Capital Budgeting Cash flow.

Prepared by:
Dr./ Nourhan Tarek.
What is the meaning of Relevant Cash Flow
(Read only)
 To evaluate investment opportunities, financial managers must determine the:
Relevant cash flows
 The Relevant cash flow=The incremental cash outflow (investment) and
resulting subsequent inflows associated with a proposed capital expenditure.
 What are the Incremental Cash flows
(Read only)
 Incremental cash flows:
 Are the additional cash flows—outflows or inflows—expected to
result from a proposed capital expenditure.
 In other word we can say that:
 Incremental cash flows are additional cash flows generated from a
new project.

Incremental project cash flow = firm cashflows with project – firm cashflows
without project
 What are the major components of cash
flow? (Read only)
• The cash flows of any project may include three basic components:
1. Initial investment: the relevant cash outflow for a proposed project at time zero.
2. Operating cash inflows: the incremental after-tax cash inflows resulting from
implementation of a project during its life.
3. Terminal cash flow: the after-tax nonoperating cash flow occurring in the final
year of a project. It is usually attributable to liquidation of the project. (Terminal
cash flow is the net cash flow that occurs at the end of a project and represents
the after-tax proceeds from disposal of the project assets and recoupment of
working capital.)
 Note that all the projects whether for expansion, replacement or renewal or other
purpose have the first two components. Some, however lack of the final component
“terminal cashflow”
Graph of the major components of
cashflows
 Relevant cash flows: Expansion Versus
Replacement Decisions (Read Only).
 Developing relevant cash flow estimates is most straightforward in the
case of expansion decisions. In this case, the initial investment,
operating cash inflows, and terminal cash flow are merely the after-
tax cash outflow and inflows associated with the proposed capital
expenditure.
 Identifying relevant cash flows for replacement decisions is more
complicated, because the firm must identify the incremental cash
outflow and inflows that would result from the proposed
replacement.
 Relevant cashflows for Replacement Decision:
calculation of the three components of relevant cash
flow for replacement decision (V.Important)
 Problem 1
Covol industries has estimated the cash flows over the 6-year lives for two projects,
A and B. These cash flows are summarized in the following table.
Project A Project B
Initial Investment $50,000 $22,000
Year Operating Cash inflow
1 $12,000 $7,000
2 $14,000 $7,000
3 $17,000 $7,000
4 $19,000 $7,000
5 $12,000 $7,000
6 $11,000 $7,000

If project A were actually a replacement for project B and if the $22,000 initial
investment shown for project B were the after-tax cash inflow expected from
liquidating it, what would be the relevant cash flows for this replacement decision?
 Answer Problem 1
Year Relevant Cashflow
(New A – old B)
Initial investment ($28,000)
($50,000 - $22,000) =$28,000
1 $5,000
($12,000 - $7,000) = $5,000
2 $7,000
($14,000 - $7,000)=$7,000
3 $10,000
($17,000 - $7,000)=$10,000
4 $12,000
($19,000 - $7,000) = $12,000
5 $5,000
($12,000 - $7,000) = $5,000

6 $6,000
($11,000 - $7,000) = $6,000
 Continue Answer Problem 1

From the previous answer of relevant cash flow we

conclude that the replacement decision would be a
better decision for Covol industries.
 Problem 2
Powel Corporation has estimated the cash flows over the 6-year lives for two
projects, X and Y. These cash flows are summarized in the following table.
Project X Project Y
Initial Investment $60,000 $30,000
Year Operating Cash inflow
1 $15,000 $9,000
2 $17,000 $9,000
3 $20,000 $9,000
4 $15,000 $9,000
5 $14,000 $9,000

If project X were actually a replacement for project Y and if the $30,,000 initial
investment shown for project B were the after-tax cash inflow expected from
liquidating it, what would be the relevant cash flows for this replacement decision?
 Answer Problem 2
Year Relevant Cashflow
(New X – old Y)
Initial investment ($30,000)
($60,000 - $30,000) =$28,000
1 $6,000
($12,000 - $9,000) = $5,000
2 $8,000
($17,000 - $9,000)=$7,000
3 $11,000
($20,000 - $9,000)=$10,000
4 $6,000
($15,000 - $9,000) = $5,000
5 $5,000
($14,000 - $9,000) = $5,000
 Continue Answer Problem2

• From the previous answer of relevant cash flow we

conclude that the replacement decision would be a better
decision for Powel Coropration.
The Basic format of determining the initial
investment
 The Basic format of determining the initial
investment
• There are three main items important to calculate the initial
investment:

1. Installed cost of
new assets.

2. After- tax proceed

from sale of old
assets.

