financial management i_chapter 7

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Financial Management 1

BBPW3103Chapter 7

Cash Flow of Capital Budgeting


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Guidelines In estimating Cash Flowfor Capital Budgeting

It is an additional cash flow

Involves the change of cash flow in a project

Suppose that Project A will increased the cashsales revenue from RM1 million to RM1.5million.

So, only RM0.5 million will take into account

as change of cash flow


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Guidelines In estimating Cash Flowfor Capital Budgeting (Cont.)

It takes into account the effects of taxation The cash flow that must take into account is the cash

flow after tax For example : If the tax 30% and total cash flow is

RM1 million. So, only RM700,000 will takes intoaccount

Does not take into account the effect offinancing In estimating cash flow, these costs are not takes into

account especially interest costs of financing The effects of this financing had been taken into

account when the cost of capital is used to discount

the cash flow. If it is taken into account, the effect of this financing

is taken into account twice.


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Guidelines to estimate cash flow of capitalbudgeting Disregard Sunk Cost : Sunk Cost is the cost that has

been spent that does not influences the decision onaccepting / rejecting a project. This sunk cost doesnot take into account in calculating of cash flow. Forexample, research laboratory

Do Not Disregard Opportunity Cost : Opportunity cost

can be defined as the cash flow that could had beenobtained if the project under consideration. This costshould into account as cash outflow due to decreasethe company cash flow. For example, rental income


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Guidelines to estimate cash flow of capitalbudgeting (Cont.)

Do Not Disregard Side Effect : Refer to effect of

accepting the projects. For example, the effect ofproducing new product such as increasing the cashoutflow

There are 3 types of cash flow based on the

time occurs Initial Outlay (IO)

Operating Cash Flow (OCF)

Terminal Cash Flow (TCF)


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Initial Outflow

Is the total cash outflow at the beginningof the project occur.

There are a few main items that areinvolved in the estimating of IO

Cost of purchasing, installing and transportingthat are involved for the new asset

Change to the net working capital

Sales revenue after tax for the old assets thatmust be sold if the project is accepted


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Cost of Purchasing, Installing andTransporting New Assets

Only cost that be spent to enable theproject to be operational will be takes intoaccount

The cost that not involved directly such assunk cost must didnt take into account


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Changes To Net Working Capital

NWC is differences of current assets and currentliabilities

NWC = Current Assets Current Liabilities Example : The opening of new factory is expected to

increase the level of account payable by RM500,000, theaccount receivable by RM800,000, the level of inventoryby RM400,000 and the level of short term loans byRM100,000.

The change of NWC is

= Acc. Receivable + Inventory - Acc. Payable- Short Term Loans= RM800,000 + RM400,000 RM500,000

RM100,000= RM600,000


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Revenue From Sale of Old AssetsAfter Tax

A new project may need the company to replaceold asset by buy new assets

The sales of old assets will generate cash inflow

to the company and this cash flow must betaxed.

Tax is imposed on the components of capitalgains only and not the entire revenue from the

sale of the assets Capital gain is the surplus of selling from asset

book value


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Revenue From Sale of Old AssetsAfter Tax (Cont.)

There are several equation that must be considered thatis: Sales Revenue

= Selling Price Increase in Tax

Increase in Tax= Tax Rate x Capital Gain

Capital Gain

= Selling Price Book Value

Book Value

= Original Price Accumulated Depreciation Accumulated Depreciation

= Annual Depreciation x Year of Used

Annual Depreciation

= Original Cost Lifetime


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Example 7.1 : Project A involves thereplacement of an old grinding machinewith a new grinding machine. The old

grinding machine was bought at the priceof RM250,000 3 years ago and has alifetime of 5 years. What is the salesrevenue of the asset after tax if this old

machine can be sold at the price ofRM120,000 now and the marginal tax rateis 30%?


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Obtain the book value of the old asset

Accumulated Depreciation

= (RM250,000 5 years) x 3 years

= RM150,000

Net Book Value

= Original Price Accumulated Depreciation

= RM250,000 RM150,000

= RM100,000

Obtain the capital gain

= Selling Price Book Value

= RM120,000 RM100,000

= RM20,000


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Obtain the effect of taxation

= Surplus x Tax Rate

= RM20,000 x 30%

= RM6,000

Define the sales revenue after tax

= Selling Price Increase in Tax

= RM120,000 RM6,000

= RM114,000


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Example 7.2 : Teguh company plans to purchase anew cement mixing machine, replacing the oldmachine. The old machine was purchased 6 yearsago at RM200,000 and was depreciated using the

straight line method for lifetimes of 10 years.If the company plans to replace this old machine, itcan be sold at the RM120,000. the price of the newmachine is RM300,000 while transporting cost is

RM20,000 and the installation cost is RM10,000.This machine will increase the raw materials byRM20,000 and the account payable increased byRM10,000. The tax rate is 30%. What is the initialoutlay for the machine.


