lec6. cash flows

8/13/2019 Lec6. Cash Flows

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Cash Flows

inCapital Budgeting


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Estimation of Cash Flows


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Rules of estimation of cash flows:

Cash flows matternot accounting

earnings.

I ncrementalcash flows matter.

Opportunity costs matter.

Taxes matter

Sunk costs dont matter.We want incremental after-tax cash flows.


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Methods of Depreciation:

Straight line method-

Depreciable value of asset

Life of asset (no. of years)

Written Down Value Method-1styr. Depreciation = Depreciable value of asset X Rate of Dep.

WDV1= Depreciable value of assetDepreciation

2ndyr. Depreciation = WDV1X Rate of dep.WDV2= WDV1Dep. of 2

ndyr.

Depreciation =

Depreciable value of asset = Cost + shipping & installation

charges


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Depreciation and Taxes

The computation of the after-tax cash flows

requires a careful treatment of non-cash expenseitems such as depreciation. Depreciation is anallocation of cost of an asset. It involves anaccounting entry and does not require any cash

outflow; the cash outflow occurs when the assetsare acquired.

Depreciation calculated as per the income taxrules, is a deductible expense for computing taxes.

In itself it has no direct impact on cash flows, butit indirectly influences cash flow since it reducesthe firms tax liability. The saving resulting fromdepreciation is called depreciation tax shield.


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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:


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Look at all incremental cash flows occurring as a

result of the project

Initial outlay

Differential Cash Flowsover the life of the

project (also referred to as annual cash flows)

Terminal Cash Flows

Evaluate Cash Flows


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1) Evaluate Cash Flows

0 1 2 3 4 5 n6 . . .


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Capital Budgeting Steps:


0 1 2 3 4 5 n6 . . .

Initial

outlay


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0 1 2 3 4 5 n6 . . .

Terminal

Cash flowInitial

outlay


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0 1 2 3 4 5

Terminal

Cash flow

Annual Cash Flows

Initial

outlay


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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


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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


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Evaluate Cash Flows

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

(127,000)

+ ( 20,000)

(Depreciable Asset)

+ (Investment in working capital)

+ After-tax proceeds from sale of old asset

Net Initial Outlay


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Evaluate Cash Flows


(127,000)+ ( 20,000)

(147,000)

+ (Investment in working capital)

+ After-tax proceeds from sale of old asset

Net Initial Outlay


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Evaluate Cash Flows


(127,000)+ ( 20,000)

(147,000)

+ ( 4,000)

+ 0

Net Initial Outlay


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a) Initial Outlay: What is the cash flow at

time 0?

(127,000)+ ( 20,000)

(147,000)

+ ( 4,000)+ 0

(151,000)


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b) Annual Cash Flows: What incremental

cash flows occur over the life of the project?


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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 Each Year, Calculate:


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Incremental Revenue- Incremental Costs




Incremental Earnings after Taxes

+ Depreciation Reversal

Annual Cash Flow

For Years 1 - 5:


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85,000- Incremental Costs






Annual Cash Flow

For Years 1 - 5:


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85,000(29,750)


Incremental Earnings before Taxes- Tax on Incremental EBT



Annual Cash Flow

For Years 1 - 5:


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85,000

(29,750)

(29,400)





Annual Cash Flow

For Years 1 - 5:


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85,000(29,750)

(29,400)

25,850




Annual Cash Flow

For Years 1 - 5:


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85,000(29,750)

(29,400)

25,850

(8,789)



Annual Cash Flow

For Years 1 - 5:


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85,000(29,750)

(29,400)

25,850(8,789)

17,061


Annual Cash Flow

For Years 1 - 5:


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85,000(29,750)

(29,400)

25,850(8,789)

17,061

29,400

Annual Cash Flow

For Years 1 - 5:


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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


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Evaluate Cash Flows



50,000 Salvage Value

+/- Tax effects of capital gain/loss

+ Recapture of Net Working CapitalTerminal Cash Flow


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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?


