Corporate Finance 3

Developing Relevant Cash Flows

Chapter 3


To evaluate investment alternatives, the after-tax cash outflows and inflows associated with each project must be determined.

When a proposed purchase is intended to replace an existing asset, the incremental cash outflows and inflows that will result from the investment must be measured.

The cash flows of any project having the conventional pattern can include three basic components:

(1)an initial investment,(2)operating cash inflows, (3)terminal cash flow.

All projects, whether for expansion, replacement, renewal, or some other purpose, have the first two components. Some, however, lack the final component, terminal cash flow.


1. INITIAL INVESTMENT

The term initial investment refers to the relevant cash outflow to be considered in evaluating a prospective capital expenditure.

The basic variables that must be considered in determining the initial investment associated with a capital expenditure are:

a) The cost of a new asset is the purchase price it requires.

b) Transportation and installation costs are defined as any added costs necessary to get an asset into operation.

c) Proceeds from the sale of old assets

If a new asset is intended to replace existing assets that are being sold, the proceeds from the sale are considered a cash inflow. If costs are incurred in the process of removing the old assets, the proceeds from the sale of the old assets are reduced by these removal costs.

The proceeds from the sale of a replaced asset are often referred to as the liquidation value of the asset.



d) Taxes must be considered in calculating the initial investment whenever a new asset replaces an old asset that has been sold.

EXAMPLE

Let us assume that a firm purchased an asset two years ago for $10000, having a normal recovery period of 5 years. The firm is using the straight-line depreciation method. What will happen if the firm now decides to sell the asset and replace it?

If the firm sells the old asset for $8000, which is more than its book value (10000 2x2000 = $6000), the gain above book value is taxed. The total taxable income of the firm will increase with $2000 ($8000 $6000), and therefore the firm will pay a higher corporate income tax with 16% $2000 = $320.

If the firm sells the asset for $5000, an amount less than its book value, it experiences a loss of $1000 equal to the difference between the book value and the sale price ($5000 - $6000), and therefore the firm will pay a lower corporate income tax with 16% $1000 = $160.


e) Change in net working capital

Net working capital is the amount by which a firms current assets exceed its current liabilities. The difference between the change in current assets and the change in current liabilities would be the change in net working capital.The change in net working capital is not taxable because it merely involves a net build-up or reduction of current accounts.

EXAMPLE Beta Enterprises is contemplating expanding its operations to meet the growing demand for its products. In addition to Beta acquiring a variety of new capital equipment, financial analysts expect that the following changes in current accounts will occur:current assets are expected to increase by $2200, and current liabilities are expected to increase by $900, resulting in a $1300 increase in net working capital. Current account Change in balanceCash + $400Accounts receivable + $1000Inventory + $800Current assets + $2200Accounts payable + $900Current liabilities + $900Change in net working capital + $1300


Change in net working capital

Calculating the initial investment

Cost of new asset + Transportation and installation costs - Proceeds from sale of old assets +/- Taxes on sale of old assets +/- Change in net working capital

Initial investment

The Alpha Company is trying to determine the initial investment required to replace an old machine with a new, much more sophisticated model. The proposed machines purchase price is $38000 and an additional $2000 will be required to install it. It will be depreciated using the straight-line depreciation method, over its normal five-years recovery period. The old machine was purchased three years ago at a cost of $24000 and was being depreciated using the straight-line depreciation method, over its normal five-year recovery period. The firm has found a buyer willing to pay $15000 for the old machine and to remove it at his own expense. The firm expects that a $3500 increase in current assets and an $1800 increase in current liabilities will accompany the replacement. The firm is profitable.

Calculating the initial investmentExemple

EXAMPLE The only component of the initial investment required by the proposed

purchase that is difficult to obtain is taxes. Depreciation of the old machine = $24000 / 5 years = $4800/year The book value of the old machine = $24000 3x $4800 = $9600 Since the firm is planning to sell the old machine for $15000, more

than its book value, it will realize an increase with $5400 ($15000 $9600) of the total taxable income,

and therefore the firm will pay a higher corporate income tax with 16% x $5400 = $864.

Calculating the initial investment

The net cash outflow required at time zero:

Cost of new machine $38000+ Transportation and installation costs $2000- Proceeds from sale of old machine $15000+ Taxes on sale of old machine $864+ Change in net working capital $1700 ($3500 - $1800)Initial investment $27564

Calculating the initial investmentExemple

2. OPERATING CASH INFLOWSThe benefits expected from a capital expenditure are measured by its operating cash inflows, which are incremental after-tax cash inflows. Interpreting the term after-tax. Benefits expected to result from proposed capital expenditures must be measured on an after-tax basis, since the firm will not have the use of any benefits until it has satisfied the governments tax claims.

