Cash Flows

in

Capital Budgeting

Estimation of Cash Flows

Rules of estimation of cash flows:

Cash flows matternot accounting earnings. Incremental cash flows matter. Opportunity costs matter. Taxes matter Sunk costs dont matter. We want incremental after-tax cash flows.

Methods of Depreciation:
Straight line methodDepreciation = Depreciable value of asset Life of asset (no. of years) Written Down Value Method1st yr. Depreciation = Depreciable value of asset X Rate of Dep. WDV1 = Depreciable value of asset Depreciation 2nd yr. Depreciation = WDV1 X Rate of dep. WDV2 = WDV1 Dep. of 2nd yr.

Depreciable value of asset = Cost + shipping & installation charges

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 firms tax liability. The saving resulting from depreciation is called depreciation tax shield.

Example: Our firm must decide whether to purchase a new plastic molding machine for Rs 127,000. How do we decide? The relevant project information follows:

The cost of the new machine is Rs127,000. Installation will cost Rs20,000. Rs4,000 in net working capital will be needed at the time of installation. The project will increase firm revenues by Rs85,000 per year, but operating costs will increase by 35% of the revenue increase. Simplified straight line depreciation is used. Life of project is 5 years, and the firm is planning to keep the project for 5 years. Salvage value at year 5 will be Rs50,000. 14% cost of capital; 34% marginal tax rate.

Evaluate Cash Flows

Look at all incremental cash flows occurring as a result of the project Initial outlay Differential Cash Flows over the life of the project (also referred to as annual cash flows) Terminal Cash Flows

 Terminal

Cash Flows- its incremental cash flow in any period. However, the last or terminal year of an investment may have additional cash flows. Salvage Value- is the most common example of terminal cash flows. Salvage value may be defined as the market price of an investment at the time of its sale.

1) Evaluate Cash Flows

...

Capital Budgeting Steps:

1) Evaluate Cash Flows
Initial outlay

...

Capital Budgeting Steps:

1) Evaluate Cash Flows
Initial outlay

Terminal Cash flow

...

Capital Budgeting Steps:

1) Evaluate Cash Flows
Initial outlay

Terminal Cash flow

Annual Cash Flows

a) Initial Outlay: What is the cash flow at time 0?

(Purchase Price of the Asset) + (shipping and installation costs) (Depreciable Asset) + (Investment in working capital) + After-tax proceeds from sale of old asset Net Initial Outlay

Evaluate Cash Flows

a) Initial Outlay: What is the cash flow at time 0?

(127,000) + (shipping and installation costs) (Depreciable Asset) + (Investment in working capital) + After-tax proceeds from sale of old asset Net Initial Outlay

Evaluate Cash Flows

a) Initial Outlay: What is the cash flow at time 0?

(127,000) + ( 20,000) (Depreciable Asset) + (Investment in working capital) + After-tax proceeds from sale of old asset Net Initial Outlay

Evaluate Cash Flows

a) Initial Outlay: What is the cash flow at time 0?

(127,000) + ( 20,000) (147,000) + (Investment in working capital) + After-tax proceeds from sale of old asset Net Initial Outlay

Evaluate Cash Flows

a) Initial Outlay: What is the cash flow at time 0?

(127,000) + ( 20,000) (147,000) + ( 4,000) + After-tax proceeds from sale of old asset Net Initial Outlay

Evaluate Cash Flows

a) Initial Outlay: What is the cash flow at time 0?

(127,000) + ( 20,000) (147,000) + ( 4,000) + 0 Net Initial Outlay

a) Initial Outlay: What is the cash flow at time 0?

(127,000) + ( 20,000) (147,000) + ( 4,000) + 0 (151,000)

b) Annual Cash Flows: What incremental cash flows occur over the life of the project?

For Each Year, Calculate:

Incremental Revenue - Incremental Costs - Depreciation on project Incremental Earnings before Taxes - Tax on Incremental EBT Incremental Earnings after Taxes + Depreciation Reversal Annual Cash Flow

For Years 1 - 5:
Incremental Revenue - Incremental Costs - Depreciation on project Incremental Earnings before Taxes - Tax on Incremental EBT Incremental Earnings after Taxes + Depreciation Reversal Annual Cash Flow

For Years 1 - 5:
85,000 - Incremental Costs - Depreciation on project Incremental Earnings before Taxes - Tax on Incremental EBT Incremental Earnings after Taxes + Depreciation Reversal Annual Cash Flow

For Years 1 - 5:
85,000 (29,750) - Depreciation on project Incremental Earnings before Taxes - Tax on Incremental EBT Incremental Earnings after Taxes + Depreciation Reversal Annual Cash Flow

