funds point of view·   Explicit cost funds point of view·   Total funds point of view

In capital budgeting, the explicit cost funds point of view is commonly adopted – that is why our discussion so far defined cash flows from that point of view. However, one can adopt any other point of view as well. What is important is that the measures of cash flow and cost of capital must be consistent with the point of view adopted.

Financing Investment

Equity 70 Fixed assets 120

Long-term debt 75

Short-term debt 45 Current assets 100

Spontaneous 30 current liab.

220 220

Equity

70

Current liabilities

Long-term

funds 145Explicit

cost funds

190

Total

funds

220

Various Points of View

Cash Flows Relating to Equity

The equity-related cash flow stream reflects the contributions made and benefits receivable by equity shareholders. It may be divided into three components as follows :

Initial investmentInitial investment :: Equity funds committed to the projectEquity funds committed to the project

Operating cash flowsOperating cash flows :: Profit after tax – Preference dividend + Profit after tax – Preference dividend + Depreciation + Other non-cash chargesDepreciation + Other non-cash charges

Liquidation and retirement cash Liquidation and retirement cash flow (Terminal cash flow)flow (Terminal cash flow)

:: Net salvage value of fixed assets Net salvage value of fixed assets

++

Net salvage value of current assets Net salvage value of current assets

- -

Repayment of term loansRepayment of term loans

- -

Redemption of preference capital Redemption of preference capital

- -

Repayment of working capital advances Repayment of working capital advances

––

Retirement of trade credit and other duesRetirement of trade credit and other dues

Cash Flows Relating to Long-term Funds

As discussed earlier in this chapter, the cash flow stream relating to long-term funds

consists of three components as follows :

Initial investmentInitial investment :: Long-term funds invested in the project. This is equal to: Long-term funds invested in the project. This is equal to: fixed assets + working capital marginfixed assets + working capital margin

Operating cash inflowOperating cash inflow :: Profit after taxProfit after tax

++

DepreciationDepreciation

++

Other non-cash chargesOther non-cash charges

++

Interest on long-term borrowings (1-tax rate)Interest on long-term borrowings (1-tax rate)

Terminal cash flowTerminal cash flow :: Net salvage value of fixed assetsNet salvage value of fixed assets

++

Net recovery of working capital marginNet recovery of working capital margin

Cash Flows Relating to Total Funds

The cash flow stream relating to total funds consists of three components as follows:

Initial investmentInitial investment :: All the funds committed to the project. This is simply All the funds committed to the project. This is simply the total outlay on the project consisting of fixed assets the total outlay on the project consisting of fixed assets as well as current assets (gross)as well as current assets (gross)

Operating cash inflowOperating cash inflow :: Profit after taxProfit after tax

++

DepreciationDepreciation

++

Other non-cash chargesOther non-cash charges

++

Interest on long-term borrowings (1-tax rate)Interest on long-term borrowings (1-tax rate)

++

Interest on short-term borrowings (1-tax rate)Interest on short-term borrowings (1-tax rate)

Terminal cash flowTerminal cash flow :: Net salvage value of fixed assetsNet salvage value of fixed assets

++

Net salvage value of current assetsNet salvage value of current assets

How Financial Institutions Define Cash flows

In evaluating project proposals submitted to them, financial institutions define project cash flows as follows :

 

Cash outflows

 Capital expenditure on the project (net interest during construction)

+Outlays on working capital

 Cash inflows

 Operating inflow : Profit after tax

+ Depreciation + Interest and lease rental

 Terminal inflow : Recovery of working capital (at book

value) + Residual value of capital assets

(land at 100% and other capital assets at 5% on initial cost)

How the Planning Commission Defines

Costs and Benefits

11 A project may be viewed from the point of view of equity capital or long-A project may be viewed from the point of view of equity capital or long-term funds.term funds.

22 Cost and return (benefit) streams have been defined consistently with the Cost and return (benefit) streams have been defined consistently with the point of view adopted. Further, they are defined in pre-tax terms.point of view adopted. Further, they are defined in pre-tax terms.

33 A fairly long planning horizon is envisaged. This perhaps reflects the fact A fairly long planning horizon is envisaged. This perhaps reflects the fact that the projects considered by the Planning Commission, in general, have that the projects considered by the Planning Commission, in general, have a long economic life.a long economic life.

