CASH FLOW ILLUSTRATIONS To show how cash flows are determin determined ed bearing bearing in mind the principles principles discussed above two illustrations are presented in this section. Illustr Illustratio ation n 1 Naveen Naveen Enterp Enterprise rises s is consid consideri ering ng a capita capitall projec projectt about about which the following information is available: The investm investment ent outlay outlay on the project project will be Rs. 100 100 million. million. This consists consists of of Rs.100 Rs.100 million on plant and machinery machinery and Rs. 20 million million on net working working capital. The entire outlay will be incurred at the beginning of the project. The project project will be financed financed with Rs. 45 million million of equity equity capital, capital, Rs. 5 million oi preference capital, and Rs. 50 million of debt capital. Preference capital will carry a dividend rate of 15 percent; debt capital will carry an interest rate of 15 percent. The life of of the project project is expecte expected d to be 5 years. years. At At the end of 5 years, years, fixed fixed assets will fetch a net salvage value of Rs. 30 million whereas net working capital will be liquidated at its book value. The project project is expected expected to increase increase the revenues revenues of the firm by Rs. 120 million per year. The increase in costs on account of the project is expected to be Rs. 80 million per year (This includes all items of cost other than depreciation, interest, and tax). The effective tax rate will be 30 per cent. Plant and machinery will be depreciated at the rate of 15 percent per year as per the written down value method. Hence, the depreciation charges will be: First year Second year Third Third yea year Fourth year Fifth year
: : : : :
Rs. 12.00 million Rs. 10.20 million Rs. 8.67 8.67 millio illion n Rs. 7.37 million Rs. 6.26 million Exhibit 9.2 Project Cash Flows Years
(Rs. In millions)
0
1
2
3
4
5
1
Fixed Assets
(80.00)
-
-
-
-
-
2
Net Working Capital
(20.00)
-
-
-
-
-
3
Revenues
-
120
120
120
120
120
4
Costs (Other than depreciation and interest)
-
80
80
80
80
80
5
Depreciation
-
12.00 10.20
8.67
7.37
6.26
6
Profit before Tax
-
28.00 29.80 31.33 32.63
33.74
7
Tax
-
8.40
8
Profit after Tax
-
19.60 20.86 21.93 22.84
9
Net Salvage Value
-
-
-
-
-
30.00
1 0 1 1 1 2 1 3 1 4
Recovery of Net Working capital
-
-
-
-
-
20.00
(100.0 0)
-
-
-
-
-
Initial Investment Operating cash inflow
-
Terminal Flow
8.94
9.40
9.79
31.60 31.06 30.60 30.21
-
-
-
-
-
10.12 23.62
29.88 50.00
Net Cash Flow (11+12+13)
(100.0 0)
31.60 31.06 30.60 30.21
79.88
Book value of investment
100.00
88.00 77.80 69.13 61.76
-
Illustration II India Pharma Ltd is engaged in the manufacture of pharmaceuticals. The Company was established in 1998 and has registered a steady growth in sales since then. r:s.ently the company manufactures 16 products and has an annual turnover of Rs. 2,200 million. The company is considering the manufacture of a new antibiotic preparation, K-cin, for which the following information has been gathered. . K-cin is expected to have a product life cycle of five years and thereafter it would be withdrawn from the market. The sales from this preparation are expected to be as follows: Year
Sales (Rs in millions)
1 2 3 4 5
100 150 200 150 100
