Reinaldo should primarily focus on the cash flows in making capital-budgeting decisions in my opinion. It is better to start a project which has large cash flows because there is a need for regular cash inflow in order to earn profits, the larger the inflow the quicker are the chances to earn profits. Cash flow statements give an accurate amount of the cash balances , whereas the operating profits indicates the actual profits derived after charging all expenses and income whether paid or payable , accrued or incurred 1q. Even the operating profits play an important role on determining the health of the company which can not be neglected either. Cash flows and profits go hand in hand. If there is no cash flow there is no profit and vice-versa. Cash flows deal with the:
Inflow and the outflow of the firms cash during a financial year
Analyses the time and the risk factor of the expected benefits
Determines from where the money is coming and how is it being spent
Maximizes the market value of the companies shares
Describes all the activities related to cash over an accounting period , it is created in such a way that it shows the cash flows from all the different activities of a business, i.e.-
Cash Flows from Operating activities
Cash flows from Investing Activities and
Cash Flows from Financing Activities
It also enhances the Net Present Value
Operating Profit is the profit earned from a normal business operation after neglecting the effects of interest and taxes. It's also termed as EBIT (Earnings Before Interest and Tax) or Operating Income. It can be calculated as:
Operating Profit = Operating Revenue - Operating Expenses.
Clearly Cash Flows and Operating Profit play a vital role in determining the health of a company as well as in making capital-budgeting decisions which is precisely described below.
Capital budgeting gives you an idea whether a firms assets and long term investments such as products, machinery, plants etc are viable and is it worth investing, would the firm run in the long run ,earning profits . Basically it's a planning process wherein we can decide whether the business can be continued or terminated. Capital Budgeting determines the future benefits which shall occur after few years as well as the funds which are invested. It should meet the factors such as determining the profits of a project, should maximize the stockholders wealth, etc. provides an effective touch while selecting a project. It also monitors the following techniques which use the incremental cash flows from respective investments such as:
Profitability Index
Net Present Value
Internal Rate Of Return etc
Quite often we completely emphasize on the profits while evaluating a firm's performance, neglecting the most reliable method of control i.e. the cash flow. But cash flows generally should be carefully looked after. If a company has large cash flows and if it's not properly managed then it can be taken over by some other firm. Also if a company makes a profit of 20% and has very low cash flow, despite of the good profits made it can go bankrupt as it may not have enough cash to clear off its debts, give dividends etc. On comparing your cash flow with the profits, if your cash flow is higher than your profits you either increase you debts or liquidating your assets which is negative for your business. Whereas if your cash flow is less than your profit it means that you are purchasing new plants and equipments for clearing off your debts and future expansion which is a positive sign .We certainly should be interested in profits, because any firm would be interested in earning profits during each accounting year. If the profit increases than the previous year it's a positive sign but at the same time the cash flows cannot be ignored either, as they are equally important.
According to me, we should be interested in Incremental cash flow as it is the additional amount which a company receives while starting a new project. A positive incremental amount is a positive sign which means that a company's cash flow will increase. While Incremental Profit is the profit which is left by paying all the shareholders and investors, whereas Total Profits are the profits earned before taxations.
How does depreciation affect free cash flows?
Depreciation is the reduction in the value of the asset due to time, usage etc. which has already being purchased. Free cash flow is the total leftover cash i.e. the amount left after the company pays off all its expenses while reinvestments are made in order to ensure the smooth functioning. When we start up with our company we generally put in a lot of cash which decreases the free cash flow but obviously when you invest so much for the growth, the rate of return should also be high. If the result is positive then the firm is profitable but a negative cash flow value does not necessarily mean that the company is at loss.
Depreciation being a non -cash value does not directly affect the cash flow , as the asset has already being purchased its not recorded in the cash flow statement . As the cash is not directly involved depreciation decrease the net income but it does not reduce the cash account in the balance sheet. It does affect indirectly as when the profits are high we pay more taxes which further affects the cash flow statement , it being a non cash value it is added back or rolled back in order to get correct cash flows resulting into increase in free cash flows .
How do sunk costs affect the determination of cash flows?
