Financial Management I 10. Analysis of Project Cash Flows CTRL+L Full Screen suresh.suralkar@gmail.com, Phone: 40434385Introduction: Analysis of Project Cash Flows It is an analysis of invest inflows and cash inflows. It is most important and most difficult step in capital budgeting. Important because of project viability decisions and difficult because of forecasting error. For example, Alaska pipeline project, initial cost estimate was about $700 million, however final cost was about $7 billion. Year 0 1 2 J 4 5 6 7 8 150 10 15 30 50 50 40 30 20 Initial <————__ Operating Cash Inflows —-—-——————_+ |, Investment 50 Terminal Cash Flow 2/911. Cash Flow Estimation Following principles are followed while estimating the cash flows of a project ¢ Separation Principle ¢ Incremental Principle ¢ Post-tax Principle ¢ Consistency Principle. ‘<7 e1. Cash Flow Estimation: Separation Principle Separation Principle There are two sides of a project viz. investment side (or asset side) and financing side. Cash flows associated with these sides should be separated. For example, a firm is considering a one-year project that requires an investment of Rs. 1,000 in fixed assets and working capital at time 0. The project is expected to generate a cash inflow of Rs. 1200 at the end of year 1. This is the only cash inflow expected from the project. Project is financed by debt carrying an interest rate of 15% maturing after 1 year. 41. Cash Flow Estimation: Separation Principle Project | Financing Side Investment Side Time Cash Flow Time Cash Flow 0 + 1,000 0 - 1,000 1 - 1,150 1 + 1,200 Cost of capital: 15% Cost of return: 20% Note that the cash flows on investment side do not show cost of financing (interest in our example). Financing costs are included in the cash flows on the financing side, which reflects in cost of capital. Cost of capital is used as a hurdle rate against which rate of return on investment side is judged. eae1. Cash Flow Estimation: Separation Principle Important point to be noted that the cash flows on investment side should not include financing costs, because they will be reflected in the cost of capital against which the rate of return will be evaluated. Operationally, this means that interest on debt is ignored while computing profits and taxes thereon. Alternatively, if interest is deducted in the process of arriving at profit after tax, an amount equal to ‘interest(1-tax rate)’ should be added to ‘profit after tax’. Note that 6/711. Cash Flow Estimation: Separation Principle Profit before interest and tax (1 — tax rate) = (Profit before tax + interest) (1 — tax rate) = (Profit before tax) (1-tax rate)+ interest(1-tax rate) = Profit after tax + interest(1-tax rate) Thus, whether the tax rate is applied directly to the ‘Profit before interest and tax’ or whether tax-adjusted interest, which is simply ‘Interest(1-tax rate)’ is added to the profit after tax, we get the same result. 7/911. Cash Flow Estimation: Incremental Principle Incremental Principle Cash flow of a project must be measured in incremental terms. To find a project’s incremental cash flows, you have to look at what happens to the cash flows of the firm with the project and without the project. The difference between the two reflects the incremental cash flows attributable to the project. That is Project cash flow for year t = Cash flow for the firm with the project for year t — Cash flow for the firm without the project for year t. een1. Cash Flow Estimation: Incremental Principle While estimating the incremental cash flows of a project, following guidelines must be used. Consider All Incidental Effects: These include some enhancements and some detract effects on profitability. All these effects must be taken into account. Ignore Sunk Costs: A sunk cost refers to an outlay already incurred in the past or already committed irrevocably. Include Opportunity Costs: Opportunity cost is the value of the next best alternative forgone. If a project uses resources already available with the firm, there is a potential for an opportunity cost. 9/91. Cash Flow Estimation: Incremental Principle Question the Allocation of Overhead Costs: Costs which are only indirectly related to a project or service are referred to as overhead costs. They include general administrative expenses, managerial salaries, legal expenses, rent and so on. Estimate Working Capital Properly: Working capital (or more precisely, net working capital) is defined as (current assets, loans and advances) — (current liabilities and provisions). Outlays on working capital have to be properly considered while project cash flows. Working capital changes over time. soot1. Cash Flow Estimation: Post-tax Principle Post-tax Principle Cash flows should be measured on an after tax basis. Average tax rate is the total tax as a proportion of the total income of the business. The marginal tax rate is the tax rate applicable to the income at margin i.e. the next rupee of income. The marginal tax rate is higher than the average tax rate because of various tax incentives. 