The capital equipment required for manufacturing K-cin is Rs.100 million and it will be depreciated at the rate of 15 percent per year as per the WDV method for tax purposes. The expected net salvage value after five years is Rs. 20 million. The net working capital requirement for the project is expected to be 20 percent 01 sales. At the end of 5 years, the net working capital is expected to be liquidated at par, barring an estimated loss of Rs. 5 million on account of bad debt. The bad debt loss will be a tax-deductible expense. The accountant of the firm has provided the following cost estimates for Kcin:
Raw material cost Variable labour cost Fixed annual operating and maintenance cost Overhead allocation (excluding depreciation, Maintenance and interest)
: : :
30 percent of sales 20 percent of sales Rs. 5 million
:
10 percent of sales
While the project is charged an overhead allocation, it is not likely to have any effect on overhead expenses as such. The manufacture of K-cin would also require some of the common facilities of the firm. The use of these facilities would call for reduction in the production of other pharmaceutical preparations of the firm. This would entail a reduction of Rs. 15 million of contribution margin The tax rate applicable to the firm is 30 percent. Based on the above information, the cash flows for the project have been worked out in Exhibit 9.3. A few points about this exhibit are in order: The loss of contribution (item 7) is an opportunity cost. Overhead expenses allocated to the project have been ignored as they do not represent incremental overhead expenses for the firm as a whole. It is assumed that the level of net working capital is adjusted at the beginning 01 the year in relation to the expected sales for the year. For example, net working capital at the beginning of year 1 (i.e. at the end of year 0) will be Rs. 20 million that is 20 percent of the expected revenues of Rs. 100 million for year 1. Likewise, the level of net working capital at the end of year 1 (i.e. at the beginning of year 21 will be Rs. 30 million that is 20 percent of the expected revenues of Rs.l50 million for year 2. Exhibit 9.3 Cash Flows for the K-cin Project Years
(Rs. In millions)
0
1
2
3
4
5
(100.0 0)
-
-
-
-
-
20
30
40
30
20
0
1
Capital Investment
2
Level of Net working Capital (Ending)
3
Revenues
-
100
150
200
150
100
4
Raw Material Cost
-
30
45
60
45
30
5
Labour Cost
-
20
30
40
40
20
6
Operating and Maintenance Cost
-
5
5
5
5
5
7
Loss of Contribution
-
15
15
15
15
15
8
Depreciation
-
9.21
7.83
15.00 12.75 10.84
9 1 0 1 1 1 2 1 3 1 4 1 5 1 6 1 7 1 8 1 9
Bad Debt Loss
-
Profit Before Tax
(100.0 0)
Tax Profit After Tax Net Salvage Value of Equipment Recovery of Net Working capital Capital Invetment Operating Cash Inflow (12+8+9) Networking capital
-
-
-
-
-
5
15.00 42.25 69.16 45.79
17.17
4.50
5.15
12.68 20.75 13.74
10.50 29.58 48.41 32.05
12.02
-
-
-
-
-
20.00
-
-
-
-
-
15.00
(100.0 0)
-
-
-
-
-
-
25.50
20.00
42.33 59.25 41.26
10.00 10.00
Terminal Cash inflow (13+14)
-
-
-
Net Cash flow (15+16-17+18)
120.00
15.50
24.85
10.00 10.00 -
-
35
32.33 69.25 51.26
59.85
Illustration III Ojus Enterprises is determining the cash flow for a project involving replacement of an. old machine by a new machine. The old machine bought a few years ago has a book value of Rs. 400,000 and it can be sold to realize a post tax salvage value Rs. 500,000. It has a remaining life of five years after which its net salvage value is expected to be Rs. 160/000. It is being depreciated annually at a rate of 15 percent under the written down value method. The net working capital required for the old machine is Rs. 400,000. The new machine costs Rs.1,600,000. It is expected to fetch a net salvage value of Rs.800,000 after 5 years when it will no longer be required the depreciation rate applicable to it is 15 percent under the written down value method. The net working capital required for the new machine is Rs.500,000. The new machine is expected to bring a saving of Rs.257,143 annually in manufacturing costs (other than depreciation). The tax rate applicable to the firm is 30 percent. Exhibit 9.4 Cash Flows for a Replacement Project Years