Sunk costs do not affect the cash flows. Sunk costs are the expenditures which have been incurred already and which are unrecoverable. But you should not consider them when you have got to make a decision whether the project has to be continued or terminated. Sunk costs are not related to the investment that is it is irrespective of whichever project u take but cash flows are directly related to the investments. For e.g. you enter a restaurant and order a meal, but it was so bad that you stopped eating after a few bites. The price of the meal is your sunk cost. Sunk costs never affect your decision making. Sunk costs are fixed costs but not vice-versa. As they have already been occurred these costs cannot be changed i.e. it is independent of any activity that will occur in the future.
What is the project's initial outlay?
Initial Outlay of a project is the total cost required to start and run that project i.e. the start up cost. For e.g. when you purchase machinery, the cost of the machinery along with its applied costs such as costs for installation, flooring and the taxes. The total amount spent in order to start your business is the initial outlay. By calculating the initial outlay and including the business plan will give us an idea as how profitable is our business going to be.
The initial outlay can be calculated in simple 4 steps:
Step 1: Sum up all the expenses which were required while starting the project which includes costs of the plant and equipments, machinery, taxes, employee's salary, etc.
Step 2: Find out the increase/decrease on the initial cash introduced to start up the business.
Step 3: Calculate the tax credits provided while starting you project.
Step 4: Add up the steps and you the get the projects initial outlay.
Projects Initial Outlay:
Investment in Fixed Assets
7900000
Shipping and Installation costs
100000
Investment in Working capital
100000
Projects Initial Outlay
8100000
What are the differential cash flows over the project life?
YEAR 0
YEAR 1
YEAR 2
YEAR 3
YEAR 4
YEAR 5
Sales Qty
70,000
120,000
140,000
80,000
60,000
Sales Price
300
300
300
300
260
DIFFERENTIAL CASH FLOWS
Sales
21,000,000
36,000,000
42,000,000
24,000,000
15,600,000
(MINUS) VC
12,600,000
21,600,000
25,200,000
14,400,000
10,800,000
(MINUS) FC
200,000
200,000
200,000
200,000
200,000
(=) EBDIT
8,200,000
14,200,000
16,600,000
9,400,000
4,600,000
(MINUS) Depreciation
1,600,000
1,600,000
1,600,000
1,600,000
1,600,000
(=) EBIT
6,600,000
12,600,000
15,000,000
7,800,000
3,000,000
(MINUS)Taxes
2,244,000
4,284,000
5,100,000
2,652,000
1,020,000
(PLUS) Depreciation
1,600,000
1,600,000
1,600,000
1,600,000
1,600,000
(=) Operating CF
5,956,000
9,916,000
11,500,000
6,748,000
3,580,000
(MINUS)Incremental WC
100,000
2,000,000
1,500,000
600,000
-1,800,000
-940,000
(MINUS) Capital Investment
8,000,000
-
-
-
-
-
Free CF
-8,100,000
3,956,000
8,416,000
10,900,000
8,548,000
7,540,000
15 Percent
0.865
0.756
0.657
0.572
0.497
NPV
34,40,335.40
63,65,441.60
71,70,565
48,91,165.60
37,48,712.58
WC 0
WC 1
WC 2
WC 3
WC 4
WC 5
WC Needed
100,000
2,100,000
3,600,000
4,200,000
2,400,000
1,560,000
WC 1 - WC 0
WC 2 - WC 1
WC 3 - WC 2
WC 4 - WC 3
WC 5 - WC4 - Liquidated WC
Incremental WC
100,000
2,000,000
1,500,000
600,000
-1,800,000
-940,000
What is terminal cash flow?
Terminal cash flow is the last phase in a project's cash flow that is it will occur during the termination of a project. In short it is the value of your business when you sell it off at a particular period of time.
While terminating your business you even make your balance sheet from where you determine the profits earned, losses occurred, etc. It is the present value from where you can calculate stable growth rate from the future cash flow. It returns the companies operation to where they were at the time of accepting the project.
Terminal Cash Flow = Salvage Value + Working Capital
= 0 + 1,560,000
= $ 1,560,000
Draw a cash flow diagram for this project?
The Cash flow diagram describes or gives a pictorial representation of the cash inflows or outflows. A financial problem can be spotted and you can determine whether it can be solved with the help of this diagram. It's a tool which records all the transactions of the project that have or going to occur in future.
