(195)---ADDITIONAL ASPECTS OF INCREMENTAL CASH FLOW ANALYSIS

Additional Aspects of Incremental Cash Flow Analysis

• Sunk costs

Sunk costs are outlays incurred in the past. They are the results of past decisions, and cannot be changed by future decisions. Since they do not influence future decisions, they are irrelevant costs. They are unavoidable and irrecoverable historical costs; they should simply be ignored in the investment analysis.

To illustrate, let us assume the example,

The soft drink company before deciding to introduce a new product, the company has conducted a market test. The results of the market test were found to be favorable. Should company include the market test costs in the evaluation of the new product? The answer is “no”. The costs of the market test have already been incurred and they are sunk costs; the decision to introduce a new product cannot affect them. They are, therefore, irrelevant to the decision of introducing new product.

Consider another example.

A company setup a plant for a cost of 200$ million to manufacture ball bearings. The project proved to be bad for the company, and it started accumulating losses. The total outflows to date is 300$ million. The company is thinking of abandoning the plant. Some executives consider it suicidal to abandon a plant on which 300$ million have already been spent. Others feel it equally unwise to continue with a plant, which has been incurring losses and officers no possibility of any satisfactory return on that money spent. The arguments of both the groups do not make sense. The 300$ million spent by the company is a sunk cost; therefore, it is irrelevant. It is also not correct to discard the plant since it is not earning a satisfactory return on a sunken investment. The company should take the decision to sell or not to sell the plant today in light of the future cash flows and return.

(194)---ADDITIONAL ASPECTS OF INCREMENTAL CASH FLOW ANALYSIS

Additional Aspects of Incremental Cash Flow Analysis

• Opportunity costs of resources

Sometimes a proposed investment project may use the existing resources of the firm for which explicit, or adequate, cash outlays may not exist. The opportunity cost of such projects should be considered. Opportunity costs are the expected benefits, which the company would have derived from those resources if they were not committed to the project.

Assume, for example, that the company is considering a project, which requires 7000 cubic area. Also suppose that the firm has 10000 cubic feet area available. What is the cost of the area available within the firm if it is used by the project? One answer could be that since no cash outlay is involved, therefore, no charges should be made to the project. But from the point of the alternative investment opportunity foregone by transferring this available area to the project, it seems desirable to charge the opportunity cost of the area to the project. Suppose that the company could rent the area at 18$ per cubic feet, and then 126000$ should be considered as the opportunity cost of using the area. The opportunity cost of the other resources can also be computed in the same manner. It may be sometimes difficult to estimate opportunity cost. If the resources can be sold, its opportunity cost is equal to the market price. It is important to note that the alternative use rule is a corollary of the incremental cash flow rule.

• Incidental effects

An investment project under consideration may influence the cash flow of other investment opportunities, or the existing projects or products. The incremental cash flow rule applies here; it tells us to identify all cash flows, direct or incidental, occurring as a result of the acceptance of an investment opportunity. It is, therefore, important to note that all incidental effects, in terms of cash flows, should be considered in the evaluation of an investment opportunity.

(193)---ADDITIONAL ASPECTS OF INCREMENTAL CASH FLOW ANALYSIS

Additional Aspects of Incremental Cash Flow Analysis

The incremental principle should be carefully used in determining an investment’s cash flows. All cash flows occurring because of the investment consideration should be included. Cash flows, which would occur otherwise, whether or not the project is undertaken, should not be taken into account. Similarly, cash flows, which have occurred before the consideration of an investment, are irrelevant in taking the decision now. The following examples of some more aspects of incremental cash flow analysis.

• Allocated overheads

Firms generally have a practice of allocated budgeted general overheads to projects, including the new projects under consideration. Since the general overheads will be incurred whether or not the new projects are undertaken, those allocated overheads should be ignored in computing the net cash flows of an investment. However, some of the overheads may increase because of the new project; these specific to the project should be charged to the project. The incremental cash flow rule indicates that only incremental overheads are relevant.

The allocation of overheads is a difficult question in practice. One or two investment projects may not cause any change in overhead items such as supervision, rent, employees’ welfare or accounting. But the cumulative effect of many investments may ultimately result in an increase in overheads. This creates a problem of cash flow estimation. It is difficult to know when the overheads will change. Efforts should be made to identify such changes so that they may be included in the calculation of net cash flows.