3. Change in net
working capital
 Finding the initial Investments
1. Calculation of Installed Cost of new assets

• Installed cost of new assets = the cost of new assets + Installation

cost
 Finding the initial Investments
2. Calculation of After-tax proceed from the
sale of old assets

After-tax Proceed from the sale of old assets = Proceed from sale of
old assets ± tax on the sale of old assets
 Finding the initial Investments
3. Calculation of change in Net Working
Capital

Change in net working capital = change in current assets – change in

current liabilities.
 Finding the initial Investments

We can say that Initial investment can be calculated as follows:

Initial Investment = Installed Cost of new assets – After-tax proceed
from the sale of old assets ± change in working capital
 Problem 3
Finding Initial Investment

 Rosell industries has spent $5,000 researching a new project. The

project requires $25,000 worth of new machinery, which would cost
$3,500 to install.
 The company would realize $5,000 in after-tax proceeds from the sale
of old machinery. If Rosell’s working capital is unaffected by this
project, what is the initial investment amount for this project?
 Answer of Problem 3
Initial Investment Calculation
Purchase of new machinery $25,000
(+) Installation Cost $3,500
Installed Cost of new Assets (depreciable value) $28,500
(-) After-tax proceeds from sale of old assets $(5,000)
(±) change working capital $0
Initial Investment $23,500
 Problem 4
Finding Initial Investment
 Irvin’s enterprise is planning to purchase a high-powered machine for
$60,000 and incur an additional $8,000 in installation expenses.
 It is replacing similar equipment that can be sold to net $30,000,
resulting in taxes from a gain on the sale of $10,500. Because of this
transaction, current assets will increase by $5,000 and current
liabilities will increase by $3,000.
 Calculate the initial investment in the high-powered machine.
 Answer of Problem 4
 Initial investment = purchase price + installation costs – after-tax proceeds
from sale of old asset + change in net working capital
 After Tax Proceeds from sale of old assets= proceed from the sale of old
asset- tax from the sale of old assets= $30,000 – $10,500 = $19,500
 Change in net working capital = change incurrent assets – change in current
liabilities =$5,000 – $3,000 = $2,000
 Initial Investment= $60,000 + $8,000 – $19,500 + $2,000 = $46,500
 Answer of Problem 4
Initial Investment Calculation
Purchase of new machinery $60,000
(+) Installation Cost $8,000
Installed Cost of new Assets (depreciable value) $68,000
(-) After-tax proceeds from sale of old assets $(19,500)
(+) change working capital $2,000
Initial Investment $46,500
 Book Value
Book value is the strict accounting value of an asset, calculated by
subtracting its accumulated depreciation from its installed cost.

Book Value = Installed Cost – Accumulated depreciation

 Problem 5
Book Value
 Grenoble Enterprise,, 2 years ago acquired a machine tool with an
installed cost of $130,000.
 Under MACRS (Modified Accelerated Cost Recovery System) for a 5-
year recovery period, 20% and 32% of the installed cost would be
depreciated in years 1 and 2, respectively.
 Calculate the book value of Grenoble’s machine at the end of year 2

Note that MACRS is a system used to

determine the depreciation for tax
purposes
 Answer of Problem 5
 Book Value = Installed Cost – Accumulated Depreciation
 Accumulated Depreciation = Installed cost X Accumulated
depreciation percentage from (MACRS Table).
 Accumulated Depreciation = $130,000 X (20% + 32%)
 Accumulated Depreciation = $130,000 X 0.52 = $67,600 (this is the
accumulated depreciation of the machine at the end of year 2)
 Then:
 Book value = $130,000 – 67,600 = $62,400
Taxes on the sale of old asset (present
machine)

