Cashflowmvit 13117382206982-phpapp01-110726230250-phpapp01

11
ESTIMATION OF CASH FLOWSESTIMATION OF CASH FLOWS
By CA N.VenkatakrishnanBy CA N.Venkatakrishnan
@@
MVITMVIT
1212THTH
MAY 2011MAY 2011

22
OVERVIEW OF CAPITALOVERVIEW OF CAPITAL
BUDGETING ANDBUDGETING AND
EXPENDITUREEXPENDITURE ;;
What is Capital Budgeting;What is Capital Budgeting;
 The process of identifying, evaluating andThe process of identifying, evaluating and
selecting investments whose returns (cashselecting investments whose returns (cash
flows) are expected to extend beyond oneflows) are expected to extend beyond one
year ie Long term Investmentsyear ie Long term Investments

33
CAPITAL EXPENDITURE VS REVENUE EXPENDITURECAPITAL EXPENDITURE VS REVENUE EXPENDITURE
Capital ( CAPEX)
Deferred revenue ( CAPEX)Revenue ( OPEX)

44
CAPITAL EXPENDITURECAPITAL EXPENDITURE ;;
Purchase of capital equipmentPurchase of capital equipment
Furniture and FixturesFurniture and Fixtures
ComputersComputers
Communication EquipmentCommunication Equipment
Land and BuildingsLand and Buildings
Electrical InstallationElectrical Installation
Office EquipmentOffice Equipment
Major repairs to any Asset which would enhance the life of thatMajor repairs to any Asset which would enhance the life of that
particular Asset.particular Asset.

55
REVENUE EXPENDITUREREVENUE EXPENDITURE ;;
Manufacturing costsManufacturing costs
Salary, Bonus Gratuity etc-Employee costsSalary, Bonus Gratuity etc-Employee costs
RentRent
ElectricityElectricity
InterestInterest
Communication ExpensesCommunication Expenses
AdvertisementAdvertisement
Marketing ExpensesMarketing Expenses

66
IMPORTANCE OF CASH FLOWS /CAPITALIMPORTANCE OF CASH FLOWS /CAPITAL
BUDEGETING DECISIONS;BUDEGETING DECISIONS;
1)Affect the profitability of the company –Earning Assets of the1)Affect the profitability of the company –Earning Assets of the
company.company.
2)Will have a long term effect over the company2)Will have a long term effect over the company
3)Not easily reversible without much Financial loss.3)Not easily reversible without much Financial loss.
4)Involves huge costs and scarce resources4)Involves huge costs and scarce resources
DIFFICULTIES IN CAPITAL EXPENDITURE DECISIONS;DIFFICULTIES IN CAPITAL EXPENDITURE DECISIONS;
1)Relate to uncertain future Period involving various risk factors.1)Relate to uncertain future Period involving various risk factors.
2)Costs and revenue accrue at different time periods.2)Costs and revenue accrue at different time periods.

77
CLASSIFICATION OF INVESTMENT PROJECTCLASSIFICATION OF INVESTMENT PROJECT
PROPOSALS;PROPOSALS;
11. New products or expansion. New products or expansion of existing productsof existing products
2. Replacement2. Replacement of existing equipment or buildingsof existing equipment or buildings
3. Infrastructure Projects3. Infrastructure Projects
4. Research and development4. Research and development
5. Exploration5. Exploration
6. Mandatory Requirements (e.g., safety or pollution related)6. Mandatory Requirements (e.g., safety or pollution related)
7. Others-welfare related like Townships etc.7. Others-welfare related like Townships etc.
All these could be Independent or Mutually Exclusive.All these could be Independent or Mutually Exclusive.