1
(Rs. In’000)
0
1
2
3
4
5
-1600 500 -100 -1200
-
-
-
-
-
Investment Outlay a) Cost of New Asset b) Salvage Value of Old Asset c) Increase in Net working Capital
d) Total Net Investment
2
Operating Inflows Over the Project Life a) After-Tax Savings in Manufacturing cost b) Depreciation on New Machine c) Depreciation on Old Machine d) Incremental depreciation (b+c) e) Tax Saving on incremental Depreciation f) Net Operating cash inflow (a+e)
3
-
180.0 0 204.0 0 51.00 153.0 0 45.90
225.9 234.0 0 0
180.0 0 173.4 0 43.35 130.0 5 39.02
180.0 0 147.3 9 36.85 110.5 4 33.16
219.0 213.1 2 6
180.0 0 125.2 8 31.32 93.96 28.19 208.1 9
Terminal Cash Inflow a) Net Terminal Value of New Machine b) Net Terminal Value of Old Machine c) Recovery of incremental Net Working Capital d) Total Terminal Cash Inflow (a+b+c)
4
-
180.0 0 240.0 0 600.0 0 180.0 0 54.00
Net Cash Flow (1d+2f+3d)
-
-
-
-
-
-
-
-
800.0 0 160.0 0 100.0 0 740.0 0
1200.0 0
234.0 225.9 0 0
219.0 213.1 948.1 2 6 9
Illustration IV Magnum Technologies Limited is evaluating an electronics project for which the following information has been assembled: The total outlay on the project is expected to be Rs. 50 million. This consists of Rs. 30 million of fixed assets and Rs. 20 million of current assets. The total outlav of Rs. 50 million is proposed to be financed a follows: Rs.15 millions equity. Rs. 20 millions of term loans, Rs. 10 millions of bank finance {or working capital, and Rs. 5 million of trade credit. The term loan is repayable in five equal annual installments of Rs. 4 million each. The first installment will be 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 I ·ill remain at Rs. 10 million and Rs. 5 million till they are paid back or retired at the end of five years. The interest rates on the term loan and bank finance for working capital will be 10 percent and 12 per cent respectively.
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 sets will be 15 per cent as per the written down value method. 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. The tax rate applicable to the firm is 30 percent.
Cash Relating to Equity The equity-related cash flow stream reflects the contributions made benefits accruing to equity shareholders. It may be divided into three components as follows: = Initial investment = Operating cash flows
: :
Equity funds committed to the project Profit after tax - Preference dividend + Depreciation + Other non-cash charges = Liquidation and retirement : Net salvage value of fixed assets + Net salvage value of current assets Repayment of term loan Redemption of preference capital Repayment of working capital advances Retirement of trade credit and other dues While the first two components, namely, ‘initial investment’ and ‘operating cash inflows’ as fairly self-explanatory, the third term, namely, 'liquidation and retirement cash flows' as a result little explanation. It represents the net cash flows accruing to equity shareholders t of liquidation of various assets in the project and retirement/redemption of all other claims. Remember that equity shareholders have a residual interest in the project and hence what is left after meeting the claims of all others belongs to equity shareholders. Exhibit 9.6 Net Cash Flows Relating to Equity Years