The horizontal line is called as the 'time line' along which you plot all your cash flows occurring at that respective period. Negative line is the line drawn downwards from the time line on which all your expenses such as lease payments and others are plotted. The funds which you receive are plotted on the positive line drawn upwards from the time line that is all the positive cash flows. Given below is the Period versus Cash Flow table:
PERIOD
CASH FLOW
Year 0
-8,100,000
Year 1
3,956,000
Year 2
8,416,000
Year 3
10,900,000
Year 4
8,548,000
Year 5
4,520,000
What is the net present value?
Net Present Value (NPV) is nothing but the Present Value (PV) plus any immediate occurring cash flow. Net Present Value is the difference between the present values of the cash inflows and the cash outflows .NPV acts as an indicator of the value of an investment. It understands the time value of money which is used to enhance and increase the projects long term investments and differentiates between the projects rate of return and the opportunity costs. It can also help us to know whether a new project can be introduced.NPV majorly focuses on the cash flows and is used for capital budgeting. It analyzes the profitability of a project. With the help of the NPV we determine whether a project adds up or subtracts a certain value from the company.
Advantages:
Easy to understand and calculate
Considers time value of money
Decision making becomes a lot more easier as to accept a project with a positive NPV
By maximizing investment NPV shareholders wealth is maximized
NPV can be calculated as follows:
NPV = C0 + C1
(1 + r) n
Where,
C0 - initial investment or the cash flow during Year 0,
C1 - expected cash flow,
n - Number of years,
1/1 + r=the discount factor.
We can determine whether a project can be taken up or not based on the NPV values from the following table:
VALUE
DESCRIPTION
If NPV > 0
Accept the project as the project adds value to the company.
If NPV < 0
Reject the project as the project subtracts value from the company.
If NPV = 0
The decision should be situational as the project neither adds nor does it subtract any value from the firm.
This kind of classification which is called as the Net Present Value Rule is done when the decision of choosing between two or more mutually exclusive projects is to be done. Generally when the NPV = 0 that is when the project contributes nothing to the firm, the project is then chosen on the grounds of other methods apart from the calculations.
The required rate of return is 15% and the tenure is 5 years. So the value for the interest factor is found out by referring to the Present Value Interest Factor Annuity table. The value is found by taking the average for 14 and 16%. The PVIF values are then multiplied by the Free Cash Flow values to find out the NPV values for each year respectively.
Free Cash flow
-81,00,000
$3,956,000
$8,416,000
$10,900,000
$8,548,000
$4,520,000
PVIF 15%
0.86965
0.75635
0.65785
0.5722
0.49775
NPV
-81,00,000
34,40,335.40
63,65,441.60
71,70,565
48,91,165.60
25,49,830
NPV Total
$16,117,337.60
The NPV total calculated is $17,516,220.18 which is greater than 0 and is a positive value.
What is the internal rate of return?
Internal Rate Of Return (IRR) which is also known as the rate of return is a very good decision making tool used in capital budgeting to determine and compare the profitability of the investments that is it's the compounded return rate received on the capital invested. With the help of the IRR it the quality, efficiency of a project is determined. IRR is the rate which makes the present value of the cash flows equal to the initial outlay of the company's initial investment. While calculating the IRR the Net Present Value of a project is made zero by the discount rate. You can find out the expected rate of growth that a project will generate. The more the Internal Rate of Return the better is it for the company. Classification of projects is done with the help of the IRR that is if a project has higher IRR it is desirable to undertake that project, in short project with a higher IRR is given the top priority.
Advantages of IRR:
It is easier to understand as it is calculated as a simple percentage
Goes with the basic thing required for decision-making and that is it considers the time value of money
Shows how the interest rates change due to decisions that is they are very sensitive
Calculation for IRR:
Initially NPV is equal to zero,
Even if the calculated IRR is less than the expected or estimated IRR, a project with sufficiently higher IRR rate than the other provided options is considered as the best choice and has a descent chance of strong growth.