88
EXECUTIVES/PROFESSIONALS INVOLVED IN CAPITALEXECUTIVES/PROFESSIONALS INVOLVED IN CAPITAL
BUDEGETINGBUDEGETING;;
1. Engineering Teams-for outlays1. Engineering Teams-for outlays
2.2. Plant Managers- for giving their inputsPlant Managers- for giving their inputs
3. Production Team of Engineers-for operational costs3. Production Team of Engineers-for operational costs
4.4. Marketing Team.– for estimationMarketing Team.– for estimation
5.5. Finance Team- For working out the Financial dataFinance Team- For working out the Financial data
6 Capital Expenditures Committee6 Capital Expenditures Committee
7. President7. President
8. Board of Directors8. Board of Directors

99
CAPITAL BUDGETING AND ESTIMATING CASH FLOWSCAPITAL BUDGETING AND ESTIMATING CASH FLOWS;;
THE CAPITAL BUDGETING PROCESS;THE CAPITAL BUDGETING PROCESS;
Generate investment proposals consistent with the firm’s strategicGenerate investment proposals consistent with the firm’s strategic
objectives.objectives.
Estimate after-tax incremental operating cash flows for the investmentEstimate after-tax incremental operating cash flows for the investment
projects.projects.
Evaluate project incremental cash flowsEvaluate project incremental cash flows
Select projects based on a value-maximizing acceptance criterion.Select projects based on a value-maximizing acceptance criterion.
Reevaluate implemented investment projects continually and performReevaluate implemented investment projects continually and perform
post audits for completed projectspost audits for completed projects

10
DIFFICULTIES IN ESTIMATION;DIFFICULTIES IN ESTIMATION;
 Inaccurate data can distort the cash flow projections andInaccurate data can distort the cash flow projections and
eventually the conclusions may prove wrong.eventually the conclusions may prove wrong.
 Future cannot be predicted with certainty.Future cannot be predicted with certainty.
 The company has to rely on a lot of external DataThe company has to rely on a lot of external Data
especially for new projects.especially for new projects.
 Accurate projections are important because the companyAccurate projections are important because the company
may accept an unviable proposal or reject a good proposal.may accept an unviable proposal or reject a good proposal.

11
PRINCIPLES OF CASH FLOWPRINCIPLES OF CASH FLOW;;
To arrange proper Financing for a project, it is imperative to ascertain theTo arrange proper Financing for a project, it is imperative to ascertain the
correct profitability of the Project. The project cash flows consider almostcorrect profitability of the Project. The project cash flows consider almost
every kind of inflows of cashevery kind of inflows of cash ..
1)Consistency principle1)Consistency principle;;
 cash flows should be consistent as to the discount rates and estimatingcash flows should be consistent as to the discount rates and estimating
the cash flows. If distorted, then the purpose will be defeated.the cash flows. If distorted, then the purpose will be defeated.
 Investors’ and Inflation factors have to be factored in the cash flowInvestors’ and Inflation factors have to be factored in the cash flow
2)Post Tax principle2)Post Tax principle;;
 Cash flows have to factor in the taxes applicable. Whether it is theCash flows have to factor in the taxes applicable. Whether it is the
company’s average tax or the projects marginal tax would depend on thecompany’s average tax or the projects marginal tax would depend on the
situation of the company. eg Previous existing Losses.situation of the company. eg Previous existing Losses.
 Non cash charges do affect cash flows.Non cash charges do affect cash flows.

12
PRINCIPLES OF CASH FLOW;PRINCIPLES OF CASH FLOW;
3)Incremental principle;3)Incremental principle;
 According to this principle, only differences due to the decision needsAccording to this principle, only differences due to the decision needs
to be considered. Other factors may be important but not to theto be considered. Other factors may be important but not to the
decision at hand.decision at hand.
 Incidental Effects: Any kind of project taken by a company remainsIncidental Effects: Any kind of project taken by a company remains
related to the other activities of the firm. Because of this, a particularrelated to the other activities of the firm. Because of this, a particular
project influences all the other activities carried out, either negatively orproject influences all the other activities carried out, either negatively or
positively. It can increase the profits for the firm or it may cause losses.positively. It can increase the profits for the firm or it may cause losses.
4)Separation principle;4)Separation principle; This principle recognizes the fact that any projectThis principle recognizes the fact that any project
cash flow estimation has two sides viz Investment and Financing.cash flow estimation has two sides viz Investment and Financing.

