Estimation of Cash Flow

ESTIMATION OF CASH FLOWS By CA N.Venkatakrishnan @ MVIT 12 TH MAY 2011

ESTIMATION OF CASH FLOWS 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

ESTIMATION OF CASH FLOWS CAPITAL EXPENDITURE VS REVENUE EXPENDITURE Capital ( CAPEX) Deferred revenue ( CAPEX) Revenue ( OPEX)

ESTIMATION OF CASH FLOWS 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.

ESTIMATION OF CASH FLOWS REVENUE EXPENDITURE ; Manufacturing costs Salary, Bonus Gratuity etc-Employee costs Rent Electricity Interest Communication Expenses Advertisement Marketing Expenses

ESTIMATION OF CASH FLOWS 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.

ESTIMATION OF CASH FLOWS 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.

ESTIMATION OF CASH FLOWS EXECUTIVES/PROFESSIONALS INVOLVED IN CAPITAL BUDEGETING ; 1. Engineering Teams-for outlays Plant Managers- for giving their inputs 3. Production Team of Engineers-for operational costs Marketing Team.– for estimation Finance Team- For working out the Financial data 6 Capital Expenditures Committee 7. President 8. Board of Directors

ESTIMATION OF CASH FLOWS 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

ESTIMATION OF CASH FLOWS 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.

ESTIMATION OF CASH FLOWS 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.

ESTIMATION OF CASH FLOWS 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.

ESTIMATION OF CASH FLOWS DATA 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. .

ESTIMATION OF CASH FLOWS Difference between Accounting and cash Flow approach; In rupees Cash Flow approach 50,000 20000 6000 4000 --------- 30000 20000 6000 14000 Accounting approach 50,000 20000 6000 4000 10000 40000 10000 3000 7000 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

ESTIMATION OF CASH FLOWS 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.

ESTIMATION OF CASH FLOWS 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.

ESTIMATION OF CASH FLOWS 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.

ESTIMATION OF CASH FLOWS 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.

ESTIMATION OF CASH FLOWS COMPONENTS OF CASH FLOW; 1)INITIAL INVESTMENT OR OUTLAY/OUTFLOW- Purchase price of “new” assets b) +Capitalized expenditure-Freight , Insurance, Transportation, Training of Manpower to use the machine,CD etc 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

ESTIMATION OF CASH FLOWS 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

ESTIMATION OF CASH FLOWS 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.

ESTIMATION OF CASH FLOWS 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.

ESTIMATION OF CASH FLOWS Determination of Inflows yn y4 y3 y2 Y1 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

ESTIMATION OF CASH FLOWS Investments, costs and Revenues( in rs 000) Y5 200 20 180 400 Y4 200 20 180 220 Y3 200 20 180 40 Y2 100 20 80 -140 Y1 100 20 80 -220 Revenues Costs -300 Undiscounted cash flow -300 Cum cash flow -300 NPV=400 Pay back period=2.78 years

ESTIMATION OF CASH FLOWS Computation of cash flows Y5 180 0.621 111.78208.70 Y4 180 0.683 122.94 96.92 Y3 180 0.751 135.18 -26.02 Y2 80 0.826 66.08 -161.2 Y1 80 0.909 72.72 -227.78 Year Cash flows -300 DCF(@10%) DCF -300 Cum DCF NPV=208.7 Pay back period=3.21 years

ESTIMATION OF CASH FLOWS Computation of cash flows-in 000Rs y5 180 60 120 36 144 y4 180 60 120 36 144 y3 180 60 120 36 144 y2 80 60 20 6 74 y1 80 60 20 6 74 Year 0 Cash Outflow -300 Gross Income Depreciation(300000/5) Taxable Income Tax@30% CFAT

ESTIMATION OF CASH FLOWS Computation of cash flows Y5 180 144 0.621 89.42 124.30 Y4 180 144 0.683 98.35 34.88 Y3 180 144 0.751 108.14 -63.47 Y2 80 74 0.826 61.12 -171.61 Y1 80 74 0.909 67.27 -232.73 Year 0 Cash flows -300 CFAT DCF(@10%) DCF -300 Cum DCF NPV=124.3 Pay back period=3.65 years

ESTIMATION OF CASH FLOWS BEFORE TAX AFTER TAX NPV( Rs 000) 280 124.31 23,67 -44.63 PAY BACK PERIOD 3.06 3.65 4.6 >5 Rate(%) 0 10 20 30 PAY BACK PERIOD 2.78 3.21 3.85 4.95 NPV (Rs 000) 400 208.7 85.5 2.2

ESTIMATION OF CASH FLOWS 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.

ESTIMATION OF CASH FLOWS 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 percent Has “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.

ESTIMATION OF CASH FLOWS Thank you

Estimation of Cash Flow

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