Cash Flows in Capital Budgeting

Estimation of Cash Flows

Rules of estimation of cash flows: Cash flows matter—not accounting earnings. Incremental cash flows matter. Opportunity costs matter. Taxes matter Sunk costs don’t matter. We want incremental after-tax cash flows.

Methods of Depreciation: Straight line method- Depreciable value of asset Life of asset (no. of years) Written Down Value Method- 1st 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. Depreciation = Depreciable value of asset = Cost + shipping & installation charges

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% 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 1 2 3 4 5 n 6 . . .

Capital Budgeting Steps: 1) Evaluate Cash Flows Initial outlay 1 2 3 4 5 n 6 . . .

Capital Budgeting Steps: 1) Evaluate Cash Flows Terminal Cash flow Initial outlay 1 2 3 4 5 n 6 . . .

Capital Budgeting Steps: 1) Evaluate Cash Flows Terminal Cash flow Initial outlay 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 Net Salvage Value= Salvage value +- Tax on capital gain/loss Which of these are Cash Flows?

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 33,000 Net Salvage value + 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? 33,000 Net Salvage value 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? 33,000 Net Salvage value 4,000 Recapture of NWC 37,000 Terminal Cash Flow

Project NPV: CF(0) = -151,000 CF(1 - 4) = 46,461 Discount rate = 14% NPV = 27,721 We would accept the project.

Calculation of Cash Flows

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.

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

Replacement of Old Machine Example 2: 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

Calculation for Depreciation 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

Calculation for Depreciation 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

Calculation for Depreciation 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

Calculation for Depreciation 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

Calculation for Depreciation 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

Calculation for Depreciation B: 18000 C: 72,000 D: 400,000 E: 133,320 F: 266,680 Incremental depreciation: E - B

Calculation for Depreciation B: 18000 C: 72,000 D: 400,000 E: 133,320 F: 266,680 Incremental depreciation: 115,320

Depreciation Schedule (WDV)

Cash Flow of Replacement Project

Terminal cash flow Net Salvage value of new machine 200000 Less: Net Salvage value of old machine 20000 Terminal cash flow 180000

Cash Flow of Replacement Project