FINS1613: Business Finance

Semester 1, 2017

Section III: Capital Budgeting

The Indirect Method

A thorough understanding of the relationships among the balance sheet, income statement, and
cash flow statement can be developed by following the financial events of a firm over a fiscal year.
This problem illustrates how each pro forma incremental financial statement relates to sales,
purchases, capital expenditures, depreciation, taxes, and working capital items, such as
inventories, accounts receivable, and accounts payable.

For each year listed below, prepare the incremental balance sheet, incremental operating income
statement, and incremental cash flow statement.

Year 0 (Capital Expenditures)

A project begins its life with a $5,000 cash allocation from the firm. This entire amount will be
used to buy manufacturing equipment with a useful life of 10-years that will be depreciated at
prime cost.




Year 1 (Depreciation)

During the fiscal year, the firm expects to sell 600 finished products at a price of $8.00 each.
The raw materials required are expected to cost $2.50 per each. At the end of the fiscal year,
the firm will depreciate the manufacturing equipment and pay taxes.

… SKIPPING FORWARD SEVERAL YEARS…

Year 7a (Working Capital)

The firm’s balance sheet at the end of year 6 is provided in the worksheets. In year 7, the
following events will happen:
(A) The firm expects to buy inventory for 200 items at a price $25 each, paying the supplier
in cash.
(B) During the fiscal year, the firm expects to sell 130 finished products at a price of $32
each. Of these, 80 are sold in cash and 50 by credit.
(C) The firm expects to make a cash payment of $2,160 on raw materials previously
purchased from suppliers on credit.
(D) At the end of the fiscal year, the firm will pay taxes.


Year 7b (After-Tax Salvage)


Assume that, concurrent with the end of fiscal year 7, the firm sells the manufacturing
equipment for $3,000.
Questions:

1. In year 0, how can you use the amount of capital expenditures to adjust incremental
operating earnings and find incremental cash flows?












2. In year 1, how can you use the amount of depreciation to adjust incremental operating
earnings to find incremental cash flows?












3. Define net working capital as:

Net Working Capital = Accounts Receivable + Inventory - Accounts Payable,
where all amounts are book values. In year 7a, how does what happens to net working
capital over a fiscal year reflect the difference between incremental operating earnings
and incremental cash flows?












4. In year 7b, how can you use the amount of after-tax salvage to adjust incremental
operating earnings to find incremental cash flows?












5. Combine your answers from questions 1 through 4 to derive the indirect method:
 Year 0

Income Statement Cash Flow Statement

Incremental revenues Operating activities

Incremental costs Incremental cash collected from revenues
Incremental depreciation Incremental cash payments from expenses
Earnings before interest and taxes (EBIT) Incremental taxes (30% of EBIT)
Incremental taxes (30%) Cash provided by operating activities
Incremental earnings
Investment activities
Incremental capital expenditures
Incremental after-tax salvage
Cash from investing activities

Incremental cash flow

Balance Sheet (End of Year, Incremental Values)

Assets Liabilities
Cash Accounts payable
Accounts receivable Other liabilities
Inventories
Net property, plant, & equipment Total liabilities

Shareholder’s equity

Total assets Total liabilities and shareholder’s equity

 Year 1

Income Statement Cash Flow Statement

Incremental revenues Operating activities

Incremental costs Incremental cash collected from revenues
Incremental depreciation Incremental cash payments from expenses
Earnings before interest and taxes (EBIT) Incremental taxes (30% of EBIT)
Incremental taxes (30%) Cash provided by operating activities
Incremental earnings
Investment activities
Incremental capital expenditures
Incremental after-tax salvage
Cash from investing activities

Incremental cash flow

Balance Sheet (End of Year, Incremental Values)

Assets Liabilities
Cash Accounts payable
Accounts receivable Other liabilities
Inventories
Net property, plant, & equipment Total liabilities

Shareholder’s equity

Total assets Total liabilities and shareholder’s equity

 Year 6

Balance Sheet (End of Year, Incremental Values)

Assets Liabilities
Cash 6,000 Accounts payable 3,900
Accounts receivable 1,200 Other liabilities
Inventories 4,600
Net property, plant, & equipment 2,000 Total liabilities 3,900

Shareholder’s equity 9,900

Total assets 13,800 Total liabilities and shareholder’s equity 13,800

 Year 7

Income Statement Cash Flow Statement

Incremental revenues Operating activities

Incremental costs Incremental cash collected from revenues
Incremental depreciation Incremental cash payments from expenses
Earnings before interest and taxes (EBIT) Incremental taxes (30% of EBIT)
Incremental taxes (30%) Cash provided by operating activities
Incremental earnings
Investment activities
Incremental capital expenditures
Incremental after-tax salvage
Cash from investing activities

Incremental cash flow

Balance Sheet (End of Year, Incremental Values)

Assets Liabilities
Cash Accounts payable
Accounts receivable Other liabilities
Inventories
Net property, plant, & equipment Total liabilities

Shareholder’s equity

Total assets Total liabilities and shareholder’s equity

 Year 7: After-tax Salvage Worksheet

Accounting gain and tax computation Cash flows

Sale price Sale price
Book value Taxes (30% of capital gain)
Capital Gain After-tax salvage
Taxes (30%)