CASH FLOW ESTIMATION

Free Cash Flow = Net Operating Income after Tax + Non-cash expenses –Increase in Capital
Expenditure – Increase in Net Working Capital

The Non-Cash expenses we take here is Depreciation.

Capital expenditure is the investment in the operating assets (long lived assets).

Net Working capital is the difference of current assets and current liabilities i.e CA – CL

Net Operating Income after Tax = EBIT (1-T)

FCF = EBIT (1-T) +Depreciation – Increase in Operating Capital –increase in NWC

Tax is paid on all gains.

Tax rebate is availed on all losses.

If the asset having a book value of Rs. 20,000 is sold at Rs. 25,000.

Cash received 25,000

Gain on sale 5,000

Tax on gain 40% (2,000)

Net Cash Flow 23,000

If the asset is sold at Rs 18,000

Cash Received 18,000

Loss on Sale 2,000

Tax Rebate40% 800

Net cash flow 18,800

Depreciation is an expense taken in income statement, but it is added back for the computation
of cash flow.
Methods of Depreciation:

Straight Line Method Depreciation per year = (Cost – Salvage value)/ Estimated Life

Accelerated Method

MACRS: Modified Accelerated Cost recovery System

Depreciation rates are already calculated with an assumption that 100% of the cost is recovered
that means no salvage value

3 years class: 33%,45%,15%,7%

5 years Class 20%,32%,19%12%,11%,6%

7 years class 14%,25%,17%,13%,9%,9%,9%,4%

R REPLACEMENT ANALYSIS

Four years back , an equipment was purchased at $ 3600 with 8 years life and $ 400 salvage
value at the end of the period. With that equipment, the company is producing and selling
goods for $ 2500 per year. The operating cost of goods sold is $ 1,200 except depreciation. The
depreciation is calculated on a straight line method. The old machine may be sold at $ 600 at
the end of 8th year

Today Company is thinking to replace this old machine with a new one having a cost of $ 4,000 with four
years of life. This new machine will not increase the production, so the production and sales remains
$ 2500 per year but will reduce the operating cost to $ 280 each year. The machine is subject to 3 years
MACRS (Deprecation) method. 33%,45%,15%,7%. The company is in a tax Bracket of 40%
If the new machine is acquired then old machine may be sold today at $2,000 (Book Value).
The cost of capital is 10%

Depreciation/year = (3600-400)/8 = 400

Depreciation for four years =1600

Book value = 3600-1600= 2,000

Should this old equipment be replaced with a new one or not?

Cost of the old Machine $ 3,600

Depreciation of old machine (1,600)
Book Value of old Machine 2,000
Cost of new (4,000)
Cash flow from old machine 2,000

Additional cash to be paid (Cash outflow) Investment in year 0 (2,000)

Incremental new - old
0 1 2 3 4

Investment (2,000)

Revenue-New 2500 2500 2500 2500

-old (2500) (2500) (2500) (2500)

Change in Revenue - - - -

Operating Cost-New (280) (280 (280) (280)

-Old (1200) (1200) (1200) (1200)

Change in OC (Cost Savings) 920 920 920 920

Depreciation-New (1320) (1800) (600) (280)

Old (400) (400) (400) (400)

Change in depreciation (920) (1400) (200) 120

Net change in savings - (480) 720 1040

Tax (40%) - 192 (288) (416)

Net change after Tax - (288) 432 624

Add Depreciation 920 1400 200 ( 120)

Total (2000) 920 1112 632 504

Add Sale of old Machine 600

Tax on Gain of old Machine(600-400) (80)

Free Cash Flows (2,000) 920 1112 632 1024

PVIF at 10% 1 1/(1.1)=0.909 1/(1.1)2=0.826 1/(1.1)3=0.751 1/(1.1)4=0.683

PV (2,000) 836.28 918.58 474.63 699.39

NPV 929.68

The new equipment is to be replaced with an old one

NEW PROJECT

Cost of the equipment 100,000

Units Sold 5500

Increase in units sold 4%

Sales price per unit $ 12
variable Cost per unit $6.0
Non variable cost yr. 1 $ 2,000
Project WACC 10%
Tax rate 40%
Working Capital 20,000
Depreciation 3 years MACRS Class (33%, 45%,15%, 7%)
Life of new project is 4 years.

Working capital will be recovered at the end of the period

Equipment will become scrap and will have no value at the end of 4th year

Year 0 1 2 3 4

Investment

Equipment (100,000)

Working Capital (20,000)

Units sold 5500 5720 5949 6187

Sales 66,000 68,640 71,388 74,244

Variable Cost (33,000) (34,320) (35,694) (37,122)
Fixed cost (2,000) (2,000) (2,000) (2,000)
Depreciation (33,000) (45,000) (15,000) (7,000)
EBIT (2,000) (12,680) 18,694 28,122
Tax 40% (EBIT * 40%) 800 5,072 (7,478) (11,249)
EBIT(1-T) (1200) (7,608) 11,216 16,873
Add Depreciation 33,000 45,000 15,000 7,000
Recovery of WC 20,000
Free Cash Flow (120,000) 31,800 37,392 26,216 43,873
PVIF at 10 PVIF at 10% 1 1/(1.1)=0.909 1/(1.1)2=0.826 1/(1.1)3=0.751 1/(1.1)4=0.683

PV (120,000) 28,907 30,886 19,688 29,965

NPV (10,525)
1. Allen Air Lines is now in the terminal year of a project. The equipment originally
cost $20 million, of which 80% has been depreciated. Carter can sell the used equipment
today to another airline for $5 million, and its tax rate is 40%. What is the equipment’s
after-tax net salvage value?

