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Saturday, March 5, 2022

Estimation of Cash Flow in Capital Budgeting- Financial Management notes BBA, B.Com, MBA and CA Online Tuition Project & Assignment Solutions

Links to Financial Management notes: -

Time Value of Money

https://rblacademy.blogspot.com/2021/06/time-value-of-money-formulae-financial.html

https://rblacademy.blogspot.com/2021/06/time-value-of-money-part-i-solved.html

https://rblacademy.blogspot.com/2021/06/time-value-of-money-part-2-solved.html

https://rblacademy.blogspot.com/2021/06/time-value-of-money-part-3-solved.html

https://rblacademy.blogspot.com/2021/05/time-value-of-money-i-financial.html

Leverage Analysis

https://rblacademy.blogspot.com/2021/08/financial-management-notes-leverage.html

Cost of Capital

https://rblacademy.blogspot.com/2021/08/cost-of-capital-solved-problems.html

EBIT – EPS Analysis

https://rblacademy.blogspot.com/2021/08/ebit-eps-analysis-financial-break-even.html

Capital Structure Analysis

https://rblacademy.blogspot.com/2022/02/capital-structure-theories-solved.html

Planning & Designing of Capital Structure

https://rblacademy.blogspot.com/2022/03/planning-designing-of-capital-structure.html

Estimation of Cash Flow in Capital Budgeting

https://rblacademy.blogspot.com/2021/06/part-1-estimation-of-cash-flow-in.html

https://rblacademy.blogspot.com/2021/06/part-2-estimation-of-cash-flow-in.html

https://rblacademy.blogspot.com/2021/06/part-3-estimation-of-cash-flow-in.html

https://rblacademy.blogspot.com/2022/03/estimation-of-cash-flow-in-capital.html

Techniques of Capital Budgeting

https://rblacademy.blogspot.com/2021/05/techniques-of-capital-budgeting.html

https://rblacademy.blogspot.com/2021/05/capital-budgeting-i-httprblacademycom.html

https://rblacademy.blogspot.com/2021/05/financial-management-capital-budgeting.html

https://rblacademy.blogspot.com/2021/06/techniques-of-capital-budgeting-solved_2.html

https://rblacademy.blogspot.com/2021/06/techniques-of-capital-budgeting-solved_14.html

https://rblacademy.blogspot.com/2021/06/techniques-of-capital-budgeting-solved.html

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

Calculation on Depreciation

	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

Calculation of Depreciation:

	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.

6. RBL Ltd. is planning to purchase a machine for Rs. 2,00,000 which will help company to generate following earnings in the next five years

Years	Year 1	Year 2	Year 3	Year 4	Year 5
EBDT	60,000	65,000	68,000	70,000	70,000

The purchase of machine will result in increase of working Capital by 20,000. The machine will be depreciated on SLM basis and has salvage value of Rs. 50,000. The company is subject to tax at the rate of 40 per cent. Calculate initial, subsequent and terminal cash flow of the machine.

Solution:

Cash outflow in the beginning = Cost of Machine + Working Capital

= Rs. 2,00,000 + Rs. 20,000 = Rs. 2,20,000

Terminal Cash flow = Salvage value + Working Capital = Rs. 50,000 + Rs. 20,000 = Rs. 70,000.

Depreciation = cost of machine +Salvage value / estimated life of project

= (Rs. 2,00,000 – Rs. 50,000) / 5 = Rs. 30,000

	Year 1	Year 2	Year 3	Year 4	Year 5
EBDT	60,000	65,000	68,000	70,000	70,000
Less: Depreciation	(30,000)	(30,000)	(30,000)	(30,000)	(30,000)
EBT	30,000	35,000	38,000	40,000	40,000
Less: Tax @ 40 %	(12,000)	(14,000)	(15,200)	(16,000)	(16,000)
PAT	18,000	21,000	22,800	24,000	24,000
ADD: Depreciation	40,000	40,000	40,000	40,000	40,000
Annual Cash Inflow	58,000	61,000	62,800	64,000	64,000
Terminal Cash inflow					Rs. 70,000

