CASH FLOW ILLUSTRATIONSTo show how cash flows are defined, bearing in mind the principles discussed above, three illustrations of gradually increasing complexity are presented in this section.Illustration IZAAK Enterprises is considering a new investment project about which the following information is available.i.The total outlay on the project will be $ 10 million. This consists of $ 6 million on plant and equipment and $4 million on gross working capital. The entire outlay will be incurred at the beginning of the project.ii.The project will be financed with $ 4 million of equity capital, $ 3 million of long term debt (in the form of debentures), $ 2 million of short-term bank borrowings, and $ 1 million of trade credit. This means that $ 7 million of long term funds (equity + long-term debt) will be applied towards plant and equipment ($ 6 million) and working capital margin (Rs 1 million)- working capital margin is defined as the contribution of long term funds towards working capital. The interest rate on debentures will be 15 per cent and interest rate on short-term borrowings will be 18 per cent.iii-The life of the project is expected to be 5 years and the plant and equipment would fetch a salvage value of $ 2 million. The liquidation value of working capital will be equal to $ 2 million, the book value.iv-The project will increase the revenues of the firm by $ 6 million per year. The increase in operating expense on account of the project will be $ 4 million per year. (this includes all items of expense other than depreciation, interest, and taxes.) the effective tax rate will be 50 percent.v-Plant and equipment will be depreciated at the rate of 331/3 percent per year as per the written down value method. So the depreciation charges will be

(Rs in million)

First yearSecond yearThird yearFourth yearFifth year2.001.330.890.590.40

Given the above details the post-tax, incremental cash flows relating to long-term funds are worked out in Exhibit 7.1. Some clarifications about this exhibit are in order. The initial investment, occurring at the end of year 0, is $ 7 million. This represents the commitment of long-term funds to the project. (Note that the total outlay on the project is $ 10 million. However, our focus is on flows relating to long-term funds.) The operating cash inflow, relating to long terms funds, at the end of year 1 is $ 3.07 million. This is defined as follows:Profit after tax + Depreciation + Interest on debentures (1-tax rate)$ 0.845 million + $ 2 million + $ 0.45 million (1-0.50)The operating cash inflows for the subsequent years have been calculated similarly. The terminal cash flow relating to long-term funds is equal to:Net salvage value of plant and equipment + Net recovery of working capital marginIt may be noted that when the project is terminated, its liquidation value will be equal to;Net salvage value of plant and equipment + Net recovery of working capital The first component belongs to the suppliers of long-term funds. The second component is applied to repay the current liabilities and recover the working capital margin.Cash Flow for the New Project(Rs in million) years 0 1 2 3 4 5

A-Plant and equipmentB-Working capital marginC-RevenuesD-Operating costsE-DepreciationF-Interest on short-term bank borrowingsG-Interest on debenturesH-Profit before taxI-TaxJ-Profit after taxK-Net salvage value of plant and equipmentL-Net recovery working capital margin(6.00)(1.00)

8.003.502.000.36

0.451.6900.8450.845

8.003.501.3330.36

0.452.3571.1761.178

8.003.500.8890.36

0.452.8011.4011.400

8.003.500.5930.36

0.453.0971.5491.548

8.003.500.3950.36

0.453.2951.6481.6472.001.00

M-Initial investment (A + B)N-Operating cash inflows (J+E+G (I-T))O-Terminal cash flow (K+L)P-Net cash flow (M+N+O)(7.00)

(7.00)3.070

3.0702.736

2.7362.514

2.5142.366

2.3662.2673.0005.267

-VIEWING A PROJECT FRoM DIFFERENT POINTS OF VIEWIn the preceding discussion we looked at a project from the point of view of long-term funds and defined its cash flows accordingly. However, a project may be viewed from two other points of view as well: the equity point of view and the total funds point of view. To compare the alternative points of view-the equity point of view, the long-term funds point of view, and the total funds point of view-let us consider an example.Magnum Technologies Limited is evaluating an electronics project for which the following information has been assembled:1-The total outlay on the project is expected to be Rs 50million. This consists of Rs 30 million of fixed assets and Rs 20million of current assets.2-The total outlay of Rs 50million is proposed to be financed as follows: Rs 15million of equity, Rs 20 million of term loans, Rs 10 million of bank finance for working capital, and Rs 5million of trade credit.3-The term loan is repayable in five equal annual installments of Rs 4 million each. The first installment will fall due at the end of the first year and the last installment at the end of the fifth year. The levels of bank finance for working capital and trade credit will remain at Rs 10million and Rs 5million till they are paid back or retired at the end of five years.4-The interest rates on the term loan and bank finance for working capital will be 15 per cent and 18 per cent respectively.5-The expected revenues from the project will be Rs 60 million per year. The operating costs, excluding depreciation, will be Rs 42 million. The depreciation rate on the fixed assets will be 33 1/3 per cent as per the written down value method.6-The net salvage value of fixed assets and current assets at the end of year 5 will be Rs 5 million and Rs 20 million respectively. 7-The tax rate applicable to the firm is 50 per cent

Cash Flows Relating to EquityThe equity-related cash flow stream reflects the contributions made and benefits receivable by equity shareholders. It may be divided into three components as follows:*Initial investment: Equity funds committed to the project*Operating cash inflows : Profit after tax Preference dividend + Depreciation + Other non-cash charges*Liquidation and retirement cash flows (terminal cash flows) : Net salvage value of fixed assets+Net salvage value of current assets-Repayment of term loans-Redemption of preference capital-Repayment of working capital advances-Retirement of trade credit and other duesWhile the first two components, namely, initial investment and operating cash inflows are fairly self-explanatory, the third term, namely, liquidation and retirement cash flows requires a little explanation. It represents the net cash flows accruing to equity shareholders as a result of liquidation of various assets in the project and retirement/ redemption of all other sources of financing. Remember that equity shareholders have a residual interest in the project and hence what is left after meeting the claims of all other suppliers of finance belongs to equity shareholders.Exhibit 7.4 works out the cash flows from the equity point of view for the electronics project of Magnum Technologies Limited.

