1. Cash Flows in Capital Budgeting

2. Estimation of Cash Flows

3. 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.

6. 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

7. 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:

8. 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.

9. 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

10. 1) Evaluate Cash Flows 1 2 3 4 5 n 6
. . .

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

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

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

14. 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

15. 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

16. 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

17. 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

18. 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

19. Evaluate Cash Flows
a) Initial Outlay: What is the cash flow at “time 0?”
(127,000)
+ ( 20,000)
(147,000)
+ ( 4,000)
Net Initial Outlay

20. a) Initial Outlay: What is the cash flow at “time 0?”
(127,000)
+ ( 20,000)
(147,000)
+ ( 4,000)
(151,000)

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

22. 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

23. 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

24. 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

25. 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

26. 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

27. 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

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

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

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

31. 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

32. 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

33. Evaluate Cash Flows
c) Terminal Cash Flow: What is the cash flow at the end of the project’s life?
50, Salvage Value
+/- Tax effects of capital gain/loss
+ Recapture of Net Working Capital
Terminal Cash Flow

34. Tax Effects of Sale of Asset:
Salvage value = 50,000
Book Value =
depreciable asset - total amount depreciated
Book Value = 147, ,000
= 0
Capital Gain = SV - BV
= 50, = 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?

35. Evaluate Cash Flows
c) Terminal Cash Flow: What is the cash flow at the end of the project’s life?
50, Salvage Value
(17,000) Tax on Capital Gain
33, Net Salvage value
+ Recapture of NWC
Terminal Cash Flow

36. Evaluate Cash Flows
c) Terminal Cash Flow: What is the cash flow at the end of the project’s life?
33, Net Salvage value
4, Recapture of NWC
Terminal Cash Flow

37. Evaluate Cash Flows
c) Terminal Cash Flow: What is the cash flow at the end of the project’s life?
33, Net Salvage value
4, Recapture of NWC
37, Terminal Cash Flow

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

39. Calculation of Cash Flows

40. 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 35%, and is evaluating projects with 10% as the cost of capital. Determine the feasibility of the project.

41. 1 2 3 4 5
Cost of Machine
140000
NWC
6000
Sales
130000
Expenses
40000
Depreciation
28000
PBT
62000
35%
21700
PAT
40300
Recapture of NWC
Initial Cashflow
146000
Annual Cashflows
68300
Terminal Cashflows
Cashflows
74300
NPV

42. Replacement of Old Machine
Example 2:
Book Value of Old Machine: Rs90,000
Sale price of Old Machine: Rs90,000
Remaining life: 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): /3%
Saving in Manufacturing Costs: Rs100,000
Tax rate applicable: 50%

43. Cash Flow of Replacement Project
Investment:
Cost of New machine: 400,000
Less: Sale of old machine: 90,000
Net investment: 310,000

44. Calculation for Depreciation
A: Book Value of old machine in year 1
B: Less 20%
C: =Book value of old machine in year 2
D: Book value of new machine in year 1
E: Less 33 1/3%
F: = Book value of new machine in year 2
Incremental depreciation: E - B

45. Calculation for Depreciation
B: Less 20%
C: =Book value of old machine in year 2
D: Book value of new machine in year 1
E: Less 33 1/3%
F: = Book value of new machine in year 2
Incremental depreciation: E - B

46. 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 33 1/3%
F: = Book value of new machine in year 2
Incremental depreciation: E - B

47. Calculation for Depreciation
B: 18,000
C: 72,000
D: Book value of new machine in year 1
E: Less 33 1/3%
F: = Book value of new machine in year 2
Incremental depreciation: E - B

48. Calculation for Depreciation
B: 18,000
C: 72,000
D: 400,000
E: Less 33 1/3%
F: = Book value of new machine in year 2
Incremental depreciation: E - B

49. 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

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

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

52. Depreciation Schedule (WDV)

53. Cash Flow of Replacement Project

54. Terminal cash flow Net Salvage value of new machine 200000
Less: Net Salvage value of old machine
Terminal cash flow

55. Cash Flow of Replacement Project