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Financial Management 1 BBPW3103

Chapter 7 Cash Flow of Capital Budgeting

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Guidelines In estimating Cash Flow for Capital Budgeting

It is an additional cash flow


Involves

the change of cash flow in a project Suppose that Project A will increased the cash sales revenue from RM1 million to RM1.5 million. So, only RM0.5 million will take into account as change of cash flow

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Guidelines In estimating Cash Flow for Capital Budgeting (Cont.)

It takes into account the effects of taxation

Does not take into account the effect of financing

The cash flow that must take into account is the cash flow after tax For example : If the tax 30% and total cash flow is RM1 million. So, only RM700,000 will takes into account

In estimating cash flow, these costs are not takes into account especially interest costs of financing The effects of this financing had been taken into account when the cost of capital is used to discount the cash flow. If it is taken into account, the effect of this financing 3 mardi_umar83@yahoo.com is taken into account twice.

Guidelines In estimating Cash Flow for Capital Budgeting (Cont.)

Guidelines to estimate cash flow of capital budgeting

Disregard Sunk Cost : Sunk Cost is the cost that has been spent that does not influences the decision on accepting / rejecting a project. This sunk cost does not take into account in calculating of cash flow. For example, research laboratory Do Not Disregard Opportunity Cost : Opportunity cost can be defined as the cash flow that could had been obtained if the project under consideration. This cost should into account as cash outflow due to decrease the company cash flow. For example, rental income
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Guidelines In estimating Cash Flow for Capital Budgeting (Cont.)

Guidelines to estimate cash flow of capital budgeting (Cont.)

Do Not Disregard Side Effect : Refer to effect of accepting the projects. For example, the effect of producing new product such as increasing the cash outflow

There are 3 types of cash flow based on the time occurs

Initial Outlay (IO) Operating Cash Flow (OCF) Terminal Cash Flow (TCF)
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Guidelines In estimating Cash Flow for Capital Budgeting (Cont.)

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Initial Outflow
Is the total cash outflow at the beginning of the project occur. There are a few main items that are involved in the estimating of IO

Cost

of purchasing, installing and transporting that are involved for the new asset Change to the net working capital Sales revenue after tax for the old assets that must be sold if the project is accepted
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Cost of Purchasing, Installing and Transporting New Assets


Only cost that be spent to enable the project to be operational will be takes into account The cost that not involved directly such as sunk cost must didnt take into account

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Changes To Net Working Capital

NWC is differences of current assets and current liabilities NWC = Current Assets Current Liabilities Example : The opening of new factory is expected to increase the level of account payable by RM500,000, the account receivable by RM800,000, the level of inventory by RM400,000 and the level of short term loans by RM100,000. The change of NWC is = Acc. Receivable + Inventory - Acc. Payable - Short Term Loans = RM800,000 + RM400,000 RM500,000 RM100,000 = RM600,000 9
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Revenue From Sale of Old Assets After Tax


A new project may need the company to replace old asset by buy new assets The sales of old assets will generate cash inflow to the company and this cash flow must be taxed. Tax is imposed on the components of capital gains only and not the entire revenue from the sale of the assets Capital gain is the surplus of selling from asset book value

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Revenue From Sale of Old Assets After Tax (Cont.)

There are several equation that must be considered that is:


Sales Revenue = Selling Price Increase in Tax Increase in Tax = Tax Rate x Capital Gain Capital Gain = Selling Price Book Value Book Value = Original Price Accumulated Depreciation Accumulated Depreciation = Annual Depreciation x Year of Used Annual Depreciation = Original Cost Lifetime
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Revenue From Sale of Old Assets After Tax (Cont.)

Example 7.1 : Project A involves the replacement of an old grinding machine with a new grinding machine. The old grinding machine was bought at the price of RM250,000 3 years ago and has a lifetime of 5 years. What is the sales revenue of the asset after tax if this old machine can be sold at the price of RM120,000 now and the marginal tax rate is 30%?
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Revenue From Sale of Old Assets After Tax (Cont.)

Obtain the book value of the old asset Accumulated Depreciation = (RM250,000 5 years) x 3 years = RM150,000 Net Book Value = Original Price Accumulated Depreciation = RM250,000 RM150,000 = RM100,000 Obtain the capital gain = Selling Price Book Value = RM120,000 RM100,000 = RM20,000 mardi_umar83@yahoo.com

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Revenue From Sale of Old Assets After Tax (Cont.)


Obtain the effect of taxation = Surplus x Tax Rate = RM20,000 x 30% = RM6,000 Define the sales revenue after tax = Selling Price Increase in Tax = RM120,000 RM6,000 = RM114,000

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Revenue From Sale of Old Assets After Tax (Cont.)

Example 7.2 : Teguh company plans to purchase a new cement mixing machine, replacing the old machine. The old machine was purchased 6 years ago at RM200,000 and was depreciated using the straight line method for lifetimes of 10 years. If the company plans to replace this old machine, it can be sold at the RM120,000. the price of the new machine is RM300,000 while transporting cost is RM20,000 and the installation cost is RM10,000. This machine will increase the raw materials by RM20,000 and the account payable increased by RM10,000. The tax rate is 30%. What is the initial outlay for the machine.
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Revenue From Sale of Old Assets After Tax (Cont.)