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Evaluate Cash Flows




(17,000) Tax on Capital Gain

+ Recapture of NWCTerminal Cash Flow


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Evaluate Cash Flows





4,000 Recapture of NWCTerminal Cash Flow


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Evaluate Cash Flows





4,000 Recapture of NWC

37,000 Terminal Cash Flow


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CF(0) = -151,000

CF(1 - 4) = 46,461

CF(5) = 46,461 + 37,000 = 83,461

Discount rate = 14%

NPV = 27,721We would accept the project.

Project NPV:

Calculation of Cash Flows


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0 1 2 3 4 5

Cost of Machine 127000

Installation Cost 20000

Net working Capital 4000

Initial Flow 151000

Revenues 85000 85000 85000 85000 85000

Operating Costs 29750 29750 29750 29750 29750

Depreciation 29400 29400 29400 29400 29400EBT 25850 25850 25850 25850 25850

Tax 8789 8789 8789 8789 8789

EAT 17061 17061 17061 17061 17061

Depreciation reversal 0 29400 29400 29400 29400 29400

Operating Flow 46461 46461 46461 46461 46461

Net Salvage value 33000

Recovery of WCM 4000

Terminal Flow 37000

Net Cash Flow 151000 46461 46461 46461 46461 83461

NPV @ 14% -151000 40755.3 35750 31360 27509 43347 17872127721

Calculation of Cash Flows


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Problem

Amul Ltd. is considering a proposal of buying a newmachine 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 willrequire 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.


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0 1 2 3 4 5

Cost of Machine 140000

NWC 6000

Sales 130000 130000 130000 130000 130000Expenses 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

Depreciation

Reversal

28000

28000

28000 28000

28000

Initial Cashflow 146000

AnnualCashflows 68300 68300 68300 68300 68300

Terminal

Cashflows

Recapture of NWC 6000

Cashflows 146000 68300 68300 68300 68300 74300


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Replacement of Old Machine

Book Value of Old Machine: Rs90,000Sale 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: Rs200,000Depreciation(WDV): 33 1/3%

Saving in Manufacturing Costs: Rs100,000

Tax rate applicable: 50%


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Cash Flow of Replacement Project

Investment:

Cost of New machine: 400,000Less: Sale of old machine: 90,000

Net investment: 310,000


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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


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Depreciation

A: 90,000

B: 18,000

C: =Book value of old machine in year 2







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Depreciation

A: 90,000

B: 18,000

C: 72,000







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Depreciation

A: 90,000

B: 18,000

C: 72,000

D: 400,000






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Depreciation

A: 90,000

B: 18,000

C: 72,000

D: 400,000

E: 133,320




i i

C i f i i


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Depreciation

A: 90,000

B: 18000

C: 72,000

D: 400,000

E: 133,320

F: 266,680



D i i

C l l i f D i i


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Depreciation

A: 90,000

B: 18000

C: 72,000

D: 400,000

E: 133,320

F: 266,680

Incremental depreciation: 115,320



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1 2 3 4 5BV of old machine at begnning 90000 72000 57600 46080 36864

Depreciation @ 20% 18000 14400 11520 9216 7372.8BV 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 52688.07Incremental depreciation 115320 74484.44 47739.26 30292.15 18967.28

Depreciation Schedule (WDV)


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0 1 2 3 4 5

Savings in manufacturing costs 100000 100000 100000 100000 100000

Incremental depreciation 115320 74484.4 47739.26 30292.1 18967

Incremental Taxable profit -15320 25515.6 52260.74 69707.9 81033Incremental Tax @50% -7660 12757.8 26130.37 34853.9 40516

Incremental Profit after Tax -7660 12757.8 26130.37 34853.9 40516

Depreciation reversal 115320 74484.4 47739.26 30292.1 18967

Operating Flow (PAT+Dep.) 107660 87242.2 73869.63 65146.1 59484



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Terminal cash flow

Salvage value of new machine 200000

Less: Salvage value of old machine 20000

Net salvage value 180000


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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 12438064381


lec6. cash flows

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