ESTIMATION OF PROJECT CASH FLOWS

OUTLINE

• Elements of the Cash Flow Stream

• Principles of Cash Flow Estimation

• Cash Flows for a Replacement Project

• Biases in Cash Flow Estimation

INTRODUCTION

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 capital budgeting.

Forecasting project cash flows involves numerous variables and many participate in this exercise. Capital outlays are estimated by engineering and product development departments; revenue projections are provided by the marketing group; and operating costs are estimated by production people, cost accountants, purchase managers, personnel executives, tax experts and others.

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

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ELEMENTS OF THE CASH FLOW STREAM

To evaluate a project you must determine the relevant cash flows ,which are the

incremental after-tax cash flows associated with the project.

The cash flow stream of a conventional project-a project which involves cash outflowsfollowed by cash inflows-comprises three basic components:

• Initial Investment - The initial investment is the after-tax cash outlay on capital expenditure and net , working capital when the project is set up.

• Operating Cash Inflows - The operating cash inflows are the after taxcash inflows resulting from the operations of the project during its economic life.

• Terminal Cash Inflow – The terminal cash inflow is the after-tax cash flow resulting from the liquidation of the project at the end of its economic life.

ELEMENTS OF THE CASH FLOW STREAM

Exhibit 12.1 depicts on a time line the cash flows for an illustrative project, with each ofthe cash flow components labeled.

Time Horizon for AnalysisMinimum of the following • Physical Life of the Plant - This refers to the period during which the plant remains in a physically usable condition, i.e., the number of years the plant would perform the function for which it had been acquired.

• Technological Life of the Plant - The technological life of a plant refers to the period of time for which the present plant would not be rendered obsolete by a new plant.

• Product Market Life of the Plant - The product market life of a plant refers to the period for which the product of the plant enjoys a reasonably satisfactory market.

• Investment Planning Horizon of the Firm - The time period for which a firm wishes to look ahead for purposes of investment analysis may be referred to as its investment planning horizon. It naturally tends to vary with the complexity and size of the investment.

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 side of the

project should be separated.

• 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. Alternatively, 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 'Profit after tax'. Note that:

INCREMENTAL PRINCIPLETo 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

1. Consider all incidental effects - Product cannibalization(launching a product which can take a share of the existing product)

competitive business – Not relevant in Incremental analysismonopoly business – relevant(means If I introduce this thing then what will be the impact on percentage of sales of my existing products ) in Incremental analysis

2. Ignore sunk costs(not relavent to what I make the decision) - A sunk cost refers to an outlay already incurred in the past or already committed irrevocably(forever).

3. Include opportunity costs - The opportunity cost of a resource is the benefit that can be derived from it by putting it to its best alternative use.The resource may be rented out. In this case the opportunity cost is the rental revenue foregone by undertaking the project

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INCREMENTAL PRINCIPLEThe resource may be sold. In this case the opportunity cost is the value realized from the sale of the resource after paying taxes.

The resource is required elsewhere in the firm. In this case the cost of replacing the resource represents its opportunity cost.

4. Question the allocation of overhead costs - For purposes of investment analysis, what matters is the incremental overhead costs (along with other incremental costs) attributable to the project and not the allocated overhead costs.

5. Estimate net working capital properly –When the project is set up, there is an initial investment in working capital. This tends to change over time as the output of the project changes

While fixed asset investments are made during the early years of the project and depreciated over time, working capital is renewed periodically and hence is not subject to depreciation. Thus the working capital at the end of the project life is assumed to have a salvage value equal to its book value.

POST-TAX PRINCIPLECash flows should be measured on an after-tax basis. Some firms may ignore tax paymentsand try to compensate this mistake by discounting the pre-tax cash flows at a rate that is higher than the cost of capital of the firm. You should always use after-tax cash flows along with after-tax discount rate. Cash flows should be measured after taxes.

The important issues in assessing the impact of taxes are

1 Tax Rate: The average tax rate is the total tax burden as a proportion of the total income of the business. The marginal tax rate (tax applicable to the respective project)is the tax rate applicable to the income at margin- the next rupee of income. The marginal tax rate is typically higher than the average tax rate because of various tax incentives.

The income from a project typically is marginal. Put differently, it is additional to theincome generated by the assets of the firm already in place. Hence, the marginal tax rate ofthe firm is the relevant rate for estimating the tax liability of the project.

