Chapter - 10

Determining
Cash Flows for
Investment Analysis
Chapter Objectives
 Show the conceptual difference between
profit and cash flow.
 Discuss the approach for calculating
incremental cash flows.
 Highlight the interaction between financing
and investment decisions.

By Akash Saxena
Introduction
 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.

By Akash Saxena
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

By Akash Saxena
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.
By Akash Saxena
Components of Cash Flows
 Initial Investment
 Net Cash Flows
 Revenues and Expenses
 Depreciation and Taxes
 Change in Net Working Capital
 Change in accounts receivable  
 Change in inventory  
 Change in accounts payable  
 Change in Capital Expenditure
 Free Cash Flows

By Akash Saxena
Components of Cash Flows
 Terminal Cash Flows
 Salvage Value
 Salvage value of the new asset
 Salvage value of the existing asset now
 Salvage value of the existing asset at the end of its
normal
 Tax effect of salvage value  
 Release of Net Working Capital

By Akash Saxena
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 could charge depreciation either on
the straight-line or the written-down value
basis.
 For the tax purposes, depreciation is
computed on the written down value (WDV)
of the block of assets.
By Akash Saxena
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 of depreciation
tax shield on (BV – SV)
 Salvage value > Book value:
 After-tax salvage value = Salvage value – PV of depreciation
tax shield lost on (SV  BV)

T  d 
PVDTSn      BVn  SVn 
k  d 

By Akash Saxena
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
detailed calculations for a long period become quite
intricate. The financial analysis of such projects should
incorporate an estimate of the value of cash flows after
the horizon period without involving detailed
calculations.
 A simple method of estimating the terminal value at the
end of the horizon period is to employ the following
formula, which is a variation of the dividend—growth
model:

NCFn  1  g  NCFn 1
TVn  
kg kg
By Akash Saxena
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
incremental basis.
 The incremental cash proceeds from salvage
value is considered.

By Akash Saxena
Additional Aspects of Incremental
Cash Flow Analysis
 Allocated Overheads
 Opportunity Costs of Resources
 Incidental Effects
 Contingent costs  
 Cannibalisation  
 Revenue enhancement  
 Sunk Costs
 Tax Incentives
 Investment allowance  Until
 Investment deposit scheme  
 Other tax incentives  

By Akash Saxena
Investment Decisions Under Inflation
 Executives generally estimate cash flows assuming unit costs
and selling price prevailing in year zero to remain unchanged.
They argue that if there is inflation, prices can be increased to
cover increasing costs; therefore, the impact on the project’s
profitability would be the same if they assume rate of inflation to
be zero.
 This line of argument, although seems to be convincing, is
fallacious for two reasons.
 First, the discount rate used for discounting cash flows is generally
expressed in nominal terms. It would be inappropriate and
inconsistent to use a nominal rate to discount constant cash flows.
 Second, selling prices and costs show different degrees of
responsiveness to inflation:
 The depreciation tax shield remains unaffected by inflation since
depreciation is allowed on the book value of an asset, irrespective of its
replacement or market price, for tax purposes.

By Akash Saxena
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 then discounted at
the nominal required rate of
return, or
 the discount rate should be Nominal discount rate = (1 + Real discount rate)(1 + inflation rate)  1
converted into real terms and
used to discount the real cash
flows.
 Always remember: Discount
nominal cash flows at nominal
discount rate; or discount real
cash flows at real discount
rate.

By Akash Saxena
Financing Effects in Investment
Evaluation
 According to the conventional capital budgeting
approach cash flows should not be adjusted for the
financing effects.
 The adjustment for the financing effect is made in the
discount rate. The firm’s weighted average cost of
capital (WACC) is used as the discount rate.
 It is important to note that this approach of adjusting
for the finance 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
firm’s target capital structure.

By Akash Saxena