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 noncash 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
firms investments.
It is the cash flow, which should be
discounted
to
find
out
an
investments NPV.
FCF = NOPAT+ Dep +/ NWC
CAPEX + TV.

Calculation of Operating Cash Inflows

Year Year Year Year Year
1
2
3
4
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

**
**

**

**

**

**

Capital Budgeting
Decisions

 The investment decisions of a firm are generally

known as capital budgeting.
A capital budgeting decisions may be defined
as the firms 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 firms investment decisions would generally
include expansion, acquisition,
modernisation and replacement of the longterm assets. Sale of a division or business
(divestment) is also as an investment
decision.

Steps in Capital Budgeting

Process

Step
Step
Step
Step
Step

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

 The firms value will increase if

investments are profitable and add to
the shareholders 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
shareholders 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.
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 isPB Rs 50,000 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 projects
payback?
3 years + 12 (1,000/3,000) months
3 years + 4 months

 Certain virtues:
Simplicity
Cost effective

Serious vices:

Cash flows after payback

Time 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:

C3
Cn
C1
C2
NPV

I0
2
3
n
(1 k )
(1 k ) (1 k ) (1 k )
n
Ct
NPV
I0
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

Project
A

Project
B

-56,125

-56,125

14,000

22,000

16,000

20,000

18,000

18,000

20,000

16,000

25,000

17,000

Total

93,000

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.
Yea Project
B
Two projects
A & B Project
both costing
Rs.50. Calculate NPV
r
A
at 5% and 10% and rank the project.
1

100

30

25

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(PVAF ) = 0
6,r

Rs 20,000 Rs 5,430(PVAF6,r )
PVAF6,r

Rs 20,000

3.683
Rs 5,430

Year

Machine A

Machine B

-56,125

-56,125

14,000

22,000

16,000

20,000

18,000

18,000

20,000

16,000

5
Total

25,000
93,000

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

PV @19%

PV of CF

-56,125

1.000

- (56,125)

14,000

0.840

11,760

16,000

0.706

11,296

18,000

0.593

10,674

20,000

0.499

9,980

25,000

0.419

10,475

Net

- (1940)

Machine A @17%
Year

Cash Flow

PV @17%

PV of CF

-56,125

1.000

- (56,125)

14,000

0.855

11,970

16,000

0.731

11,696

18,000

0.624

10,232

20,000

0.534

10,680

25,000

0.456

11,400

Net

853

Machine B @19%
Year

Cash Flow

PV @19%

PV of CF

-56,125

1.000

- (56,125)

22,000

0.84

18,480

20,000

0.706

14,120

18,000

0.593

10,674

16,000

0.499

7,984

17,000

0.419

7,123

Net

2256

Machine B @21%
Year

Cash Flow

PV @21%

PV of CF

-56,125

1.000

- (56,125)

22,000

0.826

18,172

20,000

0.683

13,660

18,000

0.564

10,152

16,000

0.466

7,456

17,000

0.385

6,545

Net

-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

Multiple 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
1
-504 2862

2
3
4
5700
6070
2000

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

10,00
0

12,00
0

14,00 16,00
0
0

20,000

Depreciation

8,000

8,000

8,000 8,000

8,000

Earning before Interest

and Tax

2,000

4,000

6,000 8,000

12,000

Less: Tax @ 50%

1,000

2,000

3,000 4,000

6,000

Earning after Interest and

Tax

1,000

2,000

3,000 4,000

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%

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
ANPV =
Select the project with highest ANPV
ANPVA = = = 4,523
ANPVB= = = 4,359

The Practice of Capital Budgeting

Survey by Graham & Harvey 2001 [Survey of
392 CEOs]
% Always or
Almost
Always
Internal Rate of
Return

75.6%

Net Present Value

74.9%

Pay-back Period

56.7%

Discounted Payback
Period

29.5%

Accounting Rate of
Return

30.3%

Profitability Index

11.9%

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

Net CF from
Proposed
Machine

Net CF from
Present
Machine

Incremental
Cash Flow

1,64,000

1,37,200

26,480

1,83,400

1,25,520

57,680

1,62,400

1,06,800

55,600

1,51,200

90,000

61,200

8,000

8,000