Page 147 - DMGT207_MANAGEMENT_OF_FINANCES

Management of Finances

Notes 2. In the final year, each machine is sold in its respective cash flow stream. To get the after tax
effect, we must estimate the book and cash value and compute the net cash value from the
sale of each asset, as given below:
New Machine Existing Machine
Book value in 4 years 40,000 0
Cash value in 4 years 30,000 10,000
Gain (Loss) on sale in 4 years (10,000) 10,000
Tax saving (additional taxes) 5,000 (5,000)
Plus Cash Received 30,000 10,000
Net Cash Value 35,000 5,000
Thus, we have cash flow in the final year as follows:
New Machine Existing Machine
Annual inflows from step 3 1,65,000 1,05,000
Return of working capital 20,000 -
Sale of machine 35,000 5,000
Final year cash flow 2,20.000 1,10.000
Step 5 - Calculate the Differential after Tax stream: We subtract the existing machine stream
from the new machine stream as follows:
Year New Machine Existing Machine Difference
0 (1,85,000) 0 (1,85,000)
1 1,65,000 1,05,000 60,000
2 1,65,000 1,05,000 60,000
3 1,65,000 1,05,000 60,000
4 2,20,000 1,10,000 1,10,000
This stream shows both the timing and amount of net cash outlay and net cash inflow over the
life of the new machine. All effects are differential - the difference between having the investment
and not having it, and can be evaluated with time-value of money techniques as have been
discussed earlier.
Cost of capital: As mentioned above, the cost of capital is an important element as basic input
information in capital investment decisions. It provides a yard stick to measure the work of
investment proposals and thus, perform the role of accept reject criterion. It is also referred to a
cut-off-rate, target rate, minimum required rate of return, standard return and so on. In the
present value method of discounted cash flow techniques, the cost of capital is used as the
discount rate to calculate the NPV.

Notes The PI Index or benefit cost ratio method similarly employs to determine the
present value of future cash inflows. In case of internal rate of return method, the computed
IRR is compared with the cost of capital, and accept only the cases where they are more
than cost of capital.
In operational terms, cost of capital refers to the discount rate that would be used in
determining the present values of estimated future cash proceeds and eventually deciding
whether the project is worth accepting or not.

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