Guidelines for Calculating Incremental Cash Flows in Financial Management, Exercises of Financial Theory

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Cashflow Estimation

S S S Kumar

Financial Management

Cashflows and capital budgeting  (^) Decisions are only as good as the information used to make them.  Cashflows estimation is a multi disciplinary approach

Incremental cash flows  (^) Incremental cash flows are cash flows that will occur if a project is accepted, but that will not occur if the investment is rejected.  “What is different if project is accepted?” The cash flows of the firm with the project minus the cash flows of the firm without the project Project CFt  Firm'sCFt with project  Firm'sCFt without project

Basic Cash Flow Pattern Initial After-Tax Cash Flow ( CF 0 ) Expected Annual After-Tax Operating Cash Flows ( CF (^) tt ) t= 1 2 3 n-1 n CF 1 CF 2 CF 3 CFN-1 CFN Terminal Cash Flow ( ECFn ) If CF 0 < PV of CFt , then benefits exceeds costs, the NPV is positive. ACCEPT the Project     n t t t t k CF PV of CF 1 (^1 )

Initial cashflow  (^) The initial cashflow is basically the amount of money the firm has to spend to get the new project started.  Cash outflow at beginning of project (time period zero)  (^) Includes cost of acquiring fixed assets (purchase price plus other costs incurred in getting asset to your company and up and running, such as shipping, installation, etc.)  Also includes changes in net working capital caused by proposed project

Net working capital  (^) Increase in NWC = outflow (additional cost of project)  (^) Decrease in NWC = inflow (savings created by project)

Terminal Cashflows  Include after tax salvage value and reduction in net working capital

1. After-tax proceeds from sale of fixed asset(s)
2. Generally, the sale of a “capital asset” generates a capital gain (asset sells for more than book value) or capital loss (asset sells for less than book value).

Terminal Cashflows  (^) Include after tax salvage value and reduction in net working capital

1. After-tax proceeds from sale of fixed asset(s)
2. Return of NWC to its original (before-project) level a. If the project caused an increase in NWC in the beginning, that increased investment is no longer needed when the project is completed. Those funds are freed up to be used elsewhere. Amount of NWC is counted as cash inflow in DCF. b. If the project caused a decrease in NWC in the beginning, that benefit no longer exists at end of project. Amount of NWC is counted as cash outflow in DCF.

Why?  (^) The cost of capital already incorporates interest and dividend affects in the analysis by way of discounting process.  (^) If we include them as cash flows, we would be double counting capital costs.

Cashflows: points to remember  (^) Sunk costs  (^) Opportunity costs  Inflation treatment  (^) Overhead allocations  Include all externalities

16 Cashflows: points to remember Example: Currently your salary is Rs 12 lakhs per annum. You decide to enroll in this programme by opting for a half – pay job for this year. The annual tuition fees for the programme is approximately Rs.250,000. What is the total cost of your PG course?

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Practice question

A four-year project has cash flows before taxes

and depreciation of $12,000 per year. The

project requires the purchase of a $50,

asset that will be depreciated over five years,

straight line. At the end of the fourth year the

asset will be sold for $18,000. The firm's

marginal tax rate is 35%. Calculate the cash

flows associated with the project. (For

convenience assume the gain on the sale of

the asset is taxed at 35%.)