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Procedures Of Cash Flows Estimation In Capital Budgeting


Cash flow indicates a cash outflow and cash inflows. It is necessary to estimate the cash flow in the process of analyzing investment proposal. While analyzing the cash flow, it is also necessary to estimate the cash outflow as well as cash inflow. Estimation of the net cash flow in an investment project should cover the following procedures:

Step 1: Determination Of Net Investment or Net Cash Outlay Or Initial Cash Outlay.

Initial investment or start-up costs are net cash outflows at present cost. It refers to the sum of all cash outflows and cash inflows occurring at zero time periods. Net investment refers to the amount of which will be required for the acquisition of fixed assets. Thus initial investment of a new fixed assets or project comprises cost, freight, installation charges, custom duty etc.
Determination of net investment in replacement case is different than investment of new proposal. The following factors also effect on the determination of net investment of a replacement proposal. The various factors are as follows:

Salvage Value
Salvage value means the value which is estimated to be realized on account of the sales of assets at the end of its useful life. To calculate the amount of depreciation, it is deducted from the cost of assets. Salvage value is also known as residual value.
Salvage value can be divided as follows:
i. Book Salvage value: Remaining value of the fixed assets after charging depreciation is known as book salvage value. It is determined as follows:
Book salvage value = Cost of assets - Accumulated depreciation

ii Cash Salvage Value: Actual sales value of remaining assets is known as cash salvage value. The book salvage value may be equal or more or less than cash salvage value. The existing asset's cash salvage value effect the net investment when an asset is replaced.

Tax Adjustment
When cash and book salvage value of asset is differentiate in this situation we have to adjust the tax. Cash salvage value affects on an estimation of initial cash outlay.
i. If book salvage value is equal to cash salvage value:
If existent assets are sold at their book value there is no tax adjustment because tax is adjusted in profit or loss.

ii. If cash salvage value is more than book salvage value but less than original cost:
When company sells fixed assets more than book salvage value less than original cost this more value is known as normal gain. In normal gain company has to pay tax. For example, the assets which is purchased at $ 500,000 five years before. The book value today is $ 250,000 and cash salvage value today is $ 300,000. In this case, the profit will be $ 50,000, which is known as normal gain. If there is the provision of 40% normal tax $ 20,000 ( 40% of $ 50,000) must be paid as tax.
If the company desired to purchased the new assets of $ 600,000, the net investment can be determined as follows:

Purchase price of new assets.....................................= - 600,000
Cash salvage value of old assets................................= + 300,000
Tax paid........................................................................= - 20,000
Net investment = - 320,000

Note: cash outflow is indicated my minus(-) and cash inflow is indicated by plus (+).

iii. If cash salvage value is more than book salvage value as well as original value:
The difference between cash salvage value and original value of assets is known as capital gain and different between original value and book value is known as normal gain. It should be cleared as follows:
Normal gain = Original value - Book salvage value
Capital gain = Cash salvage value - Original value

Both capital and normal gain have to pay tax but capital gain tax may be low than normal gain tax. For example,
Original value of assets = $ 300,000
Book salvage value of assets = $ 200,000
Cash salvage value of assets = $ 330,000
Then, capital gain = cash salvage value - original value = 330,000 - 300,000 = $ 30,000.
Normal gain = Original value - Book salvage value = 300,000 - 200,000 = $ 100,000.

Let capital gain tax rate 25% and normal tax rate is 40% in that case tax paid will be:
Normal tax(40% of 100,000) = $ 40,000
Capital gain tax (25% of $ 30,000) = $ 7,500

If company desired to purchase the new assets of $ 600,000, the new investment can be determined as follows:
Purchase price of new assets ...................= -600,000
cash salvage value of old assets..............= + 330,000
Tax paid on capital gain.............................= -7,500
Tax paid on normal gain..........................= -40,000
Net investment........................................= -317,500

iv. If cash salvage value is less than book salvage value:
Sometimes company sells fixed assets less than book salvage value. Company suffer from loss. In this situation, it can save tax. In other words, when company faces loss, the tax need not to be paid. As a result, the taxable amount comes to be surplus at a certain percentage. For example:
Book salvage value of assets = $ 300,000
Cash salvage value of assets = $ 250,000
Loss = 300,000- 250,000 = $ 50,000
Tax saving:
Let tax rate = 40%
Tax saving = 40% of $ 50,000 = $ 20,000.

