CASH FLOW ESTIMATION
Free Cash Flow = Net Operating Income after Tax + Non-cash expenses –Increase in Capital
Expenditure – Increase in Net Working Capital
The Non-Cash expenses we take here is Depreciation.
Capital expenditure is the investment in the operating assets (long lived assets).
Net Working capital is the difference of current assets and current liabilities i.e CA – CL
Net Operating Income after Tax = EBIT (1-T)
FCF = EBIT (1-T) +Depreciation – Increase in Operating Capital –increase in NWC
Tax is paid on all gains.
Tax rebate is availed on all losses.
If the asset having a book value of Rs. 20,000 is sold at Rs. 25,000.
Cash received 25,000
Gain on sale 5,000
Tax on gain 40% (2,000)
Net Cash Flow 23,000
If the asset is sold at Rs 18,000
Cash Received 18,000
Loss on Sale 2,000
Tax Rebate40% 800
Net cash flow 18,800
Depreciation is an expense taken in income statement, but it is added back for the computation
of cash flow.
Methods of Depreciation:
Straight Line Method Depreciation per year = (Cost – Salvage value)/ Estimated Life
Accelerated Method
MACRS: Modified Accelerated Cost recovery System
Depreciation rates are already calculated with an assumption that 100% of the cost is recovered
that means no salvage value
3 years class: 33%,45%,15%,7%
5 years Class 20%,32%,19%12%,11%,6%
7 years class 14%,25%,17%,13%,9%,9%,9%,4%
R REPLACEMENT ANALYSIS
Four years back , an equipment was purchased at $ 3600 with 8 years life and $ 400 salvage
value at the end of the period. With that equipment, the company is producing and selling
goods for $ 2500 per year. The operating cost of goods sold is $ 1,200 except depreciation. The
depreciation is calculated on a straight line method. The old machine may be sold at $ 600 at
the end of 8th year
Today Company is thinking to replace this old machine with a new one having a cost of $ 4,000 with four
years of life. This new machine will not increase the production, so the production and sales remains
$ 2500 per year but will reduce the operating cost to $ 280 each year. The machine is subject to 3 years
MACRS (Deprecation) method. 33%,45%,15%,7%. The company is in a tax Bracket of 40%
If the new machine is acquired then old machine may be sold today at $2,000 (Book Value).
The cost of capital is 10%
Depreciation/year = (3600-400)/8 = 400
Depreciation for four years =1600
Book value = 3600-1600= 2,000
Should this old equipment be replaced with a new one or not?
Cost of the old Machine $ 3,600
Depreciation of old machine (1,600)
Book Value of old Machine 2,000
Cost of new (4,000)
Cash flow from old machine 2,000
Additional cash to be paid (Cash outflow) Investment in year 0 (2,000)
Incremental new - old
0 1 2 3 4
Investment (2,000)
Revenue-New 2500 2500 2500 2500
-old (2500) (2500) (2500) (2500)
Change in Revenue - - - -
Operating Cost-New (280) (280 (280) (280)
-Old (1200) (1200) (1200) (1200)
Change in OC (Cost Savings) 920 920 920 920
Depreciation-New (1320) (1800) (600) (280)
Old (400) (400) (400) (400)
Change in depreciation (920) (1400) (200) 120
Net change in savings - (480) 720 1040
Tax (40%) - 192 (288) (416)
Net change after Tax - (288) 432 624
Add Depreciation 920 1400 200 ( 120)
Total (2000) 920 1112 632 504
Add Sale of old Machine 600
Tax on Gain of old Machine(600-400) (80)
Free Cash Flows (2,000) 920 1112 632 1024
PVIF at 10% 1 1/(1.1)=0.909 1/(1.1)2=0.826 1/(1.1)3=0.751 1/(1.1)4=0.683
PV (2,000) 836.28 918.58 474.63 699.39
NPV 929.68
The new equipment is to be replaced with an old one
NEW PROJECT
Cost of the equipment 100,000
Units Sold 5500
Increase in units sold 4%
Sales price per unit $ 12
variable Cost per unit $6.0
Non variable cost yr. 1 $ 2,000
Project WACC 10%
Tax rate 40%
Working Capital 20,000
Depreciation 3 years MACRS Class (33%, 45%,15%, 7%)
Life of new project is 4 years.
Working capital will be recovered at the end of the period
Equipment will become scrap and will have no value at the end of 4th year
Year 0 1 2 3 4
Investment
Equipment (100,000)
Working Capital (20,000)
Units sold 5500 5720 5949 6187
Sales 66,000 68,640 71,388 74,244
Variable Cost (33,000) (34,320) (35,694) (37,122)
Fixed cost (2,000) (2,000) (2,000) (2,000)
Depreciation (33,000) (45,000) (15,000) (7,000)
EBIT (2,000) (12,680) 18,694 28,122
Tax 40% (EBIT * 40%) 800 5,072 (7,478) (11,249)
EBIT(1-T) (1200) (7,608) 11,216 16,873
Add Depreciation 33,000 45,000 15,000 7,000
Recovery of WC 20,000
Free Cash Flow (120,000) 31,800 37,392 26,216 43,873
PVIF at 10 PVIF at 10% 1 1/(1.1)=0.909 1/(1.1)2=0.826 1/(1.1)3=0.751 1/(1.1)4=0.683
PV (120,000) 28,907 30,886 19,688 29,965
NPV (10,525)
