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Cash Flows in Capital Budgeting

Decisions

Managerial Accounting

Prepared by Diane TannerUniversity of North Florida

Chapter 17

Cash Flows in Capital Budgeting

• Only incremental amounts are considered• Two categories of cash flows

• Operating activities• Activities which occur as a result of business

operations during the year• Found on the income statement

• Investing activities• Acquisition of long-term assets

• Cash received from sale of long-term assets

Investing Cash Flows in Capital Budgeting

• Two primary investing cash flows– Purchase of investment assets at year 0– Cash from the sale of long-term assets

• Salvage value is an expected cash flow• If sold at the end of the useful life for the salvage

value, no gain or loss will occur

Cash Basis

Provides:• Amounts earned• Amounts incurredAn indicator of real profits

Provides:• Cash inflows • Cash outflows

Accrual Vs. Cash Basis

Accrual Basis

Operations can be based on:

Capital Budgeting Assumptions

• Assume all revenue is received in the period earned– i.e., Revenue = cash inflows

• Assume that all expenses are paid in the same period incurred – i.e., All expenses = cash outflows– Non-cash items that are never paid nor received

• Depreciation expense• Amortization expense• Gains on disposal of long-term assets• Losses on disposal of long-term assets

Indirect Method of Calculating Operating Cash Flows

• Begin with accrual basis net income • Remove items that are not cash flows

–Add• Noncash expenses (e.g., depreciation, amortization)• Losses from disposition of long-term assets

– Subtract• Gains from disposition of long-term assets

Note that basic accruals and deferrals need not be adjusted because of the assumptions

made in capital budgeting.

Direct Method of Calculating Operating Cash Flows

• Also known as the shield method• Calculating cash basis net income

– Omit all non-cash amounts– Income taxes will be based on cash basis income

before taxes• Add/subtract the tax shields

Tax Shields• Tax savings/costs due to reporting expenses that have

no cash flow effect • Four common tax shields

– Depreciation tax shield• Depreciation expense × tax rate

– Amortization tax shield• Amortization expense × tax rate

– Loss tax shield• Loss on disposal × tax rate

– Gain negative tax shield• Gain on disposal × tax rate

Tax savings due to reporting an

expense that does not use cash

Additional tax cost due to reporting a revenue that does not generate cash

Depreciation tax shield = Depreciation expense x income tax rate

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Operating Cash Flows – Indirect MethodFiCo is deciding whether to purchase equipment with a cost of $74,000, an estimated residual value of $6,000, and an estimated life of 8 years. FinTru predicts the equipment will reduce annual payroll costs to $360,000 from the current level of $423,000. Cash operating expenses related to the new equipment are expected to be $41,200 per year. FiCo’s cost of capital is 7.4%, its required rate of return is 8.8%, and its income tax rate is 31%. Calculate annual incremental operating cash flows.  

Incremental payroll cost savings ($423,000 - $360,000) $63,000 Incremental cash operating expenses (41,200) Incremental depreciation ($74,000 - $6,000)/8 (8,500) Income before taxes 13,300 Income taxes expense (31% x $13,300) (4,123) Incremental net income 9,177 Add depreciation 8,500 Operating cash flows $17,677

10

Operating Cash Flows – Shield MethodFiCo is deciding whether to purchase equipment with a cost of $74,000, an estimated residual value of $6,000, and an estimated life of 8 years. FinTru predicts the equipment will reduce annual payroll costs to $360,000 from the current level of $423,000. Cash operating expenses related to the new equipment are expected to be $41,200 per year. FiCo’s cost of capital is 7.4%, its required rate of return is 8.8%, and its income tax rate is 31%. Calculate annual incremental operating cash flows.  

Incremental payroll cost savings $63,000 Incremental cash operating expenses (41,200) Incremental depreciation (8,500) Income before taxes 13,300 Income taxes expense (4,123) Incremental net income 9,177 Add depreciation 8,500 Operating cash flows $17,677

$63,000(41,200) -- 21,800 (6,758) 15,042 Cash basis income

Depreciation tax shield = $8,500 x 31% = $2,635

2,635$17,677

Tax savings:$6,758 - $4,123 = $2,635

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The End