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Project Cash Flows An Overview Estimates of cash flows are key towards investment evaluation.
Estimating the cash flows is the most difficult aspect of capital budgeting process. In gigantic & complex projects forecasting errors can be quite large. Forecasting cash flows involves numerous variables and multiple participants Capital Outlays: Engineering & Product Development Departments evenue Projections: !ar"eting Department Operating Costs: Production Dept# Cost Accountants# Purchase !anager# Personnel E$ecutives etc% Finance manager coordinate the efforts of various departments and obtain information from them! ensure that the forecasts are based on a set of consistent assumptions! keep the exercise focused on relevant variables and minimi"e the inherent biases in estimation.
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%&!&&& %'!&&& (&!&&& '&!&&& '&!&&& )&!&&& *&!&&& * / ( ) End of 0ear ' -
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'eparation Principle
$here are two sides of a project 7 Investment 5ide 6or Asset 'ide8 7 Financing 5ide 5eparation principle suggests that the cash flows associated with these sides should be separated. # firm is considering a % year project requiring an investment of %!&&& in fixed assets and working capital at time &. $he project is expected to generate a single cash inflow of %!*&& at the end of year %. $he project will be financed entirely by debt carrying an interest rate of %'9 p.a. and maturing after % year. $here are no taxes involved within the project.
'eparation Principle
Financing Side $ime & % +ash Flow : %!&&& 7 %!%'& Investment Side $ime & % +ash Flow 7 %!&&& : %!*&&
+ash flows on the investment side of the project do not reflect financing costs 6interest on debt8 in the above example. $he financing costs are included in the cash flows on the financing side and reflected in the cost of capital figure 6i.e. %'9 p.a. in the above example8. $he cost of capital is used as the hurdle rate against which the rate of return on the investment side 6i.e. *&9 in the above example8 is evaluated. +he separation principle emphasi.es that while de&ining the cash &lows on the investment side# &inancing costs should not )e considered )ecause they will )e re&lected in the cost o& capital &igure against which rate o& return &igure will )e evaluated%
*ncremental Principle
#ccording to this principle! cash flows of a project must be measured in incremental terms. $he question to be answered is what happens to the cash &lows o& the &irm with the project and without the project. $he difference between the above two will reflect the incremental cash flows attributable to the project.
for the firm with the project for year <t= > +F for Project CF+F t = the firm without the project for year <t= CF 1 Cash Flows
*ncremental Principle
In estimating the incremental cash flows of a project! the following considerations must be adhered to
+onsider #ll Incidental Effects Ignore 5unk +osts Include ,pportunity +osts ?uestion the #llocation of ,verhead +osts Ensure 1roper Estimation of @et Aorking +apital
Income from a project typically is marginal. 3$; of the firm is the relevant rate for estimating the tax liability of the project.
A+ vs !+
Taxable Income of Project B I@; -'!&&&
Income Sla s (in I!") Hp to .!''& .!''% > (&!-'& #bove (&!-'& #a$ "ate A%%lica le %& 9 %' 9 *'9
Tax Payable by Project .!''& x &.%& B I@; .'' 6(&!-'& > .!''&8 x &.%' B I@; (!)-' 6-'!&&& > (&!-'&8 x &.*' B I@; /!'/..'& ATR B C6.'' : (!)-' : /!'/..'&8D-'!&&&E x %&& B %F.. 9 MTR B *' 9 6G #$;8
Firm as well as the project can incur losses. Following are the possible scenarios.
Scenario % * ( ) 5tand #lone Project Incurs 2osses Incurs 2osses 3akes 1rofits 3akes 1rofits Incurs 2osses Firm Incurs 2osses 3akes 1rofits Incurs 2osses 3akes 1rofits 7 Action Iefer tax savings $ake tax savings in the year of loss Iefer taxes until the firm makes profits +onsider taxes in the year of profit Iefer tax savings until the project makes profits
@on cash charges can have an impact on cash flows if they a&&ect the ta$ lia)ility. e%g% Depreciation $ax Jenefit of Iepreciation
Iepreciation x 3$;
Aritten Iown Kalue 6AIK8 method of depreciation allowed for tax purposes as per Income $ax #ct in India. Iepreciation +harge
IE1t B JKt(6r B JK&6%7r8t(6r IE1 B Iep +harge! JK B Jook Kalue! r B ;ate of
Iifference may be Permanent or +emporary. Permanent Di&&erence: +aused by an item which is included for calculating either $I or #1! but not )oth. +emporary Di&&erence: +aused by an item which is included for calculating )oth $I and #1! but in di&&erent time periods. Ieferred tax liability 6or asset8 arises because of temporary differences between $I and #1. # deferred tax liability 6asset8 is recogni"ed when the charge in the financial statements is less 6more8 than the amount allowed for tax purposes.
