CASH FLOW ESTIMATION IN CAPITAL BUDGETING: A CASE STUDY

As part of its expansion process, a dairy company is considering the installation of

another Ultra-heat treatment plant in one of its production yards. The project,
that mainly includes among other things the purchase of the plant, will initially
cost nearly 85,000 (all amounts are in thousands of PKR). However, upon carrying
of that huge machine, transportation costs of 5,000 will be born. Besides the
machine will be installed by a special team which will cost the company 10,000.
Since the existing space in the factory work area is not sufficient to accommodate
such a large sized additional plant, the company intends to use another piece of
land adjacent to the work place which was purchased by the company some nine
years back for 10,400 and was meant to be used as a junk-yard. This small piece
of land is believed to have a current market value of at least 34,000. The company
engineers have also conducted a small feasibility study to evaluate whether, or
not, to invest in that expensive equipment. The study cost 12,300 and the project
seems to be worthwhile at a first glance.

The plant is assumed to have a useful life of four years during which it is expected
to give inflows (net of any corresponding outflows) of 37,820, 40,130, 48,687 and
30,952 respectively. After successful completion of its useful life, the residual
value of the plant is expected to be in the neighborhood of 14,000. The piece of
land which will be used to install the plant when purchased is expected to have a
market value of 47,000 after four years.

The company lies in the 20% tax bracket and uses the Modified Accelerated Cost
Recovery System (MACRS) for depreciating its long-term assets. The Depreciation
rates used as per MACRS for a three-year property class asset are provided in the
following table:
Table 1: Depreciation rates for a three-year property class asset as per MACRS
Recovery Depreciation Rate
Year
1 33.33%
2 44.45%
3 14.81%
4 7.41%
Total 100.00%

Required: What are the relevant incremental net cash inflows and outflows
associated with the purchase of the plant?

Solution:
To solve this case, we will need to separately determine the project’s:
1. Initial Cash Outflow

2. Interim Incremental Net Operating Cash Flows

3. Terminal Year Incremental Net Operating Cash Flows

So, let’s proceed by first extracting all the relevant information from the problem
just described.

Data Extracted:
Cost of the Asset = 85,000
Transportation Charges = 5,000
Installation Charges = 10,000
Feasibility Study (Sunk Costs) = 12,300
Opportunity Cost of Land = 34,000
Useful life of the project (asset) = 4 years
Salvage value of the asset = 14,000
Expected Cost of Land after four years = 47,000
Income Tax Rate = 20%
Depreciation Method used by the company = MACRS

Step 1: Estimating the Initial Cash Outflow:

Cost of the New Asset 85,000
Transportation Charges 5,000
Installation Cost 10,000
Opportunity Cost of Land 34,000
Less: Tax reduction due to purchase of land (34,000 @20% tax) (6,800)
Initial Cash Outflow 127,200
Depreciable basis of the asset = 85000 + 5000 + 10000 = 100,000

Step 2: Calculating Interim Incremental Net Cash Flows (Years 1 to 3):

Year 1 Year 2 Year 3 Year 4
1 Net increase in operating income 37,820 40,130 48,687 30,952
.
2 - Net increase in depreciation (33,330) (44,450) (14,810) (7,410)
. exp.
3 = Net increase in income before taxes 4,490 (4,320) 33,877 23,542
.
4 - Net increase (decrease) in taxes (898) 864 (6,775) (4,708)
.
5 Incremental net cash flow (1 – 4) 36,922 40,994 41,912 26,244
.

Step 3: Calculating Terminal Year Incremental Net Cash Flow:

Incremental Cash flow for the terminal year before project 26,244
windup
+ Final Salvage Value of the Asset 14,000
- Additional taxes to be paid due to sale of the asset (@20%) (2,800)
+ Opportunity Cost (Sale of) Land 47,000
- Additional taxes to be paid due to sale of the land (@20%) (9,400)
Terminal Year Incremental Net Cash Flow 75,044

Hence the incremental net cash flows for the project are:
End of Year

0 1 2 3 4

Net Cash Flows (127,200) 36,922 40,994 41,912 75,044

Thus, for an initial cash outflow of 127,200, the firm expects to generate net cash
flows of 36,922, 40,994, 41,912, and 75,044 over the next four years. Based on
these figures, the firm then uses any of the capital budgeting techniques to see
whether the project is worth accepting or not.