Estimation of Cash Flow

1. 11
ESTIMATION OF CASH FLOWSESTIMATION OF CASH FLOWS
By CA N.VenkatakrishnanBy CA N.Venkatakrishnan
@@
MVITMVIT
1212
THTH
MAY 2011 MAY 2011

2. 22
ESTIMATION OF CASH FLOWSESTIMATION OF CASH FLOWS
OVERVIEW OF CAPITAL OVERVIEW OF CAPITAL
BUDGETING AND EXPENDITUREBUDGETING AND EXPENDITURE ;;
What is Capital Budgeting;What is Capital Budgeting;
 The process of identifying, evaluating and The process of identifying, evaluating and
selecting investments whose returns (cash selecting investments whose returns (cash
flows) are expected to extend beyond one flows) are expected to extend beyond one
year ie Long term Investments year ie Long term Investments

3. 33
ESTIMATION OF CASH FLOWSESTIMATION OF CASH FLOWS
CAPITAL EXPENDITURE VS REVENUE EXPENDITURECAPITAL EXPENDITURE VS REVENUE EXPENDITURE
Capital ( CAPEX)
Deferred revenue ( CAPEX) Revenue ( OPEX)

4. 44
ESTIMATION OF CASH FLOWSESTIMATION OF CASH FLOWS
CAPITAL EXPENDITURECAPITAL EXPENDITURE ;;
Purchase of capital equipmentPurchase of capital equipment
Furniture and FixturesFurniture and Fixtures
ComputersComputers
Communication EquipmentCommunication Equipment
Land and BuildingsLand and Buildings
Electrical InstallationElectrical Installation
Office EquipmentOffice Equipment
Major repairs to any Asset which would enhance the life of that Major repairs to any Asset which would enhance the life of that
particular Asset.particular Asset.

5. 55
ESTIMATION OF CASH FLOWSESTIMATION OF CASH FLOWS
REVENUE EXPENDITUREREVENUE EXPENDITURE ;;
Manufacturing costsManufacturing costs
Salary, Bonus Gratuity etc-Employee costsSalary, Bonus Gratuity etc-Employee costs
RentRent
ElectricityElectricity
Interest Interest
Communication ExpensesCommunication Expenses
AdvertisementAdvertisement
Marketing ExpensesMarketing Expenses

6. 66
ESTIMATION OF CASH FLOWSESTIMATION OF CASH FLOWS
IMPORTANCE OF CASH FLOWS /CAPITAL BUDEGETING IMPORTANCE OF CASH FLOWS /CAPITAL BUDEGETING
DECISIONS;DECISIONS;
1)Affect the profitability of the company –Earning Assets of the 1)Affect the profitability of the company –Earning Assets of the
company.company.
2)Will have a long term effect over the company2)Will have a long term effect over the company
3)Not easily reversible without much Financial loss.3)Not easily reversible without much Financial loss.
4)Involves huge costs and scarce resources4)Involves huge costs and scarce resources
DIFFICULTIES IN CAPITAL EXPENDITURE DECISIONS;DIFFICULTIES IN CAPITAL EXPENDITURE DECISIONS;
1)Relate to uncertain future Period involving various risk factors.1)Relate to uncertain future Period involving various risk factors.
2)Costs and revenue accrue at different time periods.2)Costs and revenue accrue at different time periods.

7. 77
ESTIMATION OF CASH FLOWSESTIMATION OF CASH FLOWS
CLASSIFICATION OF INVESTMENT PROJECT PROPOSALS;CLASSIFICATION OF INVESTMENT PROJECT PROPOSALS;
11. New products or expansion. New products or expansion of existing products of existing products
2. Replacement2. Replacement of existing equipment or buildings of existing equipment or buildings
3. Infrastructure Projects3. Infrastructure Projects
4. Research and development4. Research and development
5. Exploration5. Exploration
6. Mandatory Requirements (e.g., safety or pollution related)6. Mandatory Requirements (e.g., safety or pollution related)
7. Others-welfare related like Townships etc.7. Others-welfare related like Townships etc.

All these could be Independent or Mutually Exclusive.All these could be Independent or Mutually Exclusive.