Cash Flow Relating to Long-term FundsAs discussed earlier in this chapter, the cash flow stream relating to long-term funds consists of three components as follows:Initial investment: Long-term funds invested in the project.This is equal to: fixed assets + working capital margin.Operating cash inflow: profit after tax+Depreciation+Other non-cash charges+Interest on long-term borrowings (1 tax rate)Terminal cash flow: Net salvage value of fixed assets+Net recovery of working capital margin

Exhibit 7.4-Net Cash flows relating to equity

(Rs in million) years 0 1 2 3 4 5

A-Equity fundsB-RevenuesC-Operating costsD-DepreciationE-Interest on working capital advanceF-Interest on term loanG-Profit before taxH-TaxI-Profit after taxJ-Preference dividendK-Net salvage value of fixed assetsL-Net salvage value of current assetsM-Repayment of term-loansN-Redemption of preference capitalO-Repayment of short-term bank borrowingsP- Retirement of trade creditors(15.00)

60.0042.0010.001.803.003.201.601.60---4.00--

-60.0042.006.671.802.407.133.573.56---4.00--

-60.0042.004.441.801.809.964.984.98---4.00--

-60.0042.002.961.801.2012.046.026.02---4.00--

-60.0042.001.981.800.6013.626.816.81-5.0020.004.00-10.00

5.00

Q-Initial investment (A)O-Operating cash inflows (I-J+D)S-liquidation and retirement cash flows (K+L-M-N-O-P)T-Net cash flow (Q+R+S)(15.00)

(15.00)11.60(4.00)7.6010.23(4.00)6.239.42(4.00)5.428.98(4.00)4.988.79(4.00)11.79

Exhibit 7.5 shows the cash flows relating to long-term funds for the electronics project of Magnum Technologies Limited

Cash Flow Relating to Total FundsThe cash flow stream relating to total funds consists of three components as follows:Initial investment: All the funds committed to the project. This is simply the total outlay on the project consisting of fixed assets as well as current assets

Operating cash inflow: Profit after tax+ Depreciation+Other non-cash charges+Interest on long-term borrowings (1- tax rate)+Interest on short-term borrowings (1- tax rate)Terminal cash flow: Net salvage value of fixed assets+Net salvage value of current assets

Exhibit 7.5

Net Cash Flows Relating to Long-term Funds

(Rs in million) years 0 1 2 3 4 5

A-Fixed assetsB-Working capital marginC-RevenuesD-Operating costsE-DepreciationF-Interest on working capital advanceG-Interest on term loanH-Profit before taxI-TaxJ-Profit after taxK-Net salvage value of fixed assetsL-Net recovery of working capital margin(30.00)(5.0)

60.0042.0010.001.803.003.201.601.60

60.0042.006.671.802.407.133.573.56

60.0042.004.441.801.809.964.984.98

60.0042.002.961.801.2012.046.026.02

60.0042.001.981.800.6013.626.816.815.005.00

M-Initial investment (A+B)N-Operating cash inflows (J+E+G(I-T))O-Terminal cash flow (K+L)(35.00)

13.10

11.43

10.32

9.58

9.0910.00

P-Net cash flow (M+N+O)(35.00)13.1011.4310.329.5819.09

Exhibit 7.6 shows the net cash flows from the point of view of total funds for the electronics project of Magnum Technologies Limited

5-HOW FINANCIAL INSTITIUTIONS AND THE PLANNING COMMISSION DEFINE CASH FLOWSFinancial InstitutionsIn evaluating project proposals submitted to them, financial institutions (all-India financial institutions as well as state-level financial institutions) define project cash flows as follows:Cash outflowsFixed assetsCost of project+- working capital margin-interest during construction periodCurrent assets+Increase in current assets with increase in the level of production

EXHIBIT 7.6

Net Cash Flows Relating to Total Funds(Rs in million) years 0 1 2 3 4 5

A-Total fundsB-RevenuesC-Operating costsD-DepreciationE-Interest on working capital advanceF-Interest on term loanG-Profit before taxH-TaxI-Profit after taxJ-Net salvage value of fixed assetsK-Net salvage value of current assets(30.00)

60.0042.0010.001.803.003.201.601.60

60.0042.006.671.802.407.133.573.56

60.0042.004.441.801.809.964.984.98

60.0042.002.961.801.2012.046.026.02

60.0042.001.981.800.6013.626.816.815.0020.00

L-Initial investment (A)M-Operating cash inflows (G+D+F(I-t)+E(1-t))N-Terminal cash flow (J+K)(50.00)

14.00

12.33

11.22

11.98

9.99

25.00

O-Net cash flow (L+M+N)(50.00)14.0012.3311.2311.9834.99