Estimation of Cash Flows

ESTIMATION OF CASH FLOWS
By CA N.Venkatakrishnan
@
MVIT
12TH MAY 2011
1
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
2
CAPITAL EXPENDITURE VS REVENUE EXPENDITURE
Capital ( CAPEX)
Revenue ( OPEX) Deferred revenue ( CAPEX)
3
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.
4
REVENUE EXPENDITURE;
Manufacturing costs
Salary, Bonus Gratuity etc-Employee costs
Rent
Electricity
Interest
Communication Expenses
Advertisement
Marketing Expenses
5
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.
6
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.
7
EXECUTIVES/PROFESSIONALS INVOLVED IN CAPITAL
BUDEGETING;
1. Engineering Teams-for outlays

4. Plant Managers- for giving their inputs
3. Production Team of Engineers-for operational costs
6. Marketing Team.– for estimation
7. Finance Team- For working out the Financial data
6 Capital Expenditures Committee
7. President
8. Board of Directors
8
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
9
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.
10
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.
11
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.
12
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.
13
Difference between Accounting and cash Flow approach; In rupees
Particulars Accounting Cash Flow

approach approach
Revenues-sales(1) 50,000 50,000
Less ;Cost of sales(2)
Materials 20000 20000
Labor 6000 6000
other expenses 4000 4000
Depreciation 10000 ---------
Total cost 40000 30000
Earnings/Cash Flow before Tax(1-2) 10000 20000
Taxes say 30% 3000 6000
Net Earnings/Cash flow after Tax 7000 14000
14
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.
15
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
FixedOverheads
Sunk costs.
16
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.
17
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.
18
COMPONENTS OF CASH FLOW;
1)INITIAL INVESTMENT OR OUTLAY/OUTFLOW-

d) Purchase price of “new” assets
b) +Capitalized expenditure-Freight , Insurance, Transportation, Training

of Manpower to use the machine,CD etc
h) 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
19
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
20
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.
21
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.
22
Determination of Inflows
Particulars Y1 y2 y3 y4 yn
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
23
Investments, costs and Revenues( in rs 000)
Y1 Y2 Y3 Y4 Y5
Revenues 100 100 200 200 200
Costs -300 20 20 20 20 20
Undiscounted cash flow -300 80 80 180 180 180
Cum cash flow -300 -220 -140 40 220 400
NPV=400
Pay back period=2.78 years

24
Computation of cash flows
Year Y1 Y2 Y3 Y4 Y5
Cash flows -300 80 80 180 180 180
DCF(@10%) 0.909 0.826 0.751 0.683 0.621

DCF -300 72.72 66.08 135.18 122.94 111.78
Cum DCF -227.78 -161.2 -26.02 96.92 208.70
NPV=208.7
25
Computation of cash flows-in 000Rs
Year 0 y1 y2 y3 y4 y5
Cash Outflow -300
Gross Income 80 80 180 180 180
Depreciation(300000/5) 60 60 60 60 60
Taxable Income 20 20 120 120 120
Tax@30% 6 6 36 36 36
CFAT 74 74 144 144 144
26
Computation of cash flows
Year 0 Y1 Y2 Y3 Y4 Y5
Cash flows -300 80 80 180 180 180
CFAT 74 74 144 144 144
DCF(@10%) 0.909 0.826 0.751 0.683 0.621
67.27 61.12 108.14 98.35 89.42
DCF -300 -232.73 -171.61 -63.47 34.88 124.30
Cum DCF
NPV=124.3
27
BEFORE TAX AFTER TAX
NPV (Rs 000) PAY BACK Rate(%) PAY BACK NPV( Rs 000)
PERIOD PERIOD
400 2.78 0 3.06 280
208.7 3.21 10 3.65 124.31
85.5 3.85 20 4.6 23,67
2.2 4.95 30 >5 -44.63
28
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.
29
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.
30
Thank you
31

Estimation of Cash Flows

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ESTIMATION OF CASH FLOWS

What is Capital Budgeting;

 The process of identifying, evaluating and

Revenue ( OPEX) Deferred revenue ( CAPEX)

Purchase of capital equipment

1)Affect the profitability of the company –Earning Assets of the

DIFFICULTIES IN CAPITAL EXPENDITURE DECISIONS;

1)Relate to uncertain future Period involving various risk factors.

1. New products or expansion of existing products

All these could be Independent or Mutually Exclusive.

1. Engineering Teams-for outlays

THE CAPITAL BUDGETING PROCESS;

Generate investment proposals consistent with the firm’s strategic

 Inaccurate data can distort the cash flow projections and

2)Post Tax principle;

 Incidental Effects: Any kind of project taken by a company remains

1)CASH FLOW VS ACCOUNTING PROFIT;

Cash Flow method is a better method of measuring Economic Viability;

There are Accounting ambiguities in determining net profits under

Cash Flow method recognizes the Time value of money where as

Particulars Accounting Cash Flow

Net Earnings/Cash flow after Tax 7000 14000

Relevant for cash outflows;

 Cost of the Investment

Irrelevant for cash outflows

Effect of working capital;

1)INITIAL INVESTMENT OR OUTLAY/OUTFLOW-

b) +Capitalized expenditure-Freight , Insurance, Transportation, Training

h) 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

Find out the initial investment ;

2) OPERATING CASH FLOWS/NET ANNUAL CASH FLOWS;

Represents cash inflows on account of sales/revenue generation minus

Every Investment is expected to generate future benefits in the form of

Represents annual cash flows generated from the investments.

Represent net flows before depreciation and after taxes.

Revenues 100 100 200 200 200

Undiscounted cash flow -300 80 80 180 180 180

Cum cash flow -300 -220 -140 40 220 400

Pay back period=2.78 years

DCF(@10%) 0.909 0.826 0.751 0.683 0.621

400 2.78 0 3.06 280

208.7 3.21 10 3.65 124.31

85.5 3.85 20 4.6 23,67

2.2 4.95 30 >5 -44.63

Affects investment evaluation leading to wrong decision making.

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