Cash Flow Estimation

Cash flow is not the same thing as profit, at least, for two reasons.
First, profit, as measured by an accountant, is based on accrual concept. (Revenue is recognized when it is earned, rather than when cash is received) Second, method of computing profit. The measurement of profit excludes some non-cash items such as depreciation.

COMPONENTS OF CASH FLOWS

Initial Investment (Cost of new project + Installation cost +/- Change in Net Working Capital) Net Cash Flows Net Profit Depreciation Net Working Capital Change in accounts receivable Change in inventory Change in accounts payable Net Cash Flows Terminal Cash Flows Salvage Value Salvage value of the new asset Release of Net Working Capital

Initial Investment

Net Working Capital

It is the difference between change in current assets (e.g., receivable and inventory) and change in current liabilities (e.g., accounts payable) to profit. Increase in net working capital (increase inventory + increase a/c receivables increase a/c payable) in the initial stage of the project should be added to the initial investment. The increase in net working capital can be continuously increased in the later stage of the project due to increase in sales. At the end of the life of the project the additional net working capital return back to the firm.

Terminal Cash Inflow

Salvage value may be defined as the market price of an investment at the time of its sale. Besides salvage value, terminal cash flows will also include the release of net working capital. It is reasonable to assume that funds initially tied up in net working capital at the time the investment was undertaken would be released in the last year when the investment is terminated. Last year of the project: Net CF for last year + Terminal Cash flow.

Net Cash Inflows

It is the cash flow available to service both lenders and shareholders, who have provided, respectively, debt and equity, funds to finance the firm s investments. It is this cash flow, which should be discounted to find out an investment s NPV. NCF = NOPAT+ Dep +/ NWC CAPEX + TV. * [NOPAT = EBIT (1-t)]

Calculation of Operating Cash Inflows

Year 1 Year 2 Year 3 Year 4 Year 5 Sales Revenue Less: Expenses (excl. Depn & Interest) EBDIT Less: Depreciation PBIT Less: Tax NOPAT Add: Depreciation Less: Increase in Working Capital (if any) Less: Interim CAPEX (If any) Add: Terminal Cash Flow Net Cash Inflows ** ** ** ** *** ** ** * ** * ** * * * *** ** ** * ** * ** * * * *** ** ** * ** * ** * * * *** ** ** * ** * ** * * * *** ** ** * ** * ** * * * ** **

Cash flow adjustments in case of Replacement Projects

1. Deduct the salvage value of old machine from the Initial investment in new machine. 2. Calculate the incremental revenue [Incremental revenue minus incremental expenses]. If there is a reduction of expenses due to improved machine that should be added to revenue. 3. Calculate Incremental Depreciation. 4. Net cash flow = 2+3

Case of Replacement Projects (Incremental Cash flow)

Year 1 2 3 4 5 Net CF from Proposed Machine 1,64,000 1,83,400 1,62,400 1,51,200 8,000 Net CF from Present Machine 1,37,200 1,25,520 1,06,800 90,000 0 Incremental Cash Flow 26,480 57,680 55,600 61,200 8,000

Capital Budgeting Decisions

 The investment decisions of a firm are generally known as capital budgeting. A capital budgeting decisions may be defined as the firm s decisions to invest its current funds most efficiently in the long term assets in anticipation of an expected flow of benefits over a series of years. The firm s investment decisions would generally include expansion, acquisition, modernisation and replacement of the long-term assets. Sale of a division or business (divestment) is also as an investment decision.

Steps in Capital Budgeting Process

Step I: Proposal Generation Step II: Review & Analysis Step III: Decision Making Step IV: Implementation Step V: Follow-up

 The firm s value will increase if investments are profitable and add to the shareholder s wealth. Thus, investment should be evaluated on the basis of a criteria, which is compatible with the objective of shareholders wealth maximization. An investment will add to the shareholder s wealth if its yields benefits in excess of cost of capital.

Steps to evaluate of an investment

1. Estimation of cash flows. 2. Estimation of the required rate of return (the opportunity cost of capital). 3. Application of a decision rule for making the choice.

Investment decisions rule

It should provide for an objective and unambiguous way of separating good projects from bad projects. It should help ranking of projects according to their true profitability. It should help to choose among mutually exclusive projects that project which maximises the shareholders wealth.

