project cash flows-unit ii-part 4

8/6/2019 Project Cash Flows-Unit II-Part 4

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Project Cash Flows

Estimation, Principles, Biases


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Cash Flows

- They are the incremental after-tax cash flows

associated with the project.

- A conventional project has 3 basic components:

(i) Initial Investment- the after-tax cash outlay oncapital expenditure and net working capital.

(ii) Operating Cash Inflows- the after-tax cash inflows

resulting from project operations during economic

life.

(iii) Terminal Cash Inflow- the after-tax cash flow

resulting from liquidation of the project at the end

of economic life.2


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Cash Flow Analysis- its time

horizonThe time horizon for cash flow analysis is minimum of thefollowing:

(a) Physical life of the plant- period during which plant remains

in a physically usable condition. It inter- alia depends onwear and tear of plant. This is more useful in determining

the depreciation rather than investment decision making.

(b) Technological life of plant- period for which the existing plant

would not be rendered obsolete by new technological

developments. It is difficult as new developments are not

governed by any law or guesses.

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Cash Flow Analysis- its time

horizon(contd..)(c) Product market life of the plant- refers to the period

for which the product of the plant enjoys a

reasonably satisfactory market.

(d) Investment planning horizon of the firm- time

period for which a firm wishes to look ahead for

purposes of investment analysis is referred to its

investment planning horizon. It may be different for

small investments, medium sized investments, large

investments and infrastructure projects. As such

varies with complexity and size of investment 4


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Principles of Cash Flow Estimation

Principles to be followed during cash flow

estimation-

(a) Separation principle(b) Incremental principle

(c) Post- tax principle

(d) Consistency principle

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Separation Principle

The principle states that the cash flows concerning

the two sides of a project i.e. investment side and

financing side should be separately estimated. For

e.g.

A firm has project of 1 year with investment of Rs. 1000

and no working capital at time 0.

Only Expected Cash Inflow= Rs. 1200 at end of 1 year.

The project is debt financed which carries interest rate

of 15% maturing after 1 year.

Assume that there are no taxes.

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Separation Principle (contd)

Project

Financing Side Investment Side

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Time Cash Flow

0 +1000

1 -1150

Time Cash Flow

0 -1000

1 +1200

Cost of Capital: 15% Rate of Return: 20%


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Separation Principle (contd)

The cash flows on investment side do not

reflect financing costs.

The financing costs are included in the cashflows on the financing side & reflected in cost

of capital figure.

The cost of capital is the hurdle rate against

which rate of return on investment side is

judged.

This implies that interest on debt is ignored

while computing profits and taxes thereon . 8


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Incremental Principle

This principle suggests to measure the cash

flow of the firm with the project and without

the project. Stated mathematically:

(Project cash flow for 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)

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Incremental Principle(contd)

During estimation following guidelines to be ensured:

(a) Consider all the incidental effects, for e.g. the

project may enhance or detract the profitability of

some existing activities by being complementary or

competitive respectively.

(b) Ignore sunk costs (it refers to an outlay already

incurred in the past or already committed

irrevocably) . Remember the bygones are bygones

and are not relevant in decision making.

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(c) Include opportunity costs- the concept arises when

existing resources are used. It specifies in cost the

benefit that can be derived by applying the resource

to any other best alternative use.

(d) Question the allocation of overhead costs- overhead

costs like managerial salaries, legal expenses, rent

etc. should be allocated to the project only when

they relate to it. They should be incremental

overhead costs and not allocated overhead costs.

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(e) Estimate Net Working Capital Properly- as investor funds

support fixed assets and net working capital. Also remember:

- GWC refers to total current assets. It is supported by non-

interest bearing current liabilities (NIBCL) like trade credit,provisions, advances from customers etc.

- NWC is GWC NIBCL. It is financed by equity, preference and

debt. Requirement of NWC changes with output.

- NWC is renewed periodically & is not subject to depreciation.

It has salvage value equal to book value at the end of project.

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Post tax Principle

Cash flows should always be measured on an after-

tax basis.

Do not discount pre-tax cash flows with a rate higher

than cost of capital to compensate for tax payments.