If the company desired to purchase the new assets of $ 600,000, the new investment can be determined as follows:
Purchase price of new assets ...............= - 600,000
Cash salvage value of old assets..........= + 250,000
Tax save on loss on sale of assets........= + 20,000
New investment.....................................= -330,000

Working Capital
Working capital may be defined as the funds required within a business for supporting day to day business activities. Working capital may increase in case of new proposal. These increases working capital increase cash outflow. Some times working capital may decrease and these decrease working capital increase cash inflow. In other words, reduction refer
s to the returning investing, It should be cleared as follows:
Increase in working capital = cash outflow(-)
Decrease in working capital = cash inflow (+)

Investment Tax Credit
In order to encourage the industry, sometime government may provide facilities of tax credit. It reduces initial cash outlay. There are many methods of determining the investment tax credit allowance, however, following method is considered more appropriate:

Investment tax credit = Original cost of assets X ITC rate/100
Where, ITC = Investment tax credit.

On the basis of the above noted points, the net cash outlay of the replacement proposal can be estimated. To estimate the net cash outlay or net investment
the following table can be used:

Particulars..................................................................Amount
Purchasing price of new assets................................(-) XXX
Transportation and installation cost.........................(-) XXX
Increase or decrease in working capital.................(+/-) XXX
Cash salvage value of existing assets......................(+) XXX
Tax adjustments (outstanding or saving)................(+/-) XXX
Investment Tax credit................................................(+) XXX
Net cash outlay..........................................................(-) XXX

Step 2: Determination of annual net cash inflow or cash inflow after tax:
It is second step of capital budgeting which is determined after the determination of net cash outflow of investment proposal. In this step, net cash inflow is determined during the life of the project. It is called net cash inflow or cash flow after tax. It is determined on the basis of accounting for cash flow concept. To determine the net cash inflow, interest amount is not included. To determine net cash flow following table is taken:

Particulars................................................New machine.................Old machine
Annual sales (Revenue)..........................................XXX............................XXX
Less: Cash expenses...............................................XXX............................XXX
Earning before depreciation and tax.........................XXX............................XXX
Less : Annual depreciation(D)..................................XXX............................XXX
Earning before tax(EBT)...........................................XXX............................XXX
Less: Tax.................................................................XXX............................XXX
Earning after tax (EAT).............................................XXX............................XXX
Add back depreciation..............................................XXX............................XXX
Net cash flow or cash flow after tax(CFAT)...............XXX............................XXX

Alternative way of calculating differential cash flow after tax:

Particulars........................................................Amount
Annual increase in sales ...................................XXX
Less: increase in cash expenses.......................XXX
Or,
Add: decrease in cash expenses.......................XXX
Differential cash flow before tax........................XXX
Less: differential depreciation...........................XXX
Differential net income before tax......................XXX
Less: Tax...........................................................XXX
Differential net income after tax........................XXX
Add back differential depreciation....................XXX
Annual differential CFAT.................................XXX

Step 3: Determination of net cash inflow for the final year:

Final year net cash flow may be different due to course of working capital and salvage value of assets. If working capital is invested in initial stage, less in net cash outflow and plus in final year net cash inflow. it is called release of working capital. If working capital is reduced in initial year, Plus in net cash outflow and less is final year net cash inflow. Similarly, final year net cash inflow is affected by salvage value of assets. If salvage value of assets is not given, CFAT is effected only by working capital. The tax is adjusted on profit or loss on sales of assets. To determine the final year's CFAT following table is taken:

For New Proposal:
Annual cash flow......................................................XXX
Add: cash salvage value of project.........................XXX
Less: tax paid on profit on sale of assets...............XXX
Add: tax save on loss on sale of assets..................XXX
Add: working capital increases...............................XXX
Less: working capital decreases.............................XXX
Net cash inflow for final year.................................XXX

Differential Cash Flow(Replacement Proposal)
Particulars.................................................New machine................Old machine
Annual cash flow after tax..............................XXX..............................XXX
Add: cash salvage of machine........................XXX..............................XXX
Less: Tax paid................................................(XXX)...........................(XXX)
Add: Tax save..................................................XXX..............................XXX
Add: working capital increase...........................XXX..............................XXX
Less: working capital decrease.......................(XXX)............................(XXX)

Net cash inflow for the final year....................XXX...............................XXX







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