Estimation of Cash Flows

ESTIMATION OF CASH FLOWS
• Show the conceptual difference between profit and cash

flow
• Discuss the approach for calculating incremental cash

flows
• Explain the treatment of inflation in capital budgeting
• Highlight the interaction between financing and

investment decisions

Source: Brealey&Myers ,I M Pandey and
Khan and Jain
Estimation of Cash Flows
Investment decisions involve -a careful consideration of various
factors
• Profitability
• Safety
• Liquidity
• Solvency
Estimation of Cash Flows
Special care should be taken in making these decisions on account of
the following reasons
• Involvement of heavy funds
• Long term implications
• Irreversible decisions
• Most difficult to make

PROFITS VS. CASH FLOWS
• Profits vs. cash flows: Cash flows are different from
profits. Profit is not necessarily a cash flow; it is the
difference between revenue earned and expenses
incurred rather than cash received and cash paid.
• Also, in the calculation of profits, an arbitrary

distinction between revenue expenditure and
capital expenditure is made.


Khan and Jain
Conventional and Non-conventional cash flows
• A conventional investment has cash flows the pattern of an

initial cash outlay followed by cash inflows. Conventional
projects have only one change in the sign of cash flows; for
example, the initial outflow followed by inflows for example
-+++++
• A non-conventional investment, on the other hand, has cash
outflows mingled with cash inflows throughout the life of the
project. Non-conventional investments have more than one
change in the signs of cash flows, for example,
-+++-++-
BASIC PRINCIPLES IN CASH FLOW
ESTIMATION
• Separation principle
• Incremental principle
• Post-tax principle
• Consistency principle
SEPARATION PRINCIPLE
Project
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, 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.
INCREMENTAL CASH FLOWS
Incremental cash flows:
• Cash flows should be estimated on an
incremental basis. Incremental cash flows
are found out by comparing alternative
investment projects.
• The comparison may simply be between cash

flows with and without the investment
proposal under consideration when real
alternatives do not exist.
Khan and Jain
POST-TAX PRINCIPLE
• Cash Flows should be measured on an after-tax basis
• The income from a project typically is marginal.
• The marginal tax rate of the firm is the relevant rate for
estimating the tax liability of the project.
• Marginal tax rate is the tax rate applicable to the income at

margin
CONSISTENCY PRINCIPLE
• Incorporate
Inflation in the estimates of future
cash flows and apply a nominal discount rate
to the same.
• Alternatively, you can estimate the future cash

flows in real terms and apply a real discount
rate to the same.
COMPONENTS OF CASH FLOWS
Components of cash flows:
Three components of cash flows can be identified:
• initial investment
• annual cash flows, and
• terminal cash flows.

Khan and Jain
INITIAL INVESTMENT
Initial investment:
Initial investment will comprise the original cost
(including freight and installation charges) of
the project, plus any increase in working capital.
In the case of replacement decision, the after-

tax salvage value of the old asset should also be
adjusted to compute the initial investment.
Khan and Jain
NET CASH FLOW
Net cash flow:
Annual net cash flow is the difference between

cash inflows and cash outflows including taxes.
Tax computations are based on accounting
profits.
Care should be taken in properly adjusting

depreciation while computing net cash flows.
Khan and Jain
DEPRECIATION
•Depreciation:

Depreciation is a non-cash item, but it affects cash flows through tax

shield. The following formula can be used to calculate change in
net cash flows from operations


Khan and Jain
WORKING CAPITAL AND CAPITAL
EXPENDITURE
Working capital and capital expenditure:
In practice, changes in working capital items —

debtors (receivables), creditors (payable) and
stock (inventory) — affect cash flows.
Also, the firm may be required to incur capital

expenditure during the operation of the
investment project.
Khan and Jain
WORKING CAPITAL AND CAPITAL
EXPENDITURE
• The
following formula should be used to
compute the investment’s net cash flows or
free cash flows:

Khan and Jain
FREE CASH FLOWS AND DISCOUNT RATE
Free cash flows and the discount rate:
Free cash flows are available to service both the

shareholders and the debt holders. Therefore,
debt flows (interest charges and repayment of
principal) are not considered in the computation
of free cash flows.