(192)---CASH FLOW ESTIMATES

Cash Flow Estimates for a New Product

A new product may be a slight modification of the firm’s existing product or it may be altogether different, innovative product. The cash flow estimates for a new product will depend on forecasts of sales and operating expenses. Sales forecasts require information on the on the quantity of sales and the price of the product. The selling price and sales quantity depend on the nature of competition. Anticipating the competitors’ reactions when an innovative product is introduced is not easy. Thus, the estimation of cash flows for a new product poses considerable difficulty and challenge. The marketing executives developing sales forecasts should be aware with the forecasting techniques as well as they should have the ability of understanding the dynamics of competition. Hence the cash flow estimation for a new product is both an art and a science.

Cash Flow Estimates for Replacement Decision

Replacement decisions include decisions to replace the existing assets with new assets. Firms undertake replacement decisions either for cost reduction or quality improvement or both. It is relatively easy to estimate cash flow for replacement decision. Generally, these decisions do not involve sales forecasts. They need an assessment of the possible cost saving or improvement in the quality of product, which, to a large extent, depends on the technical specifications of the requirement.

(191)---COMPONENT OF NET ANNUAL CASH FLOWS

Component of Net Annual Cash Flows

• Free cash flows

In addition to an initial cash outlay, an investment project may require some reinvestment of cash flow

For example, replacement investment for maintaining its revenue-generating ability during its life

As a consequence, net cash flow will be reduced by cash outflow for additional capital expenditures (CAPEX). Thus, net cash flow will be equal to: after tax operating income plus depreciation minus (plus) increase (decrease) in net working capital and minus capital expenditure:

NCF = EBIT (1 – T) + DEP – NWC – CAPEX

Net cash flows as defined as defined by above equation are called free cash flow (FCF). It is the cash flow available to service both lenders and shareholders, who have provided, respectively, debt and equity, funds to finance the firm’s investments. It is this cash flow, which should be discounted to find out an investment’s net present value (NPV).

Above equation provides the most valid definition of free cash flows or net cash flow. Since net cash flows are stated on incremental basis in investment analysis, that equation may be rewritten as follows:

FCF = delta EBIT (1 – T) + delta DEP – delta NWC – delta CAPEX

Where delta indicates change (increase or decrease)

(190)---COMPONENT OFNET ANNUAL CASH FLOWS

Component of Net Annual Cash Flows

• Net working capital

In reality, the actual cash receipts and cash payments will differ from revenues (sales) and expenses as given in the profit and loss account. This difference is caused by changes in working capital items, which include trade debtors (account receivables), trade creditors (accounts payable) and stock (inventory). Consider the following situations:

• Changes in accounting receivables. The firm’s customers may delay payment of bills which increase receivable. Since revenues (sales) include credit sales, it will overstate cash inflow. Thus, increase (or decrease) in receivable should be subtracted from (or added to) revenues for computing actual cash receipts.
• Changes in inventory. The firm may pay cash for materials and production of unsold output. The unsold output increases inventory. Expenses do not include cash payments for unsold inventory, and therefore, expenses understate actual cash payments. Thus, increase (or decrease) in inventory should be added to (or subtracted from) expenses for computing actual cash payments.
• Change in accounting payable. The firm may delay payments for materials and production of sold output (sales). This will cause accounts payable (suppliers’ credit) to increase. Since accounts payable is included in expenses, they overstate actual cash payments. Thus, increase (or decrease) in accounts payable should be subtracted from (or added to) expenses for computing actual cash payments.

It is, thus, clear that changes in working capital items should be taken into account while computing net cash inflow from the profit and loss account. Instead of adjusting each item of working capital, we can simply adjust the change in net working capital, viz. the difference between change in current assets and change in current liabilities to profit. Increase in net working capital should be subtracted from and decrease added to after-tax operating profit.

Thus, we can calculate net cash flow as below,

NCF = EBIT (1 – T) + DEP – NWC

Where NWC is net working capital

(189)---COMPONENTS OF ANNUAL NET CASH FLOWS

Components of Annual Net Cash Flows

• Depreciation and taxes

The computation of the after-tax cash flows requires a careful treatment of non-cash expense item such as depreciation. Depreciation is an allocation of cost of an asset. It involves an accounting entry and does not require any cash outflow; the cash outflow occurs when the assets are acquired.

Depreciation, calculated as per the income tax rule, is a deductible expense for computing taxes. In itself, it has no direct impact on cash flows, but it indirectly influences cash flow since it reduces the firm’s tax liability. Cash outflow for taxes saved is in fact an inflow of cash. The saving resulting from depreciation is called depreciation tax shield.

