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 firms investments.
It is this cash flow, which should be discounted
to find out an investments 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. Dep
n
& 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 Net CF from
Proposed Machine
Net CF from
Present Machine
Incremental Cash
Flow
1 1,64,000 1,37,200 26,480
2 1,83,400 1,25,520 57,680
3 1,62,400 1,06,800 55,600
4 1,51,200 90,000 61,200
5 8,000 0 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
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 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 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 (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.


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


C
C
Inflow Cash Annual
Investment Initial
= Payback
0
=
years 4
12,500 Rs
50,000 Rs
PB = =
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:

=

+
=

+
+ +
+
+
+
+
+
=
n
t
t
t
n
n
I
k
C
I
k
C
k
C
k
C
k
C
1
0
0
3
3
2
2 1
) 1 (
NPV
) 1 ( ) 1 ( ) 1 ( ) 1 (
NPV
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
0 -56,125 -56,125
1 14,000 22,000
2 16,000 20,000
3 18,000 18,000
4 20,000 16,000
5 25,000 17,000
Total 93,000 93,000
Machine A
Year Cash Flow Present Value @ 10% PV of CF
0 -56,125 1.000
1 14,000 0.909 12,726
2 16,000 0.826 13,216
3 18,000 0.751 13,518
4 20,000 0.683 14,660
5 25,000 0.621 15,525
Total 69,645
Machine B
Year Cash Flow Present Value @ 10% PV of CF
0 -56,125 1.000
1 22,000 0.909 19,998
2 20,000 0.826 16,520
3 18,000 0.751 13,518
4 16,000 0.683 10,928
5 17,000 0.621 10.557
Total 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.(71,52156,125)

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 Project B
1 100 30
2 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
Rs 20,000 Rs 5,430(PVAF )
PVAF
Rs 20,000
Rs 5,430
6,
6,
6,
=
=
= =
r
r
r
3683 .
Year Machine A Machine B
0 -56,125 -56,125
1 14,000 22,000
2 16,000 20,000
3 18,000 18,000
4 20,000 16,000
5 25,000 17,000
Total 93,000 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
0 -56,125 1.000 - (56,125)
1 14,000 0.840 11,760
2 16,000 0.706 11,296
3 18,000 0.593 10,674
4 20,000 0.499 9,980
5 25,000 0.419 10,475
Net - (1940)
Machine A @17%
Year Cash Flow PV @17% PV of CF
0 -56,125 1.000 - (56,125)
1 14,000 0.855 11,970
2 16,000 0.731 11,696
3 18,000 0.624 10,232
4 20,000 0.534 10,680
5 25,000 0.456 11,400
Net 853
Machine B @19%
Year Cash Flow PV @19% PV of CF
0 -56,125 1.000 - (56,125)
1 22,000 0.84 18,480
2 20,000 0.706 14,120
3 18,000 0.593 10,674
4 16,000 0.499 7,984
5 17,000 0.419 7,123
Net 2256
Machine B @21%
Year Cash Flow PV @21% PV of CF
0 -56,125 1.000 - (56,125)
1 22,000 0.826 18,172
2 20,000 0.683 13,660
3 18,000 0.564 10,152
4 16,000 0.466 7,456
5 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 2 3 4
-504 2862 -6070 5700 -2000

Year 0 1 2 3 4
Cash Flow -504 2862 -6070 5700 -2000
Discount Rate NPV
10.0% -504 2601.818 -5016.53 4282.494 -1366.03 -2.24
15.0% -504 2488.696 -4589.79 3747.843 -1143.51 -0.76
20.0% -504 2385 -4215.28 3298.611 -964.506 -0.17
25.0% -504 2289.6 -3884.8 2918.4 -819.2 0.00
30.0% -504 2201.538 -3591.72 2594.447 -700.256 0.01
33.1% -504 2150.263 -3426.36 2417.356 -637.262 0.00
35.0% -504 2120 -3330.59 2316.72 -602.136 -0.01
40.0% -504 2044.286 -3096.94 2077.259 -520.616 -0.01
42.8% -504 2004.202 -2976.68 1957.448 -480.969 0.00
45.0% -504 1973.793 -2887.04 1869.695 -452.437 0.01
50.0% -504 1908 -2697.78 1688.889 -395.062 0.05
55.0% -504 1846.452 -2526.53 1530.664 -346.5 0.08
60.0% -504 1788.75 -2371.09 1391.602 -305.176 0.08
65.0% -504 1734.545 -2229.57 1268.887 -269.832 0.03
66.7% -504 1716.857 -2184.33 1230.462 -258.993 0.00
70.0% -504 1683.529 -2100.35 1160.187 -239.461 -0.09
75.0% -504 1635.429 -1982.04 1063.557 -213.244 -0.30
80.0% -504 1590 -1873.46 977.3663 -190.52 -0.61
85.0% -504 1547.027 -1773.56 900.2428 -170.743 -1.03
90.0% -504 1506.316 -1681.44 831.0249 -153.467 -1.57
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 1 2 3 4 5
Earnings before Interest Depn. And
Tax
10,000 12,000 14,000 16,000 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%
Calculation of Accounting Rate of Return
Comparing Mutually Exclusive Projects
with Unequal lives
Year Project A Project B
0 70,000 85,000
1 28,000 35,000
2 33,000 30,000
3 38,000 25,000
4 20,000
5 15,000
6 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
ANPV
A
=
11,248

(10%,3 )
=
11,248
2.485
= 4,523
ANPV
B
=
18,985

(10%,6 )
=
18,985
4.355
= 4,359

The Practice of Capital Budgeting
% 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%
Survey by Graham & Harvey 2001 [Survey of 392 CEOs]