Evaluation Criteria
Payback Period (PB) Discounted payback period (DPB) Net Present Value (NPV) Internal Rate of Return (IRR) Profitability Index (PI) Accounting Rate of Return (ARR)

PAYBACK Period
Payback period is the number of years required to recover the original cash outlay invested in a project.
C0 Initial Investment Payback = ! Annual Cash Inflow C

Example: Assume that a project requires an outlay of Rs 50,000 and yields annual cash inflow of Rs 12,500 for 7 years. The payback period for the project is
Rs 50,000 PB ! ! 4 years Rs 12,500

 Unequal cash flows: In case of unequal cash inflows, the payback period can be found out by adding up the cash inflows until the total is equal to the initial cash outlay. Suppose that a project requires a cash outlay of Rs.20,000, and generates cash inflows of Rs.8,000; Rs.7,000; Rs.4,000; and Rs.3,000 during the next 4 years. What is the project s payback? 3 years + 12 (1,000/3,000) months 3 years + 4 months

 Certain virtues:
Simplicity Cost effective

Serious vices:
4Cash flows after payback 4Time value of money

Discounted Payback Period:

Net Present Value

It is the difference between the sum of the present value of future net cash inflows & the initial investment. Decision rule: NPV > 0 : Accepted NPV < 0 : Rejected NPV = 0 : Indifferent

Net Present Value

The formula for the net present value can be written as follows:
C1 C2 C3 Cn   .   I0 NPV ! 2 3 n (1  k ) (1  k ) (1  k ) (1  k ) n Ct  I0 NPV ! t t !1 (1  k )

Example
Assume there are two mutually exclusive projects with similar initial investment of Rs.56,125 and expected life of 5years but different expected cash flows. The cost of capital is 10%.
Year
0 1 2 3 4 5 Total

Project A
-56,125 14,000 16,000 18,000 20,000 25,000 93,000

Project B
-56,125 22,000 20,000 18,000 16,000 17,000 93,000

Machine A
Year Cash Flow Present Value @ 10% PV of CF 0 1 2 3 4 5 -56,125 14,000 16,000 18,000 20,000 25,000 Total 1.000 0.909 0.826 0.751 0.683 0.621 12,726 13,216 13,518 14,660 15,525 69,645

Machine B
Year 0 1 2 3 4 5 Cash Flow -56,125 22,000 20,000 18,000 16,000 17,000 Total Present Value @ 10% 1.000 0.909 0.826 0.751 0.683 0.621 PV of CF 19,998 16,520 13,518 10,928 10.557 71,521

 NPV of Machine A = Rs.13,520 i.e. Rs.(69,645 56,125) NPV of Machine B = Rs.15,396 i.e. Rs.(71,521 56,125)

Limitations:
Ranking of projects: as per the NPV rule is not independent of discount rates. Two projects A & B both costing Rs.50. Calculate NPV at 5% and 10% and rank the project.
Year Project A 1 2 100 25 Project B 30 100

Internal Rate of Return

The internal rate of return (IRR) is the rate that equates the investment outlay with the present value of cash inflow received after one period. This also implies that the rate of return is the discount rate which makes NPV = 0.

 Accept Reject decision: The higher is better. Should more than cut-off rate / required rate of return.

Calculation of IRR
When Cash Flows structure is annuity Step 1: Determine the payback period Step 2: Check PVIFA table Step 3: Find the two Pay back value, one is higher & one is lower Step 4: Determine IRR by interpolation Example: Let us assume that an investment would cost Rs 20,000 and provide annual cash inflow of Rs 5,430 for 6 years.

NPV !  Rs 20,000 + Rs 5,430(PVAF6,r ) = 0 Rs 20,000 ! Rs 5,430(PVAF6,r ) PVAF6,r Rs 20,000 ! ! 3.683 Rs 5,430

Year 0 1 2 3 4 5 Total

Machine A -56,125 14,000 16,000 18,000 20,000 25,000 93,000

Machine B -56,125 22,000 20,000 18,000 16,000 17,000 93,000

Selecting a Guidance Rate

Computation: For the mixed stream of cash flow structure: Step 1: Calculate the average annual cash inflows Step 2: Determine the fake payback period Step 3: Look at the PVIFA table Step 4: Find the guidance rate.

Machine A @19%
Year Cash Flow 0 1 2 3 4 5 -56,125 14,000 16,000 18,000 20,000 25,000 Net PV @19% 1.000 0.840 0.706 0.593 0.499 0.419 PV of CF - (56,125) 11,760 11,296 10,674 9,980 10,475 - (1940)

Machine A @17%
Year 0 1 2 3 4 5 Cash Flow -56,125 14,000 16,000 18,000 20,000 25,000 Net PV @17% 1.000 0.855 0.731 0.624 0.534 0.456 PV of CF - (56,125) 11,970 11,696 10,232 10,680 11,400 853

Machine B @19%
Year 0 1 2 3 4 5 Cash Flow -56,125 22,000 20,000 18,000 16,000 17,000 Net PV @19% 1.000 0.84 0.706 0.593 0.499 0.419 PV of CF - (56,125) 18,480 14,120 10,674 7,984 7,123 2256

Machine B @21%
Year 0 1 2 3 4 5 Cash Flow -56,125 22,000 20,000 18,000 16,000 17,000 Net PV @21% 1.000 0.826 0.683 0.564 0.466 0.385 PV of CF - (56,125) 18,172 13,660 10,152 7,456 6,545 -140