1313
DATA REQUIRED-IDENTIFYING RELEVANT CASH FLOWSDATA REQUIRED-IDENTIFYING RELEVANT CASH FLOWS
1)CASH FLOW VS ACCOUNTING PROFIT1)CASH FLOW VS ACCOUNTING PROFIT ;;
Cash Flow method is a better method of measuring Economic Viability;Cash Flow method is a better method of measuring Economic Viability;
Accounting Profits/losses include Non Cash Expenses and will not give anAccounting Profits/losses include Non Cash Expenses and will not give an
accurate picture of the EV of the Investment proposal. Cash Flows willaccurate picture of the EV of the Investment proposal. Cash Flows will
describe the Cash Transactions the company will experience once thedescribe the Cash Transactions the company will experience once the
Project is accepted.Project is accepted.
There are Accounting ambiguities in determining net profits underThere are Accounting ambiguities in determining net profits under
Accounting profits eg Valuation of Inventories, ,allocation of costs, methodsAccounting profits eg Valuation of Inventories, ,allocation of costs, methods
of depreciation, provisions etc. Cash Flow method provides a near perfectof depreciation, provisions etc. Cash Flow method provides a near perfect
picture of the EV of the Investment proposal.picture of the EV of the Investment proposal.
Cash Flow method recognizes the Time value of money where asCash Flow method recognizes the Time value of money where as
Accounting profits are more historical and on accrual basis.Accounting profits are more historical and on accrual basis.

1414
Difference between Accounting and cash Flow approach; In rupeesDifference between Accounting and cash Flow approach; In rupees
ParticularsParticulars
Revenues-sales(1)Revenues-sales(1)
Less ;Cost of sales(2)Less ;Cost of sales(2)
MaterialsMaterials
LaborLabor
other expensesother expenses
DepreciationDepreciation
Total costTotal cost
Earnings/Cash Flow before Tax(1-2)Earnings/Cash Flow before Tax(1-2)
Taxes say 30%Taxes say 30%
Net Earnings/Cash flow after TaxNet Earnings/Cash flow after Tax
AccountingAccounting
approachapproach
50,00050,000
2000020000
60006000
40004000
1000010000
4000040000
1000010000
30003000
70007000
Cash FlowCash Flow
approachapproach
50,00050,000
2000020000
60006000
40004000
------------------
3000030000
2000020000
60006000
1400014000

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2)INCREMENTAL CASH FLOWS;2)INCREMENTAL CASH FLOWS;
 These are cash flowsThese are cash flows WITHWITH the Proposed Project MINUS thethe Proposed Project MINUS the
company’s cash flowcompany’s cash flow WITHOUTWITHOUT the Project.the Project.
 Cash Flows (and only those cash flows) which are directly attributableCash Flows (and only those cash flows) which are directly attributable
to the Investment are considered.to the Investment are considered.
 Eg Fixed Overhead costs which remain the same whether the proposalEg Fixed Overhead costs which remain the same whether the proposal
is accepted or rejected are not considered.is accepted or rejected are not considered.
 If there is an increase in the FO costs due to the new proposal theyIf there is an increase in the FO costs due to the new proposal they
may be considered.may be considered.

1616
Relevant and Irrelevant cash outflows;Relevant and Irrelevant cash outflows;
Relevant for cash outflows;Relevant for cash outflows;
 Cost of the InvestmentCost of the Investment
Variable costs-Material and LaborVariable costs-Material and Labor
Additional Fixed overheadsAdditional Fixed overheads
TaxesTaxes
Effects of InflationEffects of Inflation
Opportunity costsOpportunity costs
Irrelevant for cash outflowsIrrelevant for cash outflows
Fixed OverheadsFixed Overheads
Sunk costs.Sunk costs.

