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Part 1 Estimation of Cash Flow in Capital Budgeting problems with solutions
1. The cost of a machine is 10, 00,000. It has an estimated life of 10 years after which it would be disposed off (scrap value nil). Profit or Earning before depreciation and taxes (EBDT/PBDT) is estimated to be 2, 75,000 p.a. Find out the yearly cash flow from the machinery, (given the tax rate @ 40%).
Solution
Depreciation = Cost of machine/ estimated life of machine =
Rs. 10,00,000/10 = Rs. 1,00,000
|
Particulars |
Amount (Rs.) |
|
EBDT /PBDT |
2,75,000 |
|
Less: Depreciation |
(1,00,000) |
|
PBT /EBT |
1,75,000 |
|
Less Tax @ 40 % of EBT/PBT |
(70,000) |
|
PAT/EAT |
1,05,000 |
|
Add: Depreciation |
1,00,000 |
|
Cash flow |
2,05,000 |
2. ABC LLP is evaluating a capital
budgeting proposal for which relevant figures are as follows:
Cost of the Plant 10,00,000
Installation cost 1, 00,000
Economic life 5 years
Scrap value Rs. 50,000
Profit before depreciation and tax
Rs. 4,00,000 and Tax rate 40 %.
Solution
Depreciation = cost of plant + Installation cost – Scrap or
Salvage value / economic life of plant
= (10,00,000 + 1,00,000 – 50,000) /5 = Rs. 2,10,000
|
Particulars |
Amount (Rs.) |
|
EBDT /PBDT |
4,00,000 |
|
Less: Depreciation |
(2,10,000) |
|
PBT /EBT |
1,90,000 |
|
Less Tax @ 40 % of EBT/PBT |
(76,000) |
|
PAT/EAT |
1,14,000 |
|
Add: Depreciation |
2,10,000 |
|
Cash flow |
3,24,000 |
3. A firm buys an asset costing
10,00,000 and expects operating profits (before depreciation and tax) of
3,00,000 p.a. for the next four years after which the asset would be disposed
off for 4,50,000. Find out the cash flows for different years. Also calculate
terminal cash flow. Depreciation is to be charged at 20 % p.a. on WDV basis and
rate of tax is 30 %.
Solution:
Initial cash outflow = Rs. 10,00,000
Terminal Cash inflow = Salvage value ± Tax on Gain/loss of asset
= Rs. 4,50,000 – Tax on gain on sale of asset
= Rs. 4,50,000 – (30 % of Rs.40,400) = Rs. 4,50,000 – Rs. 12,120 = Rs. 4,37,880
Capital Gain on sale of asset =
Scrap value of asset – WDV of asset at the time of disposal
= Rs. 4,50,000 – RS. 4,09,600
= Rs.40,400
Note: In case of gain, tax
amount on gain on sale of asset will be subtracted. In case of loss, tax amount
on loss on sale of asset will be subtracted
Capital Loss on sale of asset =
WDV of asset at the time of disposal- Scrap value of asset
|
|
Year 1 (Rs.) |
Year 2(Rs.) |
Year 3(Rs.) |
Year 4(Rs.) |
|
PBDT |
3,00,000 |
3,00,000 |
3,00,000 |
3,00,000 |
|
Less Depreciation |
(2,00,000) |
(1,60,000) |
(1,28,000) |
(1,02,400) |
|
PBT |
1,00,000 |
1,40,000 |
1,72,000 |
1,97,600 |
|
Less Tax @30 % of PBT |
(30,000) |
(42,000) |
(51,600) |
(59,280) |
|
PAT |
70,000 |
98,000 |
1,20,400 |
1,38,320 |
|
Add Depreciation |
2,00,000 |
1,60,000 |
1,28,000 |
1,02,400 |
|
Cash Flow |
2,70,000 |
2,58,000 |
2,48,000 |
2,40,720 |
|
Terminal Cash Flow |
|
|
|
Rs. 4,37,880 |
|
|
Year 1(Rs.) |
Year 2(Rs.) |
Year 3(Rs.) |
Year 4(Rs.) |
Year 5(Rs.) |
|
WDV |
10,00,000 |
10,00,000- 2,00,000 = 8,00,000 |
8,00,000 –1,60,000 = 6,40,000 |
6,40,000 - 1,28,000 = 5,12,000 |
5,12,000- 1,02,400 = 4,09,600 |
|
Depreciation |
20 % of 10,00,000 = 2,00,000 |
20 % of 8,00,000 = 1,60,000 |
20 % of Rs. 6,40,000 = Rs. 1,28,000 |
20 % of 5,12,000 = 1,02,400 |
|
4. From following income statement
of project determine annual cash flow for the company.
|
Income
Statement of the Project |
|
|
Net Sales revenue |
7,70,000 |
|
- Cost of Goods Sold |
(3,00,000) |
|
- General Expenses |
(1,50,000) |
|
- Depreciation |
(70,000) |
|
Profit before interest and taxes |
2,50,000 |
|
- Interest |
(50,000) |
|
Profit before tax |
2,00,000 |
|
- Tax@ 30% |
(60,000) |
|
Profit after tax |
1,40,000 |
Solution
|
Cash flow of the Project |
|
|
Net Sales revenue |
7,70,000 |
|
- Cost of Goods Sold |
(3,00,000) |
|
- General Expenses |
(1,50,000) |
|
- Depreciation |
(70,000) |
|
Profit before interest and taxes |
2,50,000 |
|
- Tax@ 30% |
(75,000) |
|
Profit after tax |
1,75,000 |
|
Add: Depreciation |
70,000 |
|
Cash Flow |
2,45,000 |
Note: In the
capital budgeting decision process, cash inflows in the form of raising the
funds and cash outflows in the form of interest and dividend payments, are
ignored.
