Cashflow

1

ESTIMATION OF CASH FLOWS

By CA N.Venkatakrishnan

@

MVIT

12TH MAY 2011

2


OVERVIEW OF CAPITAL BUDGETING AND EXPENDITURE;

What is Capital Budgeting;

The process of identifying, evaluating and selecting investments whose returns (cash flows) are expected to extend beyond one year ie Long term Investments

3


CAPITAL EXPENDITURE VS REVENUE EXPENDITURE

Capital ( CAPEX)

Deferred revenue ( CAPEX) Revenue ( OPEX)

4


CAPITAL EXPENDITURE;

Purchase of capital equipment

Furniture and Fixtures

Computers

Communication Equipment

Land and Buildings

Electrical Installation

Office Equipment

Major repairs to any Asset which would enhance the life of that particular Asset.

5


REVENUE EXPENDITURE;

Manufacturing costs

Salary, Bonus Gratuity etc-Employee costs

Rent

Electricity

Interest

Communication Expenses

Advertisement

Marketing Expenses

6


IMPORTANCE OF CASH FLOWS /CAPITAL BUDEGETING DECISIONS;

1)Affect the profitability of the company –Earning Assets of the company.

2)Will have a long term effect over the company

3)Not easily reversible without much Financial loss.

4)Involves huge costs and scarce resources

DIFFICULTIES IN CAPITAL EXPENDITURE DECISIONS;

1)Relate to uncertain future Period involving various risk factors.

2)Costs and revenue accrue at different time periods.

7


CLASSIFICATION OF INVESTMENT PROJECT PROPOSALS;

1. New products or expansion of existing products

2. Replacement of existing equipment or buildings

3. Infrastructure Projects

4. Research and development

5. Exploration

6. Mandatory Requirements (e.g., safety or pollution related)

7. Others-welfare related like Townships etc.

All these could be Independent or Mutually Exclusive.

8


EXECUTIVES/PROFESSIONALS INVOLVED IN CAPITAL BUDEGETING;

1. Engineering Teams-for outlays

2. Plant Managers- for giving their inputs

3. Production Team of Engineers-for operational costs

4. Marketing Team.– for estimation

5. Finance Team- For working out the Financial data

6 Capital Expenditures Committee

7. President

8. Board of Directors

9


CAPITAL BUDGETING AND ESTIMATING CASH FLOWS;

THE CAPITAL BUDGETING PROCESS;

Generate investment proposals consistent with the firm’s strategic objectives.

Estimate after-tax incremental operating cash flows for the investment projects.

Evaluate project incremental cash flows

Select projects based on a value-maximizing acceptance criterion.

Reevaluate implemented investment projects continually and perform post audits for completed projects

10


DIFFICULTIES IN ESTIMATION;

Inaccurate data can distort the cash flow projections and eventually the conclusions may prove wrong.

Future cannot be predicted with certainty.

The company has to rely on a lot of external Data especially for new projects.

Accurate projections are important because the company may accept an unviable proposal or reject a good proposal.

11


PRINCIPLES OF CASH FLOW;To arrange proper Financing for a project, it is imperative to ascertain the

correct profitability of the Project. The project cash flows consider almost

every kind of inflows of cash .1)Consistency principle;

cash flows should be consistent as to the discount rates and estimating the cash flows. If distorted, then the purpose will be defeated.

Investors’ and Inflation factors have to be factored in the cash flow

2)Post Tax principle;

Cash flows have to factor in the taxes applicable. Whether it is the company’s average tax or the projects marginal tax would depend on the situation of the company. eg Previous existing Losses.

Non cash charges do affect cash flows.

12


PRINCIPLES OF CASH FLOW;

3)Incremental principle; According to this principle, only differences due to the decision needs

to be considered. Other factors may be important but not to the decision at hand.

Incidental Effects: Any kind of project taken by a company remains related to the other activities of the firm. Because of this, a particular project influences all the other activities carried out, either negatively or positively. It can increase the profits for the firm or it may cause losses.

4)Separation principle; This principle recognizes the fact that any project cash flow estimation has two sides viz Investment and Financing.

13

ESTIMATION OF CASH FLOWSDATA REQUIRED-IDENTIFYING RELEVANT CASH FLOWS

1)CASH FLOW VS ACCOUNTING PROFIT;

Cash Flow method is a better method of measuring Economic Viability;

Accounting Profits/losses include Non Cash Expenses and will not give an accurate picture of the EV of the Investment proposal. Cash Flows will describe the Cash Transactions the company will experience once the Project is accepted.