Biases in Cash Flow Estimation

Project executives often commit planning fallacy, implying that they display overoptimism which stems from the following:

• Native Optimism

• Attribution error

• Anchoring

• Myopic euphoria

• Competitor neglect

• Organisational pressure

• Stretch targets

Tempering the Optimism

The human tendency for optimism is inevitable. Likewise, organisational influences that promise optimism will persist. Yet, optimism needs to be tempered.

How can this be done? Dan Lovallo and Daniel Kahneman suggest that decision makers should use the outside view. This calls for looking at the outcomes of similar projects or initiatives and using that evidence to inject greater objectivity in forecasting exercise. Empirical evidence suggest that when people are asked to take the outside view, their forecasts become more objective and reliable.

The advantage of the outside view is most pronounced for initiatives which have not been attempted earlier such as entering a new market or building a plant using a new technology. Ironically, the inside view is often preferred in such a case. As Dan Lovallo and Daniel Kahneman put it: “Managers feel that if they don’t fully account for the intricacies of the proposed project, they would be derelict in their duties. Indeed, the preference for the inside view over the outside view can feel almost like a moral imperative.”

Understatement of Profitability

• There can be an opposite kind of bias relating to the terminal

benefit which may depress a project’s true profitability.

• Under-estimation of the terminal benefit of the project may be

due to the following reasons:

• Salvage values are under-estimated.

• Intangible benefits are ignored.

• The value of future options is overlooked.

SUMMARY Estimating cash flows - the investment outlays and the cash inflows after the Estimating cash flows - the investment outlays and the cash inflows after the

project is commissioned - is the most important, but also the most difficult step in project is commissioned - is the most important, but also the most difficult step in capital budgeting.capital budgeting.

Forecasting project cash flows involves many individuals and departments . The Forecasting project cash flows involves many individuals and departments . The role of the financial manager is to coordinate the efforts of various departments and role of the financial manager is to coordinate the efforts of various departments and obtain information from them, ensure that the forecasts are based on a set of obtain information from them, ensure that the forecasts are based on a set of consistent economic assumptions, keep the exercise focused on relevant consistent economic assumptions, keep the exercise focused on relevant variables, and minimise the biases inherent in cash flow forecasting. variables, and minimise the biases inherent in cash flow forecasting.

The cash flow stream of a conventional project – a project which involves cash The cash flow stream of a conventional project – a project which involves cash outflows followed by cash inflows – comprises of three basic components: (i) initial outflows followed by cash inflows – comprises of three basic components: (i) initial investment, (ii) operating cash inflows, and (iii) terminal cash inflow.investment, (ii) operating cash inflows, and (iii) terminal cash inflow.

The initial investment is the after-tax cash outlay on capital expenditure and net The initial investment is the after-tax cash outlay on capital expenditure and net working capital when the project is set up. The operating cash inflows are the after-working capital when the project is set up. The operating cash inflows are the after-tax cash inflows resulting from the operations of the project during its economic tax cash inflows resulting from the operations of the project during its economic life. The terminal cash inflow is the after-tax cash flow resulting from the life. The terminal cash inflow is the after-tax cash flow resulting from the liquidation of the project at the end of its economic life. liquidation of the project at the end of its economic life.

The time horizon for cash flow analysis is usually the minimum of the following: The time horizon for cash flow analysis is usually the minimum of the following: physical life of the plant, product market life of the plant, and investment planning physical life of the plant, product market life of the plant, and investment planning horizon of the firm.horizon of the firm.

The following principles should be followed while estimating the cash flows of a The following principles should be followed while estimating the cash flows of a project: separation principle, incremental principle, post-tax principle, and project: separation principle, incremental principle, post-tax principle, and consistency principle.consistency principle.

There are two sides of a project, viz., the investment (or asset) side and the There are two sides of a project, viz., the investment (or asset) side and the financing side. The separation principle says that the cash flows associated with financing side. The separation principle says that the cash flows associated with these sides should be separated. While estimating the cash flows on the investment these sides should be separated. While estimating the cash flows on the investment side do not consider financing charges like interest or dividend.side do not consider financing charges like interest or dividend.

