The estimation of this, through difficult, is the most crucial step in investment analysis. Here are some important points about that calculation.
• Profits vs. cash flows
That flows are different from profits. Profit is not necessarily that flow; it is the difference between revenue earned and expenses incurred rather than cash received and paid. Also, in the calculation of profits, an arbitrary distinction between revenue expenditure is made.
• Incremental flows
That flows should be estimated on Incremental basis. Incremental flows are found out by comparing alternative investment projects. The comparison may simply be between cash flows with and without the investment proposal under consideration when real alternatives do not exist.
• Components of cash flows
Three components of these flows can be identified: one- initial investment two- annual flows, and three- terminal flows.
• Initial investment
Initial investment will comprise the original cost (including freight and installation charges) of the project, plus any increase in working capital. In the case of replacement decision, the after-tax salvage value of the old asset should also be adjusted to compute the initial investment.
• Net cash flow
Annual net flow is the difference between cash inflows including taxes. Tax computations are based on accounting profits. Care should be taken in properly adjusting deprecation while computing net flows.
Depreciation is a not-flow through tax shield. The following formula can be used to calculate change in net flows from operations
• Working capital and capital expenditure
In practice, changes in Working capital items - debtors (receivable), creditors (payable) and stock (inventory) - affect cash flows. Also, the firm may be required to incur capital expenditure, during the operation of the investment project.
• Free flows and the discount rate
Free flows are available to service both the shareholders and the debt holders. Therefore, debt flows (interest charges and repayment of principle) are not considered in the computation of free flows. The financing effect is captured by the firms weighted cost of debt and equity, which is used to discount the projects cash flows. This approach is based on two assumptions:
1. The projects risk is the same as the firms risk
2. The firms debt ratio is consistent and the projects debt capacity is the same as the firms.
• Terminal flows
Terminal cash are those, which occur in the projects last year in addition to annual cash flows. They would consist of the after tax salvage value of the project and working capital released (if any). In case of replacement decision, the foregone salvage value of old asset should also be taken into account.
• Terminal value of new product
Terminal value of new product may depend on that, which could be generated much beyond the assumed analysis or horizon period. The firm may make reasonable assumption regarding the cash flow growth rate after the horizon period.
• Incremental flows
The term incremental flows should be interpreted carefully. The concept should be extended to include the opportunity cost of the existing facilities used by the proposal. Sunk cost and the allocated overheads are irrelevant in computing cash flows. Similarly, a new project may cannibalize sales of the existing products. The projects cash flows should adjust for the reduction in flows on account of the cannibalization.
The net present value rule gives correct answer to choose an investment under inflation if it is treated consistently in cash flows and discount rate. The discount rate is a market determined rate and therefore, includes the expected inflation rate. It is thus generally stated in nominal terms. It should also be stated in nominal terms to obtain an unbiased net present value. Alternatively, the real cash flows can be discounted at the real discount rate to calculate unbiased net present value.
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