Cash Flow Analysis

Project Cash Flow Analysis (Module 4)

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Project Cash Flows – An Overview Estimates of cash flows are key towards investment evaluation. Estimating the cash flows is the most difficult aspect of capital budgeting process. In gigantic & complex projects forecasting errors can be quite large. Forecasting cash flows involves numerous variables and multiple participants:  Capital Outlays: Engineering & Product Development Departments  Revenue Projections: Marketing Department  Operating Costs: Production Dept, Cost Accountants, Purchase Manager, Personnel Executives etc. Finance manager coordinate the efforts of various departments and obtain information from them, ensure that the forecasts are based on a set of consistent assumptions, keep the exercise focused on relevant variables and minimize the inherent biases in estimation.

Elements of Cash Flow Stream • For project evaluation, the relevant cash flows are the incremental after-tax cash flows associated with the project. • A conventional project involves cash outflows followed by cash inflows. • Three basic cash flow components of a conventional project:  Initial Investment: After-tax cash outlay on capital expenditure and net working capital when the project is set up.  Operating Cash Inflows: After-tax cash inflows resulting from the operations of the project during its economic life.  Terminal Cash Inflow: After-tax cash flow resulting from the liquidation of the project at the end of its economic life.

Cash Flow Components Terminal Cash Inflow 50,000

Operating Cash Inflows

0

10,000 15,000 30,000 50,000 50,000 40,000 20,000

1 7 1,50,000 Initial Investment

2 8

3

4 End of Year

5

6

30,000

Time Horizon for Cash Flow Analysis The time horizon for cash flow analysis is generally the minimum of the following:  Physical Life of the Plant  Technological Life of the Plant  Product Market Life of the Plant  Investment Planning Horizon of the Firm

Principles of Cash Flow Estimation • Separation (or Exclusion of Financing Cost) Principle • Incremental Principle • Post-Tax Principle • Consistency (or Long-term Funds) Principle

Separation Principle • There are two sides of a project - Investment Side (or Asset Side) - Financing Side • Separation principle suggests that the cash flows associated with these sides should be separated. A firm is considering a 1 year project requiring an investment of 1,000 in fixed assets and working capital at time 0. The project is expected to generate a single cash inflow of 1,200 at the end of year 1. The project will be financed entirely by debt carrying an interest rate of 15% p.a. and maturing after 1 year. There are no taxes involved within the project.

Separation Principle 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%

Rate of Return: 20%

 Cash flows on the investment side of the project do not reflect financing costs (interest on debt) in the above example.  The financing costs are included in the cash flows on the financing side and reflected in the cost of capital figure (i.e. 15% p.a. in the above example).  The cost of capital is used as the hurdle rate against which the rate of return on the investment side (i.e. 20% in the above example) is evaluated. The separation principle emphasizes that while defining the cash flows on the investment side, financing costs should not be considered because they will be reflected in the cost of capital figure against which rate of return figure will be evaluated.

Incremental Principle • According to this principle, cash flows of a project must be measured in incremental terms. • The question to be answered is what happens to the cash flows of the firm with the project and without the project. • The difference between the above two will reflect the incremental cash flows attributable to the project. for the firm with the project for year ‘t’ – CF for Project CFCF t = the firm without the project for year ‘t’ CF = Cash Flows

Incremental Principle In estimating the incremental cash flows of a project, the following considerations must be adhered to:     

Consider All Incidental Effects Ignore Sunk Costs Include Opportunity Costs Question the Allocation of Overhead Costs Ensure Proper Estimation of Net Working Capital

* Ref text for details

Post Tax Principle • Cash flows of a project should always be measured on an after-tax basis. • Firms should always use after-tax cash flows along with the after-tax discount rate. • The important issues in assessing the impact of taxes on a project are:  What tax rate should be used to assess tax liability.  How should losses be treated.  What is the effect of non-cash charges.

Post Tax Principle Tax Rates  Average Tax Rate (ATR): Total tax burden as a proportion of the total income of the business.  Marginal Tax Rate (MTR): Tax rate applicable to the income at margin i.e. the next rupee of income. MTR is higher than ATR because tax rates are progressive.

• Income from a project typically is marginal. • MTR of the firm is the relevant rate for estimating the tax liability of the project.

ATR vs MTR •

Taxable Income of Project = INR 65,000 Income Slabs (in INR)

Tax Rate Applicable

Up to 7,550

10 %

7,551 – 30,650

15 %

Above 30,650

25%

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Tax Payable by Project 7,550 x 0.10 = INR 755 (30,650 – 7,550) x 0.15 = INR 3,465 (65,000 – 30,650) x 0.25 = INR 8,587.50

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ATR = [(755 + 3,465 + 8,587.50)/65,000] x 100 = 19.7 % MTR = 25 % (> ATR)

Post Tax Principle Treatment of Losses

• Firm as well as the project can incur losses. • Following are the possible scenarios. Scenario

Project

Firm

Action

1

Incurs Losses

Incurs Losses

Defer tax savings

2

Incurs Losses

Makes Profits

Take tax savings in the year of loss

3

Makes Profits

Incurs Losses

Defer taxes until the firm makes profits

4

Makes Profits

Makes Profits

Consider taxes in the year of profit

Stand Alone

Incurs Losses

-

Defer tax savings until the project makes profits

Post Tax Principle Effect of Non-Cash Charges

• Non cash charges can have an impact on cash flows if they affect the tax liability. e.g. Depreciation • Tax Benefit of Depreciation Depreciation x MTR

• Written Down Value (WDV) method of depreciation allowed for tax purposes as per Income Tax Act in India. • Depreciation Charge DEPt = BVt-1r = BV0(1-r)t-1r DEP = Dep Charge, BV = Book Value, r = Rate of

Post Tax Principle Deferred Tax Liability • Taxable Income (TI) generally different from Accounting Profit (AP).

