Cash Flow Projections

cash flow projection

Cash Flow Projections

The first and most critical input of the Discounted Cash Flow model is the cash flow projections. As stated earlier, the Discounted Cash Flow value is as good as the assumptions used in developing the projections. These projections should reflect the best estimates of the management and take into account various macro and microeconomic factors affecting the business. Some of the important points to be kept in mind with regard to cash flow projections based on the projection of the profitability are stated below:

• Cash flow projections should reasonably capture the growth prospects and earnings capability of a company. The earning margins of a company should be determined based on its past performance, any envisaged savings, pressure on margins due to competition, etc.

• The effect of expansion schemes can present more complex problems. For these, the valuer will have to use his judgment about their profitability. The state of execution at the time of valuation should be given due consideration. Mere paper plans for expansion should not be taken into account. If reasonable indications of expected future profit are available, then such profits taken on a reasonable basis – to take care of the risk and uncertainty involved – may be included in the projections of the company. If, however, the profits are expected to be realized after a lapse of some years or if material amounts have yet to be incurred before profits are realized, due consideration will have to be given to these circumstances. In such circumstances, the separate value may be given to such new investments and the same is added to the value of the existing stream of business.

• Discontinuation of a part of the business, expansion programmes and any major change in the policies of the company may provide occasions for making a break with the past.

• The discontinuation of a part of the business can be easily dealt with by a valuer. A part of the profits earned by such business in the past will have to be excluded from the projections.

• Effects of change in the policy of the company may be taken into account if such changes are known in advance and the effects are capable of being quantified. Changes in the utilization of the productive capacity, changes in the organizational set-up, changes in the product-mix, changes in the financing policy are some examples of the situation that may have to be faced by a valuer. Their treatment in the projection of future profits will depend entirely upon the effect which in the opinion of the valuer, such changes will have on such future profits.

• In turnaround cases, the uncertainty of higher profits is much greater. Careful evaluation of the steps actually taken to implement a turnaround strategy must be undertaken before a valuer accepts management’s claims that in future the company will earn profits. If Income Approach Share Valuation necessary, reports of technical or other consultants should be called for.

• In case of companies witnessing cyclical fluctuations, care should be taken to select the forecast period, which should necessarily cover the entire business cycle of a company.

• An appropriate allowance must be made for capital expenditure in projections. They should not include capital expenditure only for capacity expansion or growth but also for maintenance of the existing capacity.

• Working capital requirement forms another important component. Projections should appropriately account for working capital needs of the business in its different phases.

• Income tax outflow also impacts the value of a business and should incorporate any tax benefits like tax holiday, accumulated losses, etc. In making projections, notional tax calculated at the rates expected to be applicable to the company in future should normally be deducted. For instance, the rate may change if the company is planning to undertake activities in which tax incidence is lower. Where such rates are not available, the current rates of taxes may be considered a good indicator. Tax benefits due to accumulated losses, accumulated development rebates or allowance, investment allowance, unabsorbed depreciation etc. should not generally be adjusted to the tax rate; instead, these should be considered separately. The past unabsorbed tax shelter is valued by using discounted cash flow method, for the actual years in which the tax shelter would be availed of a reduction in the effective tax rate due to exemptions for new industrial unit relief, export profits etc., should be very carefully considered, depending on the period for which they would be available. A cautious valuer would perhaps compute an effective tax rate each year for the forecast period, based on the current year’s tax rate and statutory deductions available and a reasonable view of profits.

Also read: Discounted Cash Flow: An Income Approach of Valuation