DETERMINING CASH FLOWS FOR INVESTMENT ANALYSIS Chapter 10 DETERMINING CASH FLOWS FOR INVESTMENT ANALYSIS

LEARNING OBJECTIVES Show the conceptual difference between profit and cash flow Discuss the approach for calculating incremental cash flows Explain the treatment of inflation in capital budgeting Highlight the interaction between financing and investment decisions

INTRODUCTION Sound investment decisions should be based on the net present value (NPV) rule. Problems to be resolved in applying the NPV rule What should be discounted? In theory, the answer is: We should always discount cash flows. What rate should be used to discount cash flows? In principle, the opportunity cost of capital should be used as the discount rate.

CASH FLOWS VERSUS PROFIT 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. Second, for computing profit, expenditures are arbitrarily divided into revenue and capital expenditures.

INCREMENTAL CASH FLOWS Every investment involves a comparison of alternatives: When the incremental cash flows for an investment are calculated by comparing with a hypothetical zero-cash-flow project, we call them absolute cash flows. The incremental cash flows found out by comparison between two real alternatives can be called relative cash flows. The principle of incremental cash flows assumes greater importance in the case of replacement decisions.

Example Suppose a firm is considering replacing an equipment at book value of Rs. 5000 and market value of Rs. 3000. New equipment will require an initial cash outlay of Rs 10,000, and is estimated to generate cash flows of Rs 8,000, Rs 7,000 and Rs 4,500 for the next 3 years. The book value of old machine is a sunk cost. Market value is opportunity cost. Thus, on an incremental basis the net cash outflow of new equipment is: Rs 10,000 – Rs 3,000 = Rs 7,000. Also, The differences of the cash flows of new equipment over the cash flows of old equipment are incremental cash flows.

COMPONENTS OF CASH FLOWS Initial Investment Net Cash Flows Depreciation and Taxes Net Working Capital Change in accounts receivable   Change in inventory   Change in accounts payable   Free Cash Flows Terminal Cash Flows Salvage Value Salvage value of the new asset Salvage value of the existing asset now Salvage value of the existing asset at the end of its normal Tax effect of salvage value   Release of Net Working Capital

Initial Investment Initial investment is the net cash outlay in the period in which an asset is purchased. A major element of the initial investment is gross outlay or original value (OV) of the asset, which comprises of its cost (including accessories and spare parts) and freight and installation charges. Original value is included in the existing block of assets for computing annual depreciation.

Example of Initial Investment Wattle Extract Project: Initial Investment

Net Cash Flows Consist of annual cash flows occurring from the operation of an investment, but it is also be affected by changes in net working capital and capital expenditures during the life of the investment. The computation of the after-tax cash flows requires a careful treatment of non-cash expense items such as depreciation. Depreciation, calculated as per the income tax rules influences cash flows indirectly by way of depreciation tax shield.

Calculation of Depreciation For Tax Purposes Two most popular methods of charging depreciation are: straight-line Diminishing balance or written-down value (WDV) methods. For reporting to the shareholders, companies in India could charge depreciation either on the straight-line or the written- down value basis. No choice of depreciation method and rates for the tax purposes is available to companies in India. Depreciation is computed on the written down value of the block of assets and rates are specified.

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 should be subtracted from and decrease added to after-tax operating profit.

Free Cash Flows It is the cash flow available to service both lenders and shareholders, who have provided, respectively, debt and equity, funds to finance the firm’s investments. It is this cash flow, which should be discounted to find out an investment’s NPV.

Terminal Cash Flow: Salvage Value Salvage value is a terminal cash flow. Salvage value may be defined as the market price of an investment at the time of its sale. No immediate tax liability (or tax savings) arises on the sale of an asset because the value of the asset sold is adjusted in the depreciable base of assets.

Effects of Salvage Value Salvage value of the new asset: It will increase cash inflow in the terminal (last) period of the new investment. Salvage value of the existing asset now: It will reduce the initial cash outlay of the new asset. Salvage value of the existing asset at the end of its normal life: It will reduce the cash flow of the new investment of in the period in which the existing asset is sold.

Release of Net Working Capital Besides salvage value, terminal cost 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.

