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CASH FLOW ILLUSTRATIONS

To show how cash flows are defined, bearing in mind the principles discussed above,
three illustrations of gradually increasing complexity are presented in this section.
Illustration I
ZAAK Enterprises is considering a new investment project about which
the following information is available.
i.The total outlay on the project will be $ 10 million. This consists of $ 6

million on plant and equipment and $4 million on gross working capital. The
entire outlay will be incurred at the beginning of the project.
ii.The project will be financed with $ 4 million of equity capital, $ 3 million of
long term debt (in the form of debentures), $ 2 million of short-term bank
borrowings, and $ 1 million of trade credit. This means that $ 7 million of
long term funds (equity + long-term debt) will be applied towards plant and
equipment ($ 6 million) and working capital margin (Rs 1 million)- working
capital margin is defined as the contribution of long term funds towards
working capital. The interest rate on debentures will be 15 per cent and
interest rate on short-term borrowings will be 18 per cent.
iii-The life of the project is expected to be 5 years and the plant and
equipment would fetch a salvage value of $ 2 million. The liquidation value
of working capital will be equal to $ 2 million, the book value.
iv-The project will increase the revenues of the firm by $ 6 million per year.
The increase in operating expense on account of the project will be $ 4
million per year. (this includes all items of expense other than depreciation,
interest, and taxes.) the effective tax rate will be 50 percent.
v-Plant and equipment will be depreciated at the rate of 331/3 percent per
year as per the written down value method. So the depreciation charges will
be
First year
Second year
Third year
Fourth year
Fifth year

(Rs in million)
2.00
1.33
0.89
0.59
0.40

Given the above details the post-tax, incremental cash flows relating to long-term
funds are worked out in Exhibit 7.1. Some clarifications about this exhibit are in
order. The initial investment, occurring at the end of year 0, is $ 7 million. This
represents the commitment of long-term funds to the project. (Note that the total
outlay on the project is $ 10 million. However, our focus is on flows relating to longterm funds.) The operating cash inflow, relating to long terms funds, at the end of
year 1 is $ 3.07 million. This is defined as follows:
Profit after tax + Depreciation + Interest on debentures (1-tax rate)
$ 0.845 million + $ 2 million + $ 0.45 million (1-0.50)
The operating cash inflows for the subsequent years have been calculated similarly.
The terminal cash flow relating to long-term funds is equal to:
Net salvage value of plant and equipment + Net recovery of working capital
margin

It may be noted that when the project is terminated, its liquidation value will be
equal to;
Net salvage value of plant and equipment + Net recovery of working capital
The first component belongs to the suppliers of long-term funds. The second
component is applied to repay the current liabilities and recover the working capital
margin.
Cash Flow for the New Project
(Rs in million)
years
0
1
2
3
4
5
A-Plant and equipment
(6.00)
B-Working capital margin
(1.00)
C-Revenues
8.00
8.00
8.00
8.00
8.00
D-Operating costs
3.50
3.50
3.50
3.50
3.50
E-Depreciation
2.00
1.333 0.889 0.593 0.395
F-Interest on short-term bank
0.36
0.36
0.36
0.36
0.36
borrowings
G-Interest on debentures
0.45
0.45
0.45
0.45
0.45
H-Profit before tax
1.690 2.357 2.801 3.097 3.295
I-Tax
0.845 1.176 1.401 1.549 1.648
J-Profit after tax
0.845 1.178 1.400 1.548 1.647
K-Net salvage value of plant and
2.00
equipment
1.00
L-Net recovery working capital
margin
M-Initial investment (A + B)
(7.00)
N-Operating cash inflows (J+E+G
3.070 2.736 2.514 2.366 2.267
(I-T))
3.000
O-Terminal cash flow (K+L)
(7.00) 3.070 2.736 2.514 2.366 5.267
P-Net cash flow (M+N+O)
-VIEWING A PROJECT FRoM DIFFERENT POINTS OF VIEW
In the preceding discussion we looked at a project from the point of view of longterm funds and defined its cash flows accordingly. However, a project may be
viewed from two other points of view as well: the equity point of view and the total
funds point of view. To compare the alternative points of view-the equity point of
view, the long-term funds point of view, and the total funds point of view-let us
consider an example.
Magnum Technologies Limited is evaluating an electronics project for which
the following information has been assembled:
1-The total outlay on the project is expected to be Rs 50million. This consists of Rs
30 million of fixed assets and Rs 20million of current assets.
2-The total outlay of Rs 50million is proposed to be financed as follows: Rs 15million
of equity, Rs 20 million of term loans, Rs 10 million of bank finance for working
capital, and Rs 5million of trade credit.
3-The term loan is repayable in five equal annual installments of Rs 4 million each.
The first installment will fall due at the end of the first year and the last installment
at the end of the fifth year. The levels of bank finance for working capital and trade