There are Accounting ambiguities in determining net profits under Accounting profits eg Valuation of Inventories, ,allocation of costs, methods of depreciation, provisions etc. Cash Flow method provides a near perfect picture of the EV of the Investment proposal.

Cash Flow method recognizes the Time value of money where as Accounting profits are more historical and on accrual basis.

14

ESTIMATION OF CASH FLOWSDifference between Accounting and cash Flow approach; In rupees

Particulars

Revenues-sales(1)

Less ;Cost of sales(2)

Materials

Labor

other expenses

Depreciation

Total cost

Earnings/Cash Flow before Tax(1-2)

Taxes say 30%

Net Earnings/Cash flow after Tax

Accounting approach

50,000

20000

6000

4000

10000

40000

10000

3000

7000

Cash Flow approach

50,000

20000

6000

4000

---------

30000

20000

6000

14000

15


2)INCREMENTAL CASH FLOWS; These are cash flows WITH the Proposed Project MINUS the

company’s cash flow WITHOUT the Project.

Cash Flows (and only those cash flows) which are directly attributable to the Investment are considered.

Eg Fixed Overhead costs which remain the same whether the proposal is accepted or rejected are not considered.

If there is an increase in the FO costs due to the new proposal they may be considered.

16


Relevant and Irrelevant cash outflows;

Relevant for cash outflows;

Cost of the Investment

Variable costs-Material and Labor

Additional Fixed overheads

Taxes

Effects of Inflation

Opportunity costs

Irrelevant for cash outflows

Fixed Overheads

Sunk costs.

17


INGREDIENTS OF CASH FLOW STREAMS;

Tax effect-

>Cash flows are to be considered net of taxes.

> If the company is loss making any profit earned can be set off against the losses incurred earlier.

Effect on Other Projects;

>May have an effect on the proposed project. eg, an existing product may suffer due to the new project. This has to be factored. The new project evaluation cannot be isolated and taken as it is.

>Any reduction in cash flow of other projects will have a bearing on the Incremental cash flow of the proposed project.

Effect of Indirect Expenses;

>depends on whether the amount of overheads will change as a result of the of the decision. If yes, then it should be factored. If there is going to no change, then they are not relevant.

18


Effect of Depreciation; Is a non cash expenditure which does not have a cash outflow but has to

deducted while working out the tax on the net cash flows and evaluation there after.

Companies Act prescribes various depreciation rates

Normally two methods are used-Straight line method or WDV method.

Income tax Act provides rates which are also followed by many companies in their books.

Effect of working capital;

Constitutes another important ingredient which directly affects the proposal. It is a cash out flow in the year there is an increase in the net WC requirement. It could be from t0 to tn.

19

ESTIMATION OF CASH FLOWSCOMPONENTS OF CASH FLOW;

1)INITIAL INVESTMENT OR OUTLAY/OUTFLOW-a) Purchase price of “new” assets

b) +Capitalized expenditure-Freight , Insurance, Transportation, Training of Manpower to use the machine,CD etc

c) Opportunity costs incurred.. eg own land/house used for the project.

d)+ (-)Increase (decrease) =Net Working Capital.

e)- Net proceeds from sale of “old” Assets ,if replacement

f) + (-) Taxes (savings) due to the sale of ‘old ‘machines/assets

f) = Initial cash outflow

20


An old machine is to be replaced. It was bought 4 years ago for rs 120,000 and now sold as salvage for Rs 10000.The accumulated depreciation amounts to Rs 112000.

The cost of the new machine is Rs 200,000.The installation costs amount to Rs 4000 and training costs Rs 5000.The increase in net working capital amounts to Rs 3000.Tax rate is 30%.

Find out the initial investment ;

Cost of machine- 200,000

Installation cost- +4000

Training costs- +5000

Increase in WC- +3000

Salvage value- -10000

Tax on CG@30- - 600

Rs 201,400

21


2) OPERATING CASH FLOWS/NET ANNUAL CASH FLOWS;

Represents cash inflows on account of sales/revenue generation minus cash out flow on account of expenses.

Every Investment is expected to generate future benefits in the form of cash flows from operations.

Represents annual cash flows generated from the investments.