1/711. Cash Flow Estimation: Consistency Principle Consistency Principle Cash flows and the discount rates applied to these cash flows must be consistent with respect to the investor group and inflation. Investor groups are of equity shareholders and lenders. In dealing with inflation, you have two choices. You can use expected inflation in the estimates of future cash flows and apply a nominal discount rate to the same. Else, you can estimate the future cash flows in real terms and apply a real discount rate to the same. vy)9y2. Identifying the Relevant Cash Flows Projects have following components of cash flows ¢ Initial investment ¢ Annual net cash flows ¢ Terminal cash flows. 13/912. Identifying the Relevant Cash Flows Initial investment This 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. 14/712. Identifying the Relevant Cash Flows Annual net cash flows An investment is expected to generate annual cash flows from operations after an initial cash outlay has been made. Cash flows should always be estimated on an after-tax basis. 15/712. Identifying the Relevant Cash Flows Terminal cash flows Last or the terminal year of an investment may have additional cash flows or salvage value. Salvage value is defined as the market price of an investment at the time of its sale. The cash proceeds net of taxes from the sale of the assets will he treated as cash inflow in the terminal (last) year. 16/714. Replacement, Cash Flow Estimation Bias Cash flows for new projects or expansion projects is relatively easy. In such cases, the initial investment, operating cash inflows and terminal cash flows are the after-tax cash flows associated with the proposed project. Estimating the cash flows for a replacement project is somewhat complicated because you have to determine the incremental cash outflows and inflows in relation to the existing project. Biases in cash flow estimation As the cash flows have to be forecasted far into the future, errors occur in estimation. Biases may lead to over stating or under stating of true project profitability. 45. Evaluating Projects with Unequal Life The choice between projects with different lives should be made by evaluating them for equal periods of time. Example A firm has to choose between two projects X and Y which have different lives. 0 1 2 3 4 |NPV, 10% xX 120 30 30 30 40 215.1 Y 60 40 40 - - 129.42 Project Y looks better due to lower PV of its costs. But these projects are of different lives. vaso5. Evaluating Projects with Unequal Life Cash Flows 0 1 2 3 4 NPV, 10% Yi 60 40 40 0 0 129.42 Y2 0 0 60 40 40 106.96 Y=Y1+Y2 60 40 100 40 40 236.38 xX 120 30 30 30 30 215.10 We would choose X since the PV of its costs is lower. This is the correct procedure for comparing NPVs of the projects for equal periods of time. 19/916. Adjusting Cash Flow for Inflation A common problem which complicates the investment decision making is inflation. The rule is to be consistent in treating inflation in the cash flows and the discount rate. Inflation is a fact of life all over the world. Because the cash flows of a project occur over a long period of time, a firm should be concerned about the inflation on the project’s profitability. Capital budgeting results will be biased if the inflation is not correctly factored in the analysis. Inflation rate is accounted as below. 90/716. Adjusting Cash Flow for Inflation — + Nominal Rate 1+ Real Rate = ————___—_. 1+ Inflation Rate -. 1+Nomial Rate = (1+Real Rate) (1+Inflation Rate) “Nominal Rate = (1+Real Rate) x (1+Inflation Rate) - 1...(1) -.Nominal Rate = 1+Real Rate +Inflation Rate + RR x IR Note that all rates are in decimals. Ignoring RR x IR, since the product is a small value, we get Nominal Rate = 1 + Real Rate + Inflation Rate keeEK of tea