Cash Flows for Investment Analysis

• Sound investment decisions should be based on the net present value (NPV) rule.

• Problem to be resolved in applying the NPV rule:– What should be discounted? In theory, the

answer is obvious: We should always discount cash flows.

– What rate should be used to discount cash flows? In principle, the opportunity cost of capital should be used as the discount rate.

Cash Flows Versus Profit

• Cash flow is not the same thing as profit, at least, for two reasons:– First, profit, as measured by an accountant, is

based on accrual concept.

– Second, for computing profit, expenditures are arbitrarily divided into revenue and capital expenditures.

CF (REV EXP DEP) DEP CAPEX

CF Profit DEP CAPEX

Incremental Cash Flows

• Every investment involves a comparison of alternatives:– When the incremental cash flows for an investment are

calculated by comparing with a hypothetical zero-cash-flow project, we call them absolute cash flows.

– The incremental cash flows found out by comparison between two real alternatives can be called relative cash flows.

• The principle of incremental cash flows assumes greater importance in the case of replacement decisions.

Example

• A firm wants to replace an old equipment, capable of generating Rs.2,000; Rs.1,500 & Rs.500 during next 3 years. It has a B.V. of Rs.5,000 & M.V. of Rs.3,000.

• Firm is considering a new equipment of Rs.10,000, capable of generating cash flows of Rs.8,000, Rs.7,000 & Rs.4,500 in next 3 years.

• Both old & new equipments are assumed to have 0 resale value after 3 years.

• It is further assumed that taxes do not exist (Depreciation becomes irrelevant if taxes do not exist).

Computation of incremental cash flows: Replacement Decision

Cash flows(Rs.)Year 0 1 2 3

Cash flows of new (10,000) 8,000 7,000 4,500EquipmentLess, Cash flows (3,000) 2,000 1,000 500Of old EquipmentIncremental cash (7,000) 6,000 6,000 4,000Flows (old – new)What will happen if both the old & new equipments have the resale

value of Rs.500 & Rs.2,500 respectively?Net cash inflow will be Rs.2,000 as the firm will forgo the

opportunity of realising Rs.500 from the sale of old one, if the firm goes for the new one.

Components of Cash Flows1. Initial Cash Outflow.

• A typical investment will have three components of cash flows:

• 1. Initial cash outflow,• 2. Annual net cash flows,• 3. Terminal cash flows.

• 1. Initial cash outflow: refers to gross investments for purchase of assets(+) expenditure for making machines operational(+) opportunity cost of the asset.

Components of Cash Flows…..2. Annual Net Cash flows

• 2. Annual Net Cash flows: recognizes cash flows on after tax basis.

• Since depreciation plays a crucial role for computation of tax (depreciation tax shield) it has to be treated twice in computation of cash flows:

• NCF = REV –EXP –DEP – TAX +DEP• = EBIT –TAX + DEP• = EBIT(1-T) + DEP

Components of Cash Flows….. 2. Annual Net Cash flows….contd..• Increase in Net Working Capital: Investment in

fixed assets leads to an increase in the amount of current assets required for enhancing the level of production – simultaneous increase in current liabilities. It has to be subtracted from after tax operating profit.

• NCF = EBIT (1-T) + DEP – Increase in NWC• Reinvestment of additional capital: for

maintaining revenue generating ability of the fixed asset.

• Free Cash Flow = NCF = EBIT(1-T)+DEP – Increase in NWC -CAPEX

Components of Cash Flows…..3. Terminal Cash Flows

3. Terminal Cash Flows: • represents salvage or scrap value.• Takes place when life of project comes to an end – tn

period.• Salvage value is estimated on the basis of cost of asset

& accumulated depreciation or sale value of used asset.• Amount of clean-up & removal expenses, if any, is

subtracted from this amount.• Moreover, some amount of net working capital is

released as a result of cessation of the operation. This amount is added to the salvage value.