Taxes are paid on profits and calculated as follows:

Taxes = Tax rate X Profit
Taxes = Tax rate X (Revenue – Expenses – Depreciation)
Tax = T (REV – EXP – DEP)

Where T is the corporate tax rate. Notice that the expression within brackets is taxable income, which is equal to earning before interest and taxes (EBIT), or net operating income (NOI). Thus,
Tax = T (EBIT)

Net cash flow (NCF) can also be measured in the following way if we substitute above equations:

NCF = REV – EXP) – T (REV – EXP – DEP)
NCF = REV – EXP) – T (REV – EXP) + T (DEP)
NCF = (REV – EXP) (1 – T) + T (DEP)
NCF = EBDIT (1 – T) + T (DEP)

It may be noted from the above computation that depreciation has provided a tax shield (DTS) equal to tax rate multiplied by the amount of depreciation:

Depreciation tax shield = Tax rate X Depreciation

We can obtain yet another definition of net cash flows by adjusting above net cash flow equation,

NCF = REV – EXP – TAX – DEP
NCF = EBIT – TAX + DEP

And if we use the definition of tax as given in above equation, then:

NAF = EBIT – T (EBIT) + DEP = EBIT (1 – T) + DEP

(188)---DEPRECIATION FOR TAX PURPOSES IN CASH FLOW

Depreciation for Tax Purposes in Cash Flow

Two most popular methods of charging depreciation are:

1. Straight line method
2. Diminishing balance or written-down value (WDV) method

For reporting to the shareholders, companies could charge depreciation either on the straight-line or the written-down value basis. However, no choice of depreciation method and rates for the tax purpose is available to companies.

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 block assets. Block assets means a group of assets falling within a class of assets, being building, machinery, plant or furniture, in respect of which some percentage of depreciation is prescribed. Ocean-going ships are also included in the block of assets.

For example, plant and machinery has been divided into three blocks with three rates of depreciation: 25%, 50% and 100%. Most of the plants and machinery's are covered in the 25% depreciation block. No depreciation is allowed on land.

Depreciation base

In the case of block assets, the written down value is calculated as follows:

• The aggregate of the written down value of all assets in the block at the beginning of then year
• Plus the actual cost of any asset in the block acquired during the year
• Minus the proceeds from the sale of any asset in the block during the year (provides such reduction does not exceed the written down value of the block arrived in the first two items above)

Thus, in a replacement decision, the depreciation base of a net asset (assuming that the new and the old assets belong to the same block assets) will be equal to:

Cost of new equipment + written down value of old equipment – salvage value of old equipment

(187)---TERMINA CASH FLOWS - RELEASE OF NET WORKING CAPITAL

Terminal Cash Flows – Release of Net Working Capital

Terminal cash flows will 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 investment was undertaken would be released in the last year when the investment is terminated. As discussed earlier posts, the net working capital in reality may charge in every period of the investment’s life. Such charges should be considered in computing annual net cash flows. Increase in net working capital is a cash outflow while decrease in net working capital is cash inflow. In practice, it may not be possible for a firm to recover the entire net working capital at the end of the project’s life. The actual amount of net working capital recovered should be considered as the cash inflow in the terminal year.

(186)---TAX EFFECTS OF SALVAGE VALUE IN CASH FLOWS

Tax Effects of Salvage Value in Cash Flows

A company will incur a book loss if an asset is sold for a price less than the asset’s book (depreciated) value. On the other hand, the company will make a profit if the asset’s salvage value is more than its book value. The profit on the sale of an asset may be divided into ordinary income and capital gain. Capital gain on the sale of an asset is equal to salvage value minus original value of the asset, and ordinary income is equal to original value minus book value (depreciable value) of the asset. Capital gains are generally taxed at a rate lower than ordinary rate. Does a company pay tax on profit or get tax credit on loss on the sale of an asset? In a number of countries, the sale of an asset has tax implications. But as per the current tax rules, the depreciable base of the block assets is adjusted for the sale of the block asset and no taxes are computed when the asset is sold.

The net salvage value (i.e., net salvage from the sale of the asset) can be calculated as follows assuming tax implications of the sale of assets:

(1). SV <>

proceeds = salvage value + tax credit on loss

Net proceeds = SV – T (SV – BV)

(2). SV > BV but SV <>

Net proceeds = salvage value – tax on profit

Net proceeds = SV – T (SV – BV)

(3). SV > OV: Ordinary profit and capital gain

Net proceeds = salvage value – tax on ordinary profit – tax on capital gain

Net proceeds = SV – T (OV – BV) – Tc (SV – OV)

Where;
SV = Salvage value
BV = Book value
OV = Original value
T = Ordinary corporate income tax rate
Tc = Capital gain tax rate

(185)---COMPONENT OF CASH FLOWS

Component of Cash Flows

Terminal cash flows

The last or terminal year of an investment may have additional cash flows.