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Change in Net Working Capital= Inventory Acc. Payable= RM20,000 RM10,000= RM10,000 (outflow)

Accumulated Depreciation= Original Price Lifetime x Used Time= (RM200,000 10 years) x 6 years= RM120,000

Net Book Value= Purchase Price Accumulated Depreciation= RM200,000 RM120,000= RM80,000


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Capital Gain= Selling Price Book Value= RM120,000 RM80,00= RM40,000

Increase in Tax= Capital Gaun x Tax Rate= RM40,000 x 30%= RM12,000

Sales Revenue After Tax= Selling Price Increase in Tax= RM120,000 RM12,000= RM108,000


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Initial Outlay

= New Machine Price

+ Transportation Cost

+ Installation Cost

Sale Revenue for Old Asset

= RM300,000 + RM20,000

+ RM10,000 RM108,000

= RM232,000


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Operating Cash Flow (Cont.)

Example 7.3 : Refer to the Teguh Companyinformation for the effect of this project on thelevel of sales, operating expenditure anddepreciation expenses.

The following are the information that has beenobtained The new machine will be used for 4 years and is

depreciated via straight line to the scrap value ofzero.

At the end of 4 years, this machine is expected to besold at the price of RM70,000. With this replacement,the company expected to increase the sales revenueby RM50,000 per year

At the same time, the case expenditure will reduce by

RM5,000 per year.


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Related Information

S = RM50,000

E = -RM5,000

Change of Depreciation

Old depreciation = RM50,000

New machine depreciation

= (RM300k + RM20K + RM10K) 4

= RM82,500

Change of depreciation

= RM82,500 RM50,000

= RM32,500


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The Operating Cash Flow

= (S -E -D)(1 t) + D

= [RM50,000 (-RM5,000) RM32,500](1 0.3) + RM32,500

= (RM50,000 + RM5,000 RM32,500)

(0.7) + RM32,500= RM48,250


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Terminal Cash Flow

Total cash flow at the end of the project

There are several items that related to the TCFthat is

Sales revenue after tax of new assetsThe cash flow receive for asset that has been soldmust be taxed.

For example, an asset in the project can be sold atthe price of RM100,000. So, the sales revenue after

tax is= Selling Price Increase in Tax

= RM100,000 (RM100,000 x 0.3)

= RM70,000


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Terminal Cash Flow (Cont.)

Other expenditure related with projecttermination.

The termination of a project involves a clean up cost,moving cost and refurbishment cost. The formula ofExpenditure After tax is

= Expenditure Tax

Suppose a project expected to involves of RM250,000for clean-up cost. If the tax rate is 30%, the clean-upexpenditure tax is

= RM250,000 (RM250,000 x 30%)

= RM250,000 RM75,000

= RM175,000


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Regaining the original level of NetWorking Capital.NWC will be increase at the beginning of the

project

When the project is terminated, the company willreturn to its original position before the projectwas implemented

If the NWC increased in the beginning of the

project, the NWC will decrease to the originalposition.

If the NWC decreased in the beginning of theproject, the NWC will increase again to the originalposition


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Regaining the original level of Net WorkingCapital.

Example 7.4 : Use the Teguh Company that is evaluating thereplacement of an old grinding machine with a new grinding

machine. Based on the information, the TFC of the project is

Sales revenue after tax of newmachine [RM120,000 (1 0.3)]

RM84,000

Other termination expenditure RM0

Regaining the level of net workingcapital

RM10,000

TCF RM94,000


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Application of Cash Flow for CapitalBudgeting in Decision Making

After the calculation made about IO, OCFand TCF, the company must to makedecision either to accept the project or not

based on PBP and NPV technique. Assumethe cost of capital is 12% and the targetedPBP is 3 years.

IO = RM232,000

OCF = RM48,250

TCF = RM94,000


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Application of Cash Flow for CapitalBudgeting in Decision Making (Cont.)

PBP Technique

The cumulative cash flow for the 3 years,

the PBP is RM144,750 that is less than theinitial cash outlay. So, the project must berejected.


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Application of Cash Flow for CapitalBudgeting in Decision Making (Cont.)

NPV Technique

The NPV value isRM25,680.75. So, theproject must be rejected.

financial management i_chapter 7

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