TOPIC 6

CASH FLOWS IN CAPITAL

BUDGETING

Capital Budgeting Steps

The CFs of any project may include three (3) basic components:
1. Initial investment: the relevant cash outflow for a proposed
project at time zero.
2. Operating cash inflows: the incremental after-tax cash inflows
resulting from implementation of a project during its life.
3. Terminal CF: the after-tax non-operating CF occurring in the final
year of a project. It is usually attributable to liquidation of the
project.

WRMAS

Relevant Cash Flows: Expansion vs. Replacement

Decisions
Developing relevant CF estimates is most straightforward in
the case of expansion decisions.
Identifying relevant CFs for replacement decisions is more
complicated, because the firm must identify the incremental
cash outflow and inflows that would result from the proposed
replacement.

WRMAS

INITIAL OUTLAY
Initial Outlay-What is the CF at time 0?
The immediate cash outflow necessary to purchase the asset and put
it in operating order.
May include: Purchase cost, Set-up cost, Installation,
Shipping/Freight, increased working-capital requirements, tax
implications (if the project replaces an existing project/asset)
Purchase price of an asset
+ Shipping, modification and installation costs
+ Depreciable asset/Installed cost of new asset

Proceeds from sale of old asset

- Tax on sale of old asset
After-tax proceeds from sale of old asset

+ Investment in net working capital

INITIAL OUTLAY
WRMAS

X
X
XX
X
(X)
(XX)
XX
XXX

Initial Outlay
After tax proceeds from sale of old assets
If the sale is different from the book value of the asset, then
there is a tax effect.
Book value = initial cost accumulated depreciation
After-tax sale = sale T(sale book value)
Exercise 1
Blue Jay Industries is considering the purchase of a new
machine to replace the old machine. At the end of the project,
the old machine can be sold for RM50,000. The machine is 8
years old, cost RM200,000, had a 10-year useful life, and is
being depreciated to zero using the straight-line method. Blue
Jay's income tax rate is 35%. What is the after-tax proceeds from
sale of the old machine? (A: RM46,500)

WRMAS

Initial Outlay-Example
Example 1 An Expansion (Ninja Farm)
After the long drought of 2011, the manager of Ninja Farm is
considering the installation of an irrigation system. The system
has an invoice price of $100,000 and will cost an additional
$15,000 to install. It is estimated that it will increase revenues by
$20,000 annually, and operating expenses will also increase by
$5,000. The system will be depreciated straight-line over its
depreciable life (5 years) to a zero salvage value. The system can
actually be sold for an estimated $25,000 at the end of 5 years.
Tax rate is 40% and the firms required rate of return is 16%.
Should the firm purchase the new system?

WRMAS

Initial Outlay-Example
Example 2 A Replacement (Carrot Water)
Carrot Water Co. is considering replacing a canning machine. The old
machine is being depreciated by the straight-line method over a 10year recovery period from a depreciable cost basis of $120,000. The
old machine has 5 years of remaining usable live, at which time its
salvage value is expected to be zero, and it can be sold now for
$40,000. The purchase price of the new machine is $250,000 and it
will have shipping and installation costs of $12,500. It has a 5-year
life and an expected salvage value of $25,000. Annual savings of
electricity, labor and materials from use of the new machine are
estimated at $40,000. The new machine will require an additional
inventory of spare parts of $30,000. The company has 40% tax, and
its cost of capital is 16%. What should the firm do?

WRMAS

Initial Outlay-Example
Initial Outlay Example 1-Ninja Farm (Year 0)

Initial Outlay Example 2-Carrot Water (Year 0)

WRMAS

ANNUAL CASH FLOW

What incremental CFs occur over the life of the project?
Annual free CF is the incremental after-tax CF resulting from the
project being considered. (Note, depreciation is a non-cash expense
but influences the CFs through impact on taxes)
For Years 1 n:
Incremental revenue (New sales Old sales)
- Incremental costs (OR + Decremental costs)
Earnings before depreciation, interest and taxes (EBDIT)
- Depreciation on project*
Earnings before interest and taxes (EBIT)
- Tax on EBIT
Earnings after taxes (EAT)
+ Depreciation reversal
ANNUAL (OPERATING) CASH FLOWS
*If a replacement problem,
Depreciation = Depreciation of New Equipment Depreciation of Old
Equipment
WRMAS

Annual Cash Flow-Example

Annual CF Example 1-Ninja Farm (Year 1-5)

Annual CF Example 1-Carrot Water (Year 1-5)

10

TERMINAL CASH FLOW

What is the CF at the end of the projects life?
The CF resulting from termination and liquidation of a project at
the end of its economic life.
It represents the after-tax cash flow, exclusive of operating cash
inflows, that occurs in the final year of the project.
The proceeds from sale of the new and the old asset, often called
salvage value, represent the amount net of any removal or
cleanup costs expected upon termination of the project.
net proceeds from the sale > book value tax payment
(outflow)
net proceeds from the sale < book value tax rebate
(inflow)

WRMAS

11

Terminal Cash Flow

NWC represents the reversion of any initial NWC investment.
(reduction in net working capital).
With termination of the project, the need for the increased net
working capital investment is assumed to end.
Salvage Value*
Proceeds from SV of new asset
X
-/+ Tax on SV of new asset
X
After-tax proceeds from SV of new asset
XX
Proceeds from SV of old asset
X
-/+ Tax on SV of old asset
X
After-tax proceeds from SV of old asset
(XX)
+
Recapture net working capital
XX
TERMINAL CASH FLOW
XXX
*If a replacement problem,
Salvage Value = Salvage Value of New Equipment Salvage Value of Old
Equipment
WRMAS

12

Terminal Cash Flow-Example

Terminal CF Example 1-Ninja Farm (Year 1-5)

Terminal CF Example 1-Carrot Water (Year 1-5)

WRMAS

13