ch 10 revised
TRANSCRIPT
-
7/28/2019 Ch 10 Revised
1/28
DETERMINING CASH FLOWS FORINVESTMENT ANALYSIS
CHAPTE
R 10
-
7/28/2019 Ch 10 Revised
2/28
LEARNING OBJECTIVES
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 andinvestment decisions
2
-
7/28/2019 Ch 10 Revised
3/28
INTRODUCTION
Sound investment decisions should be based on thenet present value (NPV) rule.
Problems to be resolved in applying the NPV rule What should be discounted? In theory, the answer is:
We should always discount cash flows.
What rate should be used to discount cash flows? In
principle, the opportunity cost of capital should beused as the discount rate.
3
-
7/28/2019 Ch 10 Revised
4/28
CASH FLOWS VERSUS
PROFIT
Cash flow is not the same thing as profit, at least, fortwo reasons.
First, profit, as measured by an accountant, is based on accrualconcept.
Second, for computing profit, expenditures are arbitrarily dividedinto revenue and capital expenditures.
CAPEXDEPProfitCF
CAPEXDEP)DEPEXPREV(CF
4
-
7/28/2019 Ch 10 Revised
5/28
INCREMENTAL CASH FLOWS
Every investment involves a comparison of alternatives:
When the incremental cash flows for an investment arecalculated by comparing with a hypothetical zero-cash-flow
project, we call them absolute cash flows.
The incremental cash flows found out by comparisonbetween two real alternatives can be called relative cashflows.
The principle of incremental cash flows assumes greaterimportance in the case ofreplacement decisions.
5
-
7/28/2019 Ch 10 Revised
6/28
Example
Suppose a firm is considering replacing an equipment at bookvalue of Rs. 5000 and market value of Rs. 3000. New
equipment will require an initial cash outlay of Rs 10,000, and
is estimated to generate cash flows of Rs 8,000, Rs 7,000 and Rs
4,500 for the next 3 years. The book value of old machine is a sunk cost. Market value is
opportunity cost.
Thus, on an incremental basis the net cash outflow of new
equipment is: Rs 10,000 Rs 3,000 = Rs 7,000.Also, The differences of the cash flows of new equipment over
the cash flows of old equipment are incremental cash flows.
6
-
7/28/2019 Ch 10 Revised
7/28
COMPONENTS OF CASH
FLOWS
Initial Investment
Net Cash Flows
Depreciation and Taxes
Net Working Capital
Change in accounts receivable
Change in inventory Change in accounts payable
Free Cash F lows
Terminal Cash Flows
Salvage Value
Salvage value of the new asset
Salvage value of the exi sting asset now
Salvage value of the exi sting asset at the end of its normal
Tax eff ect of salvage value
Release of Net Working Capi tal
7
-
7/28/2019 Ch 10 Revised
8/28
Initial InvestmentInitial investment is the net cash outlay in the period
in which an asset is purchased.
A major element of the initial investment is gross
outlay or original value (OV) of the asset, whichcomprises of its cost (including accessories and spare
parts) and freight and installation charges.
Original value is included in the existing block of
assets for computing annual depreciation.
8
-
7/28/2019 Ch 10 Revised
9/28
Example of Initial Investment9
Wattle Extract Project: InitialInvestment
-
7/28/2019 Ch 10 Revised
10/28
Net Cash Flows
Consist of annual cash flows occurring from the operation of
an investment, but it is also be affected by changes in net
working capital and capital expenditures during the life of the
investment.
The computation of the after-tax cash flows requires a careful
treatment of non-cash expense items such as depreciation.Depreciation, calculated as per the income tax rules influences
cash flows indirectly by way of depreciation tax shield.
10
Net cash flow Revenues Expenses Taxes
NCF REV EXP TAX
= - -
= - -
-
7/28/2019 Ch 10 Revised
11/28
Calculation of Depreciation For
Tax Purposes
Two most popular methods of charging depreciation are:
straight-line
Diminishing balance or written-down value (WDV)methods.
For reporting to the shareholders, companies in India couldcharge depreciation either on the straight-line or the written-down value basis.
No choice of depreciation method and rates for the taxpurposes is available to companies in India.
Depreciation is computed on the written down value of theblock of assets and rates are specified.
11
-
7/28/2019 Ch 10 Revised
12/28
-
7/28/2019 Ch 10 Revised
13/28
Free Cash Flows
It is the cash flow available to service both lenders
and shareholders, who have provided, respectively,
debt and equity, funds to finance the firms
investments.It is this cash flow, which should be discounted to
find out an investments NPV.
13
-
7/28/2019 Ch 10 Revised
14/28
Terminal Cash Flow: Salvage
Value
Salvage value is a terminal cash flow.
Salvage value may be defined as the market price
of an investment at the time of its sale.
No immediate tax liability (or tax savings) arises on
the sale of an asset because the value of the asset
sold is adjusted in the depreciable base of assets.
14
-
7/28/2019 Ch 10 Revised
15/28
Effects of Salvage Value
Salvage value of the new asset: It will increase cash inflow
in the terminal (last) period of the new investment.
Salvage value of the existing asset now: It will reduce theinitial cash outlay of the new asset.
Salvage value of the existing asset at the end of its normal
life:It will reduce the cash flow of the new investment of inthe period in which the existing asset is sold.
15
-
7/28/2019 Ch 10 Revised
16/28
Release of Net Working
CapitalBesides salvage value, terminal cost flows will also
include the release of net working capital.