8. 88
ESTIMATION OF CASH FLOWSESTIMATION OF CASH FLOWS
EXECUTIVES/PROFESSIONALS INVOLVED IN CAPITAL EXECUTIVES/PROFESSIONALS INVOLVED IN CAPITAL
BUDEGETINGBUDEGETING;;
1. Engineering Teams-for outlays1. Engineering Teams-for outlays
4.4. Plant Managers- for giving their inputsPlant Managers- for giving their inputs
3. Production Team of Engineers-for operational costs3. Production Team of Engineers-for operational costs
6.6. Marketing Team.– for estimationMarketing Team.– for estimation
7.7. Finance Team- For working out the Financial dataFinance Team- For working out the Financial data
6 Capital Expenditures Committee6 Capital Expenditures Committee
7. President7. President
8. Board of Directors8. Board of Directors

9. 99
ESTIMATION OF CASH FLOWSESTIMATION OF CASH FLOWS
CAPITAL BUDGETING AND ESTIMATING CASH FLOWSCAPITAL BUDGETING AND ESTIMATING CASH FLOWS ;;
THE CAPITAL BUDGETING PROCESS;THE CAPITAL BUDGETING PROCESS;
Generate investment proposals consistent with the firm’s strategic Generate investment proposals consistent with the firm’s strategic
objectives.objectives.
Estimate after-tax incremental operating cash flows for the investment Estimate after-tax incremental operating cash flows for the investment
projects. projects.
Evaluate project incremental cash flowsEvaluate project incremental cash flows
Select projects based on a value-maximizing acceptance criterion.Select projects based on a value-maximizing acceptance criterion.
Reevaluate implemented investment projects continually and perform Reevaluate implemented investment projects continually and perform
post audits for completed projectspost audits for completed projects

10. 1010
ESTIMATION OF CASH FLOWSESTIMATION OF CASH FLOWS
DIFFICULTIES IN ESTIMATION;DIFFICULTIES IN ESTIMATION;
Inaccurate data can distort the cash flow projections and Inaccurate data can distort the cash flow projections and
eventually the conclusions may prove wrong.eventually the conclusions may prove wrong.
Future cannot be predicted with certainty.Future cannot be predicted with certainty.
The company has to rely on a lot of external Data The company has to rely on a lot of external Data
especially for new projects.especially for new projects.
Accurate projections are important because the company Accurate projections are important because the company
may accept an unviable proposal or reject a good proposal.may accept an unviable proposal or reject a good proposal.

11. 1111
ESTIMATION OF CASH FLOWSESTIMATION OF CASH FLOWS
PRINCIPLES OF CASH FLOWPRINCIPLES OF CASH FLOW;;
To arrange proper Financing for a project, it is imperative to ascertain the To arrange proper Financing for a project, it is imperative to ascertain the
correct profitability of the Project. The project cash flows consider almost correct profitability of the Project. The project cash flows consider almost
every kind of inflows of cashevery kind of inflows of cash . .
1)Consistency principle1)Consistency principle; ;
cash flows should be consistent as to the discount rates and estimating cash flows should be consistent as to the discount rates and estimating
the cash flows. If distorted, then the purpose will be defeated.the cash flows. If distorted, then the purpose will be defeated.
 Investors’ and Inflation factors have to be factored in the cash flowInvestors’ and Inflation factors have to be factored in the cash flow
2)Post Tax principle2)Post Tax principle; ;
Cash flows have to factor in the taxes applicable. Whether it is the Cash flows have to factor in the taxes applicable. Whether it is the
company’s average tax or the projects marginal tax would depend on the company’s average tax or the projects marginal tax would depend on the
situation of the company. eg Previous existing Losses. situation of the company. eg Previous existing Losses.
Non cash charges do affect cash flows.Non cash charges do affect cash flows.