2. The Chen Company is considering the purchase of a new machine to replace an

obsoletone. The machine being used for the operation has both a book value and a market
value of zero; it is in good working order, however, and will last physically for at least
another 10 years. The proposed replacement machine will perform the operation so much
more efficiently that Chen’s engineers estimate it will produce after-tax cash flows (labor
savings and depreciation) of $9,000 per year. The new machine will cost $40,000
delivered and installed, and its economic life is estimated to be 10 years. It has zero
salvage value. The firm’s WACC is 10%, and its marginal tax
rate is 35%. Should Chen buy the new machine?

3. Wendy is evaluating a capital budgeting project that should last for 4 years. The
project requires $800,000 of equipment. She is unsure what depreciation method to use in
her analysis, straight-line or the 3-year MACRS accelerated method. Under straight-line
depreciation, the cost of the equipment would be depreciated evenly over its 4-year life
(ignore the half-year convention for the straight-line method).
The applicable MACRS depreciation rates are 33%, 45%, 15%, and 7%, The company’s
WACC is 10%, and its tax rate is 40%.

a. What would the depreciation expense be each year under each method?
b. Which depreciation method would produce the higher NPV, and how much
higher would it be?

4. The Campbell Company is evaluating the proposed acquisition of a new milling machine.
The machine’s base price is $108,000, and it would cost another $12,500 to modify it for
special use. The machine falls into the MACRS 3-year class, and it would be sold after 3
years for $65,000. The machine would require an increase in net working capital
(inventory) of $5,500. The milling machine would have no effect on revenues, but it is
expected to save the firm $44,000 per year in before-tax operating costs, mainly labor.
Campbell’s marginal tax rate is 35%.
a. What is the net cost of the machine for capital budgeting purposes?
(That is, what is the Year-0 net cash flow?)
b. What are the net operating cash flows in Years 1, 2, and 3?

c. What is the additional Year-3 cash flow (i.e., the after-tax salvage and the return of
working capital)?
d. If the project’s cost of capital is 12%, should the machine be purchased?

5. You have been asked by the president of your company to evaluate the proposed
acquisition of a new spectrometer for the firm’s R&D department. The equipment’s basic
price is $70,000, and it would cost another $15,000 to modify it for special use by your
firm. The spectrometer, which falls into the MACRS 3-year class, would be sold after 3
 years for $30,000. Use of the equipment would require an increase in net working capital
(spare parts inventory) of $4,000. The spectrometer would have no effect on revenues,
but it is expected to save the firm $25,000 per year in before-tax operating costs, mainly
labor. The firm’s marginal federal-plus-state tax rate is 40%.

a. What is the net cost of the spectrometer? (That is, what is the Year-0 net cash
flow?)
b. What are the net operating cash flows in Years 1, 2, and 3?
c. What is the additional (nonoperating) cash flow in Year 3?
d. If the project’s cost of capital is 10%, should the spectrometer be purchased?

6. The Balboa Bottling Company is contemplating the replacement of one of its bottling
machines with a newer and more efficient one. The old machine has a book value of
$600,000 and a remaining useful life of 5 years. The firm does not expect to realize any
return from scrapping the old machine in 5 years, but it can sell it now to another firm in
the industry for $265,000. The old machine is being depreciated by $120,000 per year,
using the straight-line method.
The new machine has a purchase price of $1,175,000, an estimated useful life and
MACRS class life of 5 years, and an estimated salvage value of $145,000. The applicable
depreciation rates are 20%, 32%, 19%, 12%, 11%, and 6%. It is expected to economize
on electric power usage, labor, and repair costs, as well as to reduce the number of
defective bottles. In total, an annual savings of $255,000 will be realized if the new
machine is installed. The company’s marginal tax rate is 35%, and it has a 12% WACC.

a. What is the initial net cash flow if the new machine is purchased and the old
One is replaced?
b. Calculate the annual depreciation allowances for both machines, and compute
the change in the annual depreciation expense if the replacement is made.
c. What are the incremental net cash flows in Years 1 through 5?
d. Should the firm purchase the new machine? Support your answer.
e. In general, how would each of the following factors affect the investment
ecision, and how should each be treated?
(1) The expected life of the existing machine decreases.
(2) The WACC is not constant but is increasing as Balboa adds more projects
into its capital budget for the year.