The cash flow of a project must be measured in incremental terms. To ascertain a The cash flow of a project must be measured in incremental terms. To ascertain a project’s incremental cash flows you have to look at what happens to the firm project’s incremental cash flows you have to look at what happens to the firm withwith the project and the project and withoutwithout the project. The difference between the two reflects the the project. The difference between the two reflects the incremental cash flows attributable to the project. incremental cash flows attributable to the project.

In estimating the incremental cash flows of a project bear in mind the following In estimating the incremental cash flows of a project bear in mind the following guidelines: (i) Consider all incidental effects. (ii) Ignore sunk costs. (iii) Include guidelines: (i) Consider all incidental effects. (ii) Ignore sunk costs. (iii) Include opportunity costs. (iv) Question the allocation of overhead costs (v) Estimate opportunity costs. (iv) Question the allocation of overhead costs (v) Estimate working capital properly.working capital properly.

Cash flows should be measured on an after-tax basis. The important issues in Cash flows should be measured on an after-tax basis. The important issues in assessing the impact of taxes are: What tax rate should be used to assess tax assessing the impact of taxes are: What tax rate should be used to assess tax liability? How should losses be treated? What is the effect of non-cash charges ?liability? How should losses be treated? What is the effect of non-cash charges ?

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

The cash flow of a project may be estimated from the point of view of all investors 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 (equity shareholders as well as lenders) or from the point of view of just equity shareholders.shareholders.

In dealing with inflation, you have two choices. You can incorporate expected In dealing with inflation, you have two choices. You can incorporate expected inflation in the estimates of future cash flows and apply a nominal discount rate to inflation in the estimates of future cash flows and apply a nominal discount rate to the same. Alternatively, you can estimate the future cash flows in real terms and the same. Alternatively, you can estimate the future cash flows in real terms and apply a real discount rate to the same. apply a real discount rate to the same.

Estimating the relevant cash flows for a replacement project is somewhat Estimating the relevant cash flows for a replacement project is somewhat complicated because you have to determine the incremental cash outflows and complicated because you have to determine the incremental cash outflows and inflows in relation to the existing project. The three components of the cash flow inflows in relation to the existing project. The three components of the cash flow stream of a replacement project are: (i) initial investment (ii) operating cash stream of a replacement project are: (i) initial investment (ii) operating cash inflows, and (iii) terminal cash flow.inflows, and (iii) terminal cash flow.

Financial institutions look at projects from the point of view of all investors.Financial institutions look at projects from the point of view of all investors.

Generally, in capital budgeting we look at the cash flow to all investors (equity Generally, in capital budgeting we look at the cash flow to all investors (equity shareholders as well as lenders) and apply the weighted average cost of capital of shareholders as well as lenders) and apply the weighted average cost of capital of the firm. A project can, of course, be viewed from other points of view like the the firm. A project can, of course, be viewed from other points of view like the equity point of view, long-term funds point of view, and total funds point of view. equity point of view, long-term funds point of view, and total funds point of view. Obviously, the project cash flow definition will vary with the point of view Obviously, the project cash flow definition will vary with the point of view adopted. adopted.

The Planning Commission suggests that a project may be viewed from the point of The Planning Commission suggests that a project may be viewed from the point of view of equity capital or long-term funds.view of equity capital or long-term funds.

As cash flows have to go far into the future, errors in estimation are bound to occur. As cash flows have to go far into the future, errors in estimation are bound to occur. Yet, given the critical importance of cash flow forecasts in project evaluation, Yet, given the critical importance of cash flow forecasts in project evaluation, adequate care should be taken to guard against certain biases which may lead to adequate care should be taken to guard against certain biases which may lead to overstatement or under-statement of true project profitability.overstatement or under-statement of true project profitability.

Knowledgeable observers of capital budgeting believe that profitability is often Knowledgeable observers of capital budgeting believe that profitability is often over-stated because the initial investment is under-estimated and the operating cash over-stated because the initial investment is under-estimated and the operating cash inflows are exaggerated. The principal reasons for such optimistic bias are inflows are exaggerated. The principal reasons for such optimistic bias are intentional overstatement, lack of experience, myopic euphoria, and capital intentional overstatement, lack of experience, myopic euphoria, and capital rationing. rationing.

Terminal benefits of a project are likely to be under-estimated because salvage Terminal benefits of a project are likely to be under-estimated because salvage values are under-estimated, intangible benefits are ignored, and the value of future values are under-estimated, intangible benefits are ignored, and the value of future options is overlooked. options is overlooked.