12. 1212
ESTIMATION OF CASH FLOWSESTIMATION OF CASH FLOWS
PRINCIPLES OF CASH FLOW;PRINCIPLES OF CASH FLOW;
3)Incremental principle; 3)Incremental principle;
According to this principle, only differences due to the decision needs According to this principle, only differences due to the decision needs
to be considered. Other factors may be important but not to the to be considered. Other factors may be important but not to the
decision at hand.decision at hand.
Incidental Effects: Any kind of project taken by a company remains Incidental Effects: Any kind of project taken by a company remains
related to the other activities of the firm. Because of this, a particular related to the other activities of the firm. Because of this, a particular
project influences all the other activities carried out, either negatively project influences all the other activities carried out, either negatively
or positively. It can increase the profits for the firm or it may cause or positively. It can increase the profits for the firm or it may cause
losses.losses.
4)Separation principle; 4)Separation principle; This principle recognizes the fact that any project This principle recognizes the fact that any project
cash flow estimation has two sides viz Investment and Financing.cash flow estimation has two sides viz Investment and Financing.

13. 1313
ESTIMATION OF CASH FLOWSESTIMATION OF CASH FLOWS
DATA REQUIRED-IDENTIFYING RELEVANT CASH FLOWSDATA REQUIRED-IDENTIFYING RELEVANT CASH FLOWS
1)CASH FLOW VS ACCOUNTING PROFIT1)CASH FLOW VS ACCOUNTING PROFIT;;
Cash Flow method is a better method of measuring Economic Viability;Cash Flow method is a better method of measuring Economic Viability;
Accounting Profits/losses include Non Cash Expenses and will not give an Accounting Profits/losses include Non Cash Expenses and will not give an
accurate picture of the EV of the Investment proposal. Cash Flows will accurate picture of the EV of the Investment proposal. Cash Flows will
describe the Cash Transactions the company will experience once the Project describe the Cash Transactions the company will experience once the Project
is accepted.is accepted.
There are Accounting ambiguities in determining net profits under There are Accounting ambiguities in determining net profits under
Accounting profits eg Valuation of Inventories, ,allocation of costs, methods Accounting profits eg Valuation of Inventories, ,allocation of costs, methods
of depreciation, provisions etc. Cash Flow method provides a near perfect of depreciation, provisions etc. Cash Flow method provides a near perfect
picture of the EV of the Investment proposal.picture of the EV of the Investment proposal.
Cash Flow method recognizes the Time value of money where as Cash Flow method recognizes the Time value of money where as
Accounting profits are more historical and on accrual basis.Accounting profits are more historical and on accrual basis.
..

14. 1414
ESTIMATION OF CASH FLOWSESTIMATION OF CASH FLOWS
Difference between Accounting and cash Flow approach; In rupeesDifference between Accounting and cash Flow approach; In rupees
Cash Flow
approach
50,000
20000
6000
4000
---------
30000
20000
6000
14000
Accounting
approach
50,000
20000
6000
4000
10000
40000
10000
3000
7000
Particulars
Revenues-sales(1)
Less ;Cost of sales(2)
Materials
Labor
other expenses
Depreciation
Total cost
Earnings/Cash Flow before Tax(1-2)
Taxes say 30%
Net Earnings/Cash flow after Tax

15. 1515
ESTIMATION OF CASH FLOWSESTIMATION OF CASH FLOWS
2)INCREMENTAL CASH FLOWS;2)INCREMENTAL CASH FLOWS;
These are cash flows These are cash flows WITHWITH the Proposed Project MINUS the the Proposed Project MINUS the
company’s cash flow company’s cash flow WITHOUTWITHOUT the Project. the Project.
Cash Flows (and only those cash flows) which are directly attributable Cash Flows (and only those cash flows) which are directly attributable
to the Investment are considered.to the Investment are considered.
Eg Fixed Overhead costs which remain the same whether the proposal Eg Fixed Overhead costs which remain the same whether the proposal
is accepted or rejected are not considered.is accepted or rejected are not considered.
If there is an increase in the FO costs due to the new proposal they If there is an increase in the FO costs due to the new proposal they
may be considered.may be considered.

16. 1616
ESTIMATION OF CASH FLOWSESTIMATION OF CASH FLOWS
Relevant and Irrelevant cash outflows;Relevant and Irrelevant cash outflows;
Relevant for cash outflows;Relevant for cash outflows;
 Cost of the InvestmentCost of the Investment
Variable costs-Material and LaborVariable costs-Material and Labor
Additional Fixed overheadsAdditional Fixed overheads
TaxesTaxes
Effects of InflationEffects of Inflation
Opportunity costsOpportunity costs
Irrelevant for cash outflowsIrrelevant for cash outflows
Fixed OverheadsFixed Overheads
Sunk costs.Sunk costs.