• Salvage value

Salvage value (SV) is the most common example of terminal cash flows. Salvage value may be defined as the market price of an investment at the time of its sale. The cash proceeds net of taxes from the sale of the assets will be treated as cash inflow in the terminal (last) year. As per the existing tax laws, no immediate tax liability (or tax savings) will arise on the sale of an asset because the value of the asset sold is adjusted in the depreciable base assets.

In the case of a replacement decisions, in addition to the salvage value of the new investment at the end of its life, two other salvage values have to be considered:

1. The salvage value of the existing asset now (at the time of replacement decision)
2. The salvage value of the existing asset at the end of its life, if it were not replaced.

If the existing asset is replaced, its salvage value not will increase the current cash inflow, or will decrease the initial cash outlay of the net assets. However, the firm will have to forgo its end-of-life salvage value. This means reduced cash inflow in the last year of the new investment.

The effects of the salvage values of existing and new assets may be summarized as flows:

• 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 the initial cash outlay of the new asset.
• Salvage value of the existing asset at the end of its nominal life. It will reduce the cash flow of the new investment of in the period in which the existing asset is sold.

Sometimes removal costs may have to be incurred to replace an existing asset. Salvage value should be computed after adjusting these costs.

(184)---COMPONENT OF CASH FLOWS

Component of Cash Flows

Annual net cash flows

An investment is expected to generate annual cash flows from operations after the initial cash outlay has been made. Cash flows should always be estimated on an after tax basis. Some people advocate computing of cash flows before tax basis and discounting them at the before-tax discount rate to find net present value (NPV). Unfortunately, this will not work in practice since there does not exist an easy and meaningful way for adjusting the discount rate on a before-tax basis.

We shall refer to the after-tax cash flows as net cash flows (NCF) and use the terms C1, C2, C3…….Cn respectively for NCF in period 1, 2, 3………n. NCF is simply the difference between cash receipts and cash payments including taxes. NCF will mostly consists 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. To illustrate, we first take the simple case where cash flows occur only from operations. Let us assume that all revenues (sales) are received in cash and all expenses are paid in cash (obviously cash expenses will exclude depreciation since it is a non-cash expense). Thus, the definition of NCF will be:

Net cash flow = Revenue – Expense – Taxes

NCF = REV – EXP – TAX

Notice that in equation taxes are deducted for calculating the after-tax cash flows. Taxes are computed on the accounting profit, which treats depreciation as a deductible expense.

(183)---COMPONENTS OF CASH FLOWS

Components of Cash Flows

A typical investment will have three components of cash flows:

1. Initial investment
2. Annual net cash flows
3. Terminal cash flows

1. Initial investment

Initial 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, which comprises 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. Similar types of assets are included in one block of assets. Original value minus depreciation is the asset’s book value (BV). When an asset is purchased for expanding revenues, it may require a lump sum investment in net working capital also. Thus initial investment will be equal to: gross investment plus increase in the net working capital. Further, in case of replacement decisions, the existing asset will have to be sold if the new asset acquired. The sale of the existing asset provides cash inflow. The cash proceeds from the sale of the existing assets should be subtracted to arrive at the initial investment. We shall use the term Co to represent initial investment.

In practice, a large investment project may comprise of a number of cost components and involve a huge initial net cash outlay.

(182)---INCREMENTAL CASH FLOWS

Incremental Cash Flows

It is important to note that all additional cash flows that are directly attributable to the investment project should be considered. A cash flow stream is a series of cash receipts and payments over the life of an investment. The estimates of amounts and timing of cash flows resulting from the investment should be carefully made on an incremental basis.

What do we mean by incremental cash flows?

Every investment involves a comparison of alternatives. The problem of choice will arise only if there are at least two possibilities. The minimum investment opportunity, which a company will always have, will be either to invest or not to invest in a project.

Assume that the question before a company is to introduce a new project. The incremental cash flow in this case will be determined by comparing cash flows resulting with and without the introduction to the new project. If the example, the company has to spend 50000$ initially to introduce the project, we are implicitly comparing cash outlay for introducing the project with a zero cash outlay of not introducing the project. When the incremental cash flows for an investment are calculated by comparing with a hypothetical zero-cash-flow project, we call the absolute cash flows.