If IRR >= required rate of return then the project should be accepted
If IRR <= required rate of return then the project should be rejected
0 = - 8,100,000 + 3,956,000 + 8,416,000 + 10,900,000 + 8,548,000 + 5,980,000
(1 + IRR) 1 (1 + IRR) 2 (1 + IRR) 3 (1 + IRR) 4 (1 + IRR) 5
= 76 %
The calculated internal rate of return (IRR) is 76% which is higher than the required rate of return which is 15%.
Acceptance of the project:
In my opinion the project should be accepted. Acceptance of a project is done on the basis of various key factors such as:
Viability
Profitability
Market need
Should yield high returns
Competitive advantage
It's objectives and goals
Reinaldo has earned descent profits worth $17,516,220.18 with respect to the initial investment which was $ 81, 00,000. The NPV which is used to find the profitability is $17,516,220.18 which is a positive value which increases the company's wealth. The Profitability Index calculated is 2.16 which is greater than 1.
The IRR determines the expected rate of return that a company will earn; it is 77% which is higher than the required rate of return so that is a positive sign. So based on the NPV and IRR it can be clearly concluded that the project should be accepted.
YEAR
PROJECT A
PROJECT B
0
($195,000)
($1,200,000)
1
$240,000
$1,650,000
The Net Present Value (NPV):
Here according to the assumption Project A and Project B are mutually exclusive having 10% as their required rate of return. So the r = 0.1
So for Project A $195,000 is the capital invested and $240,000 is the after tax net cash flow. Then NPV can be calculated as:
NPV = Cash Flow - Capital Invested
1 + r
= 240,000 - 195,000
1.1
= $23181.8
Whereas for Project B $1,200,000 is the capital invested and $1,650,000 the cash flow, NPV can be calculated as:
NPV = Cash Flow - Capital Invested
1 + r
= 1,650,000 - 1,200,000
1.1
= $300,000
Here the NPV of project B is greater than the NPV of project A.
The Profitability Index (PI):
Profitability Index (PI) is an effective tool used in capital budgeting which finds out the ratio of the current present values of a project's cash flows to the initial investments. It determines as to how much an investment in a project will result into a profit. Priority wise ranking of projects is done with the help of PI.
Profitability Index = NPV
Initial Investment
For Project A:
PI = 23181.8
195,000
= 0.11
For Project B:
PI = 300000
1,200,000
= 0.25
Note that the PI for project B is greater than that of the project A.
Internal Rate of Return (IRR):
It is an effective and most widely used tool to determine the efficiency of the investment.
For Project A:
Cash flows and the initial investment is given. The IRR can be found by referring to the Present Value Interest Factor Annuity table.
Cash Flows = $240,000
Investment = $195,000
IRR = Investment
Cash Flow
= 195,000
240,000
= 0.8125
Now look up the table for 1 year where you get the closest value to 0.8125 which is 22 hence the IRR for project A is 22%
For Project B:
Investment = $1,200,000
Cash Flow = $ 1,165,000
IRR = 1,200,000
1,165,000
= 0.7272
Refer to the same table and fin out the closest value to 0.7272 which is 38%
Clearly the IRR for Project B is greater than the IRR for project B.
Capital Rationing is a method wherein you place a cap or restrictions on the capital introduced as well as the projects. It generally occurs when the company has excess amount of capital. The acceptance or the rejection of the projects is done with capital rationing and the project prioritization is done
When we are not capital rationed we should select project A as well as B. As the NPV's of both the projects are a positive value and the IRR for both the projects is greater than the required rate of return for both the projects we should select and go ahead with project A and B. When the restrictions have not been laid we can always proceed by undertaking the 2 projects as they meet the minimum requirements of the company.
But when there exists capital rationing constraints, we should undertake the project which brings in more value or benefits and enhances the companies financial health that is we must choose a project which adds up to your companies wealth. The tools such as NPV, IRR, PI, play a very vital role in forecasting the values which will benefit the company. Even if project A and B have positive values for NPV, the PI values are positive and the IRR is greater than the required rate of return we clearly have to select Project B as these values are greater than that of Project A.
NPV (Project A) = $23181.8 is less than NPV (Project B) = $300,000
PI (Project A) = 0.11 is less than PI (Project B) = 0.25
IRR (Project A) = 20% is less than IRR (Project B) = 32%
As a result Project B is chosen or selected over Project A when there is a capital rationing constraint.
