Page 146 - DMGT207_MANAGEMENT_OF_FINANCES

Unit 6: Capital Budgeting

line depreciation. In our example, the depreciation can be calculated with two formulas as Notes
follows:
Depreciable Cost = Total Cost of machine – Book salvage value

2,40,000 – 40,000 = 2,00,000
Annual Depreciation = Depreciable Cost/Years of life
= 2,00,000/4 = 50,000
With the straight-line method, 50,000 depreciation is the same for each of the four years of the
new machines estimated service life. With other methods, the amount of depreciation differs
each year.

The depreciation on the existing machine is given at 20,000 per year down to zero book value.
Since the current book value is 80,000, the annual depreciation of 20,000 will be realised for
the remaining four years of service life.
Step 3 - Calculate Annual after Tax Cash flows: In our example, the annual cash flows will be
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.

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