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8/6/2019 Project Cash Flows-Unit II-Part 4
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Project Cash Flows
Estimation, Principles, Biases
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Cash Flows
- They are the incremental after-tax cash flows
associated with the project.
- A conventional project has 3 basic components:
(i) Initial Investment- the after-tax cash outlay oncapital expenditure and net working capital.
(ii) Operating Cash Inflows- the after-tax cash inflows
resulting from project operations during economic
life.
(iii) Terminal Cash Inflow- the after-tax cash flow
resulting from liquidation of the project at the end
of economic life.2
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Cash Flow Analysis- its time
horizonThe time horizon for cash flow analysis is minimum of thefollowing:
(a) Physical life of the plant- period during which plant remains
in a physically usable condition. It inter- alia depends onwear and tear of plant. This is more useful in determining
the depreciation rather than investment decision making.
(b) Technological life of plant- period for which the existing plant
would not be rendered obsolete by new technological
developments. It is difficult as new developments are not
governed by any law or guesses.
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Cash Flow Analysis- its time
horizon(contd..)(c) Product market life of the plant- refers to the period
for which the product of the plant enjoys a
reasonably satisfactory market.
(d) Investment planning horizon of the firm- time
period for which a firm wishes to look ahead for
purposes of investment analysis is referred to its
investment planning horizon. It may be different for
small investments, medium sized investments, large
investments and infrastructure projects. As such
varies with complexity and size of investment 4
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Principles of Cash Flow Estimation
Principles to be followed during cash flow
estimation-
(a) Separation principle(b) Incremental principle
(c) Post- tax principle
(d) Consistency principle
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Separation Principle
The principle states that the cash flows concerning
the two sides of a project i.e. investment side and
financing side should be separately estimated. For
e.g.
A firm has project of 1 year with investment of Rs. 1000
and no working capital at time 0.
Only Expected Cash Inflow= Rs. 1200 at end of 1 year.
The project is debt financed which carries interest rate
of 15% maturing after 1 year.
Assume that there are no taxes.
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Separation Principle (contd)
Project
Financing Side Investment Side
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Time Cash Flow
0 +1000
1 -1150
Time Cash Flow
0 -1000
1 +1200
Cost of Capital: 15% Rate of Return: 20%
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Separation Principle (contd)
The cash flows on investment side do not
reflect financing costs.
The financing costs are included in the cashflows on the financing side & reflected in cost
of capital figure.
The cost of capital is the hurdle rate against
which rate of return on investment side is
judged.
This implies that interest on debt is ignored
while computing profits and taxes thereon . 8
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Incremental Principle
This principle suggests to measure the cash
flow of the firm with the project and without
the project. Stated mathematically:
(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 the year t)
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Incremental Principle(contd)
During estimation following guidelines to be ensured:
(a) Consider all the incidental effects, for e.g. the
project may enhance or detract the profitability of
some existing activities by being complementary or
competitive respectively.
(b) Ignore sunk costs (it refers to an outlay already
incurred in the past or already committed
irrevocably) . Remember the bygones are bygones
and are not relevant in decision making.
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Incremental Principle(contd)
(c) Include opportunity costs- the concept arises when
existing resources are used. It specifies in cost the
benefit that can be derived by applying the resource
to any other best alternative use.
(d) Question the allocation of overhead costs- overhead
costs like managerial salaries, legal expenses, rent
etc. should be allocated to the project only when
they relate to it. They should be incremental
overhead costs and not allocated overhead costs.
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Incremental Principle(contd)
(e) Estimate Net Working Capital Properly- as investor funds
support fixed assets and net working capital. Also remember:
- GWC refers to total current assets. It is supported by non-
interest bearing current liabilities (NIBCL) like trade credit,provisions, advances from customers etc.
- NWC is GWC NIBCL. It is financed by equity, preference and
debt. Requirement of NWC changes with output.
- NWC is renewed periodically & is not subject to depreciation.
It has salvage value equal to book value at the end of project.
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Post tax Principle
Cash flows should always be measured on an after-
tax basis.
Do not discount pre-tax cash flows with a rate higher
than cost of capital to compensate for tax payments.