The cash inflow arising at the
time of raising of additional fund results in an immediate cash outflow also
when these funds are used to procure the project. As such, there is no net cash
inflow. Further, the cost of financing in the form of interest and dividend is
truly reflected in the weighted average cost of capital which is used to evaluate
the proposals. If the cost of debt or equity (ie, interest or dividends) is
deducted from the cash inflows, then this cost of raising fund will be counted
twice, first in the cash inflows and second, in the weighted average cost of
capital. This is also known as interest Exclusion Principle.
The interest payable to the
lenders and the dividend payable to the shareholders are cash flows to the
supplier of funds and not cash flow from the project. In capital budgeting, the
cash flow from the project is compared with the cost of acquiring that project.
A particular capital mix, the firm uses to finance the project is a managerial
variable and primarily determines how project cash flows are divided between
lenders and owners.
Thus, neither, the additional funds
raised nor the interest/ dividend payable on these funds are treated as
relevant cash flows for a proposal. Otherwise, there will be an error of double
counting. The general principle is that the investment decision and the
financing decision should be considered Separately. In other words, only the
operating cash flows of a proposal should be brought into and evaluated in the
capital budgeting process. The financial cash flows should be taken as constant
and be kept outside the analysis.
Initial Cash Outflow = Cost of
new plant +Installation Expenses +Other Capital Expenditure+ Additional Working
Capital - Tax benefit on account of Capital loss on sale of old plant (if any)
- Salvage value of old plant +Tax Liability on account of Capital gain on sale of
old plant (if any).
Subsequent Cash inflow = Profit
after Tax+ Depreciation+ Financial charge (1 - t) Repairs (if any) - Capital
Expenditure (if any).
Terminal Cash inflow = Salvage
value of asset ± Tax on capital
gain / loss on sale of asset + Working Capital released.
5. RBL Ltd is planning to install a
new machine costing Rs. 20,00,000 with a salvage value of Rs. 5,00,000 after 4 years of life. Following information is
available in respect of the machine. Annual Production of the company will be 1,00,000
Units for year 1 and it will increase by 10 % p.a. over immediate preceding
year production for next 3 years. Selling price = Rs. 20 per unit, Variable
cost = Rs. 10 per unit, Fixed cost 3,00,000 p.a., Tax rate is 30 %. Depreciation
is to be charged at 25 % on written Down Value. Calculate initial, subsequent
and terminal cash flow of the machine.
Solution
Initial outflow for the machine = Rs. 20,00,000.
Subsequent cash
inflow:
|
Particulars |
Year 1 (Rs.) |
Year 2(Rs.) |
Year 3(Rs.) |
Year 4(Rs.) |
|
Sales in units |
100000 units |
110000 units |
121000 units |
133100 units |
|
Selling Price per unit (Rs) |
20 |
20 |
20 |
20 |
|
Total Sales |
20,00,000 |
22,00,000 |
24,20,000 |
26,62,000 |
|
less: Variable cost (VC/unit × no. of units) |
(10,00,000) |
(11,00,000) |
(12,10,000) |
(13,31,000) |
|
less: Fixed cost |
(3,00,000) |
(3,00,000) |
(3,00,000) |
(3,00,000) |
|
EBDT |
7,00,000 |
8,00,000 |
9,10,000 |
10,31,000 |
|
Less :Depreciation |
(5,00,000) |
(3,75,000) |
(2,81,250) |
(2,10,937.5) |
|
EBT |
2,00,000 |
4,25,000 |
6,28,750 |
8,20,062.5 |
|
less: Tax @30 % of EBT |
(60,000) |
(1,27,500) |
(1,88,625) |
(2,46,018.75) |
|
PAT |
1,40,000 |
2,97,500 |
4,40,125 |
5,74,043.75 |
|
Add: Depreciation |
5,00,000 |
3,75,000 |
2,81,250 |
2,10,937.5 |
|
Annual Cash Inflow |
6,40,000 |
6,72,500 |
7,21,375 |
7,84,981.25 |
|
Terminal Cash inflow |
Rs. 5,39,843.75 |
|
|
Year 1(Rs.) |
Year 2(Rs.) |
Year 3(Rs.) |
Year 4(Rs.) |
Year 5(Rs.) |
|
WDV |
20,00,000 |
20,00,000- 5,00,000 = 15,00,000 |
15,00,000 –3,75,000 = 11,25,000 |
11,25,000 - 2,81,250 = 8,43,750 |
8,43,750- 2,10,937.5= 6,32,812.5
(WDV at the time of disposal) |
|
Depreciation |
25 % of 20,00,000 = 5,00,000 |
25 % of 15,00,000 = 3,75,000 |
25 % of Rs. 11,25,000 = Rs. 2,81,250 |
25 % of 8,43,750= 2,10,937.5 |
|
Calculation of terminal cash inflow
Terminal Cash inflow = Salvage value ± Tax on Gain/loss of asset
In this case there is a capital loss since Rs. 6,32,812.5 (WDV at the time of disposal) is
more than Rs. 5,00,000 (Salvage value of asset)
= Rs. 5,00,000 +
Tax saving on loss on sale of asset
= Rs. 5,00,000 + (30 % of Rs. 1,32,812.5) = Rs. 5,00,000 + Rs. 39,843.75 = Rs.
5,39,843.75
Capital Loss on sale of asset = WDV
of asset at the time of disposal- Scrap value of asset
Capital Gain on sale of asset =
Scrap value of asset – WDV of asset at the time of disposal
Note: While calculating Terminal
cash inflow; In case of capital gain, tax amount on gain on sale of asset will
be subtracted. In case of capital loss, tax amount on loss on sale of asset
will be added as it indicates saving for the company due to appropriation of
capital losses with other gains of the company.
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