Change in Net Working Capital = Inventory Acc. Payable = RM20,000 RM10,000 = RM10,000 (outflow) Accumulated Depreciation = Original Price Lifetime x Used Time = (RM200,000 10 years) x 6 years = RM120,000 Net Book Value = Purchase Price Accumulated Depreciation = RM200,000 RM120,000 = RM80,000
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Revenue From Sale of Old Assets After Tax (Cont.)

Capital Gain = Selling Price Book Value = RM120,000 RM80,00 = RM40,000 Increase in Tax = Capital Gaun x Tax Rate = RM40,000 x 30% = RM12,000 Sales Revenue After Tax = Selling Price Increase in Tax = RM120,000 RM12,000 = RM108,000
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Revenue From Sale of Old Assets After Tax (Cont.)

Initial Outlay = New Machine Price + Transportation Cost + Installation Cost Sale Revenue for Old Asset = RM300,000 + RM20,000 + RM10,000 RM108,000 = RM232,000
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Operating Cash Flow

Is the additional cash inflow that is expected to occur in the beginning of the first year until end of the project lifetime Among the items that must be taken into account in the estimating of OCF are as follow

Change in sales revenue Change in cash operating costs Change in taxation

The formula of OCF is = Change in sales Change in Expenditure Change in Taxation =S - E - T


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Operating Cash Flow (Cont.)

Example 7.3 : Refer to the Teguh Company information for the effect of this project on the level of sales, operating expenditure and depreciation expenses. The following are the information that has been obtained

The new machine will be used for 4 years and is depreciated via straight line to the scrap value of zero. At the end of 4 years, this machine is expected to be sold at the price of RM70,000. With this replacement, the company expected to increase the sales revenue by RM50,000 per year At the same time, the case expenditure will reduce by 20 mardi_umar83@yahoo.com RM5,000 per year.

Operating Cash Flow (Cont.)

Related Information S = RM50,000 E = -RM5,000 Change of Depreciation Old depreciation = RM50,000 New machine depreciation = (RM300k + RM20K + RM10K) 4 = RM82,500 Change of depreciation = RM82,500 RM50,000 = RM32,500
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Operating Cash Flow (Cont.)

The Operating Cash Flow = (S - E - D)(1 t) + D = [RM50,000 (-RM5,000) RM32,500](1 0.3) + RM32,500 = (RM50,000 + RM5,000 RM32,500) (0.7) + RM32,500 = RM48,250
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Terminal Cash Flow


Total cash flow at the end of the project There are several items that related to the TCF that is

Sales revenue after tax of new assets The cash flow receive for asset that has been sold must be taxed. For example, an asset in the project can be sold at the price of RM100,000. So, the sales revenue after tax is = Selling Price Increase in Tax = RM100,000 (RM100,000 x 0.3) = RM70,000
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Terminal Cash Flow (Cont.)

Other expenditure related with project termination. The termination of a project involves a clean up cost, moving cost and refurbishment cost. The formula of Expenditure After tax is = Expenditure Tax Suppose a project expected to involves of RM250,000 for clean-up cost. If the tax rate is 30%, the clean-up expenditure tax is = RM250,000 (RM250,000 x 30%) = RM250,000 RM75,000 = RM175,000 24 mardi_umar83@yahoo.com

Terminal Cash Flow (Cont.)


Regaining
NWC

the original level of Net Working Capital.


will be increase at the beginning of the project When the project is terminated, the company will return to its original position before the project was implemented If the NWC increased in the beginning of the project, the NWC will decrease to the original position. If the NWC decreased in the beginning of the project, the NWC will increase again to the original position 25
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Terminal Cash Flow (Cont.)

Regaining the original level of Net Working Capital.

Example 7.4 : Use the Teguh Company that is evaluating the replacement of an old grinding machine with a new grinding machine. Based on the information, the TFC of the project is

Sales revenue after tax of new machine [RM120,000 (1 0.3)] Other termination expenditure
Regaining the level of net working capital TCF
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RM84,000
RM0 RM10,000 RM94,000
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Application of Cash Flow for Capital Budgeting in Decision Making

After the calculation made about IO, OCF and TCF, the company must to make decision either to accept the project or not based on PBP and NPV technique. Assume the cost of capital is 12% and the targeted PBP is 3 years. IO = RM232,000 OCF = RM48,250 TCF = RM94,000
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Application of Cash Flow for Capital Budgeting in Decision Making (Cont.)

PBP Technique

The cumulative cash flow for the 3 years, the PBP is RM144,750 that is less than the initial cash outlay. So, the project must be rejected.
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Application of Cash Flow for Capital Budgeting in Decision Making (Cont.)

NPV Technique

The NPV value is RM25,680.75. So, the project must be rejected.


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