180 Corporate Finance
The physical assets of a company depreciate and need to be replaced to maintain a certain level of growth
in sales. Usually Capex is estimated as a constant percentage of revenues. Capex can be either positive or
negative depending on whether the company is making or liquidating investments. If Capex is negative, it is
a source of funds. To gain an estimate of capital investment required per rupee of sales increase, take the sum
of all capital investments less depreciation over the last five or ten years in similar projects and divide this
total by the sales increase from the beginning to the end of the period.
The working capital investment should not include cash and other equivalents. That is, non-cash working
capital is to be taken into consideration. Free cash flows thus obtained can be either positive or negative
depending on whether the business is generating a surplus or a deficit under a specific plan of growth. Due
care must be taken in estimating working capital investment. Actual year-to-year balance sheet changes
often do not reflect the average or normal needs of the business during the year.
Operating working capital is defined as:
Transaction cash balance
Plus: Accounts receivable
Plus: Inventory
Plus: Other current assets
Less: Accounts payable
Less: Taxes payable
Less: Other current liabilities
CFt= Cash flow in year
t= St–1 (1+gt) (pt) (1 – T) – (St – St–1) (Ct + Wt)where
S= Sales,
p= Profit margin = EBIT as a percentage of sales,
T= income tax rate
C= Capital investment required (net of depreciation) per rupee of sales increase,
W= net working capital per rupee of sales increase, and
g= growth rate.Estimate the most likely incremental cash flows to be generated by the project. Note that financing is not
incorporated in the cash flows. Suitable adjustments for the specific financing will be made in the discount
rate. The forecast of free cash flows requires the following inputs:
- Initial sales before the starting of the forecast period.
- Growth rate in sales for the entire forecast period. The growth rate may remain constant or change.
- The ratio of EBIT/Sales (profit margin) for the entire period.
- The ratio of total operating capital (i.e., Capex + working capital investment) to sales for the period.
Thus
Salest= Salest – 1 × (1 + gt)
EBITt= Salest (pt)
Asset Requirement = at = [(FA + WC)/S]t
(FA + WC)t= Salest × [(FA + WC)/S]t