Cash Flows

in
Capital Budgeting
Capital Budgeting: the process of planning
for purchases of long-term assets.
 Incremental Cash Flows
 Cash flows matter—not accounting
earnings.
 Sunk costs don’t matter.
 Incremental cash flows matter.
 Opportunity costs matter.
 Taxes matter: we want incremental after-
tax cash flows.
 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
1) Evaluate Cash Flows

0 1 2 3 4 5 6 ... n
 Capital Budgeting Steps:

1) Evaluate Cash Flows

Initial
outlay

0 1 2 3 4 5 6 ... n
 Capital Budgeting Steps:

1) Evaluate Cash Flows

Initial Terminal
outlay Cash flow

0 1 2 3 4 5 6 ... n
 Capital Budgeting Steps:

1) Evaluate Cash Flows

Initial Terminal
outlay Cash flow

0 1 2 3 4 5

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 project’s 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 project’s 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?

 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)
 Evaluate Cash Flows

 c) Terminal Cash Flow: What is the cash

flow at the end of the project’s 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 project’s 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 project’s life?

50,000 Salvage Value

(17,000) Tax on Capital Gain
4,000 Recapture of NWC
37,000 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
0 1 2 3 4 5
Cost of Machine 127000
Installation Cost 20000
Net working Capital 4000
Revenues 85000 85000 85000 85000 85000
Operating Costs 29750 29750 29750 29750 29750
Depreciation 29400 29400 29400 29400 29400
EBT 25850 25850 25850 25850 25850
Tax 8789 8789 8789 8789 8789
EAT 17061 17061 17061 17061 17061
Net Salvage value 33000
Recovery of WCM 4000
Initial Flow 151000
Operating Flow 46461 46461 46461 46461 46461
Terminal Flow 37000
Net Cash Flow 151000 46461 46461 46461 46461 83461

NPV @ 14% -151000 40755 35750 31360 27509 43347 178721

27721
 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 1 2 3 4 5  
Cost of Machine 140000            
NWC 6000            
Sales   130000 130000 130000 130000 130000  
Expenses   40000 40000 40000 40000 40000  
Depreciation   28000 28000 28000 28000 28000  
PBT   62000 62000 62000 62000 62000  
Tax @ 35%   21700 21700 21700 21700 21700  
PAT   40300 40300 40300 40300 40300  
Recapture of
NWC           6000  
Initial Cashflow 146000            
Annual
Cashflows   68300 68300 68300 68300 68300  
Terminal
Cashflows           6000  
Cashflows 146000 68300 68300 68300 68300 74300  
NPV 146000 62090.91 56446.28 51314.8 46649.82 46134.45 116636.3
 Replacement of Old Machine

Book Value of Old Machine: Rs90,000

Sale price of Old Machine: Rs90,000
Remaining life: 5 years
Net salvage value: Rs20,000
Depreciation(WDV): 20%

Cost of New Machine: Rs400,000

Expected life of machine: 5 years
Net Salvage Value: Rs200,000
Depreciation(WDV): 33 1/3%
Saving in Manufacturing Costs: Rs100,000
Tax rate applicable: 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
 Depreciationfor Depreciation
Calculation
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
 Depreciationfor Depreciation
Calculation
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
 Depreciationfor Depreciation
Calculation
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
 Depreciationfor Depreciation
Calculation
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
 Depreciationfor Depreciation
Calculation
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
 Depreciationfor Depreciation
Calculation
A: 90,000
B: 18000
C: 72,000

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

Incremental depreciation: E - B
 Depreciationfor Depreciation
Calculation
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 2 3 4 5
BV of old machine at begnning 90000 72000 57600 46080 36864
Depreciation @ 20% 18000 14400 11520 9216 7372.8
BV of old machine at end 72000 57600 46080 36864 29491.2
BV of new machine at begnning 400000 266680 177795.6 118536.3 79028.15
Depreciation @ 33 1/3% 133320 88884.44 59259.26 39508.15 26340.08
BV of new machine at end 266680 177795.6 118536.3 79028.15 52688.07
Incremental depreciation 115320 74484.44 47739.26 30292.15 18967.28
Cash Flow of Replacement Project
Cash Flow of Replacement Project