Net Cash Flow Estimation for Capital Budgeting

Net Cash Flow Estimation
Sundar B N
Assistant Professor

What Does “Cash Flow Estimation”
In simple terms, cash flow estimation (or cash flow forecasting) is a prediction of
how much inflow and outflow of cash a business will have at any given time.
❑ It’s a bit more complicated than that, of course, especially when non-cash
factors, like depreciation and compound interest, come into play.
❑ Either way, performing these forecasts can help you decide when to invest
in your own business and when to seek more funding.
❑ If you can build accurate and informed cash flow estimations, you’ll make
much smarter investment decisions for your business.
2

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 taxes
and discounting them at the before tax discount rate to find
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.
3

Net Cash Flows
 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 consist of annual cash flows occurring from the
operation of an investment, but it is also affected by changes in net
working capital and capital expenditures during the life of the
investment.

Net cash flow
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=Revenues-Expenses-Taxes
NCF=REV –EXP-TAX
Notice that in the above 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.
5

Depreciation and Taxes
❑ The computation of the after-tax cash flows requires a careful treatment of
non-cash expense items 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 rules, 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.
6

Consider an example
7
Suppose that an investment requires an initial cash outlay of
50,000. It is expected to generate total annual cash sales of
25,000 and to incur total annual cash expenses of `10,000 for
the next 10 years.
Also, assume that an annual depreciation of `5,000 (i.e.,
cost recovered equally over the life of the investment) will be
charged.
If taxes do not exist, depreciation is of no use in computing
cash flows and NCF will simply be: `25,000 – `10,000 =
15,000 per year.
In practice, taxes do exist and depreciation is tax deductible.
Let us assume a corporate tax rate of 35 per cent.
We can recast a profit and loss account for the investment as
given in Table.
We see that the investment yields an annual profit of `6,500.
However, this is not equal to the annual cash flow.
Depreciation is a noncash item, and should be added to
profit to compute actual cash flows.
Thus net cash flows will be equal to: 6,500+5,000 = 11,500.

Net Cash Flow Estimation for Capital Budgeting

More Related Content

Similar to Net Cash Flow Estimation for Capital Budgeting

More from Sundar B N

Recently uploaded

Net Cash Flow Estimation for Capital Budgeting