Other important points to remember are:
(a) Tax rate- apply the marginal tax rate which is the tax
rate applicable to the marginal income. This isbecause income from project is typically marginal.
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Post tax Principle (contd)
(b) Treatment of losses-
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Scenario Project Firm Action
1 Incurs losses Incurs losses Defer tax savings
2 Incurs losses Makes profit Take tax savings in year of loss
3 Makes profit Incurs losses Defer taxes until firm
makes profit
4 Makes profit Makes profit Consider taxes in the year
of profit
Stand
Alone
Incurs losses -- Defer tax saving until
project makes profit
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Post tax Principle (contd)
(c) Effect of Non Cash Charges- they impact cash flowsif they affect tax liability. The important non cash
charge is depreciation. The depreciation method
allowed in India for tax purposes is written downvalue method.
(d) Deferred tax liability and minimum alternative tax-
the post-tax cash flow is derived from profit after tax
as follows:
Profit after tax+ depreciation and amortisation+
deferred tax charge- MAT credit entitlement
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Consistency Principle
Cash flows & discount rates applied to cash flows have to be
consistent with investor group & inflation.
Investor Group-
(a) For all investors- cash flows to all investors= PBIT(1-tax rate)+Depreciation and non- cash charges- Capital expenditure-
Change in net working capital
(b) For equity share holders: cash flows for equity shareholders=
Profit after tax+ Depreciation and other non cash charges-
Preference dividend- Capital expenditures-Change in net
working capital- Repayment of debt+ Proceeds from debt
issues- Redemption of preference capital+ Proceeds from
preference issue
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Consistency Principle(contd)
Discount rates to be consistent with definition of
cash flows:
Generally, in capital budgeting, we consider cashflow to all investors and apply the weighted
average cost of capital of the firm.
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Cash Flow Discount Rate
Cash flow to all investors Weighted average cost of
capital
Cash Flow to equity share
holders
Cost of equity
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Consistency Principle(contd)
Inflation- To deal with inflation the
consistency principle suggests the following:
Generally in capital budgeting analysis nominal
cash flows are estimated and nominaldiscount rate is used.
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Cash Flow Discount Rate
Nominal Cash Flow Nominal discount rate
Real Cash Flow Real discount rate
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Biases in Cash Flow Estimation
Adequate care should be exercised to guard against
biases as it may lead to over-statement or under-
statement of true profitability.
(I) Over-statement of Profitability: Executives commit
planning fallacy and display over optimism. Over
optimism results from cognitive biases and
organisational pressures. The various types are:
(a) Native optimism- is when people exaggerate their
own talents, believing themselves to have higher
positive traits and abilities.
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Biases in Cash Flow Estimation
(b) Attribution error- is when people take credit for
positive outcomes and attribute negative outcomes
to external factors, irrespective of what the true
cause is.
(c) Anchoring- is when people are unwilling to change
their opinion after forming it although hey receive
new relevant information.
(d) Competitor neglect- is to neglect the potential
actions and abilities of competitors and focus only on
self plans and abilities.
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Biases in Cash Flow Estimation
(e) Organisational pressure- due to the limited time and money
availability in companies project sponsors exaggerate the
benefits of projects so as to get it approved among the
intense competition.
(II) Under-statement of profitability: is related to terminal
benefits being under-stated and hence depressing the
profitability of project.
Terminal cash flow=Net salvage value of fixed assets+ Net
recovery of working capital margin
Where, net salvage value(apart from land)= 5% of original cost
And, net recovery from WC= original book value(assuming
current assets do not depreciate)
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Biases in Cash Flow Estimation
The reasons for under-estimation are as follows:
(a) Under-estimation of salvage value- assigning only
5% value to fixed assets is wrong as in real life they
have substantial market value remaining. This is
because:
The actual rate of wear and tear is less than the rate
of depreciation applied.
The secular rate of inflation in India is around 6%.
(b) Intangible benefits are ignored- apart from terminal
benefits gained from tangible assets of the project,
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Biases in Cash Flow Estimation
Some intangible benefits also are gained like
development of distribution network, brand
loyalty building, research & development
work, establishment of market position etc.
It is not appropriate to overlook these benefits
due to some pre-set time horizon and
difficulty in quantification.
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