7. Vikalpa Limited is considering to purchase an asset having an estimated life of 4 years which will cost Rs. 13,00,000 with Installation cost of Rs. 2,00,000. There will be an Increase in working capital in the beginning of the year of Rs. 3,50,000. Scrap value of the new asset after 4 years will be Rs. 4,00,000. Revenues for entire life of machine from new asset is 25,00,000 p.a. other information is as follows:

Annual Cash expenses on new asset Rs. 11,00,000

Book value of old asset today is Rs. 5,00,000

Salvage value of old asset if sold today Rs. 6,00,000

Revenue generated from old asset annually Rs. 19,50,000

Annual Cash expenses of old asset Rs. 12,00,000

Depreciation on new asset is to be charged on 80% of the cost in the ratio of 4:8:6:2 over four years.

Existing asset is to be depreciated at a rate of Rs. 1,25,000 p.a. Tax rate is 30 % on revenues as well as on capital gains / losses. Calculate initial, subsequent and terminal cash flow of the machine. Calculate cash inflow from new machine, cash inflow from old machine, incremental cash inflow, terminal cash inflow and cash outflow for the information provided.

Solution

Initial Cash Outflow = Purchase price of asset + installation cost + Working Capital increase – Salvage/Scrap value of old asset ± Tax on Capital gain/loss on sale of old asset

In this case Salvage value of old asset is Rs.6,00,000 and book value is Rs. 5,00,000. Hence there is a capital gain of Rs. 1,00,000

Capital gain = Salvage value of asset – Book value of asset

Capital loss = Book value of asset – salvage value of asset

Note: There is Capital Gain in case Salvage/Scrap value > Book value and Capital loss in case Book value > Salvage /Scrap value.

While calculating initial cash outflow; Tax on capital loss on sale of asset is subtracted from initial cash outflow and tax on capital gain on sale of asset is added to initial cash outflow.

Initial cash outflow = Rs. 13,00,000 + Rs. 2,00,000 + Rs. 3,50,000 – Rs. 6,00,000 + 30 % of (Rs. 6,00,000 – Rs. 5,00,000) = Rs. 12,80,000.

Depreciation calculation:

Depreciation on new asset is to be charged on 80% of the cost in the ratio of 4:8:6:2 over four years.

So, cost of machine for depreciation purpose according to question = 80 % of (purchase price + installation cost) = 80 % of (Rs. 13,00,000 + Rs. 2,00,000) = Rs. 12,00,000.

Rs. 12,00,000 will be depreciated in the ratio of 4:8:6:2 over four years.

ð 4+8+6+2 = 20

Depreciation year wise:

	Year 1	Year 2	Year 3	Year 4
Depreciation	Rs. 12,00,000 × 4/20 = Rs. 2,40,000	Rs. 12,00,000 × 8/20 = Rs. 4,80,000	Rs. 12,00,000 × 6/20 = Rs.3,60,00	Rs. 12,00,000 × 2/20 = Rs.1,20,000

Calculation of Subsequent Cash inflow, Incremental Cash inflow & Terminal Cash Inflow

Particulars	Year 1(Rs.)	Year 2(Rs.)	Year 3(Rs.)	Year 4(Rs.)
Revenue	2500000	2500000	2500000	2500000
Less: Cash expenses	(11,00,000)	(11,00,000)	(11,00,000)	(11,00,000)
EBDT	14,00,000	14,00,000	14,00,000	14,00,000
Less : Depreciation	2,40,000	4,80,000	3,60,000	1,20,000
EBT	11,60,000	9,20,000	10,40,000	12,80,000
Less: Tax @ 30 %	3,48,000	2,76,000	3,12,000	3,84,000
PAT	8,12,000	6,44,000	7,28,000	8,96,000
Add: Depreciation	2,40,000	4,80,000	3,60,000	1,20,000
Annual cash inflow from new machine	10,52,000	11,24,000	10,88,000	10,16,000
Less: Cash inflow of old asset	(4,92,500)	(4,92,500)	(4,92,500)	(4,92,500)
Incremental cash inflow	559500	631500	595500	523500
Terminal Cash inflow				7,20,000

