Cash Flow Estimation for Capital Budgeting Decision

Rohit has recently graduated and his father a successful businessman inducted him into
his business. He was given charge of a new project and was asked to work out the
financial viability of this project. Based upon the inputs given by the marketing and
project team the following estimates were prepared:

 Project Life : 5 years

 Investment in Plant & Machinery : Rs.800 million

 Working Capital Requirement : Rs.200 million

 Estimated Annual Revenue : Rs. 1200 million per annum

 Estimated Annual Operating Cost : Rs. 800 million per annum. This does not

include depreciation, interest and tax.

 Salvage Value of Assets : 50 million

 Depreciation Rate : 25% per annum on Written Down Value

Method

 Debt Equity Ratio : 1:1

 Rate of Interest on borrowing : 10%

 Rate of return required on Equity : 16%

 Tax Rate : 30%

Based upon the above assumption Rohit prepared the following financial estimates:

 Cost of Funds = Cost of Debt x (1-Tax Rate) x ½ + Required Return on Equity x

½

= 10% (1-.30) x ½ + 16% x ½ = 3.50% + 8% = 11.50%

The estimated profit and loss for the life of the project is given below:

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Projected Profit & Loss Rs. In Million

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Particulars / Period 0 1 2 3 4 5

1. Fixed Assets 800.00

2. Revenue 1200.00 1200.00 1200.00 1200.00 1200.00
3. Cost 800.00 800.00 800.00 800.00 800.00
4. Depreciation 200.00 150.00 112.50 84.38 63.28
5. EBIT 200.00 250.00 287.50 315.63 336.72
6. Interest 50.00 50.00 50.00 50.00 50.00
7. Profit Before Tax 150.00 200.00 237.50 265.63 286.72
8. Tax 45.00 60.00 71.25 79.69 86.02
9. Profit After Tax 105.00 140.00 166.25 185.94 200.70

 Average Profit after Tax – Rs.159.58 million

 Return on Investment – Average PAT / Investment
o = Rs.159.58 million / Rs.800 million = 19.95%
 As Return on Investment is greater than the cost of funds @ 11.75% as computed
before hand the project should be accepted.

However Rohit is confused because the total PAT over the life of the project is only
Rs.797.89 and accordingly the project is not even paying back its investment.

The above analysis was put before the Board of Directors and some serious questions
were raised about the methodology used for recommending the project. Based upon the
discussion the following major observations were made:

 Profit After Tax is not a good measure of project benefits as it depends upon the
method of depreciation being used. It is better to use Cash Flow from the project
both for estimating the Cost (Outflow) and Benefits (Inflows). Depreciation being
a non cash expense should not be considered as an Operating Cash Outflow.

 The computations above have not considered the blockage of funds due to
working capital. The funds required for working capital remain blocked
throughout the life of the project and get released only when the project life is
over. Ignoring blockage of funds due to working capital ignores the cost of funds
blocked in working capital.

 It is advisable to break the cash flow into initial cash flow, operating cash flow
and terminal cash flow. The salvage value of the plant & machinery must be
considered as a relevant cash flow. Likewise the release of working capital should
also be considered upon completion of the project.

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  As the cost of debt has already been considered for calculating the cut-off rate,
interest on loan should not be considered in calculating the project benefits. The
project’s operating cash flow should not be vitiated by the means of finance used.

 Average PAT gives same weight to profits earned in all the years and therefore
ignores time value of money. Method of evaluation must consider time value of
money.

Based upon the above observations Rohit was asked to:

 Prepare a statement showing estimated cash flow showing initial cash flow,
operating cash flow and terminal cash flow.

 Compute revised Pay-Back period.

 Suggest a method for accepting/ rejecting the project considering time value of
money.

As Rohit never has any formal training in finance, he needs your help in putting
together a suitable report for the Board of Directors.