Part IV: CAPITAL BUDGETING

1
Part IV CAPITAL BUDGETING

• 4.2. Estimation of Project Cash Flows

2
4.2.1 Project Cash Flows

• The effect of taking a project is to change the
  firms overall cash flows today and in the
  future.
• To evaluate a proposed investment, we must
  consider these changes in the firms cash flows
  and then decide whether or not, they add value to
  the firm.
• The first and most important step, therefore is
  to decide
• WHICH CASH FLOWS ARE RELEVANT ?

3
Relevant Cash Flows

• The relevant cash flow for a project is a change
  in the firms overall future cash flow that comes
  about as a direct consequence of the decision to
  take that project.
• Hence, the relevant cash flow is INCREMENTAL CASH
  FLOW.
• The incremental cash flows for project
  evaluation consists of any and all changes in the
  firms future cash flows that are a direct
  consequence of taking the project.
• Any cash flow that exists regardless of whether
  or not a project is undertaken is not relevant.

4
4.2.2 Basic Principles of the Cash Flow
Estimation

1. Stand Alone Principle
2. Separation Principle
3. Incremental Principle
4. Post-Tax Principle
5. Consistency Principle.

5
1. Stand Alone Principle

• Once we identify the effect of undertaking the
  proposed project on the firms cash flows, we
  need only focus on the projects resulting
  incremental cash flows.
• Once we have determined the incremental cash
  flows from undertaking a project, we can view
  that project as a kind of minifirm with its own
  future revenues and costs, its own assets, and,
  of course, its own cash flows.
• Then compare the cash flows from this minifirm to
  the cost of acquiring it.
• We will be evaluating the proposed project purely
  on its own merits, in isolation from any other
  activities and projects.

6
2. Separation Principle

• There are two sides of a project, viz, the
  investment (or assets) side and the financing
  side.
• Cash flows associated with these sides should be
  separated.
• Suppose 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 1,200
  at the end of year 1 and this is the only cash
  inflow expected from the project. The project
  will be financed entirely by debt carrying an
  interest rate of 15 and maturing after a year.
  Assume there are no taxes.

7
Separation Principle (contd)
Project
Financing Side
Investment Side
Time Cash Flow 0 - 1,000 1
1,200 Rate of Return 20
Time Cash Flow 0 1,000 1
- 1,150 Cost of Capital15
8
Separation Principle (contd)

• The cost of capital is used as the hurdle rate
  against which the rate of return on the
  investment side (which is 20 in our case) is
  judged.
• 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 the rate of return
  figure will be evaluated.
• Operationally, this means that interest on debt
  is ignored while computing profits and taxes
  thereon.

9
Separation Principle (contd)

• 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 PAT.
• PBIT (1- T) (PBT I) (1-T) PBT (1-T) I
  (1-T) PAT I (1-T)
• Whether the tax rate is applied directly to the
  PBIT figure or whether the tax-adjusted interest
  is added to the PAT figure, we get the same
  result.

Tax-Adjusted Interest
10
3. Incremental Principle (4.2.3)

• The cash flow of the project must be measured in
  incremental terms.
• 
  -

Project Cash flow for the year t
Cash flow for the firm with the project for
year t
Cash flow for the firm without the project for
the year t
11
Guidelines to estimate incremental cash flow

• Consider all Incidental Effects
• Take into account the effect on profitability of
  the existing activities of the firm because of
  the complementary or competitive relationship
  between the project and the existing activities
  of the firm.
• For example Issue of Product Cannibalization.
• The loss of profit resulting from the product
  cannibalization may be treated as a negative
  incremental effect of the new product.
• This may however lead to the possibility of
  rejecting the new project.
• What if competitor march on the firm by
  introducing that product ?
• How the loss of sales on account of product
  cannibalization is treated will depend on whether
  or not a competitor is likely to introduce a
  close substitute to the new product that is being
  considered by the firm.

12
Guidelines (contd.)

• If the firm is operating in an extremely
  competitive business and is not protected by
  entry barriers, product cannibalization will
  occur anyway.
• Hence the cost associated with it are not
  relevant in incremental analysis.
• If the firm is sheltered by entry barriers like
  patent protection or proprietary technology or
  brand loyalty, the costs of product
  cannibalization should be incorporated in
  investment analysis.