credit will remain at Rs 10million and Rs 5million till they are paid back or retired at
the end of five years.
4-The interest rates on the term loan and bank finance for working capital will be 15
per cent and 18 per cent respectively.
5-The expected revenues from the project will be Rs 60 million per year. The
operating costs, excluding depreciation, will be Rs 42 million. The depreciation rate
on the fixed assets will be 33 1/3 per cent as per the written down value method.
6-The net salvage value of fixed assets and current assets at the end of year 5 will
be Rs 5 million and Rs 20 million respectively.
7-The tax rate applicable to the firm is 50 per cent
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 investment : Equity funds committed to the project
*Operating cash inflows : Profit after tax Preference dividend + Depreciation +
Other non-cash charges
*Liquidation and retirement cash flows (terminal cash flows) : Net salvage value of
fixed assets
+
Net salvage value of current assets
Repayment of term loans
Redemption of preference capital
Repayment of working capital advances
Retirement of trade credit and other dues
While the first two components, namely, initial investment and operating cash
inflows are fairly self-explanatory, the third term, namely, liquidation and
retirement cash flows requires a little explanation. It represents the net cash flows
accruing to equity shareholders as a result of liquidation of various assets in the
project and retirement/ redemption of all other sources of financing. Remember that
equity shareholders have a residual interest in the project and hence what is left
after meeting the claims of all other suppliers of finance belongs to equity
shareholders.
Exhibit 7.4 works out the cash flows from the equity point of view for the electronics
project of Magnum Technologies Limited.
Cash Flow 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 investment : Long-term funds invested in the project.
This is equal to: fixed assets + working capital margin.
Operating cash inflow
: profit after tax
+
Depreciation
+

Other non-cash charges


+
Interest on long-term borrowings (1 tax rate)
Terminal cash flow : Net salvage value of fixed assets
+
Net recovery of working capital margin

Exhibit 7.4-Net Cash flows relating to equity


(Rs in million)
years
0
3
4
5
A-Equity funds
B-Revenues
C-Operating costs
D-Depreciation
E-Interest on working capital
advance
F-Interest on term loan
G-Profit before tax
H-Tax
I-Profit after tax
J-Preference dividend
K-Net salvage value of fixed assets
L-Net salvage value of current
assets
M-Repayment of term-loans
N-Redemption of preference capital
O-Repayment of short-term bank
borrowings
P- Retirement of trade creditors
Q-Initial investment (A)
O-Operating cash inflows (I-J+D)
S-liquidation and retirement cash
flows (K+L-M-N-O-P)
T-Net cash flow (Q+R+S)

(15.0
0)

(15.0
0)