17. 1717
ESTIMATION OF CASH FLOWSESTIMATION OF CASH FLOWS
INGREDIENTS OF CASH FLOW STREAMS;INGREDIENTS OF CASH FLOW STREAMS;
Tax effect-Tax effect-
>Cash flows are to be considered net of taxes. >Cash flows are to be considered net of taxes.
> If the company is loss making any profit earned can be set off > If the company is loss making any profit earned can be set off
against the losses incurred earlier.against the losses incurred earlier.
Effect on Other ProjectsEffect on Other Projects; ;
>May have an effect on the proposed project. eg, an existing product >May have an effect on the proposed project. eg, an existing product
may suffer due to the new project. This has to be factored. The new may suffer due to the new project. This has to be factored. The new
project evaluation cannot be isolated and taken as it is. project evaluation cannot be isolated and taken as it is.
>Any reduction in cash flow of other projects will have a bearing on >Any reduction in cash flow of other projects will have a bearing on
the Incremental cash flow of the proposed project.the Incremental cash flow of the proposed project.
Effect of Indirect ExpensesEffect of Indirect Expenses;;
>depends on whether the amount of overheads will change as a result >depends on whether the amount of overheads will change as a result
of the of the decision. If yes, then it should be factored. If there is going of the of the decision. If yes, then it should be factored. If there is going
to no change, then they are not relevant.to no change, then they are not relevant.

18. 1818
ESTIMATION OF CASH FLOWSESTIMATION OF CASH FLOWS
Effect of Depreciation;Effect of Depreciation;
Is a non cash expenditure which does not have a cash outflow but has Is a non cash expenditure which does not have a cash outflow but has
to deducted while working out the tax on the net cash flows and to deducted while working out the tax on the net cash flows and
evaluation there after.evaluation there after.
Companies Act prescribes various depreciation ratesCompanies Act prescribes various depreciation rates
Normally two methods are used-Straight line method or WDV method.Normally two methods are used-Straight line method or WDV method.
Income tax Act provides rates which are also followed by many Income tax Act provides rates which are also followed by many
companies in their books.companies in their books.
Effect of working capital;Effect of working capital;
Constitutes another important ingredient which directly affects the Constitutes another important ingredient which directly affects the
proposal. It is a cash out flow in the year there is an increase in the net proposal. It is a cash out flow in the year there is an increase in the net
WC requirement. It could be from t0 to tn.WC requirement. It could be from t0 to tn.

19. 1919
ESTIMATION OF CASH FLOWSESTIMATION OF CASH FLOWS
COMPONENTS OF CASH FLOW;COMPONENTS OF CASH FLOW;
1)INITIAL INVESTMENT OR OUTLAY/OUTFLOW-1)INITIAL INVESTMENT OR OUTLAY/OUTFLOW-
d)d)Purchase price of “new” assetsPurchase price of “new” assets
b) +Capitalized expenditure-Freight , Insurance, Transportation, Training b) +Capitalized expenditure-Freight , Insurance, Transportation, Training
of Manpower to use the machine,CD etcof Manpower to use the machine,CD etc
h)h)Opportunity costs incurred.. eg own land/house used for the project.Opportunity costs incurred.. eg own land/house used for the project.
d)+ (-)Increase (decrease) =Net Working Capital.d)+ (-)Increase (decrease) =Net Working Capital.
e)-e)- Net proceeds from sale of “old” Assets ,if replacement Net proceeds from sale of “old” Assets ,if replacement
f) f) + (-)+ (-) Taxes (savings) due to the sale of ‘old ‘machines/assets Taxes (savings) due to the sale of ‘old ‘machines/assets