13
Guidelines (contd.)

• Ignore Sunk Costs
• Sunk cost refers to an outlay already incurred in
  the past or already committed irrevocably.
• So it is not affected by the acceptance or
  rejection of the project under consideration, and
  hence is irrelevant.
• A company is debating whether it should invest
  in a project. The company has already spent Rs 1
  million for preliminary work meant to generate
  information useful for this decision. Is this 1
  million a relevant cost for the proposed project
  ?
• BYGONES ARE BYGONES

14
Guidelines (contd.)
TANSTAFFL There aint no such thing as a free
lunch

• Include Opportunity Cost
• The value of most valuable alternative that is
  given up if a particular investment is undertaken
  Opportunity Cost
• This is the cost created for the rest of the firm
  as a consequence of undertaking the project.
• Example
• If a project uses resources already available
  with the firm, theres a potential for an
  opportunity cost.
• Is there any alternative use of the resource is
  the project is not undertaken ?

15
Guidelines (contd.)

• If a project uses a vacant factory building owned
  by the firm, the revenue that can be derived from
  renting out this building represents the
  opportunity cost.
• If a project uses an equipment which is currently
  idle, its opportunity cost is its sales price,
  net of any tax liability.
• If a project requires the services of some
  experienced engineers from an existing division
  of the firm, the cost that is borne by that
  division to replace those engineers represents
  the opportunity cost.

16
Guidelines (contd.)

• What happens when a project uses a resource that
  has no current alternative use, but some
  potential alternative use ?
• Example Excess Capacity on Some Machine AND
  Using that excess capacity for a new product
• Case I May exhaust capacity much earlier than
  otherwise and hence may call for creating new
  capacity earlier rather than later
• Opportunity cost PV of creating capacity
  earlier PV or creating capacity later.
• Case II May reduce the output of some products
  in future.
• Opportunity Cost Loss in cash flows that would
  have otherwise been generated by the sales of
  those products.

17
Guidelines (contd.)

• Question the allocation of Overhead Costs
• Overhead Costs Costs which are indirectly
  related to a product (or service)
• Eg General Admin Expenses, Managerial Salaries,
  Legal Expenses, Rent etc.
• They are allocated to various products on some
  basis like labor hrs, machine hrs, prime cost
  etc.
• They are allocated to the new project too.
• But for the purpose of investment analysis, what
  matters is the incremental overhead costs
  attributable to the project and not the allocated
  overhead costs.

18
Guidelines (contd.)

• Estimate Working Capital Properly
• Project will require that the firm invest in net
  working capital in addition to long-term assets.
• Outlays on working capital has to be properly
  considered while forecasting the project cash
  flows.
• Its is NWC which is relevant
• The requirement of WC is likely to change over
  time.
• WC are not subject to depreciation.
• Thus the WC at the end of the project life is
  assumed to have a salvage value equal to its BV.

19
4. Post-Tax Principle

• Cash flows should be measured on an after-tax
  basis
• Issues
• What tax rate should be used to assess tax
  liability ?
• How should losses be treated ?
• What is the effect of non-cash charges ?

20
Relevant Tax Rate

• The income from a project typically is marginal.
• It is additional to the income generated by the
  assets of the firm already in place.
• Hence,
• MARGINAL TAX RATE OF THE FIRM IS THE RELEVANT
  RATE FOR ESTIMATING TAX LIABILITY OF THE PROJECT.

21
Treatment of Losses
Scenario Project Firm Action
1 Incurs Losses Incurs Losses Defer tax savings
2 Incurs Losses Makes Profit Take tax savings in the year of loss
3 Makes Profit Incurs Losses Defer taxes until the firm makes profit
4 Makes Profit Makes Profit Consider taxes in the year of profit
Stand Alone Incurs Losses - Defer tax savings until the project makes profit
22
Effect of Non-cash Charges

• Non-cash charges can have an impact on cash flows
  if they affect the tax liability.
• The most important of such non-cash charges is
  depreciation.
• The tax benefit of depreciation is
• Depreciation x Marginal Tax Rate

23
5. Consistency Principle

• Cash flows and the discount rates applied to
  these cash flows must be consistent with respect
  to the investor group and inflation.
• Investors Group
• The cash flow of a project may be estimated from
  the point of view of all investors (equity
  shareholders as well as lenders) or from the
  point of view of just equity shareholders.

