Estimating Cash Flow of Capital Budgeting Project

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Estimating Cash Flow of Capital Budgeting Project

Capital budgeting is the process of assessing and selecting long-term assets based on their costs and expected returns. The method establishes a framework for developing and executing effective investment strategies. The economic feasibility of long-term investments is determined using cash flow projections. When reviewing an investment proposal, it is vital to assess the cash flow. It is also necessary to estimate the cash outflow and inflow while analysing the cash flow.

The following procedures should be included in the estimation of net cash flow in an investment project:

Step 1: Determination of Net Investment or Net Cash Outlay or Initial Cash Outlay

Net cash outflows at current cost are initial investment or start-up costs. It’s the total of all cash outflows and inflows that happen at the same time. The amount that will be required for the acquisition of fixed assets is referred to as net investment. Cost, freight, installation charges, custom duty, and other costs are included in the initial investment of new fixed assets or projects. Determination of net investment in replacement case is different than investment of new proposal. The following criteria have an impact on determining a replacement proposal’s net investment.

The following are the various factors:

Salvage Value

Salvage value refers to the value that is expected to be realised from asset sales at the end of their usable lives. Depreciation is taken from the cost of assets to determine the amount of depreciation.

Residual value is another term for salvage value.

  • 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

  • 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 differentiating in this situation, we have to adjust the tax. Cash salvage value effects on an estimation of initial cash outlay.

  • 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.

  • 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 purchase 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

  • If cash salvage value is more than book salvage value as well as original value:

    Capital gain is the difference between the cash salvage value and the asset’s original value, while normal gain is the difference between the original value and the book value. 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

  • If cash salvage value is less than book salvage value:

    Sometimes company sells fixed assets less than book salvage value. Company suffers 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 saves on loss on sale of assets…….. = + 20,000

New investment………………………………. = -330,000

Working Capital

Working capital can be described as the funds necessary by a company to support its day-to-day operations. In the event of a new proposal, working capital may increase. Increases in working capital led to an increase in cash outflow. Working capital may decrease from time to time, resulting in an increase in cash inflow. To put it another way, reduction refers to the return on investment, and it should be understood 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 the initial cash outlay. There are other methods for calculating the investment tax credit allowance; however, the technique described below is believed to be the most 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:

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:

After determining the net cash outflow of an investment plan, the second stage of capital budgeting is determined. During this step, the net cash inflow for the project is calculated. It’s known as net cash inflow or after-tax cash flow. It is calculated using the accounting for cash flow approach. The amount of interest is not taken into account when calculating the net cash inflow.

The following table is used to calculate net cash flow:

ParticularsNew machineOld machine
Annual sales (Revenue)XXXXXX
Less: Cash expensesXXXXXX
Earnings before depreciation and taxXXXXXX
Less: Annual depreciation(D)XXXXXX
Earning before tax (EBT)XXXXXX
Earning after tax (EAT)XXXXXX
Add back depreciationXXXXXX
Net cash flow or cash flow after tax (CFAT)XXXXXX

Alternative way of calculating differential cash flow after tax:

Annual increase in salesXXX
Less: increase in cash expensesXXX
Add: decrease in cash expensesXXX
Differential cash flow before taxXXX
Less: differential depreciationXXX
Differential net income before taxXXX
Less: TaxXXX
Differential net income after taxXXX
Add back differential depreciationXXX
Annual differential CFATXXX

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 early on, the net cash outflow will be lower and the net cash inflow will be higher in the final year. It’s known as working capital release.

If working capital is reduced in the first year, net cash outflow increases and net cash inflow decreases in the second year. Similarly, the salvage value of assets has an impact on net cash inflow in the final year. If the salvage value of assets is not provided, the sole factor that affects CFAT is working capital. The tax is adjusted based on the profit or loss on asset sales.

The following table is used to calculate the CFAT for the final year:

For New Proposal:

Annual cash flowXXX
Add: cash salvage value of projectXXX
Less: tax paid on profit on sale of assetsXXX
Add: tax save on loss on sale of assets XXX
Add: working capital increasesXXX
Less: working capital decreasesXXX
Net cash inflow for final yearXXX

Differential Cash Flow (Replacement Proposal)

ParticularsNew machineOld machine
Annual cash flow after taxXXXXXX
Add: cash salvage of machineXXXXXX
Less: Tax paidXXXXXX
Add: Tax saveXXXXXX
Add: working capital increaseXXXXXX
Less: working capital decreaseXXXXXX
Net cash inflow for the final yearXXXXXX

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