60.00
42.00
10.00
1.80
3.00
3.20
1.60
1.60
4.00
-

60.00
42.00
6.67
1.80
2.40
7.13
3.57
3.56
4.00
-

60.00
42.00
4.44
1.80
1.80
9.96
4.98
4.98
4.00
-

60.00
42.00
2.96
1.80
1.20
12.04
6.02
6.02
4.00
-

60.00
42.00
1.98
1.80
0.60
13.62
6.81
6.81
5.00
20.00
4.00
10.00

5.00

11.60
(4.00)
7.60

10.23
(4.00)
6.23

9.42
(4.00)
5.42

8.98
(4.00)
4.98

8.79
(4.00)
11.79

(15.0
0)
Exhibit 7.5 shows the cash flows relating to long-term funds for the electronics
project of Magnum Technologies Limited
Cash Flow Relating to Total Funds
The cash flow stream relating to total funds consists of three components as
follows:

Initial investment : All the funds committed to the project. This is simply the total
outlay on the project consisting of fixed assets as well as current assets
Operating cash inflow
: Profit after tax+ Depreciation
+
Other non-cash charges
+
Interest on long-term borrowings (1- tax rate)
+
Interest on short-term borrowings (1- tax rate)
Terminal cash flow : Net salvage value of fixed assets
+
Net salvage value of current assets
Exhibit 7.5
Net Cash Flows Relating to Long-term Funds
(Rs in million)
years
0
3
4
5
A-Fixed assets
B-Working capital margin
C-Revenues
D-Operating costs
E-Depreciation
F-Interest on working capital
advance
G-Interest on term loan
H-Profit before tax
I-Tax
J-Profit after tax
K-Net salvage value of fixed assets
L-Net recovery of working capital
margin
M-Initial investment (A+B)
N-Operating cash inflows (J+E+G(IT))
O-Terminal cash flow (K+L)
P-Net cash flow (M+N+O)

(30.0
0)
(5.0)

(35.0
0)
(35.0
0)

60.00
42.00
10.00
1.80
3.00
3.20
1.60
1.60

60.00
42.00
6.67
1.80
2.40
7.13
3.57
3.56

60.00
42.00
4.44
1.80
1.80
9.96
4.98
4.98

60.00
42.00
2.96
1.80
1.20
12.04
6.02
6.02

60.00
42.00
1.98
1.80
0.60
13.62
6.81
6.81
5.00
5.00

13.10

11.43

10.32

9.58

9.09
10.00

13.10

11.43

10.32

9.58

19.09

Exhibit 7.6 shows the net cash flows from the point of view of total funds for the
electronics project of Magnum Technologies Limited
5-HOW FINANCIAL INSTITIUTIONS AND THE PLANNING COMMISSION
DEFINE CASH FLOWS
Financial Institutions

In evaluating project proposals submitted to them, financial institutions (all-India


financial institutions as well as state-level financial institutions) define project cash
flows as follows:
Cash outflows
Fixed assets
Cost of project
+
- working capital margin
-interest during construction period
Current assets
+
Increase in current assets with increase in the level of production

EXHIBIT 7.6
Net Cash Flows Relating to Total Funds
(Rs in million)
years
0
3
4
5
A-Total funds
B-Revenues
C-Operating costs
D-Depreciation
E-Interest on working capital
advance
F-Interest on term loan
G-Profit before tax
H-Tax
I-Profit after tax
J-Net salvage value of fixed assets
K-Net salvage value of current
assets
L-Initial investment (A)
M-Operating cash inflows
(G+D+F(I-t)+E(1-t))
N-Terminal cash flow (J+K)
O-Net cash flow (L+M+N)

(30.0
0)

(50.0
0)
(50.0
0)

60.00
42.00
10.00
1.80
3.00
3.20
1.60
1.60

60.00
42.00
6.67
1.80
2.40
7.13
3.57
3.56

60.00
42.00
4.44
1.80
1.80
9.96
4.98
4.98

60.00
42.00
2.96
1.80
1.20
12.04
6.02
6.02

60.00
42.00
1.98
1.80
0.60
13.62
6.81
6.81
5.00
20.00

14.00

12.33

11.22

11.98

9.99

14.00

12.33

11.23

11.98

25.00
34.99