Calculation of Cash inflow from old machine

Particulars	Year 1 (Rs.)	Year 2(Rs.)	Year 3(Rs.)	Year 4(Rs.)
Revenue	19,50,000	19,50,000	19,50,000	19,50,000
Less: Cash expenses	(12,00,000)	(12,00,000)	(12,00,000)	(12,00,000)
EBDT	6,50,000	6,50,000	6,50,000	6,50,000
Less : Depreciation	(1,25,000)	(1,25,000)	(1,25,000)	(1,25,000)
EBT	5,25,000	5,25,000	5,25,000	5,25,000
Less: Tax @ 30 %	(1,57,500)	(1,57,500)	(1,57,500)	(1,57,500)
PAT	3,67,500	3,67,500	3,67,500	3,67,500
Add: Depreciation	1,25,000	1,25,000	1,25,000	1,25,000
Annual cash inflow from old machine	4,92,500	4,92,500	4,92,500	4,92,500

Calculation of terminal cash inflow

In this case there is a capital gain since Rs. 20 % of Rs. 15,00,000 = Rs. 3,00,000 (WDV at the time of disposal as per the question) is less than Rs. 4,00,000 (Salvage value of new asset)

Capital Gain on sale of asset = Scrap/Salvage value of asset – WDV of asset at the time of disposal

= Rs. 4,00,000 - Rs. 3,00,000 = Rs. 1,00,000

Capital gain tax = 30 % of Rs. 1,00,000 = Rs.30,000

Terminal Cash inflow = Salvage value of new machine - Tax on Capital Gain of asset + Working Capital released

= Rs. 4,00,000 - Rs.30,000 + Rs.3,50,000 = Rs. 7,20,000.

8. RBL Academy is interested in assessing the cash flows associated with the replacement of an old machine by a new machine. The old machine bought few years back has a book value of Rs. 1,20,000 which can be sold for Rs.1,20,000. The salvage value of this machine is zero after 5 years. It is being depreciated annually at the rate of 25 % p.a. (written down value method.) The cost of new machine is Rs.5,00,000 and it will not be required after 5 years. It has a salvage of Rs. 2,00,000. It will be depreciated annually at the rate of 25 % p.a. (Written down value method.) The new machine is expected to bring a saving of Rs. 1,40,000 in operating costs. Investment in working capital would remain unaffected. The tax rate applicable to the firm is 30 per cent. Find out the relevant cash flow for this replacement decision. (Ignore Tax on capital gain / loss).

Solution

Initial Cash outflow = Cost of new machine – salvage value of old machine = Rs. 5,00,000 – Rs. 1,20,000 = Rs. 3,80,000.

Subsequent annual Cash inflow calculation

Particulars	Year 1	Year 2	Year 3	Year 4	Year 5
Saving in cost (EBDT)	140000	140000	140000	140000	140000
Less: Incremental Depreciation	(95,000)	(71,250)	(53,437)	(40,078)	(30,059)
EBT	45,000	68,750	86,563	99,922	109,941
Less: Incremental Tax @ 30 %	(13,500)	(20,625)	(25,969)	29,977	32,982
Incremental PAT	31,500	48,125	60,594	69,946	76,959
Add: Incremental Depreciation	95,000	71,250	53,437	40,078	30,059
Net Cash inflow	1,26,500	1,19,375	1,14,031	1,10,023	1,07,018
Terminal cash inflow					2,00,000

Terminal Cash inflow = Salvage value of new machine = Rs. 2,00,000 (Tax ignored as per the question)

New Machine Depreciation calculation

	Year 1(Rs.)	Year 2(Rs.)	Year 3(Rs.)	Year 4(Rs.)	Year 5(Rs.)
WDV	5,00,000	5,00,000 – 1,25,000 = 3,75,000	3,75,000 - 93,750 = 2,81,250	2,81,250 – 70312.5 = 2,10,937.5	2,10,937.5 - 52,734 = 1,58,202
Depreciation	25 % of 5,00,000 = 1,25,000	25 % of 3,75,000 = 93,750	25 % of 2,81,250 = 70,312	25 % of 2,10,937 = 52,734	25 % of 1,58,202 = 39,551