 IRR by interpolation Machine A: 17.6% Machine B: 20.9% NPV of Machine A = Rs.13,520 NPV of Machine B = Rs.15,396

IRR method may suffer from

4Multiple rates

Multiple IRRs Non-conventional Cash Flows Conventional projects/ cash flows initially have single cash outflows followed by several net cash inflows over the life of the projects. There are some projects that may have more than one net cash outflow during the life of the project. Example:
Year 0 -504 1 2862 2 -6070 3 5700 4 -2000

Year Cash Flow Discount Rate 10.0% 15.0% 20.0% 25.0% 30.0% 33.1% 35.0% 40.0% 42.8% 45.0% 50.0% 55.0% 60.0% 65.0% 66.7% 70.0% 75.0% 80.0% 85.0% 90.0%

0 -504 -504 -504 -504 -504 -504 -504 -504 -504 -504 -504 -504 -504 -504 -504 -504 -504 -504 -504 -504 -504

1 2862 2601.818 2488.696 2385 2289.6 2201.538 2150.263 2120 2044.286 2004.202 1973.793 1908 1846.452 1788.75 1734.545 1716.857 1683.529 1635.429 1590 1547.027 1506.316

2 -6070 -5016.53 -4589.79 -4215.28 -3884.8 -3591.72 -3426.36 -3330.59 -3096.94 -2976.68 -2887.04 -2697.78 -2526.53 -2371.09 -2229.57 -2184.33 -2100.35 -1982.04 -1873.46 -1773.56 -1681.44

3 5700 4282.494 3747.843 3298.611 2918.4 2594.447 2417.356 2316.72 2077.259 1957.448 1869.695 1688.889 1530.664 1391.602 1268.887 1230.462 1160.187 1063.557 977.3663 900.2428 831.0249

4 -2000 -1366.03 -1143.51 -964.506 -819.2 -700.256 -637.262 -602.136 -520.616 -480.969 -452.437 -395.062 -346.5 -305.176 -269.832 -258.993 -239.461 -213.244 -190.52 -170.743 -153.467 NPV -2.24329 -0.76037 -0.17284 0 0.013865 0.000994 -0.00629 -0.01 -0.00028 0.012352 0.049383 0.080405 0.082031 0.031786 -0.00072 -0.09009 -0.29988 -0.61027 -1.03055 -1.56693

Profitability Index
Profitability index is the ratio of the present value of cash inflows, at the required rate of return, to the initial cash outflow of the investment. PI = (Sum of PV of cash inflows) / Initial Outflow Accept reject decision: BCR/ PI > 1 accepted BCR/ PI < 1 rejected

 The initial cash outlay of a project is Rs.100,000 and it can generate cash inflow of Rs.40,000, Rs.30,000, Rs.50,000 and Rs.20,000 in year 1 through 4. Assume a 10 percent rate of discount. Calculate PI / Benefit to cost ratio.

Accounting Rate of Return

The accounting rate of return is the ratio of the average after-tax profit divided by the average investment. Higher is better. Example: A project will cost Rs.40,000. Its stream of earnings before depreciation, interest and taxes (EBDIT) during first year through five years is expected to be Rs.10,000, Rs.12,000, Rs.14,000, Rs.16,000 and Rs.20,000. Assume a 50 per cent tax rate and depreciation on straight-line basis.

Calculation of Accounting Rate of Return

Period Earnings before Interest Depn. And Tax Depreciation Earning before Interest and Tax Less: Tax @ 50% Earning after Interest and Tax 1 10,000 8,000 2,000 1,000 1,000 2 12,000 8,000 4,000 2,000 2,000 3 14,000 8,000 6,000 3,000 3,000 4 16,000 8,000 8,000 4,000 4,000 5 20,000 8,000 12,000 6,000 6,000

Average After Tax profit = 16,000/5 = 3,200 Average Investment = (40,000 + 0)/2 = 20,000 ARR = 3,200/20,000 = 16%

Calculation of Accounting Rate of Return

Comparing Mutually Exclusive Projects with Unequal lives

Year 0 1 2 3 4 5 6 Project A 70,000 28,000 33,000 38,000 Project B 85,000 35,000 30,000 25,000 20,000 15,000 10,000
NPV of Project A @ 10% = 81,248 70,000 = 11,248 NPV of Project B @ 10% = 1,03,985 85,000 = 18,985

Annualized NPV

The Practice of Capital Budgeting

Survey of Graham & Harvey 2001 [Survey of 392 CEOs]
% Always or Almost Always Internal Rate of Return Net Present Value Pay-back Period Discounted Payback Period Accounting Rate of Return Profitability Index 75.6% 74.9% 56.7% 29.5% 30.3% 11.9%