Interpreting the term cash inflows. All benefits expected from a proposed project must be measured on a cash flow basis. Cash inflows represent money that can be spent, not merely accounting profits, which are not necessarily available for paying the firms bills.

The operating cash inflows in each year can be calculated as follows, using the projected earnings before depreciation, interest and taxes:

Projected earnings before depreciation, interest and taxes (EBDIT)- Depreciation= Projected earnings before interest and taxes (EBIT)- Taxes = Projected earnings before interest after taxes (EBIAT)+ Depreciation= Projected operating cash inflows (CFO)

2. OPERATING CASH INFLOWS

Interpreting the term incremental. The final step in estimating the operating cash inflows to be used in evaluating a proposed project is to calculate the incremental or relevant cash inflows.

Incremental operating cash inflows are needed, since our concern is only with how much more or less operating cash will flow into the firm as a result of the proposed project.


2. OPERATING CASH INFLOWS EXAMPLE: The Alpha Companys estimates of its revenues, expenses (excluding depreciation) and earnings before depreciation and taxes are given in the table below:

Year Projected revenues

(1)Projected expenses (excl. depreciation)

(2)

Projected earnings before depreciation and taxes [(1) - (2)]

With proposed machine1 $272000 $230000 $420002 272000 230000 420003 272000 230000 420004 272000 230000 420005 272000 230000 42000

With present machine1 220000 199000 210002 230000 211000 190003 240000 223000 170004 240000 225000 150005 225000 212000 13000


Depreciation expense for proposed and present machines for the Alpha Company:Proposed machine: $40000 / 5 years = $8000/year (for 5 years)Present machine: $4800 / year (for year 1 and 2)Since the present machine is at the end of the third year of its cost recovery period at the time the analysis is performed, it has only the final two years of cost recovery yet applicable.

Item With proposed machine

With present machine

Projected earnings before depreciation and taxes- DepreciationProjected earnings before taxes- Taxes (16%)Projected earnings after taxes+ DepreciationProjected operating cash inflows

$42000

$8000$34000$5440$28560$8000$36560

$21000

$4800$16200$2592$13608$4800$18408

2. OPERATING CASH INFLOWSEx. Calculation of Operating Cash Inflows in year 1 for Alpha Companys proposed and present machines:

2. OPERATING CASH INFLOWSProjected Operating Cash Inflows for the Alpha Company:

Year With proposed machine(1)

With present machine(2)

12345

$36560$36560$36560$36560$36560

$18408$16728$14280$12600$10920

Relevant or Incremental Operating Cash Inflows for the Alpha Company (1)-(2)$18152$19832$22280$23960$25640

Subtracting the operating cash inflows with the present machine from the operating cash inflows with the proposed machine in each year results in the incremental operating cash inflows for each year.

3. TERMINAL CASH FLOW

The cash flow resulting from termination and liquidation of a project at the end of its economic life is its terminal cash flow. Terminal cash flow, which is most often positive, can be calculated using the basic format presented below:

Proceeds from sale of proposed asset- Proceeds from sale of present asset+/- Taxes on sale of proposed asset+/- Taxes on sale of present asset+/- Change in net working capitalTerminal cash flow

3. TERMINAL CASH FLOW Proceeds from sale of assets represent the amount net of any

removal costs expected upon termination of the project.

Taxes on sale of assetsThe tax calculations apply whenever an asset is sold for a value different

from its book value.

If the net proceeds from the sale are expected to exceed book value, a tax payment shown as an outflow for the proposed asset would occur.

A tax rebate shown as a cash inflow for the proposed asset would result when the net proceeds from the sale are below book value.


Change in net working capital. The change in net working capital reflects the reversion to its original status of any net working capital investment reflected as part of the initial investment.

Most often this will show up as a cash inflow attributed to the reduction in net working capital; with termination of the project, the need for the increased net working capital investment is assumed to end.


Continuing with the Alpha Company presented earlier, assume that the firm expects to be able to liquidate the proposed machine at the end of its five-years life to net $5000 after paying removal costs. The present machine can be liquidated at the end of the five years to net $0 because it will then be completely obsolete. The firm expects to recover its $1700 net working capital investment upon termination of the project.

From the analysis of the operating cash inflows presented earlier, it can be seen that both the proposed and present machines will be fully depreciated and therefore have a book value of zero at the end of the five years.

Since the sale price of $5000 for the proposed machine is greater than its book value of $0, taxes will have to be paid on the $5000.

EXAMPLE


Proceeds from sale of proposed machine $5000(- Proceeds from sale of present machine) 0- Taxes on sale of proposed machine 16% x $5000 = $800(+ Taxes on sale of present machine) 0+ Change in net working capital $1700Terminal cash flow $5900 This represents the after-tax cash flow, exclusive of operating cash inflows, occurring upon termination of the project at the end of year 5.

Documents

Corporate Finance 3