Imp:-Tax rate consider the marginal tax rate (tax which will be due to the project) if given and not the existing tax rate

POST-TAX PRINCIPLE

2. Treatment of Losses:

3 Effect of Noncash Charges: Noncash charges can have an impact on cash flows if they affect the tax liability. The most important of such noncash charges is depreciation. The tax benefit of depreciation is:

Depreciation * Marginal Tax Rate30 * 30%of 100 = 9

EBIT&D 100 100Dep 30 0PBT 70 10030%Tax 21------30-21=9---------------------30PAT 49 70

(With dep we are saving Rs 9 which Is not given in TAX so it is kind of inflow to the business)

CONSISTENCY PRINCIPLE (means If cash flow i.e numerator belongs to Debt & Equitythen ”r“ i.e denominator should also belong to Debt & Equity)

Cash flows and discount rates applied to these cash flows must be consistent with respect to the investor group and inflation1. Investor Group : 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 investment needs of the project, if any. It is estimated as follows:Cash flows to all investors = PBIT (1 - tax rate) + Depreciation and noncash charges

- Capital expenditure - Change in working capital

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. It is estimated as follows: Cash flow to equity shareholders = Profit after tax + Depreciation & noncash charges

- Preference dividend- Capital expenditures- Change in working capital

- Repayment of debt+ Proceeds from debt issues -Redemption of preference capital+ Proceeds from preference issue - Redemption of equity share capital+ Proceeds from equity share issue

CONSISTENCY PRINCIPLEThe discount rate must be consistent with the definition of cash flow:

Cash Flow Discount RateCash flow to all investors Weighted Average cost of capital Cash flow to Equity shareholders Cost of Equity

Generally, in capital budgeting we look at the cash flow to all investors and apply theweighted average cost of capital of the firm.

2. Inflation : (Given in IM Pandey in detail) 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 the same. Alternatively, you can estimate the future cash flows in real terms and apply a real discount rate to the same.

Note that the following relationship holds between nominal and real values:The consistency principle, in essence, suggests the following match up: Cash Flow Discount Rate

Nominal cash flow Nominal discount rateReal cash flow Real discount rate

Generally, in capital budgeting analysis nominal cash flows are estimated and thenominal discount rate is used.

CASH FLOW ILLUSTRATIONSIllustration I Naveen 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 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 percent; debt capital will carry an interest rate of 15 percent.• 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 cost other than depreciation, interest, and tax.) The effective tax rate will be 30%.• Plant and machinery will be depreciated at the rate of 25 percent 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 millionDetermine the project cash flows Ans:EXCEL SHEET – EXHIBIT 12.2

Illustration 2 :India 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. 2200million. The company is considering the manufacture of a new antibiotic preparation,K-cin, for which the following information has been gathered.

1.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(Rs in Million) 1 100 2 150 3 200 4 150 5 100

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

3. The working capital requirement for the project is expected to be 20 percent of sales.At the end of 5 years, working capital is expected to be liquidated at par, barring anestimated loss of Rs. 5 million on account of bad debt. The bad debt loss will be a tax deductibleexpense.

4.The accountant of the firm has provided the following cost estimates for K-cin:Raw material cost 30 percent of salesVariable labour cost 20 percent of sales

Fixed annual operating and maintenance cost Rs. 5 millionOverhead allocation (excluding depreciation,maintenance, and interest) : 10 percent of salesWhile the project is charged an overhead allocation, it is not likely to have any effect on overhead expenses as such.

5. The manufacture 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.

6. The tax rate applicable to the firm is 40 percent.Answer : Explanation on few pointsThe loss of contribution (item 7) is an opportunity cost.Overhead expenses allocated to the project have been ignored as they do not represent incremental overhead expenses for the firm as a whole.It is assumed that the level of working capital is adjusted at the beginning of the year in relation to the expected sales for the year. For example, working capital at the beginning of year 1 (i.e. at the end of year 0) will be Rs. 20 million that is 20 percent of the expected revenues of Rs. 100 million for year 1. Likewise, the level of working capital at the end of year 1 (i.e. at the beginning of year 2) will be Rs. 30 million that is 20 percent of the expected revenues of Rs. 150 million for year 2. EXCEL SHEET – EXHIBIT 12.3

RELEVANT CASH FLOWS FOR REPLACEMENT DECISIONS

Estimating the relevant cash flows for a replacement project is somewhat 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 stream of a replacement project are determined as follows:

A question often asked is: Once we have assumed that the old asset is replaced, why should we consider the operating cash inflows and terminal cash flow subsequently?

The answer is: If you consider the advantage derived from liquidating the old asset, you should also consider the disadvantage suffered by not having the asset in the future.

CASH FLOWS FOR THE REPLACEMENT PROJECT

ILLUSTRATION: 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 five years after which its net salvage value is expected to be Rs. 160,000. It is being depreciated annually at a rate of 25 percent under the written down value method. The working capital required for the old machine is Rs. 400,000.

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 percent 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 percent.

EXCEL SHEET EXIBIT 12.4

BIASES IN CASH FLOW ESTIMATION

• OVERSTATEMENT• INTENTIONAL OVERSTATEMENT• LACK OF EXPERIENCE• MYOPIC EUPHORIA• CAPITAL RATIONING

• UNDERSTATEMENT• SALVAGE VALUES ARE UNDER-ESTIMATED• INTANGIBLE BENEFITS ARE IGNORED• VALUE OF FUTURE OPTIONS IS IGNORED

SOLVED PROBLEM 12.1Mr. Rao Finance director of Modern Synthetics limited called Mr.Diwan ,Manager Management services division of the company to explore ways and means of improving the Management Information System in the company. On the basis of their discussion it became obvious that the company needed a computer system for processing efficiently and accurately the growing volume of information generated the business. It was felt that the computer system would also facilitate the timely preparation of control reports needed by the management.