We have to take into consideration

that the taxes is calculated on the
total gain above the book value.
Calculation of Taxes on the sale of old asset
(present machine)
To calculate the amount of taxes on the sale of the present machine
(old asset) we have to calculate the following:
1) Calculate the book value.
2) calculate the gain on selling the old asset.
3) Calculate the tax

Gain on selling the old asset = sale price – book value

Taxes = Gain on selling the old assets X percentage of taxes

 Problem 6
calculation of taxes on the sale of old assets
 Based on problem 6, if Grenoble enterprises sell the old assets at $140,000. The
firm pay taxes at a rate of 40%.
 Calculate the taxes, if any, attributable to the sale of old asset.
Answer
1) From problem 6 book value = $62,400.
2) Gain on selling old asset =sale price (selling price)– Book Value
= $140,000 - $ 62,400 = $77,600
3) Taxes on selling old assets = Gain on selling old assets X Taxes Percentage.
$77,000 X 0.40 = $31,040
 Problem 7
comprehensive problem
Micro-pub inc., is considering the purchase of a new piece of equipment to replace the
current equipment. The new equipment costs $90,000 and requires $7,000 in installation
costs. It will be depreciated under MACRS using a 5-year recovery period.
The old piece of equipment was purchased 4 years ago for an installed cost of $60,000; it
was being depreciated under MACRS using a 5-year recovery period. The old equipment
can be sold today for $65,000 net of any removal or cleanup costs.
As a result of the proposed replacement, the firm’s investment in net working capital is
expected to increase by $20,000. The firm pays taxes at a rate of 40%. (MACRS Table on
next slide contains the applicable MACRS depreciation percentages.)
a. Calculate the book value of the old piece of equipment.
b. Determine the taxes, if any, attributable to the sale of the old equipment.
c. Find the initial investment associated with the proposed equipment replacement.
MACRS Depreciation Table
 Answer Problem 7
A)
 Book Value = Installed Cost – Accumulated Depreciation
 Accumulated Depreciation = Installed cost X Accumulated
depreciation percentage from (MACRS Table).
 Accumulated Depreciation = $60,000 X (20% + 32%+19% + 12%)
 Accumulated Depreciation = $60,000 X 0.83 = $49,800 (this is the
accumulated depreciation of the machine at the end of year 4)
 Then:
 Book value = $60,000 – $49,800 = $10,200
 Continue Answer Problem 7
B)
1) From question A) book value = $10,200.
2) Gain on selling old asset =selling price– Book Value
= $65,000 - $ 10,200= $49,800
3) Taxes on selling old assets = Gain on selling old assets X Taxes
Percentage.
= $49,800 x 0.40
= $19,920
 Continue Answer Problem 7
Initial Investment Calculation
Installed cost of new equipment
Cost of new equipment $90,000
(+) Installation Cost $7,000
Installed Cost of new Assets (depreciable value) $97,000
(-) After-tax proceeds from sale of old asset
Proceed from the sale of old equipment $(65,000)
(-) Tax on the sale of old equipment $(19,920)
(-)Total after-tax proceed from the sale of old asset $(45,080)
(+) change in net working capital $20,000
Initial Investment $71,980
 Problem 8
comprehensive problem
Assignment
Swan Corporation, is considering the purchase of a new piece of equipment to replace the
current equipment. The new equipment costs $100,000 and requires $9,000 in
installation costs. It will be depreciated under MACRS using a 5-year recovery period.
The old piece of equipment was purchased 4 years ago for an installed cost of $75,000; it
was being depreciated under MACRS using a 5-year recovery period. The old equipment
can be sold today for $85,000 net of any removal or cleanup costs.
As a result of the proposed replacement, the firm’s investment in net working capital is
expected to increase by $25,000. The firm pays taxes at a rate of 40%. (MACRS Table on
next slide contains the applicable MACRS depreciation percentages.)
a. Calculate the book value of the old piece of equipment.
b. Determine the taxes, if any, attributable to the sale of the old equipment.
c. Find the initial investment associated with the proposed equipment replacement.
MACRS Depreciation Table