By Anuj Joshi Anuj G Joshi Note 1 Principles involved in estimation of Project Cash Flows
Principle Description 1. Incremental Approach Cash Flows are to be estimated in incremental terms, i.e. difference between the Cash Flows of the Firm without project and with project. 2. Long Term Funds Approach Cash Flows should be assessed from the Total Long-Term Funds view point, i.e. total of Debt, Preference and Equity Funds. 3. Exclusion of Financing Costs Since the Cost of Capital used for discounting purposes includes the cost associated with Debt, Preference and Equity components of Capital, Interest on Debt and Dividends (Equity and Preference) are not considered as Cash Outflows /Expenses in the estimation. Post Tax Concept Cash Flows are to be defined in post-tax terms. Also, the Cost of Capital used for discounting should be computed in post-tax terms. Anuj G Joshi Techniques of Project Evaluation 1. Simple Payback Period 2. Discounted Payback Period 3. Payback Reciprocal 4. Accounting or Average Rate of Return 5. Net Present Value (NPV) or Discounted Cash Flow (DCF) 6. Profitability Index (PI) or Desirability Factor or Benefit Cost Ratio 7. Internal Rate of Return (IRR) and Modified Internal Rate of Return (MIRR) Anuj G Joshi Note 2 Procedure for computation for Simple Payback Period
a) Determine the Initial Investment (Cash Outflow) of the project. b) Determine CFAT (Cash Inflows) from the project for various years. c) Compute Payback period as under i. Uniform CFAT per annum Initial Investment CFAT per annum ii. Differential CFAT for various years Compute cumulative CFAT at the end of every year Determine the year in which cumulative CFAT exceeds Initial Investment Payback period = Time at which cumulative CFAT = Initial Investment (calculated on time proportion basis) d) Accept if Payback Period is less than maximum or benchmark period, else reject the project. Anuj G Joshi Note 3 Procedure for computation for Discounted Payback Period
a) Determine the Total Cash Outflow of the project (Initial Investment). b) Determine the Cash Inflow After Taxes (CFAT) for each year. c) Determine the PV factor for each year and compute Discounted CFAT (DCFAT) for each year. DCFAT = CFAT of each year X PV Factor for that year d) Determine the cumulative DCFAT at the end of every year. e) Determine the year in which cumulative DCFAT exceeds Initial Investment. f) Compute Discounted Payback Period as the time at which cumulative DCFAT = Initial Investment. This is calculated on time proportion basis. g) Accept if Discounted Payback Period less than maximum/benchmark period, else reject the project. Anuj G Joshi Note 4 Payback Reciprocal
= Average Annual Cash Inflows (CFAT p.a.) Initial Investment Anuj G Joshi Note 5 Procedure for computation of ARR
a) Determine Net Investment of the project. Net Investment = Initial Investment Salvage Value b) Determine PAT for each year PAT = CFAT Depreciation c) Determine total PAT for N years, where N = Project Life d) Compute Average PAT p.a. = (Total PAT of all years)/N years e) ARR = Average PAT p.a./Net Investment Anuj G Joshi Note 6 Procedure for computation of NPV or DCF
a) Determine the Total Cash Outflow of the project and the time periods in which they occur. b) Compute the Total Discounted Cash Outflow = Outflow X PV factor c) Determine the Total Cash Inflows of the project and the time periods in which they arise d) Compute the Total Discounted Cash Inflows = Inflow X PV factor e) Compute NPV = Discounted Cash Inflows Discounted Cash Outflows f) Accept project if NPV is positive, else reject. Anuj G Joshi Note 7 Desirability Factor
= Present Value of Operational Cash Inflows Present Value of Net Investments
Accept project if PI is greater than 1, else reject. Anuj G Joshi Note 8 Procedure for computation of IRR
a) Determine the total cash outflow of the project and the time periods in which they occur. b) Determine the total cash inflows of the project and the time periods in which they arise. c) Compute NPV at an arbitrary discount rate, say 10% d) Choose another discount rate and compute NPV. The second discount rate is chosen in such a way that one of the NPVs is negative and the other is positive. Suppose, NPV is positive at 10%, choose a higher discount rate so as to get a negative NPV. In case NPV is negative at 10%, choose a lower rate. e) Compute the change in NPV over the two selected discount rates. f) On proportion basis, compute the discount rate at which NPV is zero. Anuj G Joshi Note 9 Procedure for computation of Modified IRR
a) Determine the total Cash Outflows and Inflows of the project and the time periods in which they occur. b) Compute Terminal Value of all Cash Flows other than the Initial Investment. For this purpose Terminal Value of a Cash Flow = Amount of Cash Flow X Reinvestment Factor where, Reinvestment Factor = (1+K) n [where, n = number of years balance remaining in the project] c) Compute Total of Terminal Values as computed under b. This is taken as the Inflow from the project, to be compared with the Outflow i.e. the initial investment. d) Compute MIRR, i.e. Discount Rate such that PV of Terminal Value = Initial Investment, Note: For computing MIRR, the interpolation technique applicable to IRR may be used. Anuj G Joshi Note 10 Comparison of two mutually exclusive projects to be treated when they have Different Project Durations
A. Equivalent Annual Flows Method B. LCM Method C. Terminal Value Anuj G Joshi A. Equivalent Annual Flows Method
Cash flows are converted into an equivalent annual annuity called EAB i.e. Equivalent Annual Benefit (in case of net inflow) or EAC i.e. Equivalent Annual Cost (in case of net outflow) i.e. Total Discounted Cash Flows Total Discount Factor for the period The amounts are then compared and decisions drawn i.e. in case of cost comparison, proposal with the lower Equivalent Annual Flow will be selected, and in case of benefit comparison, proposal with higher Annual Flow will be selected. Anuj G Joshi Procedure for computation of Equivalent Annual Flows Method
a) Compute the Initial Investment of each alternative b) Determine the project lives of each alternative c) Determine the Annuity Factor relating to the project life of each alternative d) Compute Equivalent Annual Investment (EAI) = Initial Investment/Relevant Annuity Factor e) Compute CFAT per annum or Cash outflows per annum, of each alternative f) Compute EAB = CFAT p.a. EAI Compute EAC = Cash Outflows p.a. + EAI g) Select Project with maximum EAB or minimum EAI, as the case may be Anuj G Joshi B. LCM Method
Evaluate the alternatives over an interval equal to the lowest common multiple of the lives of the alternatives under consideration. Example, Proposal A has 3 years and Proposal B has 5 years. Lowest common multiple period is 15 years, during which period Machine A will be replaced 5 times and Machine B will be replaced 3 times. Cash flows are extended to this period and computations are made. The final results would then be on equal platform i.e. equal years and hence would be comparable. This is similar to the Equivalent Annual Benefits / Costs Method, discussed in Point A. Anuj G Joshi C. Terminal Value
Estimate the terminal value for the alternatives at the end of a certain period i.e. product life. In the above example, if the product can be produced only for 3 years, the salvage value at the end of the 3 rd year should be considered in the evaluation process. Anuj G Joshi