24
Consistency Principle (contd)

• The cash flow of a project from the point of view
  of all investors is the cash flow available to
  all investors after paying taxes and meeting
  investing needs of the project, if any.
• Cash flows to all investors PBIT (1-T)
• Depreciation
• - Capital Expenditure
• - Change in NWC

25
Consistency Principle (contd)

• The cash flow of a project from the point of view
  of equity shareholders is the cash flow available
  to equity shareholders after paying taxes,
  meeting investment needs, and fulfilling
  debt-related commitments.
• Cash flows to equity shareholders PBIT (1-T)
• Depreciation
• - Preference Dividend
• - Capital Expenditures
• - Change in NWC
• - Repayment of Debt
• Proceeds from debt issues
• - Redemption of preference capital
• Proceeds from preference issue

26
Consistency Principle (contd)

• The discount rate must also be consistent with
  the definition of cash flow
• Cash Flow Discount Rate
• To all investors Weighted Average
  Cost of Capital
• Cash flow to equity Cost of Equity

27
Consistency Principle (contd)

• Inflation
• Either incorporate expected inflation in the
  estimates of future cash flows and apply a
  nominal discount rate to the same.
• Or estimate future cash flows in real terms and
  apply a real discount rate to the same
• Nominal Cash flowt Real Cash flow (1 Expected
  inflation rate)t
• Nominal Discount rate
• (1 Real discount rate)(1Expected inflation
  rate) - 1

28
Elements of the Cash Flow Stream

• The cash flow stream of a conventional project
  a project which involves cash outflows followed
  by cash inflows comprises of three basic
  components
• Initial Investment After tax cash outlay
• Operating Cash Inflows After tax cash inflows
  resulting from the operations of the project
  during its economic life
• Terminal Cash Flow- After tax cash flow resulting
  from the liquidation of the project at the end of
  its economic life.

29
4.2.4 Pro-Forma Financial Statements and Project
Cash FlowsIllustration

• Suppose we think we can sell 50,000 units of a
  new product per year at a price of 4 per can.
• It costs us about 2.50 per can to make the
  product, and a new product such as this one
  typically has only a 3 year life
• We require 20 return on new products.
• Fixed costs for the project, including such
  things as rent on the production facility, will
  run 12,000 per year.
• We will need to invest a total of 90,000 in
  manufacturing equipment.
• This 90,000 will be depreciated over the 3 year
  life of the project.
• The cost of removing the equipment will roughly
  equal its actual value in 3 years, so it will be
  essentially worthless on a market value basis as
  well.
• The project will require an initial 20,000
  investment in net working capital, and the tax
  rate is 34 .

30
Illustration (contd)
Projected Income Statement Projected Income Statement
Sales (50,000 units at 4/ unit) 200,000
Variable costs ( 2.50/ unit) 125,000
75,000
Fixed costs 12,000
Depreciation ( 90,000/ 3) 30,000
EBIT 33,000
Taxes (34 ) 11,220
Net income 21,780
Notice that we have not deducted any interest
expenses
31
Illustration (contd)
Projected Capital Requirements Projected Capital Requirements Projected Capital Requirements Projected Capital Requirements Projected Capital Requirements
Year Year Year Year Year
0 1 2 3
NWC 20,000 20,000 20,000 20,000
Net fixed assets 90,000 60,000 30,000 0
Total Investment 110,000 80,000 50,000 20,000
32
Illustration (contd)

• Project Cash Flow Project Operating Cash Flow
• Change in net working capital Project
  capital spending
• Project Operating Cash flow EBIT Depreciation
  Taxes

EBIT 33,000
Depreciation 30,000
Taxes _at_ 34 - 11,220
Operating Cash Flow 51, 780
33
Illustration (contd)
Projected Total Cash Flows Projected Total Cash Flows Projected Total Cash Flows Projected Total Cash Flows Projected Total Cash Flows
Year Year Year Year Year
0 1 2 3
Operating Cash Flow 51,780 51,780 51,780
Changes in NWC - 20,000 20,000
Capital Spending - 90,000
Total Project Cash Flow - 110,000 51,780 51,780 71,780
34
Illustration (contd)

• NPV of the project is positive, and creates over
  10,000 in value and should be accepted.
• Return on this investment obviously exceeds 20
  (because NPV is positive at 20 )
• We can find out that IRR works out to be 25.8 gt
  20
• Payback period is about 2.1 years ( ? )
• ARR comes out to be 33.51 ( 21,780 / 65,000)

35
Cash flows for a replacement project
Cost of the new assets NWC required for the
new assets
After tax Salvage Value realized from the old
assets NWC required for the old assets
Initial Investment
-

Operating Cash inflows from the new assets
Operating Cash inflows from the old assets
Operating Cash Flow

-
After tax SV of the old assets Recovery of
NWC Associated with old assets
After tax SV of the new assets Recovery of
NWC Associated with new assets
Terminal Cash Flow

-
36
Illustration 1 Cash Enterprises

• Cash Enterprises is considering a capital project
  about which the following information is
  available
• The investment outlay on the project will be Rs
  100 million. This consists of Rs 80 million on
  the plant and machinery and Rs 20 million on net
  working capital. The entire outlay will be
  incurred at the beginning of the project.
• The project will be financed with Rs 45 million
  of equity capital, Rs 5 million of preference
  capital, and Rs 50 million of debt capital.
  Preference capital will carry a dividend rate of
  15 debt capital will carry an interest rate of
  15 .