f) f) == Initial cash Initial cash outflowoutflow

20. 2020
ESTIMATION OF CASH FLOWSESTIMATION OF CASH FLOWS
An old machine is to be replaced. It was bought 4 years ago for rs 120,000 An old machine is to be replaced. It was bought 4 years ago for rs 120,000
and now sold as salvage for Rs 10000.The accumulated depreciation and now sold as salvage for Rs 10000.The accumulated depreciation
amounts to Rs 112000.amounts to Rs 112000.
The cost of the new machine is Rs 200,000.The installation costs amount The cost of the new machine is Rs 200,000.The installation costs amount
to Rs 4000 and training costs Rs 5000.The increase in net working to Rs 4000 and training costs Rs 5000.The increase in net working
capital amounts to Rs 3000.Tax rate is 30%.capital amounts to Rs 3000.Tax rate is 30%.
Find out the initial investment ;Find out the initial investment ;
Cost of machine- 200,000Cost of machine- 200,000
Installation cost- +4000Installation cost- +4000
Training costs- +5000Training costs- +5000
Increase in WC- +3000Increase in WC- +3000
Salvage value- -10000Salvage value- -10000
Tax on CG@30- Tax on CG@30- - 600 - 600
Rs Rs 201,400201,400

21. 2121
ESTIMATION OF CASH FLOWSESTIMATION OF CASH FLOWS
2) 2) OPERATING CASH FLOWS/NET ANNUAL CASH FLOWSOPERATING CASH FLOWS/NET ANNUAL CASH FLOWS ;;
Represents cash inflows on account of sales/revenue generation minus Represents cash inflows on account of sales/revenue generation minus
cash out flow on account of expenses.cash out flow on account of expenses.
Every Investment is expected to generate future benefits in the form of Every Investment is expected to generate future benefits in the form of
cash flows from operations.cash flows from operations.
Represents annual cash flows generated from the investments.Represents annual cash flows generated from the investments.
Represent net flows before depreciation and after taxes.Represent net flows before depreciation and after taxes.

22. 2222
ESTIMATION OF CASH FLOWSESTIMATION OF CASH FLOWS
3)TERMINAL CASH FLOWS3)TERMINAL CASH FLOWS; ;
The cash inflow to the company during the terminal year (last The cash inflow to the company during the terminal year (last
year) is called Terminal cash flow.year) is called Terminal cash flow.
Represents some value in the asset when the asset is Represents some value in the asset when the asset is
terminated/project is completed.terminated/project is completed.
When Replacement decision is taken to replace old asset with When Replacement decision is taken to replace old asset with
new asset, the sale value of the old asset is the terminal cash new asset, the sale value of the old asset is the terminal cash
flow of the asset replaced. (eg True value exchange of Maruthi flow of the asset replaced. (eg True value exchange of Maruthi
car).car).
Due to termination of the Asset, there may be release of Due to termination of the Asset, there may be release of
some Net working capital tied up in the initial year which some Net working capital tied up in the initial year which
should also be added to the salvage of the asset in the should also be added to the salvage of the asset in the
terminal cash flows.terminal cash flows.

23. 2323
ESTIMATION OF CASH FLOWSESTIMATION OF CASH FLOWS
Determination of InflowsDetermination of Inflows
yny4y3y2Y1
Particulars
Sales
Less Operating costs
Cash Inflows before Taxes (CFBT)
Less Depn
Taxable Income
Less Tax
Earnings after Tax
Plus Depreciation
Cash inflows after Taxes ( CFAT)
PLUS salvage value (yn)
PLUS Recovery of working capital

24. 2424
ESTIMATION OF CASH FLOWSESTIMATION OF CASH FLOWS
Investments, costs and Revenues( in rs 000)Investments, costs and Revenues( in rs 000)
Y5
200
20
180
400
Y4
200
20
180
220
Y3
200
20
180
40
Y2
100
20
80
-140
Y1
100
20
80
-220

Revenues
Costs -300
Undiscounted cash flow -300
Cum cash flow -300
NPV=400
Pay back period=2.78 years

25. 2525
ESTIMATION OF CASH FLOWSESTIMATION OF CASH FLOWS
Computation of cash flowsComputation of cash flows
Y5
180
0.621
111.78
208.70
Y4
180
0.683
122.94
96.92
Y3
180
0.751
135.18
-26.02
Y2
80
0.826
66.08
-161.2
Y1
80
0.909
72.72
-227.78
Year
Cash flows -300
DCF(@10%)
DCF -300
Cum DCF
NPV=208.7
Pay back period=3.21 years

