CHAPTER 12

Cash Flows and Other Topics

in Capital Budgeting
 Time line for Solution Practice Problem 2

Cash Flows

Initial Terminal
outlay Cash flow
$590,000

0 1 2 3 4 5 6 7 8
$197,500 $197,500 $197,500 $197,500 $197,500 $158,400 $158,400 $158,400+
$41,400 =
$199,800

Annual Cash Flows

Automation Project:
Problem 2
 Cost of equipment = $550,000.
 Shipping & installation will be $25,000.
 $15,000 in net working capital required at setup.
 8-year project life, 5-year class life.
 Simplified straight line depreciation.
 Current operating expenses are $640,000 per yr.
 New operating expenses will be $400,000 per yr.
 Already paid consultant $25,000 for analysis.
 Salvage value after year 8 is $40,000.
 Cost of capital = 14%, marginal tax rate = 34%.
 Problem 2
Initial Outlay:

(550,000) Cost of new machine

+ (25,000) Shipping & installation
(575,000) Depreciable asset
+ (15,000) NWC investment
(590,000) Net Initial Outlay
For Years 1 - 5: Problem 2

240,000 Cost decrease

(115,000) Depreciation increase
125,000 EBIT
(42,500) Taxes (34%)
82,500 EAT
115,000 Depreciation reversal
197,500 = Annual Cash Flow
 CALCULATION OF ANNUAL
DEPRECIATION FOR NEW MACHINE:

Depreciable asset/class life =$575,000/5 yrs

= $115,000
The machine is used only for 5 years. From
years 6-10, no depreciation; therefore
depreciation will be $0 for these last 5 years.
 Problem 2
For Years 6 - 8:

240,000 Cost decrease

( 0) Depreciation increase
240,000 EBIT
(81,600) Taxes (34%)
158,400 EAT
0 Depreciation reversal
158,400 = Annual Cash Flow
 Problem 2
Terminal Cash Flow:

40,000 Salvage value

(13,600) Tax on capital gain
15,000 Recapture of NWC
41,400 Terminal Cash Flow
 CALCULATION OF TERMINAL CASH FLOW
Annual depreciation of new machine=$115,000
(from slide 7)
Book value = Depreciable asset – Total
amount depreciated
= $575,000 - $115,000(5yrs)
= $0
 Capital gain = Salvage value-Book Value
= $40,000-$0 = $40,000
Tax on capital gain = 34% x $40,000
= $13,600 (refer slide 8)
 Problem 2 Solution
NPV and IRR:
 CF(year 0) = -$590,000 (slide 4)
 CF(years 1 - 5) =$197,500 (slide 5)
 CF(years 6 - 7) = $158,400 (slide 7)
 CF(year 8) = $158,400 + $41,400
= $199,800 (slides 7 + 8)
 Discount rate = 14%.
 IRR = 28.13%
 NPV = $293,543.
 We would accept the project.
 FINDING NPV-
1st method (annuity + individual CF)
NPV = -$590,000 (year 0)
+ $197,500 (PVIFA 14%, years 1-5) (years 1-5)
+ $158,400 (PVIF 14%, 6th yr) (year 6)
+ $158,400 (PVIF 14%, 7th yr) (year 7)
+ $199,800 (PVIF 14%, 8th yr) (year 8)
= -$590,000
+ $197,500(3.4331)
+ $158,400 ( (0.4556)
+ $158,400 ( (0.3996)
+ $199,800 (0.3506)
= -$590,000 +$678,037 +$72,167 +$63,297 +$70,050
= -$590,000 +$883,551 = $293,551
Accept the project since NPV is positive.
 FINDING NPV-
2nd method (annuities)
NPV = -$590,000 (year 0)
+ $197,500 (PVIFA 14%, 5years) (years 1-5)
+ $158,400 (PVIFA 14%, 2 years,6&7) (PVIF 14%, 5)
(annuities years 6-7)(bring back to time 0). Refer
to TVM ppt, slides 68-71 for understanding.
+ $199,800 (PVIF 14%,10th year) (year 8)
= -$590,000
+ $197,500(3.4331)
+ $158,400 (1.6467)(0.5194)
+ $199,800 (0.3506)
= -$590,000 +$678,037 +$135,479 +$70,050
= -$590,000 +$883,556 = $293,566
Accept the project since NPV is positive.