17
INGREDIENTS OF CASH FLOW STREAMS;INGREDIENTS OF CASH FLOW STREAMS;
Tax effect-Tax effect-
>Cash flows are to be considered net of taxes.>Cash flows are to be considered net of taxes.
> If the company is loss making any profit earned can be set off> If the company is loss making any profit earned can be set off
against the losses incurred earlier.against the losses incurred earlier.
Effect on Other ProjectsEffect on Other Projects;;
>May have an effect on the proposed project. eg, an existing product>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 newmay suffer due to the new project. This has to be factored. The new
project evaluation cannot be isolated and taken as it is.project evaluation cannot be isolated and taken as it is.
>Any reduction in cash flow of other projects will have a bearing on the>Any reduction in cash flow of other projects will have a bearing on the
Incremental cash flow of the proposed project.Incremental cash flow of the proposed project.
Effect of Indirect ExpensesEffect of Indirect Expenses;;
>depends on whether the amount of overheads will change as a result of>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 tothe of the decision. If yes, then it should be factored. If there is going to
no change, then they are not relevant.no change, then they are not relevant.

18
Effect of Depreciation;Effect of Depreciation;
 Is a non cash expenditure which does not have a cash outflow but has toIs 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 evaluationdeducted while working out the tax on the net cash flows and evaluation
there after.there after.
 Companies Act prescribes various depreciation ratesCompanies Act prescribes various depreciation rates
 Normally two methods are used-Straight line method or WDV method.Normally two methods are used-Straight line method or WDV method.
 Income tax Act provides rates which are also followed by manyIncome tax Act provides rates which are also followed by many
companies in their books.companies in their books.
Effect of working capital;Effect of working capital;
 Constitutes another important ingredient which directly affects theConstitutes another important ingredient which directly affects the
proposal. It is a cash out flow in the year there is an increase in the netproposal. 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.WC requirement. It could be from t0 to tn.

1919
COMPONENTS OF CASH FLOW;COMPONENTS OF CASH FLOW;
1)INITIAL INVESTMENT OR OUTLAY/OUTFLOW-1)INITIAL INVESTMENT OR OUTLAY/OUTFLOW-
a)a) Purchase price of “new” assetsPurchase price of “new” assets
b) +Capitalized expenditure-Freight , Insurance, Transportation, Trainingb) +Capitalized expenditure-Freight , Insurance, Transportation, Training
of Manpower to use the machine,CD etcof Manpower to use the machine,CD etc
c)c) Opportunity costs incurred.. eg own land/house used for the project.Opportunity costs incurred.. eg own land/house used for the project.
d)+ (-)Increase (decrease) =Net Working Capital.d)+ (-)Increase (decrease) =Net Working Capital.
e)-e)- Net proceeds from sale of “old” Assets ,if replacementNet proceeds from sale of “old” Assets ,if replacement
f)f) + (-)+ (-) Taxes (savings) due to the sale of ‘old ‘machines/assetsTaxes (savings) due to the sale of ‘old ‘machines/assets
f)f) == Initial cashInitial cash outflowoutflow

20
An old machine is to be replaced. It was bought 4 years ago for rs 120,000An 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 depreciationand now sold as salvage for Rs 10000.The accumulated depreciation
amounts to Rs 112000.amounts to Rs 112000.
The cost of the new machine is Rs 200,000.The installation costs amountThe 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 workingto Rs 4000 and training costs Rs 5000.The increase in net working
capital amounts to Rs 3000.Tax rate is 30%.capital amounts to Rs 3000.Tax rate is 30%.
Find out the initial investment ;Find out the initial investment ;
Cost of machine- 200,000Cost of machine- 200,000
Installation cost- +4000Installation cost- +4000
Training costs- +5000Training costs- +5000
Increase in WC- +3000Increase in WC- +3000
Salvage value- -10000Salvage value- -10000
Tax on CG@30-Tax on CG@30- - 600- 600
RsRs 201,400201,400