For Years 1 - 5:
85,000 (29,750) (29,400) Incremental Earnings before Taxes - Tax on Incremental EBT Incremental Earnings after Taxes + Depreciation Reversal Annual Cash Flow

For Years 1 - 5:
85,000 (29,750) (29,400) 25,850 - Tax on Incremental EBT Incremental Earnings after Taxes + Depreciation Reversal Annual Cash Flow

For Years 1 - 5:
85,000 (29,750) (29,400) 25,850 (8,789) Incremental Earnings after Taxes + Depreciation Reversal Annual Cash Flow

For Years 1 - 5:
85,000 (29,750) (29,400) 25,850 (8,789) 17,061 + Depreciation Reversal Annual Cash Flow

For Years 1 - 5:
85,000 (29,750) (29,400) 25,850 (8,789) 17,061 29,400 Annual Cash Flow

For Years 1 - 5:
85,000 Revenue (29,750) Costs (29,400) Depreciation 25,850 EBT (8,789) Taxes 17,061 EAT 29,400 Depreciation reversal 46,461 = Annual Cash Flow

Evaluate Cash Flows

c) Terminal Cash Flow: What is the cash flow at the end of the projects life?

Salvage Value +/- Tax effects of capital gain/loss + Recapture of Net Working Capital Terminal Cash Flow

Evaluate Cash Flows

c) Terminal Cash Flow: What is the cash flow at the end of the projects life?

50,000 Salvage Value +/- Tax effects of capital gain/loss + Recapture of Net Working Capital Terminal Cash Flow

Tax Effects of Sale of Asset:

Salvage value = 50,000 Book Value = depreciable asset - total amount depreciated Book Value = 147,000 - 147,000 =0 Capital Gain = SV - BV = 50,000 - 0 = 50,000 Tax payment = 50,000 x .34 = 17,000 Which of these are Cash Flows?

Evaluate Cash Flows

c) Terminal Cash Flow: What is the cash flow at the end of the projects life?

50,000 Salvage Value (17,000) Tax on Capital Gain + Recapture of NWC Terminal Cash Flow

Evaluate Cash Flows

c) Terminal Cash Flow: What is the cash flow at the end of the projects life?

50,000 Salvage Value (17,000) Tax on Capital Gain 4,000 Recapture of NWC Terminal Cash Flow

Evaluate Cash Flows

c) Terminal Cash Flow: What is the cash flow at the end of the projects life? 50,000 (17,000) 4,000 37,000 Salvage Value Tax on Capital Gain Recapture of NWC Terminal Cash Flow

Project NPV:
CF(0)

= -151,000 CF(1 - 4) = 46,461 CF(5) = 46,461 + 37,000 = 83,461 Discount rate = 14% NPV = 27,721 We would accept the project.

Calculation of Cash Flows

Cost of Machine Installation Cost Net working Capital Initial Flow Revenues Operating Costs Depreciation EBT Tax EAT Depreciation reversal 0 Operating Flow Net Salvage value Recovery of WCM Terminal Flow Net Cash Flow 151000 NPV @ 14% 0 127000 20000 4000 151000 1 2 3 4 5

85000 85000 85000 85000 29750 29750 29750 29750 29400 29400 29400 29400 25850 25850 25850 25850 8789 8789 8789 8789 17061 17061 17061 17061 29400 29400 29400 29400 46461 46461 46461 46461

46461

46461 35750

46461 31360

46461 27509

85000 29750 29400 25850 8789 17061 29400 46461 33000 4000 37000 83461 43347 178721 27721

-151000 40755.3

Problem

Amul Ltd. is considering a proposal of buying a new machine for initial cost of Rs 1,40,000 with no salvage value. The project will require an increase in level of Net Working Capital of Rs 6,000 at year 0. The project will generate additional sales of Rs 1,30,000 and will require cash expenses of Rs 40,000 in each of its 5 year life. It will be depreciated on straight-line method. The company has to pay tax @ 35%, and is evaluating projects with 10% as the cost of capital. Determine the feasibility of the project.