(181)---ILLUSTRATING THE DIFFERENCES BETWEEN CASH FLOW AND PROFIT

Illustrating the Differences between Cash Flow and Profit

Assume that a firm is entirely equity-financed, and it receives its revenues (REV) in cash pays and its expenses (EXP) and capital expenditures (CAPEX) in cash. Also, assume that taxes do not exist. Under these circumstances, profit is equal to:

Profit = Revenues – Expenses – Depreciation

Profit = REV – EXP – DEP

And cash flow is equal to:

Cash flow = Revenues – Expenses - Capital expenditure

Cash flow = REV – EXP – CAPEX

It may be noticed from equation one and two that profit does not deduct capital expenditures as investment outlays are made. Instead, depreciation is charged on the capitalized value of investments. Cash flow, on the other hand, ignores depreciation since it is a non-cash item and includes cash paid for capital expenditures. In the accountant’s book, the net book value of capital expenditures will be equal to their capitalized value minus depreciation.

We can obtain the following definition of cash flows if we adjust equation two for relationship for relationships given equation one:

CF = (REV – EXP – DEP) + DEP –CAPEX

CF = Profit + DEP – CAPEX

Equation three makes it clear that even if revenues and expenses are expressed in terms of cash flow, still profit will not be equal to cash flows. It overstates cash inflows by excluding capital expenditures and understates them by including depreciation. Thus, profits do not focus on cash flows. Financial managers will be making incorrect decisions if they put emphasis on profits or earnings per share. The objective of a firm is not to maximize profits or earnings per share, rather it is to maximize of shareholder’s wealth, which depends on the present value of cash flows available to them. In the absence of taxes and debt, equation three provides the definition of profits available for distribution as cash dividends to shareholders. Profits fail to provide meaningful guidance for making financial decisions. Profits can be changed by affecting changes in the firm’s accounting policy without any effect on cash flows.

For example, a change in the method of inventory valuation will change the accounting profit without a corresponding change in cash flows.

(180)---CASH FLOWS FOR INVESTMENT ANALYSIS

Cash Flows and Profit

The use of net present value (NPV) rule in investment decisions requires information about cash flows. It is the inflow and outflows of cash, which matters in practice. It is cash, which a firm can invest, or pay to creditors to discharge its obligations, or distribute to shareholders as dividends. Cash flow is a simple and objectively defined concept. It is simply difference between rupees received and rupees paid out.

Cash flow should not be confused with profit. Changes in profits do not necessarily mean changes in cash flows. It is not difficult to find examples of firms in practice that experience cash shortages in spite of increasing profits. Cash flows are not the same thing as profits, at least, for two reasons.

1. Profit, as measured by an accountant, is based on accrual concept revenue (sales) is recognized when it is earned, rather than when cash is received, and expense is recognized when it is incurred rather than when cash is paid. In other words, profit includes cash revenues as well as receivable and excludes cash expenses as well as payable.
2. For computing profit, expenditures are arbitrarily divided into revenue and capital expenditures. Revenue expenditures are entirely charged to profits while capital expenditures are not. Capital expenditures are capitalized as assets (investments), and depreciated over their economic life. Only annual depreciation is charge to profit. Depreciation (DEP) is an accounting entry and does not involve any cash flow.

Thus, the measurement of profit excludes some cash flows such as capital expenditures and includes some non-cash items such as depreciation.

(179)---CASH FLOWS FOR INVESTMENT ANALYSIS

Cash Flows for Investment Analysis

The first difficult problem to be resolved in applying the NPV rule in practice is: what should be discounted? In theory, the answer is obvious: we should always discount cash flows.

In reality, estimating cash flows is most difficult task. The difficulty in estimating cash flows arises because of uncertainty and accounting ambiguities. Events affecting investment opportunities change rapidly and unexpectedly. There is no easy way to anticipate changes in events. Mostly accounting data forms the basis for estimating cash flows. Accounting data are the result of arbitrary assumptions, choices and allocations. If care is not taken in properly adjusting the accounting data, errors could be made in estimating cash flows.

We consider the cash flow estimation as the most critical step in investment analysis. A sophisticated technique applied to incorrect cash flows would produce wrong results. The management of a company should devote considerable time, effort and money in obtaining correct estimates of cash flows. The financial manager prepares the cash flow estimates on the basis of the information supplied by experts in accounting, production, marketing, economic and so on. It is his responsibility to check such information for relevance and accuracy.

The second major problem in applying the NPV rule is: what rate should be used to discount cash flows? In principle, the opportunity cost of capital should be used as the discount rate.