37
Cash Enterprises (contd)

• The life of the project is expected to be 5
  years. At the end of 5 years, fixed assets will
  fetch a net salvage value of Rs 30 million,
  whereas net working capital will be liquidated at
  its book value.
• The project is expected to increase the revenues
  of the firm by Rs 120 million per year. The
  increase in costs on account of the project is
  expected to be Rs 80 million per year. (This
  includes all items of costs other than
  depreciation, interest and tax). The effective
  tax rate will be 30 .

38
Cash Enterprises (contd)

• Plant and machinery will be depreciated at the
  rate of 25 per year as per the written down
  value method. Hence, the depreciation charges
  will be
• First year Rs 20.00 million
• Second year Rs 15.00 million
• Third year Rs 11.25 million
• Fourth year Rs 8.44 million
• Fifth year Rs 6.33 million

39
Illustration 2 Pharma Limited

• Pharma Ltd is engaged in the manufacture of
  pharmaceuticals. The company was established in
  1991 and has registered a steady growth in sales
  since then. Presently, the company manufactures
  16 products and has an annual turnover of Rs 2200
  million. The company is considering the
  manufacture of a new antibiotic preparation,
  K-cin, for which the following information has
  been gathered.

40
Pharma Limited (contd)

• K-cin is expected to have a product life cycle of
  five years and thereafter it would be withdrawn
  from the market. The sales from this preparation
  are expected to be as follows
• Year Sales (in million Rs)
• 1 100
• 2 150
• 3 200
• 4 150
• 5 100

41
Pharma Limited (contd)

• The capital equipment required for manufacturing
  K-cin is Rs 100 million and it will be
  depreciated at the rate of 25 per year as per
  the WDV method for tax purposes. The expected net
  salvage value after 5 years is Rs 20 million.
• The working capital requirement for the project
  is expected to be 20 of sales. At the end of 5
  years, working capital is expected to be
  liquidated at par, barring an estimated loss of
  Rs 5 million on account of bad debt. The bad debt
  loss will be a tax deductible expense.

42
Pharma Limited (contd)

• The accountant of the firm has provided the
  following cost estimates for K-cin
• Raw material cost 30 of sales
• Variable labor cost 20 of sales
• Fixed annual operating and maintenance cost Rs
  5 million
• Overhead allocation (excluding depreciation,
• Maintenance and interest ) 10 of sales
• While the project is charged on an overhead
  allocation, it is not likely to have any effect
  on overhead expenses as such

43
Pharma Limited (contd)

• The manufacturer of K-cin would also require some
  of the common facilities of the firm. The use of
  these facilities would call for reduction in the
  production of other pharmaceutical preparations
  of the firm. This would entail a reduction of Rs
  15 million of contribution margin.
• The tax rate applicable to the firm is 40 .

44
Illustration 3 (Ojus Enterprises)

• Ojus Enterprises is determining the cash flow for
  a project involving replacement of an old machine
  by a new machine. The old machine, bought a few
  years ago, has a book value of Rs 400,000 and it
  can be sold to realize a post-tax salvage value
  of Rs 500, 000. It has a remaining life of 5
  years after which its net salvage value is
  expected to be Rs 160,000. It is being
  depreciated annually at a rate of 25 under the
  WDV method. The working capital required for the
  old machine is Rs 400,000.

45
Ojus Enterprises (contd)

• The new machine costs Rs 1,600,000. It is
  expected to fetch a net salvage of Rs 800,000
  after 5 years when it will no longer be required.
  The depreciation rate applicable to it is 25
  under the written down value method. The net
  working capital required for the new machine is
  Rs 500,000. the new machine is expected to bring
  a saving of Rs 300,000 annually in manufacturing
  costs (other than depreciation). The tax rate
  applicable to the firm is 40 .

46
Ojus Enterprises (contd)