1
Equity Funds
(Rs. In millions)
0
1
2
3
4
5
-15.00
-
-
-
-
-
2
Revenues
-
60.00 60.00 60.00 60.00
60.00
3
Operating Cost
-
42.00 42.00 42.00 42.00
42.00
4
Depreciation
-
4.50
3.83
3.25
2.76
2.35
5
Interest on Working Capital Advance
-
1.20
1.20
1.20
1.20
1.20
6
Interest on term loan
-
2.00
1.60
1.20
0.80
0.40
7
Profit before Tax
-
10.30 11.38
12.35 13.24
14.05
8
Tax
-
3.09
3.41
3.70
3.97
4.22
9
Profit after Tax
-
7.21
7.96
8.64
9.27
9.84
Preference Dividend
-
-
-
-
-
-
-
-
-
-
-
5.00
-
-
-
-
-
20.00
-
4.00
4.00
4.00
4.00
4.00
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
5.00
-15.00
-
-
-
-
-
1 0 1 1 1 2 1 3 1 4 1 5 1 6 1 7 1 8 1 9 2 0
Net Salvage Value of Fixed Assets Net Salvage Value of Current Assets Repayment of Term Loans Redemption of Preference Capital Repayment of Short-term Bank Borrowings Retirement of Trade Creditors Initial Investment (1) Operating cash inflows (910+4) Liquidation and Retirement Cash Flows (11+12-13-14-1516) Net Cash Flow (17+18+19)
-
11.71 11.79 11.90 12.03
12.18
-
-4.00
-4.00
-4.00
-4.00
6.00
-15.00
7.71
7.79
7.90
80.3
18.18
Cash Flows Relating to Long-term Funds: As dicussed earlier in this chapter, the cash flow stream relating to long-term found 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 9.7 Net Cash Relating to Long-Term Found Years
1
Fixed Assets
(Rs. In millions)
0
1
2
3
4
5
-30.00
-
-
-
-
-
-5.00
-
-
-
-
-
2
Working Capital Margin
3
Revenues
-
60
60
60
60
60
4
Operating Costs
-
42
42
42
42
42
5
Depreciation
-
4.50
3.83
3.25
2.76
2.35
6
Interest on Working Capital Advance
-
1.20
1.20
1.20
1.20
1.20
7
Interest on Term Loan
-
2.00
1.60
1.20
0.80
0.40
8
Profit before tax
-
10.30 11.38
12.35 13.24
14.05
9
Tax
-
3.09
3.41
3.70
3.97
4.22
Profit after Tax
-
7.21
7.96
8.64
9.27
9.84
Net Salvage Value of Fix Assets
-
-
-
-
-
5.00
Net Recovery of Working capital Margin
-
-
-
-
-
5.00
-35.00
-
-
-
-
-
Operating cash inflow 10+5+7(1-T)
-
8.99
8.36
8.36
7.80
6.84
Terminal Flow (11+12)
-
-
-
-
-
10.00
-35.00
8.99
8.36
7.80
7.29
16.84
1 0 1 1 1 2 1 3 1 4 1 5 1 6
Initial Investment(1+2)
Net Cash Flow (13+14+15)
Cash Flows Relating to Total Resources: The cash flow stream relating to total resources consists of three components as follows: Initial investment
:
Operating cash inflow
:
All the resources committed to the project. This is simply the total outlay on the project consisting of fixed assets plus gross working capital. 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 9.8 Net Cash Flows Relating to Total Resources Years
(Rs. In millions)
0
1
2
3
4
5
-50.00
-
-
-
-
-
1
Total Resources
2
Revenues
-
60
60
60
60
60
3
Operating Costs
-
42
42
42
42
42
4
Depreciation
-
4.50
3.83
3.25
2.76
2.35
5
Interest on Working Capital Advance
-
1.20
1.20
1.20
1.20
1.20
6
Interest on Term Loan
-
2.00
1.60
1.20
0.80
0.40
7
Profit before tax
-
10.30 11.38
12.35 13.24
14.05
8
Tax
-
3.09
3.41
3.70
3.97
4.22
9
Profit after Tax
-
7.21
7.96
8.64
9.27
9.84
Net Salvage Value of Fix Assets
-
-
-
-
-
5.00
Net Salvage Value of Current Assets
-
-
-
-
-
20.00
Initial Investment (1)
-50.00
-
-
-
-
-
Operating cash inflow [9+4+6(1-T)+5(1-T)]
-
13.43
13.30
Terminal Flow (10+11)
-
-
25.00
13.43
38.30
1 0 1 1 1 2 1 3 1 4 1 5
Net Cash Flow (12+13+14)
-50.00
13.95 13.75 13.58 -
-
-
13.95 13.75 13.58
PROBLEMS Futura Limited is considering a capital project about which the following information is available.