Old Machine Depreciation calculation

	Year 1(Rs.)	Year 2(Rs.)	Year 3(Rs.)	Year 4(Rs.)	Year 5(Rs.)
WDV	1,20,000	1,20,000- 30,000= 90,000	90,000–22500 = 67500	67500 - 16,875= 50,625	50,625 - 12,656=37,969
Depreciation	25 % of 1,20,000= 30,000	25 % of 90,000 = 22,500	25 % of 67,500 = 16,875	25 % of 50,625= 12,656	25 % of 37,969 =9,492

Calculation of incremental Depreciation

	Year 1(Rs.)	Year 2(Rs.)	Year 3(Rs.)	Year 4(Rs.)	Year 5 (Rs)
Depreciation of new machine	1,25,000	93,750	70,312	52,734	39,551
Less: Depreciation of old machine	(30,000)	(22,500)	(16,875)	(12,656)	(9,492)
Incremental Depreciation	95,000	71,250	53,437	40,078	30,059

9. Vikalpa Ltd is evaluating to replace a semi manually operated machine with a fully automatic one. The existing machine purchased 10 years ago, with book value of Rs. 1,60,000 has remaining life of 10 years. Its Salvage value is Rs. 40,000. The current machine has maintenance expense of Rs. 30,000. The company has been offered Rs. 1,00,000 for the old machine as a trade-in on the automatic model whose delivery price (before allowance for trade-in) is 2,50,000. The estimated life of new machine is 10 years salvage value being Rs.50,000. Installation cost of new machine will be Rs. 50,000. The new machine will help in saving of Rs. 1,10,000 p.a. in operations of the plant. No Maintenance costs are to be incurred by company as it will be borne by seller of machine. The tax rate is 30% (applicable to both revenue income as well as capital gains/losses). Depreciation on both machine is on the basis of Straight line method throughout the life of both machines.. Find out the relevant cash flows.

Solution

Initial Cash Outflow = Purchase price of asset + installation cost + Working Capital increase – Salvage/Scrap value of old asset ± Tax on Capital gain/loss on sale of old asset

In this case Salvage value/ trade in value of old asset is Rs.1,00,000 and book value is Rs. 1,60,000. Hence there is a capital loss of Rs. 60,000

Capital loss = Book value of asset – salvage value of asset

While calculating initial cash outflow; Tax on capital loss on sale of asset is subtracted from initial cash outflow and tax on capital gain on sale of asset is added to initial cash outflow.

Initial cash outflow = Rs. 2,50,000 + Rs. 50,000 – Rs. 1,00,000 - 30 % of (Rs. 1,60,000 – Rs. 1,00,000) = Rs. 1,82,000

Cash inflow in all subsequent years will remain same as incremental depreciation will remain same in all years. Hence there is no need to calculate cash inflow for ten years. Cash inflow generated in first year will be similar to cash inflow in other nine years. In tenth year, terminal cash inflow will also be generated.

Depreciation on new machine = Purchase price excluding allowance for trade in + installation cost – salvage value / estimated life = (Rs. 2,50,000 + Rs. 50,000 – Rs. 50,000) / 10 = Rs. 25,000.

Depreciation on old machine = (Book value of asset – salvage value) / estimated life

= (Rs. 1,60,000 – Rs. 40,000) / 10 = Rs. 12,000

Incremental Depreciation = Depreciation on new machine - Depreciation on old machine

= Rs. 25,000 - Rs. 12,000 = Rs. 13,000

Calculation of subsequent cash inflow

	Rs.
Savings in maintenance	30,000
Saving in operation of plant	1,10,000
EBDT	1,40,000
Less: Incremental Depreciation	(13,000)
EBT	1,27,000
Less: Tax @ 30 %	(38,100)
PAT	88,900
Add: Incremental Depreciation	13,000
Net annual Cash inflow	1,01,900
Terminal cash inflow	Rs. 10,000

Calculation of Terminal Cash inflow

Terminal cash inflow = Salvage value of new machine – sacrifice of salvage value of old machine due to its disposal in the beginning of the year

= Rs. 50,000 – Rs. 40,000 = Rs. 10,000

Note: Since calculation is based on SLM, no capital gain or loss arises as book value of machine is nil at the end of tenth year (For more details, refer to Income Tax Act, 1961). In case, salvage value of old machine is greater than salvage value of new machine then terminal cash inflow will be negative.