26. 2626
ESTIMATION OF CASH FLOWSESTIMATION OF CASH FLOWS
Computation of cash flows-in 000RsComputation of cash flows-in 000Rs
y5
180
60
120
36
144
y4
180
60
120
36
144
y3
180
60
120
36
144
y2
80
60
20
6
74
y1
80
60
20
6
74
Year 0
Cash Outflow -300
Gross Income
Depreciation(300000/5)
Taxable Income
Tax@30%
CFAT

27. 2727
ESTIMATION OF CASH FLOWSESTIMATION OF CASH FLOWS
Computation of cash flowsComputation of cash flows
Y5
180
144
0.621
89.42
124.30
Y4
180
144
0.683
98.35
34.88
Y3
180
144
0.751
108.14
-63.47
Y2
80
74
0.826
61.12
-171.61
Y1
80
74
0.909
67.27
-232.73
Year 0
Cash flows -300
CFAT
DCF(@10%)

DCF -300
Cum DCF
NPV=124.3
Pay back period=3.65 years

28. 2828
ESTIMATION OF CASH FLOWSESTIMATION OF CASH FLOWS
BEFORE TAX AFTER TAXBEFORE TAX AFTER TAX
NPV( Rs 000)
280
124.31
23,67
-44.63
PAY BACK
PERIOD
3.06
3.65
4.6
>5
Rate(%)
0
10
20
30
PAY BACK
PERIOD
2.78
3.21
3.85
4.95
NPV (Rs 000)
400
208.7
85.5
2.2

29. 2929
ESTIMATION OF CASH FLOWSESTIMATION OF CASH FLOWS
IMPACT OF IMPROPER CASH FLOW ESTIMATION;IMPACT OF IMPROPER CASH FLOW ESTIMATION;
Reasons;Reasons;
Improper assessment of the project.Improper assessment of the project.
Inadequate Data.Inadequate Data.
Results;Results;
Affects investment evaluation leading to wrong decision making.Affects investment evaluation leading to wrong decision making.
Affects the profitability of the project and the company.Affects the profitability of the project and the company.
Affects the financial position of the company leading to cash crunch Affects the financial position of the company leading to cash crunch
situationssituations
Affects the existing business lines as the “new” project starts eating Affects the existing business lines as the “new” project starts eating
into the resources of the existing business.into the resources of the existing business.
Affects the reputation of the company.Affects the reputation of the company.

30. 3030
ESTIMATION OF CASH FLOWSESTIMATION OF CASH FLOWS
Case study;Case study;
““A” company is into retail business for the last 10 years with an average A” company is into retail business for the last 10 years with an average
turnover of Rs 50 crores and an average net profit of Rs 2.5 crores turnover of Rs 50 crores and an average net profit of Rs 2.5 crores
during the last 5 years. As the margins are low in retail business due to during the last 5 years. As the margins are low in retail business due to
severe competition, the average net profits of the retail Industry is severe competition, the average net profits of the retail Industry is
around 5% and A company was within the Industry standards vis a vis around 5% and A company was within the Industry standards vis a vis
the average net profit.the average net profit.
The Management wanted to expand and it took on lease a property in The Management wanted to expand and it took on lease a property in
the CBD area and modified it into an ultra modern show room .The cost the CBD area and modified it into an ultra modern show room .The cost
of the expansion was Rs 50 crores and it had to borrow the entire of the expansion was Rs 50 crores and it had to borrow the entire
amount as term loan from the bank at an interest rate of 12 %per amount as term loan from the bank at an interest rate of 12 %per
annum repayable in 10 years. Annual property lease cost is Rs 2 annum repayable in 10 years. Annual property lease cost is Rs 2
crores.crores.
The new showroom would generate an average turnover of Rs 30 The new showroom would generate an average turnover of Rs 30
crores per annum in the first 5 years with an average net profit of 1.5 crores per annum in the first 5 years with an average net profit of 1.5
crores @5percent. The gross profit is 30 percentcrores @5percent. The gross profit is 30 percent
Has “A “company taken a good decision? Make suitable assumptions Has “A “company taken a good decision? Make suitable assumptions
and advise “A “company the position ,pointing out where and in which and advise “A “company the position ,pointing out where and in which
areas of cash flow estimation they have gone wrong.areas of cash flow estimation they have gone wrong.

31. 3131
ESTIMATION OF CASH FLOWSESTIMATION OF CASH FLOWS

Thank youThank you