Represent net flows before depreciation and after taxes.

22


3)TERMINAL CASH FLOWS; The cash inflow to the company during the terminal year (last year) is called Terminal cash flow.

Represents some value in the asset when the asset is terminated/project is completed.

When Replacement decision is taken to replace old asset with new asset, the sale value of the old asset is the terminal cash flow of the asset replaced. (eg True value exchange of Maruthi car).

Due to termination of the Asset, there may be release of some Net working capital tied up in the initial year which should also be added to the salvage of the asset in the terminal cash flows.

23


Determination of Inflows

Particulars

Sales

Less Operating costs

Cash Inflows before Taxes (CFBT)

Less Depn

Taxable Income

Less Tax

Earnings after Tax

Plus Depreciation

Cash inflows after Taxes ( CFAT)

PLUS salvage value (yn)

PLUS Recovery of working capital

Y1 y2 y3 y4 yn

24

ESTIMATION OF CASH FLOWSInvestments, costs and Revenues( in rs 000)

Revenues

Costs -300

Undiscounted cash flow -300

Cum cash flow -300

NPV=400

Pay back period=2.78 years

Y1

100

20

80

-220

Y2

100

20

80

-140

Y3

200

20

180

40

Y4

200

20

180

220

Y5

200

20

180

400

25

ESTIMATION OF CASH FLOWSComputation of cash flows

Year

Cash flows -300

DCF(@10%)

DCF -300

Cum DCF

NPV=208.7


Y1

80

0.909

72.72

-227.78

Y2

80

0.826

66.08

-161.2

Y3

180

0.751

135.18

-26.02

Y4

180

0.683

122.94

96.92

Y5

180

0.621

111.78208.70

26

ESTIMATION OF CASH FLOWSComputation of cash flows-in 000Rs

Year 0

Cash Outflow -300

Gross Income

Depreciation(300000/5)

Taxable Income

Tax@30%

CFAT

y1

80

60

20

6

74

y2

80

60

20

6

74

y3

180

60

120

36

144

y4

180

60

120

36

144

y5

180

60

120

36

144

27

ESTIMATION OF CASH FLOWSComputation of cash flows

Year 0

Cash flows -300

CFAT

DCF(@10%)

DCF -300

Cum DCF

NPV=124.3


Y1

80

74

0.909

67.27

-232.73

Y2

80

74

0.826

61.12

-171.61

Y3

180

144

0.751

108.14

-63.47

Y4

180

144

0.683

98.35

34.88

Y5

180

144

0.621

89.42

124.30

28


BEFORE TAX AFTER TAX

NPV (Rs 000)

400

208.7

85.5

2.2

PAY BACK PERIOD

2.78

3.21

3.85

4.95

Rate(%)

0

10

20

30

PAY BACK PERIOD

3.06

3.65

4.6

>5

NPV( Rs 000)

280

124.31

23,67

-44.63

29


IMPACT OF IMPROPER CASH FLOW ESTIMATION;

Reasons;

Improper assessment of the project.

Inadequate Data.

Results;

Affects investment evaluation leading to wrong decision making.

Affects the profitability of the project and the company.

Affects the financial position of the company leading to cash crunch situations

Affects the existing business lines as the “new” project starts eating into the resources of the existing business.

Affects the reputation of the company.

30


Case study;“A” company is into retail business for the last 10 years with an average turnover of Rs 50 crores and an average net profit of Rs 2.5 crores during the last 5 years. As the margins are low in retail business due to severe competition, the average net profits of the retail Industry is around 5% and A company was within the Industry standards vis a vis the average net profit.The Management wanted to expand and it took on lease a property in the CBD area and modified it into an ultra modern show room .The cost of the expansion was Rs 50 crores and it had to borrow the entire amount as term loan from the bank at an interest rate of 12 %per annum repayable in 10 years. Annual property lease cost is Rs 2 crores.The new showroom would generate an average turnover of Rs 30 crores per annum in the first 5 years with an average net profit of 1.5 crores @5percent. The gross profit is 30 percentHas “A “company taken a good decision? Make suitable assumptions and advise “A “company the position ,pointing out where and in which areas of cash flow estimation they have gone wrong.

31


Thank you

Cashflow

Economy & Finance

project cash flows

returns cash flows

cash flow projections

estimation finance team

capital budegeting1

new projects

huge costs

long term investments