• Difference may be Permanent or Temporary. • Permanent Difference: Caused by an item which is included for calculating either TI or AP, but not both. • Temporary Difference: Caused by an item which is included for calculating both TI and AP, but in different time periods. • Deferred tax liability (or asset) arises because of temporary differences between TI and AP. • A deferred tax liability (asset) is recognized when the charge in the financial statements is less (more) than the amount allowed for tax purposes.

Book Value of Asset = INR 1,00,000 Year

Dep @ 10% (SLM)

Dep @ 10% (WDV)

1

1,00,000 – 10,000 = 90,000

1,00,000 – 10,000 = 90,000

2

90,000 – 10,000 = 80,000

90,000 – 9,000 = 81,000

3

80,000 – 10,000 = 70,000

81,000 – 8,100 = 72,900

4

70,000 – 10,000 = 60,000

72,900 – 7,290 = 65,610

5

60,000 – 10,000 = 50,000

65,610 – 6,561 = 59,049

6

50,000 – 10,000 = 40,000

59,049 – 5,905 = 53,144

7

40,000 – 10,000 = 30,000

53,144 – 5,314 = 47,830

8

30,000 – 10,000 = 20,000

47,830 – 4,783 = 43,047

9

20,000 – 10,000 = 10,000

43,047 – 4,305 = 38,742

10 Total Dep

10,000 – 10,000 = 0 INR 1,00,000

38,742 – 3,874 = 34,868 INR 65,132

Post Tax Principle • Minimum Alternative Tax (MAT) In case of companies, if the income-tax payable on the total income computed under the Income Tax Act is less than 10 percent of its book profit, the tax payable for the relevant previous year is deemed to be 10 percent of the book profit. • MAT Credit Entitlement If a company has paid MAT, the difference between MAT and the income tax payable on the total income otherwise, can be availed of for seven years. • Post Tax cash flows of a project Profit After Tax (PAT) + Depreciation & Amortization + Deferred tax charge – MAT credit entitlement

Consistency Principle • Cash flows and the discount rates applied to these cash flows must be consistent with respect to the investor group and inflation. • The project cash flow may be estimated from the point of view of:  All Investors (Equity owners + Lenders)  Equity Shareholders

Consistency Principle • The cash flow of a project from the view point of all investors is the cash flow available to all investors after paying taxes and meeting project reinvestment needs. • Cash flows to all investors = PBIT (1 - tax rate) + Depreciation and Non-cash Charges - Capital Expenditure - Change in Net Working Capital * PBIT = Profit Before Interest and Tax

Consistency Principle Cash flows from all investors point of view Initial Investment = Total outlay invested in the project Operating cash inflows = PAT + Depreciation + Other non-cash charges + Interest on long-term borrowings (1-tax rate) + Interest on short-term borrowings (1-tax rate) Terminal cash flows = Net salvage value of fixed assets + Net salvage value of current assets (Refer Exhibit 9.8 from text book, Question on Pg. 9.16)

Consistency Principle • The cash flow of a project from the point of view of equity shareholders is the cash flow available to equity holders after paying taxes, meeting investment needs and fulfilling debt-related commitments. • Cash flow to Equity Investors = Profit after Interest and Tax (PAIT) + Depreciation and other non-cash

charges + +

Preference Dividend Capital Expenditure Change in Net Working Capital Repayment of Debt Proceeds from Debt Issues Redemption of Preference Capital Proceeds from Preference Capital

Consistency Principle Cash Flows from Equity Investors point of view •

Initial Investment = Equity funds invested in the project

• Operating cash flows = PAT – Preference Dividend + Depreciation + Other Non-cash Charges • Terminal/Liquidation & Retirement cash flows Net salvage value of assets - Repayment of term loans - Redemption of preference capital - Repayment of working capital advances - Repayment of trade credit (Refer Exhibit 9.6 from text book, Question on Pg 9.16)

Consistency Principle • The Discount Rate must be consistent with the definition of cash flow: Cash Flow

Discount Rate

Cash flow to all investors

Weighted Average Cost of Capital (WACC)

Cash flow to equity holders

Cost of Equity (i.e. Rate of Equity Dividend)

• In capital budgeting, project cash flows are generally analyzed from all investors point of view, and WACC of the firm is applied to them towards discounting.

Consistency Principle Towards dealing with Inflation in project cash flow estimation following options are available:  Incorporating expected inflation in the estimates of future cash flows and applying a nominal discount rate to same.  Estimating the future cash flows in real (inflation adjusted) terms and applying a real discount rate to the same.

Nominal CFt = Real CFt (1 + Expected Inflation Rate)t Nominal Discount Rate = (1 + Real Discount Rate) (1 + Expected Inflation

Consistency Principle • Following match up is recommended: Cash Flow Nominal Cash Flow Real Cash Flow

Discount Rate Nominal Discount Rate Real Discount Rate

• In capital budgeting, general trend is to estimate nominal project cash flows and use nominal discount rate towards discounting them.