10. Vishnu ltd is considering replacing its old machine costing Rs. 1, 60,000 having a written down value of Rs. 64,000. The remaining economic life of the plant is 4 years with zero salvage value at the end of 4 years. However, it has current salvage value of Rs. 60,000 if disposed off today. The new machine being considered to replace old machine is of Rs. 2,50,000 having an economic life of 4 years and salvage value of Rs. 50,000. The new machine, due to its technological superiority, is expected to contribute additional annual benefit (before depreciation and tax) of Rs. 90,000. Find out the cash flows associated with this decision. Tax rate is 30%. (Ignore tax on capital gain or loss).

Solution

Cash outflow = Cost of new machine – scrap value of old machine

= Rs. 2,50,000 – Rs. 60,000 = Rs. 190,000

Depreciation on new machine = Purchase price– salvage value / estimated life

= (Rs. 2,50,000 – Rs. 50,000) / 4 = Rs. 50,000.

Depreciation on old machine = (Book value of asset – salvage value) / estimated life

= Rs. 1,60,000 / 4 = Rs. 40,000

Incremental Depreciation = Depreciation on new machine - Depreciation on old machine

= Rs. 50,000 - Rs. 40,000 = Rs. 10,000

Calculation of subsequent cash inflow

	Rs.
Incremental benefit (EBDT)	90,000
Less: Incremental Depreciation	(10,000)
EBT	80,000
Less: Tax @ 30 %	(24,000)
PAT	64,000
Add: Incremental Depreciation	10,000
Net annual Cash inflow	74,000
Terminal cash inflow	Rs. 50,000

Calculation of Terminal cash inflow

Terminal cash inflow = Salvage value of new machine – sacrifice of salvage value of old machine due to its disposal in the beginning of the year

= Rs. 50,000 – 0 (salvage value of old machine is nil) = Rs.50,000 .

11. RBL Academy purchased a machine two years back at Rs. 1,75,000 has a remaining useful life of 5 years. It is evaluating to replace the old machine with a new one which will cost Rs. 2,50,000 that includes installation cost of Rs. 10,000 and an increase in working capital of Rs. 30,000. The expected cash inflows before depreciation and taxes for both the machines are as follows:

	Year 1 (Rs.)	Year 2(Rs.)	Year 3(Rs.)	Year 4(Rs.)	Year 5(Rs.)
Existing Machine	30,000	30,000	30,000	30,000	30,000
New Machine	70,000	90,000	1,00,000	90,000	1,00,000

The company uses Straight Line Method of depreciation. Tax on income as well as on capital gains/losses is 30%. Calculate the incremental cash flows assuming sale value of existing machine: (i) Rs. 1,20,000, (ii) Rs. 60,000, (iii)Rs. 90,000 and (iv) Rs. 80,000.

Solution

Calculation of incremental initial cash outflow in different cases

Initial Cash Outflow = Purchase price of asset + installation cost + Working Capital increase – Salvage/Scrap value of old asset ± Tax on Capital gain/loss on sale of old asset

	Case 1 Rs.1,20,000	Case 2 Rs.1,25,000	Case 3 Rs.90,000	Case 4 Rs.80,000
Cost of new machine including installation cost	2,50,000	2,50,000	2,50,000	2,50,000
Less: Scrap value of old machine	(1,20,000)	(1,25,000)	(90,000)	(80,000)
Add: increase in working capital	30,000	30,000	30,000	30,000
± Tax saving / paid on loss or gain on sale of old asset	(1,500)	0	(10,500)	(13,500)
Incremental initial cash outflow	1,58,500	1,55,000	1,79,500	1,86,500

Note – Since, in Case I, III and IV, there is a capital loss. Hence, tax calculated on capital loss is subtracted from initial cash outflow. While calculating initial cash outflow; Tax on capital loss on sale of asset is subtracted from initial cash outflow and tax on capital gain on sale of asset is added to initial cash outflow.

Capital loss = Book value of asset – salvage/scrap value of asset

Capital Gain = Salvage/scrap value of asset –Book value of asset

Depreciation on old machine = cost of old machine / estimated life

= Rs. 1,75,000 / (5+2) = Rs. 25,000.