0 Cost of Machine NWC Sales Expenses Depreciation PBT Tax @ 35% PAT Depreciation Reversal Initial Cashflow Annual Cashflows Terminal Cashflows Recapture of NWC Cashflows 146000 146000 140000 6000

130000 40000 28000 62000 21700 40300 28000

130000 40000 28000 62000 21700 40300 28000

130000 40000 28000 62000 21700 40300 28000

130000 40000 28000 62000 21700 40300 28000

130000 40000 28000 62000 21700 40300 28000

68300

68300

68300

68300

68300

6000 68300 68300 68300 68300 74300

Replacement of Old Machine

Book Value of Old Machine: Sale price of Old Machine: Remaining life: Net salvage value: Depreciation(WDV):
Cost of New Machine: Expected life of machine: Net Salvage Value: Depreciation(WDV): Saving in Manufacturing Costs: Tax rate applicable:

Rs90,000 Rs90,000 5 years Rs20,000 20%

Rs400,000 5 years Rs200,000 33 1/3% Rs100,000 50%

Cash Flow of Replacement Project

Investment:
Cost of New machine: 400,000 Less: Sale of old machine: 90,000 Net investment: 310,000

Calculation for Depreciation

A: Book Value of old machine in year 1 B: Less Depreciation @ 20% C: =Book value of old machine in year 2

D: Book value of new machine in year 1 E: Less Depreciation @ 33 1/3% F: = Book value of new machine in year 2
Incremental depreciation: E - B

Depreciation Calculation for Depreciation

A: 90,000 B: Less Depreciation @ 20% C: =Book value of old machine in year 2

D: Book value of new machine in year 1 E: Less Depreciation @ 33 1/3% F: = Book value of new machine in year 2
Incremental depreciation: E - B

Depreciation Calculation for Depreciation

A: 90,000 B: 18,000 C: =Book value of old machine in year 2

D: Book value of new machine in year 1 E: Less Depreciation @ 33 1/3% F: = Book value of new machine in year 2
Incremental depreciation: E - B

Depreciation Calculation for Depreciation

A: 90,000 B: 18,000 C: 72,000

D: Book value of new machine in year 1 E: Less Depreciation @ 33 1/3% F: = Book value of new machine in year 2
Incremental depreciation: E - B

Depreciation Calculation for Depreciation

A: 90,000 B: 18,000 C: 72,000

D: 400,000 E: Less Depreciation @ 33 1/3% F: = Book value of new machine in year 2

Incremental depreciation: E - B

Depreciation Calculation for Depreciation

A: 90,000 B: 18,000 C: 72,000

D: 400,000 E: 133,320 F: = Book value of new machine in year 2

Incremental depreciation: E - B

Depreciation Calculation for Depreciation

A: 90,000 B: 18000 C: 72,000

D: 400,000 E: 133,320 F: 266,680

Incremental depreciation: E - B

Depreciation Calculation for Depreciation

A: 90,000 B: 18000 C: 72,000

D: 400,000 E: 133,320 F: 266,680

Incremental depreciation: 115,320

Depreciation Schedule (WDV)

1
BV of old machine at begnning Depreciation @ 20% BV of old machine at end BV of new machine at begnning Depreciation @ 33 1/3% BV of new machine at end Incremental depreciation

5
36864 7372.8 29491.2 79028.15 26340.08 52688.07 18967.28

90000 72000 57600 46080 18000 14400 11520 9216 72000 57600 46080 36864 400000 266680 177795.6 118536.3 133320 88884.44 59259.26 39508.15 266680 177795.6 118536.3 79028.15 115320 74484.44 47739.26 30292.15

Cash Flow of Replacement Project

0 Savings in manufacturing costs Incremental depreciation Incremental Taxable profit Incremental Tax @50% Incremental Profit after Tax Depreciation reversal Operating Flow (PAT+Dep.) 1 100000 115320 -15320 -7660 -7660 115320 2 100000 74484.4 25515.6 12757.8 12757.8 74484.4 3 100000 47739.26 52260.74 26130.37 26130.37 47739.26 4 5

100000 100000 30292.1 18967 69707.9 81033 34853.9 40516 34853.9 40516 30292.1 18967

107660 87242.2 73869.63 65146.1 59484

Terminal cash flow

Salvage value of new machine Less: Salvage value of old machine Net salvage value 200000 20000 180000

Savings in manufacturing costs 100000 100000 100000 100000 100000 Incremental depreciation 115320 74484.4 47739.3 30292.1 18967 Cash Flow of Replacement Project Incremental Taxable profit -15320 25515.6 52260.7 69707.9 81033 Incremental Tax -7660 12757.8 26130.4 34853.9 40516 Incremental Profit after Tax -7660 12757.8 26130.4 34853.9 40516 Net incremental Salvage value 180000 Initial Flow 310000 Operating Flow 107660 87242.2 73869.6 65146.1 59484 Terminal Flow 180000 Net Cash flow 310000 107660 87242.2 73869.6 65146.1 239484 NPV @ 14% 310000 94438.6 67130.1 49859.9 38571.7 124380 64381