The investment outlay on the project will be Rs 200 million. This consists of Rs 150 million on the plant and machinery and Rs 50 million on net working capital. The entire outlay will be incurred in the beginning. The life of the project is expected to be 7 years. At the end of 7 years, fixed assets will fetch a net salvage value of Rs 48 million whereas net working capital will be liquidated at its book value. The project is expected to increase the revenues of the firm by Rs 250 million per year. The increase in costs on account of the project is expected to be Rs 100 million per year (This includes all items of cost other than depreciation, interest, and tax). The tax rate is 30 percent. Plant and machinery will be depreciated at the rate of 25 percent per year as per the written down method. (a) Estimate the post-tax cash flows of the project. (b) Calculate the IRR of the project. Modern Pharma is considering the manufacture of a new drug, Floxin, for which the following information has been gathered: Floxin is expected to have a product life cycle of seven years and after that it would be withdrawn from the market. The sales from this drug are expected to be as follows: Year Sales (Rs in million)
1 80
2 120
3 160
4 200
5 160
6 120
7 80
The capital equipment required for manufacturing Floxin is Rs 120 million and it will be depreciated at the rate of 25 percent per year as per the WDV method for tax purposes. The expected net salvage value after seven years is Rs 25 million. The working capital requirement for the project is expected to be 25 percent of sales. Working capital level is adjusted at the beginning of the year in relation to the expected sales for the year. At the end of 7 years, working capital is expected to be liquidated at par, barring an estimated loss of Rs 4 million on account of bad debts which, of course, will be a tax deductible expense. The accountant of the firm has provided the following estimates for the cost of Floxin: Raw material cost Variable manufacturing cost Fixed annual operating and maintenance costs Variable selling expenses Overhead allocation
: :
30 percent of sales 10 percent of sales
: : :
Rs 10 million 10 percent of sales 10 percent of sales
(excluding depreciation, maintenance, and interest) The incremental overheads attributable to the new product are, however, expected to be only 5 percent of sales. The manufacture of Floxin will cut into the sales of an existing product thereby reducing its contribution margin by Rs 10 million per year. The tax rate for the firm is 30 percent. (a) Estimate the post-tax incremental cash flows for the project to manufacture Floxin. (b) What is the NPV of the project if the cost of capital is 15 percent? Teja International is determining the cash flows for a project involving replacement of an old machine by a new machine. The old machine bought a few years ago has a book value of Rs 800,000 and it can be sold to realise a post-tax salvage value of Rs 900,000. It has a remaining life of five years after which its net salvage value is expected to be Rs 200,000. It is being depreciated annually at a rate of 25 percent under the WDV method. The new machine costs Rs 3,000,000. It is expected to fetch a net salvage value of Rs 1,500,000 after five years. The depreciation rate applicable to it is 25 percent under the WDV method. The new machine is expected to bring a saving of Rs 650,000 annually in manufacturing costs (other than depreciation). The incremental working capital associated with this machine is Rs 500,000. The tax rate applicable to the firm is 30 percent. (a) Estimate the cash flow associated with the replacement project. (b) What is the NPV of the replacement project if the cost of capital is 14 percent? A machine costs Rs 100,000 and is subject to a depreciation rate of 25 percent under the WDV method. What is the present value of the tax savings on account of depreciation for a period of 5 years if the tax rate is 40 percent and the discount rate is 15 percent? Mahima Enterprises is considering replacing an old machine by a new machine. The old machine bought a few years ago has a book value of Rs 90,000 and it can be sold for Rs 90,000. It has a remaining life of five years after which its net salvage value is expected to be Rs 10,000. It is being depreciated annually at the rate of 20 percent as per the WDV method. The new machine costs Rs 400,000. It is expected to fetch a net salvage value of Rs 25,000 after 5 years. It will be depreciated annually at the rate of 25 percent as per the WDV method. Investment in working capital will not change with the new machine. The tax rate for the firm is 35 percent. Estimate the cash flow associated with the replacement proposal, assuming that other costs remain unchanged.