2121
2)2) OPERATING CASH FLOWS/NET ANNUAL CASHOPERATING CASH FLOWS/NET ANNUAL CASH
FLOWSFLOWS;;
Represents cash inflows on account of sales/revenue generation minusRepresents cash inflows on account of sales/revenue generation minus
cash out flow on account of expenses.cash out flow on account of expenses.
Every Investment is expected to generate future benefits in the form ofEvery Investment is expected to generate future benefits in the form of
cash flows from operations.cash flows from operations.
Represents annual cash flows generated from the investments.Represents annual cash flows generated from the investments.
Represent net flows before depreciation and after taxes.Represent net flows before depreciation and after taxes.

2222
3)TERMINAL CASH FLOWS3)TERMINAL CASH FLOWS;;
The cash inflow to the company during the terminal year (lastThe cash inflow to the company during the terminal year (last
year) is called Terminal cash flow.year) is called Terminal cash flow.
Represents some value in the asset when the asset isRepresents some value in the asset when the asset is
terminated/project is completed.terminated/project is completed.
When Replacement decision is taken to replace old asset withWhen Replacement decision is taken to replace old asset with
new asset, the sale value of the old asset is the terminal cashnew asset, the sale value of the old asset is the terminal cash
flow of the asset replaced. (eg True value exchange of Maruthiflow of the asset replaced. (eg True value exchange of Maruthi
car).car).
Due to termination of the Asset, there may be release of someDue to termination of the Asset, there may be release of some
Net working capital tied up in the initial year which should alsoNet working capital tied up in the initial year which should also
be added to the salvage of the asset in the terminal cash flows.be added to the salvage of the asset in the terminal cash flows.

2323
Determination of InflowsDetermination of Inflows
ParticularsParticulars
SalesSales
Less Operating costsLess Operating costs
Cash Inflows before Taxes (CFBT)Cash Inflows before Taxes (CFBT)
Less DepnLess Depn
Taxable IncomeTaxable Income
Less TaxLess Tax
Earnings after TaxEarnings after Tax
Plus DepreciationPlus Depreciation
Cash inflows after Taxes ( CFAT)Cash inflows after Taxes ( CFAT)
PLUS salvage value (yn)PLUS salvage value (yn)
PLUS Recovery of working capitalPLUS Recovery of working capital
Y1Y1 y2y2 y3y3 y4y4 ynyn

2424
Investments, costs and Revenues( in rs 000)Investments, costs and Revenues( in rs 000)
RevenuesRevenues
Costs -300Costs -300
Undiscounted cash flow -300Undiscounted cash flow -300
Cum cash flow -300Cum cash flow -300
NPV=400NPV=400
Pay back period=2.78 yearsPay back period=2.78 years
Y1Y1
100100
2020
8080
-220-220
Y2Y2
100100
2020
8080
-140-140
Y3Y3
200200
2020
180180
4040
Y4Y4
200200
2020
180180
220220
Y5Y5
200200
2020
180180
400400

2525
Computation of cash flowsComputation of cash flows
YearYear
Cash flows -300Cash flows -300
DCF(@10%)DCF(@10%)
DCF -300DCF -300
Cum DCFCum DCF
NPV=208.7NPV=208.7
Y1Y1
8080
0.9090.909
72.7272.72
-227.78-227.78
Y2Y2
8080
0.8260.826
66.0866.08
-161.2-161.2
Y3Y3
180180
0.7510.751
135.18135.18
-26.02-26.02
Y4Y4
180180
0.6830.683
122.94122.94
96.9296.92
Y5Y5
180180
0.6210.621
111.78111.78
208.70208.70