Other important points to remember are:

(a) Tax rate- apply the marginal tax rate which is the tax

rate applicable to the marginal income. This isbecause income from project is typically marginal.

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Post tax Principle (contd)

(b) Treatment of losses-

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Scenario Project Firm Action

1 Incurs losses Incurs losses Defer tax savings

2 Incurs losses Makes profit Take tax savings in year of loss

3 Makes profit Incurs losses Defer taxes until firm

makes profit

4 Makes profit Makes profit Consider taxes in the year

of profit

Stand

Alone

Incurs losses -- Defer tax saving until

project makes profit


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Post tax Principle (contd)

(c) Effect of Non Cash Charges- they impact cash flowsif they affect tax liability. The important non cash

charge is depreciation. The depreciation method

allowed in India for tax purposes is written downvalue method.

(d) Deferred tax liability and minimum alternative tax-

the post-tax cash flow is derived from profit after tax

as follows:

Profit after tax+ depreciation and amortisation+

deferred tax charge- MAT credit entitlement

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Consistency Principle

Cash flows & discount rates applied to cash flows have to be

consistent with investor group & inflation.

Investor Group-

(a) For all investors- cash flows to all investors= PBIT(1-tax rate)+Depreciation and non- cash charges- Capital expenditure-

Change in net working capital

(b) For equity share holders: cash flows for equity shareholders=

Profit after tax+ Depreciation and other non cash charges-

Preference dividend- Capital expenditures-Change in net

working capital- Repayment of debt+ Proceeds from debt

issues- Redemption of preference capital+ Proceeds from

preference issue

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Consistency Principle(contd)

Discount rates to be consistent with definition of

cash flows:

Generally, in capital budgeting, we consider cashflow to all investors and apply the weighted

average cost of capital of the firm.

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Cash Flow Discount Rate

Cash flow to all investors Weighted average cost of

capital

Cash Flow to equity share

holders

Cost of equity


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Consistency Principle(contd)

Inflation- To deal with inflation the

consistency principle suggests the following:

Generally in capital budgeting analysis nominal

cash flows are estimated and nominaldiscount rate is used.

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Cash Flow Discount Rate

Nominal Cash Flow Nominal discount rate

Real Cash Flow Real discount rate


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Biases in Cash Flow Estimation

Adequate care should be exercised to guard against

biases as it may lead to over-statement or under-

statement of true profitability.

(I) Over-statement of Profitability: Executives commit

planning fallacy and display over optimism. Over

optimism results from cognitive biases and

organisational pressures. The various types are:

(a) Native optimism- is when people exaggerate their

own talents, believing themselves to have higher

positive traits and abilities.

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(b) Attribution error- is when people take credit for

positive outcomes and attribute negative outcomes

to external factors, irrespective of what the true

cause is.

(c) Anchoring- is when people are unwilling to change

their opinion after forming it although hey receive

new relevant information.

(d) Competitor neglect- is to neglect the potential

actions and abilities of competitors and focus only on

self plans and abilities.

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(e) Organisational pressure- due to the limited time and money

availability in companies project sponsors exaggerate the

benefits of projects so as to get it approved among the

intense competition.

(II) Under-statement of profitability: is related to terminal

benefits being under-stated and hence depressing the

profitability of project.

Terminal cash flow=Net salvage value of fixed assets+ Net

recovery of working capital margin

Where, net salvage value(apart from land)= 5% of original cost

And, net recovery from WC= original book value(assuming

current assets do not depreciate)

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The reasons for under-estimation are as follows:

(a) Under-estimation of salvage value- assigning only

5% value to fixed assets is wrong as in real life they

have substantial market value remaining. This is

because:

The actual rate of wear and tear is less than the rate

of depreciation applied.

The secular rate of inflation in India is around 6%.

(b) Intangible benefits are ignored- apart from terminal

benefits gained from tangible assets of the project,

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Some intangible benefits also are gained like

development of distribution network, brand

loyalty building, research & development

work, establishment of market position etc.

It is not appropriate to overlook these benefits

due to some pre-set time horizon and

difficulty in quantification.

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project cash flows-unit ii-part 4

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