CALCULATION OF DEPRECIATION FOR TAX PURPOSES Two most popular methods of charging depreciation are: Straight-line and diminishing balance Written-down value (WDV) methods In India, depreciation is allowed as deduction every year on the written-down value basis in respect of fixed assets as per the rates prescribed in the Income Tax rules. Depreciation is computed on the written down value of the block of assets.

Depreciation base In the case of block of assets, the written down value is calculated as follows: The aggregate of the written down value of all assets in the block at the beginning of the year Plus the actual cost of any asset in the block acquired during the year Minus the proceeds from the sale of any asset in the block during the year Thus, in a replacement decision, the depreciation base of a new asset will be equal to: Cost of new equipment + Written down value of old equipment – Salvage value of old equipment

Cash Flow Estimates for New Products It depends on forecasts of sales and operating expenses. Sales forecasts require information on the quantity of sales and the price of the product. Anticipation of the competitors’ reactions.

Salvage Value and Tax Effects As per the current tax rules in India, the after-tax salvage value should be calculated as follows: Book value > Salvage value: After-tax salvage value = Salvage value + PV of depreciation tax shield on (BV – SV) Salvage value > Book value: After-tax salvage value = Salvage value - PV of depreciation tax shield lost on (SV  BV)

Terminal Value for a New Business The terminal value included the salvage value of the asset and the release of the working capital. Managers make assumption of horizon period because detailed calculations for a long period become quite intricate. The financial analysis of such projects should incorporate an estimate of the value of cash flows after the horizon period without involving detailed calculations. A simple method of estimating the terminal value at the end of the horizon period is to employ the following formula, which is a variation of the dividend growth model

Terminal Value of New Business / New Products New businesses have the potential of generating revenues and cash flows much beyond the assumed period of analysis, which is referred to as horizon period. A simple method of estimating the terminal value at the end of the horizon period is: where NCFn+1 is the project’s net cash flow one year after the horizon period, k is the opportunity cost of capital (discount rate) and g is the expected growth in the project’s net cash flows.

Cash Flow Estimates for Replacement Decisions The initial investment of the new machine will be reduced by the cash proceeds from the sale of the existing machine. The annual cash flows are found on incremental basis. The incremental cash proceeds from salvage value is considered.

Additional Aspects of Incremental Cash Flow Analysis Allocated Overheads Opportunity Costs of Resources Incidental Effects Contingent costs   Cannibalisation   Revenue enhancement   Sunk Costs Tax Incentives Investment allowance  Until Investment deposit scheme   Other tax incentives  

Investment Decisions Under Inflation Executives generally estimate cash flows assuming unit costs and selling price prevailing in year zero to remain unchanged. They argue that if there is inflation, prices can be increased to cover increasing costs; therefore, the impact on the project’s profitability would be the same if they assume rate of inflation to be zero. This line of argument, although seems to be convincing, is fallacious for two reasons. First, the discount rate used for discounting cash flows is generally expressed in nominal terms. It would be inappropriate and inconsistent to use a nominal rate to discount constant cash flows. Second, selling prices and costs show different degrees of responsiveness to inflation The depreciation tax shield remains unaffected by inflation since depreciation is allowed on the book value of an asset, irrespective of its replacement or market price, for tax purposes.

Nominal VS. Real Rates of Return For a correct analysis, two alternatives are available: either the cash flows should be converted into nominal terms and then discounted at the nominal required rate of return, or the discount rate should be converted into real terms and used to discount the real cash flows Important: Discount nominal cash flows at nominal discount rate; or discount real cash flows at real discount rate. Example: If a firm expects a 10 per cent real rate of return from an investment project under consideration and the expected inflation rate is 7 per cent, the nominal required rate of return on the project would be:

It would be inconsistent to discount the real cash flows of the project by the nominal discount rate. For example, in case of following cash flows discounting with 14% nominal rate of real cash flows returns negative NPV: The cash flows should be discounted with real discount rate as follows:

Financing effects in Investment Evaluation According to the conventional capital budgeting approach cash flows should not be adjusted for the financing effects. The adjustment for the financing effect is made in the discount rate. The firm’s weighted average cost of capital (WACC) is used as the discount rate. It is important to note that this approach of adjusting for the finance effect is based on the assumptions that: The investment project has the same risk as the firm. The investment project does not cause any change in the firm’s target capital structure.