It is reasonable to assume that funds initially tied
up in net working capital at the time the investmentwas undertaken would be released in the last year
when the investment is terminated.
16
-
7/28/2019 Ch 10 Revised
17/28
DEPRECIATION FOR
TAX PURPOSES
Two most popular methods of charging depreciation are:
1. Straight-line and diminishing balance
2. Written-down value (WDV) methods
In India, depreciation is allowed as deduction every year on the
written-down value basis in respect of fixed assets as per the rates
prescribed in the Income Tax rules.
Depreciation is computed on the written down value of the blockof assets.
17
-
7/28/2019 Ch 10 Revised
18/28
Depreciation base
In the case of block of assets, the written down value iscalculated as follows:
The aggregate of the written down value of all assets in the
block at the beginning of the year
Plus the actual cost of any asset in the block acquired duringthe year
Minus the proceeds from the sale of any asset in the block
during the year
Thus, in a replacement decision, the depreciation base of a new
asset will be equal to: Cost of new equipment + Written down
value of old equipment Salvage value of old equipment
18
-
7/28/2019 Ch 10 Revised
19/28
-
7/28/2019 Ch 10 Revised
20/28
Salvage Value and Tax
Effects
As per the current tax rules in India, the after-tax
salvage value should be calculated as follows:
Book value > Salvage value:
After-tax salvage value = Salvage value + PV ofdepreciation tax shield on (BV SV)
Salvage value > Book value:
After-tax salvage value = Salvage value - PV of depreciation
tax shield lost on (SV
BV)
20
-
7/28/2019 Ch 10 Revised
21/28
Terminal Value for a New
Business The terminal value included the salvage value of the asset and
the release of the working capital.
Managers make assumption of horizon period because detailedcalculations for a long period become quite intricate. Thefinancial analysis of such projects should incorporate anestimate of the value of cash flows after the horizon periodwithout involving detailed calculations.
A simple method of estimating the terminal value at the end ofthe horizon period is to employ the following formula, which isa variation of the dividend growth model
gk
NCF
gk
g1NCFTV 1nnn
21
-
7/28/2019 Ch 10 Revised
22/28
Terminal Value of New
Business / New Products
New businesses have the potential of generating revenues and
cash flows much beyond the assumed period of analysis,
which is referred to as horizon period.
A simple method of estimating the terminal value at the end of
the horizon period is:
whereNCFn+1 is the projects net cash flow one year after thehorizon period, kis the opportunity cost of capital (discount rate)
andgis the expected growth in the projects net cash flows.
22
( )1
NCF 1 NCFTV
n nn
g
k g k g
++
= =
- -
-
7/28/2019 Ch 10 Revised
23/28
Cash Flow Estimates for
Replacement Decisions
The initial investment of the new machine will be
reduced by the cash proceeds from the sale of the
existing machine.
The annual cash flows are found on incrementalbasis.
The incremental cash proceeds from salvage value
is considered.
23
-
7/28/2019 Ch 10 Revised
24/28
Additional Aspects of
Incremental Cash Flow Analysis
Allocated Overheads
Opportunity Costs of Resources
Incidental Effects
Contingent costs
Cannibalisation Revenue enhancement
Sunk Costs
Tax Incentives
I nvestment allowanceUntil I nvestment deposit scheme
Other tax incenti ves
24
-
7/28/2019 Ch 10 Revised
25/28
Investment Decisions Under
Inflation Executives generally estimate cash flows assuming unit costs and
selling price prevailing in year zero to remain unchanged. Theyargue that if there is inflation, prices can be increased to coverincreasing costs; therefore, the impact on the projects profitabilitywould be the same if they assume rate of inflation to be zero.
This line of argument, although seems to be convincing, isfallacious for two reasons.
First, the discount rate used for discounting cash flows is generallyexpressed in nominalterms. It would be inappropriate and inconsistentto use a nominal rate to discount constant cash flows.
Second, selling prices and costs show different degrees ofresponsiveness to inflation
The depreciation tax shield remains unaffected by inflation sincedepreciation is allowed on the book value of an asset, irrespective ofits replacement or market price, for tax purposes.
25
-
7/28/2019 Ch 10 Revised
26/28
Nominal VS. Real Rates of
Return For a correct analysis, two alternatives are available:
either the cash flows should be converted into nominal terms and thendiscounted at the nominal required rate of return, or
the discount rate should be converted into real terms and used to discount thereal cash flows
Important: Discount nominal cash f lows at nominal discount rate; ordiscount real cash f lows at real discount rate.
Example: If a firm expects a 10 per cent real rate of return from aninvestment project under consideration and the expected inflation rate is 7
per cent, the nominal required rate of return on the project would be:
(1.10)(1.07) 1 1.177 1 0.177 or 17.7%k= - = - =
26
-
7/28/2019 Ch 10 Revised
27/28
It would be inconsistent to discount the real cash flows of the project
by thenominal discount rate. For example, in case of following cash
flows discounting with 14% nominal rate of real cash flows returns
negative NPV:
The cash flows should be discounted with real discount rate as follows:
27
1.141 0.0654
1.07K= - =
-
7/28/2019 Ch 10 Revised
28/28
Financing effects in Investment
Evaluation
According to the conventional capital budgeting approachcash flows should not be adjusted for the financing effects.
The adjustment for the financing effect is made in the discount
rate. The firms weighted average cost of capital (WACC) isused as the discount rate.
It is important to note that this approach of adjusting for thefinance effect is based on the assumptions that:
The investment project has the same risk as the firm.
The investment project does not cause any change in the firms targetcapital structure.
28