Supreme Industries is evaluating a project for which the following information has been assembled: (a) The total outlay of the project is expected to be Rs 450 million. This consists of Rs 250 million of fixed assets and Rs 200 million of gross current assets. (b) The proposed scheme of financing is as follows: Rs 100 million of equity, Rs 200 million of term loans, Rs 100 million of working capital advances, and Rs 50 million of trade credit. (c) The term loan is repayable in 10 equal semi-annual installments of Rs 20 million each. The first installment will be due after 18 months. The interest rate on the term loan will be 15 percent. (d) The levels of working capital advance and trade credit will remain at Rs 100 million and Rs 50 million respectively till they are paid back or retired at the end of 6 years. The working capital advance will carry an interest rate of 18 percent. (e) The expected revenues for the project will be Rs 500 million per year. The operating costs (excluding depreciation and interest) are expected to be Rs 320 million per year. The depreciation rate on the fixed assets will be 331/3 percent as per the written down value method. (f) The net salvage value of fixed assets and current assets, at the end of year 6 (the project life is expected to be 6 years) will be Rs 80 million and Rs 200 million respectively. (g) The tax rate applicable to the firm is 50 percent. Define the cash flows from the point of view of (i) equity funds, (ii) longterm funds, and (iii) total funds. MINICASE Metaland is a major manufacturer of light commercial vehicles. It has a very strong R&D centre which has developed very successful models in the last fifteen years. However, two models developed by it in the last few years have not done well and were prematurely withdrawn from the market. The engineers at its R&D centre have recently developed a prototype for a new light commercial vehicle that would have a capacity of four tons. After a lengthy discussion, the board of directors of Metaland decided to carefully evaluate the financial worthwhileness of manufacturing this model which they have labelled Meta 4. You have been recently hired as the executive assistant to Vijay Mathur, Managing Director of Metaland. Vijay Mathur has entrusted you with the task of evaluating the project.
Meta 4 would be produced in the existing factory which has enough space for one more product. Meta 4 will require plant and machinery that will cost Rs 400 million. You can assume that the outlay on plant and machinery will be incurred over a period of one year. For the sake of simplicity assume that 50 percent will be incurred right in the beginning and the balance 50 percent will be incurred at the end of year 1. The plant will commence operation after one year Meta 4 project will require Rs 200 million toward gross working capital. You can assume that the gross working capital investment will occur at the end of year 1. The proposed scheme of financing is as follows: Rs 200 million of equity, Rs 200 million of term loan, Rs 100 million of working capital advance, and Rs 100 million of trade credit. Equity will come right in the beginning by way of retained earnings. Term loan and working capital advance will be raised at the end of year 1. The term loan is repayable in 8 equal semi-annual installments of Rs 25 million each. The first installment will be due after 18 months of raising the term loan. The interest rate on the term loan will be 14 percent. The levels of working capital advance and trade credit will remain at Rs 100 million each, till they are paid back or retired at the end of 5 years, after the project commences, which is the expected life of the project. Working capital advance will carry an interest rate of 12 percent. Meta 4 project is expected to generate a revenue of Rs 750 million per year. The operating costs (excluding depreciation and taxes) are expected to be Rs 525 million per year. For tax purposes, the depreciation rate on fixed assets will be 25 percent as per the written down value method. Assume that there is no other tax benefit. ] The net salvage value of plant and machinery is expected to be Rs 100 million at the end of the project life. Recovery of working capital will be at book value. The income tax rate is expected to be 30 percent. Vijay Mathur wants you to estimate the cash flows from three different points of view' (a) Cash flows from the point of all investors (which is also called the explicit cost find point of view). (b) Cash flows from the point of equity investors. (c) Cash flows as defined by financial institutions.