Book value of old machine today = Rs. 1,75,000 – depreciation of 2 years of old machine

= Rs. 1,75,000 – Rs. 50,000 = Rs. 1,25,000

Calculation of tax paid / saved

	Case 1 Rs.1,20,000	Case 2 Rs.1,25,000	Case 3 Rs.90,000	Case 4 Rs.80,000
Book value of old machine	1,25,000	1,25,000	1,25,000	1,25,000
Less : Scrap value of old machine	(1,20,000)	(1,25,000)	(90,000)	(80,000)
Capital gain / loss	5,000 loss	0	35,000 loss	45,000 loss
Tax @ 30 % on Capital gain / loss	1,500	0	10,500	13,500
Since, in Case I, III and IV, there is a capital loss. Hence, tax calculated on capital loss is subtracted from initial cash outflow.

Calculation of subsequent incremental annual cash inflow

	Year 1 (Rs.)	Year 2 (Rs.)	Year 3 (Rs.)	Year 4 (Rs.)	Year 5 (Rs.)
Cash inflow before depreciation and taxes from new machine	70,000	90,000	1,00,000	90,000	1,00,000
Less: Cash inflow before depreciation and taxes from old machine	(30,000)	(30,000)	(30,000)	(30,000)	(30,000)
Incremental Cash inflow before depreciation and taxes	40,000	60,000	70,000	60,000	70,000
Less: Incremental depreciation	(25,000)	(25,000)	(25,000)	(25,000)	(25,000)
EBT (Earning before tax)	15,000	35,000	45,000	35,000	45,000
Less: Tax @ 30 %	(4,500)	(10,500)	(13,500)	(10,500)	(13,500)
PAT	10,500	24,500	31,500	24,500	31,500
Add : incremental depreciation	25,000	25,000	25,000	25,000	25,000
Incremental annual net cash inflow	35,500	49,500	56,500	49,500	56,500
Terminal cash inflow (Release of working capital at the end of 5^th year)					30,000

Calculation of incremental Depreciation

Depreciation on new machine = cost of machine + installation cost / estimated life

= Rs. 2,50,000 / 5 = Rs. 50,000

Depreciation on old machine = cost of old machine / estimated life

= Rs. 1,75,000 / (5+2) = Rs. 25,000

Incremental Depreciation = Depreciation on new machine - Depreciation on old machine

= Rs. 50,000 – Rs. 25,000 = Rs. 25,000

12. RBL Academy Ltd. is considering an expansion plan. Approval of the plan will provide an opportunity of reducing the annual operating cost by Rs. 70,000 over next 5 years. However, it will lead to modification of replacement plans of the company. Consequently, the expenditure plans of Rs. 1,60,000 p.a. for year 3 and 5 will have to increase to Rs. 2,00,000 p.a. and reschedule to occur in year 1 and 4. All other plans will remain unaffected. Find out the relevant cash flows for the expansion plan in respect of the above for first 5 years given that the tax rate is 30% and depreciation charged is as per Straight Line method (life 5 years).

Solution

Calculation of subsequent annual cash inflow

Particulars	Year 1	Year 2	Year 3	Year 4	Year 5
Savings in annual operating cost	70,000	70,000	70,000	70,000	70,000
Less: Tax @ 30 %	(21,000)	(21,000)	(21,000)	(21,000)	(21,000)
Net Saving	49,000	49,000	49,000	49,000	49,000
Add: expenditure not required			1,60,000		1,60,000
Less: new expenditure required	(2,00,000)			(2,00,000)
Incremental tax saving	12,000	12,000	2,400	14,400	4,800
Net Cash inflow	(1,39,000)	61,000	2,11,400	(1,36,600)	2,13,800

Calculation of Incremental tax saving

Incremental tax saving due to change in expenditure plan = Tax saving on new expenditure – Tax saving on planned expenditure changed.

Particulars	Year 1	Year 2	Year 3	Year 4	Year 5
Depreciation on new expenditure	40,000	40,000	40,000	80,000	80,000
Tax saving @ 30 % (A)	12,000	12,000	12,000	24,000	24,000
Depreciation on planned expenditure	0	0	32,000	32,000	64,000
Tax saving @ 30 % (B)	0	0	9,600	9,600	19,200
Incremental tax saving (A-B)	12,000	12,000	2,400	14,400	4,800