Page 179 - DMGT405_FINANCIAL%20MANAGEMENT

Unit 9: Capital Budgeting

Step 3 – Calculate Annual after Tax Cash flows: In our example, the annual cash flows will be Notes
same each year since the revenues, costs, depreciation and taxes do not change. To compute after
tax cash flows from operations or employment of the asset there are 2 methods:
1. We begin with revenues, deduct cash expenses and taxes, and we have the cash flow, or
2. We can begin with revenues; deduct cash expenses, and non-cash expenses. Calculate taxes
and deduct them and then add back depreciation. The two methods are shown below:
New Machine Existing Machine
Accounting Cash flow Accounting Cash flow
Annual-revenues 450,000 400,900 400,000 400,000
Less: Annual cost of operation 170,000 210,000 210,000 210,000
Before tax cash flow 280,000 190,000 190,000 190,000
Less: Annual depreciation 50,000 20,000 20,000 20,000
230,000 170,000 170,000 170,000
Less: income taxes 50% 115,000 85,000 85,000
Net income after taxes 115,000 85,000 85,000 85,000
Add: Back Depreciation 50,000 20,000 20,000 20,000
After tax cash flow 165,000 105,000 105,000 105,000

Notes Any tax shield from interest payments on debt is omitted, since the effects off
financing by different methods are considered in cost of capital calculation and are not
covered in capital budgeting so as to avoid double counting of financing effects.

Step 4 – Calculate effects in final year:
In the final year two events occur:
1. The return of the working capital tied up in year zero. In our example, 20,000 is treated
as an inflow in the final year since the money is freed for other uses.
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

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