Khan and Jain
FREE CASH FLOWS AND DISCOUNT RATE
• The financing effect is captured by the firm’s
weighted cost of debt and equity, which is used to
discount the project’s cash flows.
This approach is based on two assumptions:
• the project’s risk is the same as the firm’s risk, and

• the firm’s debt ratio is constant and the project’s
debt capacity is the same as the firm’s.
Khan and Jain
TERMINAL CASH FLOWS
• Terminal cash flows are those, which occur in
the project’s last year in addition to annual
cash flows. They would consist of the after-tax
salvage value of the project and working
capital released (if any).
• In case of replacement decision, the
foregone salvage value of old asset should also
be taken into account.

Khan and Jain
TERMINAL VALUE OF NEW PRODUCT
• Terminal
value of a new product may depend on
the cash flows, which could be generated much
beyond the assumed analysis or horizon period.
• The firm may make a reasonable assumption

regarding the cash flow growth rate after the
horizon period and use the following formula for
calculating terminal value:

Khan and Jain
SUNK COSTS and OVERHEADS
• The term incremental cash flows should be
interpreted carefully. The concept should be
extended to include the opportunity cost of the
existing facilities used by the proposal.
• Sunk costs and allocated overheads are
irrelevant in computing cash flows.
• Similarly, a new project may cannibalize
sales of the existing products. The project’s
cash flows should be adjusted for the reduction
in cash flows on account of the cannibalization.
Khan and Jain
INFLATION
• Inflation: The NPV rule gives correct answer to choose an
investment under inflation if it is treated consistently In
cash flows and discount rate. The discount rate is a
market-determined rate and therefore, includes the
expected inflation rate. It is thus generally stated in
nominal terms.
• The cash flows should also be stated in nominal terms to

obtain an unbiased NPV. Alternatively, the real cash flows
can be discounted at the real discount rate to calculate
unbiased NPV.
Khan and Jain
INFLATION
• The
following equation gives the
relationship between nominal and real cost
of capital:

Khan and Jain
Points to be considered
• Ignore Sunk Costs

• Include Opportunity Costs
• Consider all Incidental Effects
• Allocation of Overhead Costs
• Estimate Working Capital properly

Khan and Jain

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ESTIMATION OF CASH FLOWS

• Show the conceptual difference between profit and cash

• Discuss the approach for calculating incremental cash

• Explain the treatment of inflation in capital budgeting

• Highlight the interaction between financing and

• Involvement of heavy funds

• Long term implications

• Most difficult to make

• Also, in the calculation of profits, an arbitrary

Source: Brealey&Myers ,I M Pandey and

• A conventional investment has cash flows the pattern of an

• Cash flows on the investment side, financing costs should not

• The comparison may simply be between cash

• Cash Flows should be measured on an after-tax basis

• The income from a project typically is marginal.

• Marginal tax rate is the tax rate applicable to the income at

• Alternatively, you can estimate the future cash

Three components of cash flows can be identified:

Source: Brealey&Myers ,I M Pandey and

In the case of replacement decision, the after-

Annual net cash flow is the difference between

Care should be taken in properly adjusting

Depreciation is a non-cash item, but it affects cash flows through tax

Source: Brealey&Myers ,I M Pandey and

In practice, changes in working capital items —

Also, the firm may be required to incur capital

Source: Brealey&Myers ,I M Pandey and

Free cash flows and the discount rate:

Free cash flows are available to service both the

Source: Brealey&Myers ,I M Pandey and

This approach is based on two assumptions:

• the project’s risk is the same as the firm’s risk, and

Source: Brealey&Myers ,I M Pandey and

• The firm may make a reasonable assumption

Source: Brealey&Myers ,I M Pandey and

• The cash flows should also be stated in nominal terms to

Source: Brealey&Myers ,I M Pandey and

• Ignore Sunk Costs

Source: Brealey&Myers ,I M Pandey and

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