Mr. Rao asked Mr. Diwan to find out which computer system would be suitable for the needs of the company and estimate the costs and benefits expected from it. Mr. Diwan talked to the representatives of a few computer manufacturing companies. On the basis of his discussion with them, he felt that the Alpha 111 system supplied by Computronics Limited was quite suitable for the needs of Modern Syntex Limited. He estimated the costs and benefits associated with this system as follows:Cost of the computer along with accessories Rs. 1.5 millionOperation and maintenance cost Rs. 0.25 million per annumSavings in clerical cost Rs. 0.6 million per annumSavings in space cost Rs. 0.1 million per annum

The computer would have an economic life of five years and it would be depreciated at the rate of 33.33 percent per year as per the written down value method. After five years, it would be disposed of for a value equal to its book value. The tax rate is 50% On examining the above information, Mr. Gupta asked Mr. Diwan to prepare projected cash flows of the capital budgeting proposal for submission to the Executive Committee of the company. EXCEL SHEET 12.1

SOLVED PROBLEM 12.2

Metcalf Engineers is considering a proposal to replace one of its hammers. The following information is available.

(a) The existing hammer was bought 2 years ago for Rs. 1 million. It has been depreciatedat the rate of 33.33percent per annum. It can be presently sold at its book value. It has a remaining life of 5 years after which, disposal, it would fetch a value equal to its then book value.

(b) The new hammer costs Rs. 1.6 million. It will be subject to a depreciation rate of33.33 per cent. After 5 years it is expected to fetch a value equal to its book value.The replacement of the old hammer would increase revenues by Rs. 0.2 million per year and reduce operating cost (excluding depreciation) by Rs. 150,000 per year. Compute the incremental post-tax cash flows associated with the replacement proposal, assuming a tax rate of 50 percent. EXCEL SHEET 12.2

SUMMING UP

• The cash flow stream of a project comprises of three components : initial investment, operating cash inflows, and terminal cash inflow

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

• Adequate care should be taken to guard against certain biases which may lead to over-statement or under- statement of true project profitability

UNSOLVED PROBLEMS 12.1Futura Limited is considering a capital project about which the following informationis available.The investment outlay on the project will be Rs. 200 million. This consists of Rs. 150 million on plant and machinery and Rs. 50 million on net working capital. The entire outlay will be incurred in the beginning.

The life of project is expected to be 7 year. At the end of 7 years, fixed assets will fetch a net salvage value of Rs. 48 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. 250 million per year. The increase in costs on account of the project is expected to be Rs. 100 million per year. (This includes all items of cost other than depreciation, interest, and tax.) The tax rate is 30 percent.

Plant and machinery will be depreciated at the rate of 25 percent per year as per the written down method.

(a) Estimate the post-tax cash flows of the project.(b) Calculate the IRR of the project.

UNSOLVED PROBLEMS 12.2Modern Pharma is considering the manufacture of a new drug, Floxin, for which the following information has been gathered: Floxin is expected to have a product life cycle of seven year and after that it would be withdrawn from the market. The sales from this drug are expected to be as followsYear 1 2 3 4 5 6 7Sales (Rs. in million) 80 120 160 200 160 120 80

The capital equipment required for manufacturing Floxin is Rs. 120 million and it will be depreciated at the rate of 25 percent per year as per the WDV method for tax purposes. The expected net salvage value after seven years is Rs. 25 million.

The working capital requirement for the project is expected to be 25 percent of sales. Working capital level is adjusted at the beginning of the year in relation to the expected sales for the year. At the end of 7 years, working capital is expected to be liquidated at par, barring an estimated loss of Rs. 4 million on account of bad debt which, of course, will be a tax-deductible expense.

The accountant of the firm has provided the following estimates for the cost of Floxin:Raw material cost : 30 percent of salesVariable manufacturing cost : 10 percent of salesFixed annual operating & maintenance cost: Rs. 10 millionVariable selling expenses : 10 percent of salesOverhead allocation (excluding depreciation, maintenance & Interest): 10 percent of sales

UNSOLVED PROBLEMS 12.2The incremental overhead attributable to the overhead are, however, expected to be only 5 percent of sales.

The manufacture of Floxin will cut into the sales of an existing product thereby reducing its contribution margin by Rs. 10 million per year.

The tax rate for the firm is 30 percent.

(a) Estimate the post-tax incremental cash flows for the project to manufacture Floxin.(b) What is the NPV of the project if the cost of capital is 15 percent?