&e% * +,- (S(M) %!&&!&&& > 10,000 B F&!&&& F&!&&& > 10,000 B /&!&&& /&!&&& > 10,000 B .&!&&& .&!&&& > 10,000 B -&!&&& -&!&&& > 10,000 B '&!&&& '&!&&& > 10,000 B )&!&&& )&!&&& > 10,000 B (&!&&& (&!&&& > 10,000 B *&!&&& *&!&&& > 10,000 B %&!&&& %&!&&& > 10,000 B & I#R 1,00,000
&e% * +,- (.&/) %!&&!&&& > 10,000 B F&!&&& F&!&&& > 9,000 B /%!&&& /%!&&& > 8,100 B .*!F&& .*!F&& > 7,290 B -'!-%& -'!-%& > 6,561 B 'F!&)F 'F!&)F > 5,905 B '(!%)) '(!%)) > 5,31 B ).!/(& ).!/(& > ,783 B )(!&). )(!&). > ,305 B (/!.)* (/!.)* > 3,87 B ()!/-/ I#R 65,132
Consistency Principle
Cash &lows and the discount rates applied to these cash flows must )e consistent with respect to the investor group and in&lation. $he project cash flow may be estimated from the point of view of #ll Investors 6Equity owners : 2enders8 Equity 5hareholders
Consistency Principle
$he cash flow of a project from the view point of all investors is the cash flow available to all investors a&ter paying ta$es and meeting project reinvestment needs. +ash flows to all investors B 1JI$ 6% 7 tax rate8 : Iepreciation and @on7cash +harges 7 +apital Expenditure 7 +hange in @et Aorking +apital
2 P7*+ 1 Pro&it 7e&ore *nterest and +a$
Consistency Principle
+ash flows from all investors point of view *nitial *nvestment B $otal outlay invested in the project Operating cash in&lows B 1#$ : Iepreciation : ,ther non7cash charges : Interest on long7term borrowings 6%7tax rate8 : Interest on short7term borrowings 6%7tax rate8 +erminal cash &lows B @et salvage value of fixed assets : @et salvage value of current assets
6 e&er E$hi)it :%; &rom te$t )oo"# <uestion on Pg% :%6=/
Consistency Principle
$he cash flow of a project from the point of view of equity shareholders is the cash flow available to equity holders a&ter paying ta$es! meeting investment needs and &ul&illing de)t(related commitments% +ash flow to Equity Investors B
charges 7 7 7 7 : 7 : 1rofit after Interest and $ax 61#I$8 : Iepreciation and other non7cash 1reference Iividend +apital Expenditure +hange in @et Aorking +apital ;epayment of Iebt 1roceeds from Iebt Issues ;edemption of 1reference +apital 1roceeds from 1reference +apital
Consistency Principle
+ash Flows from E,uity *nvestors point of view *nitial *nvestment B Equity funds invested in the project
Operating cash &lows B 1#$ > 1reference Iividend : Iepreciation : ,ther @on7cash +harges +erminal>0i,uidation & etirement cash &lows @et salvage value of assets 7 ;epayment of term loans 7 ;edemption of preference capital 7 ;epayment of working capital advances 7 ;epayment of trade credit
6 e&er E$hi)it :%= &rom te$t )oo"# <uestion on Pg :%6=/
Consistency Principle
$he Iiscount ;ate must be consistent with the definition of cash flow
Cash Flow +ash flow to all investors +ash flow to equity holders &iscount "ate Aeighted #verage +ost of +apital 6A#++8 +ost of Equity 6i.e. ;ate of Equity Iividend8
In capital budgeting! project cash flows are generally analy"ed from all investors point o& view! and 3ACC o& the &irm is applied to them towards discounting.
Consistency Principle
$owards dealing with Inflation in project cash flow estimation following options are available
Incorporating e$pected in&lation in the estimates of future cash flows and applying a nominal discount rate to same. Estimating the future cash flows in real 4in&lation adjusted/ terms and applying a real discount rate to the same.
@ominal +Ft B ;eal +Ft 6% : Expected Inflation ;ate8t @ominal Iiscount ;ate B 6% : ;eal Iiscount ;ate8 6% : Expected Inflation
Consistency Principle
Following match up is recommended
Cash Flow @ominal +ash Flow ;eal +ash Flow &iscount "ate @ominal Iiscount ;ate ;eal Iiscount ;ate
In capital budgeting! general trend is to estimate nominal project cash flows and use nominal discount rate towards discounting them.