2626
Computation of cash flows-in 000RsComputation of cash flows-in 000Rs
YearYear 00
Cash Outflow -300Cash Outflow -300
Gross IncomeGross Income
Depreciation(300000/5)Depreciation(300000/5)
Taxable IncomeTaxable Income
Tax@30%Tax@30%
CFATCFAT
y1y1
8080
6060
2020
66
7474
y2y2
8080
6060
2020
66
7474
y3y3
180180
6060
120120
3636
144144
y4y4
180180
6060
120120
3636
144144
y5y5
180180
6060
120120
3636
144144

2727
Computation of cash flowsComputation of cash flows
YearYear 00
Cash flows -300Cash flows -300
CFATCFAT
DCF(@10%)DCF(@10%)
DCF -300DCF -300
Cum DCFCum DCF
NPV=124.3NPV=124.3
Y1Y1
8080
7474
0.9090.909
67.2767.27
-232.73-232.73
Y2Y2
8080
7474
0.8260.826
61.1261.12
-171.61-171.61
Y3Y3
180180
144144
0.7510.751
108.14108.14
-63.47-63.47
Y4Y4
180180
144144
0.6830.683
98.3598.35
34.8834.88
Y5Y5
180180
144144
0.6210.621
89.4289.42
124.30124.30

2828
BEFORE TAX AFTER TAXBEFORE TAX AFTER TAX
NPV (RsNPV (Rs
000)000)
400400
208.7208.7
85.585.5
2.22.2
PAY BACKPAY BACK
PERIODPERIOD
2.782.78
3.213.21
3.853.85
4.954.95
Rate(%)Rate(%)
00
1010
2020
3030
PAY BACKPAY BACK
PERIODPERIOD
3.063.06
3.653.65
4.64.6
>5>5
NPV( RsNPV( Rs
000)000)
280280
124.31124.31
23,6723,67
-44.63-44.63

2929
IMPACT OF IMPROPER CASH FLOW ESTIMATION;IMPACT OF IMPROPER CASH FLOW ESTIMATION;
Reasons;Reasons;
Improper assessment of the project.Improper assessment of the project.
Inadequate Data.Inadequate Data.
Results;Results;
Affects investment evaluation leading to wrong decision making.Affects investment evaluation leading to wrong decision making.
Affects the profitability of the project and the company.Affects the profitability of the project and the company.
Affects the financial position of the company leading to cash crunchAffects the financial position of the company leading to cash crunch
situationssituations
Affects the existing business lines as the “new” project starts eatingAffects the existing business lines as the “new” project starts eating
into the resources of the existing business.into the resources of the existing business.
Affects the reputation of the company.Affects the reputation of the company.

3030
Case study;Case study;
““A” company is into retail business for the last 10 years with an averageA” 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 croresturnover 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 toduring the last 5 years. As the margins are low in retail business due to
severe competition, the average net profits of the retail Industry issevere competition, the average net profits of the retail Industry is
around 5% and A company was within the Industry standards vis a visaround 5% and A company was within the Industry standards vis a vis
the average net profit.the average net profit.
The Management wanted to expand and it took on lease a property inThe 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 costthe 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 entireof 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 %peramount as term loan from the bank at an interest rate of 12 %per
annum repayable in 10 years. Annual property lease cost is Rs 2annum repayable in 10 years. Annual property lease cost is Rs 2
crores.crores.
The new showroom would generate an average turnover of Rs 30The new showroom would generate an average turnover of Rs 30
crores per annum in the first 5 years with an average net profit of 1.5crores per annum in the first 5 years with an average net profit of 1.5
crores @5percent. The gross profit is 30 percentcrores @5percent. The gross profit is 30 percent
Has “A “company taken a good decision? Make suitable assumptionsHas “A “company taken a good decision? Make suitable assumptions
and advise “A “company the position ,pointing out where and in whichand advise “A “company the position ,pointing out where and in which
areas of cash flow estimation they have gone wrong.areas of cash flow estimation they have gone wrong.

3131
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