Financial Mangement (FIN 306)

Incremental Cash Flows

Lecture I

Chapter 10

Dr. Muhammad Asim Faheem

Department Of Banking and Finance

Powerpoint Templates
Page 1
 Lecture Outline
• The Importance of Cash Flow
• Estimating Cash Flow for New Projects
Incremental Cash Flow
 Sunk costs
 Opportunity costs
 Erosion costs
 Working capital
 Capital Spending and Depreciation
 Straight-line depreciation
 MACRS
 Cash Flow and the Disposal of Capital Equipment

• Projected Cash Flow for a New Project

A Case Study

Powerpoint Templates
Page 2
 The Importance of Cash Flow

 Cash flow measures the actual inflow and outflow of

cash, while profits represent merely an accounting
measure of periodic performance.

 A firm can spend its operating cash flow but not its net
income.

 Some firms have net losses (due to high depreciation

write-offs) and yet can pay dividends from cash
balances, while others show profits and may not have
the cash available for even a small dividend to
shareholders.

 Thus, cash flow is broader than net income.

Powerpoint Templates
Page 3
 The Importance of Cash Flow

In Figure 2--modified income -- it only considers the cash flow arising from
operations. Interest expense (which is a financing cash flow) is not included,
and depreciation (which had been deducted in Income Statement mainly for
tax purposes) is added back.
OCF = EBIT – Taxes + Depreciation = $5,046 - $1,555 + $1,112 = $4,603
OCF = Net Income + Interest + Depreciation = $3,313 + $178 +$1,112 = $4,603

Powerpoint Templates
Page 4
 Estimating Cash Flow for New Projects
Incremental Cash Flow

• For expansion, replacement or new project analysis,

incremental effects on revenues and expenses must be
considered.
• Careful estimation and evaluation of the timing and magnitude of
incremental cash flows is very important.

• 7 important issues to be considered and valued:

• sunk costs,
• opportunity cost,
• erosion,
• synergy gains,
• working capital,
• capital expenditures, and
• depreciation or cost recovery of
assets.
Powerpoint Templates
Page 5
 Sunk Costs

• Expenses that have already been

incurred, or that will be incurred,
regardless of the decision to accept or
reject a project.
• For example, a marketing research study exploring
business possibilities in a region would be a sunk cost,
since its expenditure has been done prior to undertaking
the project and will have to be paid whether or not the
project is taken on.
• These costs although part of the income statement,
should not be considered as part of the relevant
cash flows when evaluating a capital budgeting
proposal.

Powerpoint Templates
Page 6
 Sunk Costs

Example One, Sunk Cost? Example Two, Sunk Cost?

• The College of Business is • The capital campaign has
exploring the idea of a new been a success in raising the
building. An architect is hired money for the new building.
to draw up a building concept The same architect firm will be
for use in the capital hired to design the new
campaign. Should the costs of building. Should the costs of
the architect be included in the the architect be included in the
CF evaluation of the building CF evaluation of the building
project? project?
• ANSWER: NO • ANSWER: YES

Powerpoint Templates
Page 7
 Opportunity Costs
 Costs that may not be directly
observable or obvious, but
result from benefits being lost
as a result of taking on a
project.
 For example, if a firm decides to use an idle piece
of equipment as part of a new business, the value
of the equipment that could be realized by either
selling or leasing it would be a relevant
opportunity cost.

 These costs should be

included.
Powerpoint Templates
Page 8
 Opportunity costs

Opportunity Cost? Opportunity Cost?

• The Tea Garden is going to • The Tea Garden is going to use

expand its current operations. It the empty space on the north side
will utilize some existing shelving of their existing building for the
materials currently in storage. If it expansion. If they did not expand
do not go through with the the space would remain empty.
expansion the shelving materials
could be sold. • Opportunity Cost?

• Opportunity Cost?
• No, the empty space does not
• Yes, the fair market price of the have any potential for
used shelving materials. generating income through
leasing of the space so no cost.

Powerpoint Templates
Page 9
 Erosion costs

• Costs that arise when a new product or service competes

with revenue generated by a current product or service
offered by a firm.

• For example, if a store offers two types of

photo-copying services, a newer, more
expensive choice and an older economical
one.

• Some of the revenues generated from the

newer copier will be from older repeat
customers that would have used the older
copier and should therefore be eliminated
from revenue for the incremental cash flows
of the new copier.
Powerpoint Templates
Page 10
 Erosion costs

Example: Erosion costs.

Frosty Desserts currently sell 100,000 of its Strawberry-
Shortcake Delight each year, for $3.50 per serving.
Its cost per serving is $1.75.
Its chef has come up with a newer, richer blend, “Extra-
Creamy Strawberry Wonder,” which costs $2.00 per serving,
with retail for $4.50 and should bring in 130,000 customers
(unit sales).
Is the incremental cash flow $325,000 i.e.(130,000 x ($4.50 -
$2.00))?
No…
It is estimated that after the launch of the new dessert the
sales for the original variety will drop by 15%.
Estimate the erosion cost associated with this venture.

Powerpoint Templates
10-11
Page 11
 Erosion costs

Example: Erosion cost (Answer)

To calculate the erosion cost we must consider the
amount of lost contribution margin,
(Selling price – unit cost) from SSD’s drop in sales.
Erosion cost = Eroded Sales x (Selling Price – Unit Cost)
Erosion cost = (100,000 x 0.15) x ($3.50 - $1.75)
= $26,250
Therefore, the new launch will add only $298,750
incremental cash flow ($325,000 - $26,250).

Powerpoint Templates
Page 12
 Synergy gains

The impulse purchases or sales increases for

other existing products related to the introduction
of a new product.
For example, if a gas station with a convenience store
attached, adds a line of fresh donuts and bagels, the
additional sales of coffee and milk, would result in
synergy gains.

We often think of these in economic terms…

Substitute Products mean erosion
Complementary products mean synergy gains

Powerpoint Templates
Page 13
 Working Capital
• Additional cash flows arising from changes in current
assets such as inventory and receivables (uses) and
current liabilities such as accounts payables (sources) that
occur as a result of a new project.

• Generally, at the end of the project, these additional cash

flows are recovered and must be accordingly shown as
cash inflows.

• Even though the net cash outflows -- due to

increase in net working capital at the start--
may equal the net cash inflow arising from
the liquidation of the assets at the end, the
time value of money makes these costs
relevant.

Powerpoint Templates
Page 14
 Capital Spending and Depreciation

Capital expenditures are “investments in long-term assets”

and are allowed to be expensed on an annual basis. This
provides a future tax shield for the cash flow in subsequent
years.

The portion written off in the income statement, each year, is called the
depreciation expense; and the accumulated total kept track of in the
Balance Sheet is known as Accumulated Depreciation.

Thus, the book value of an asset equals its original cost less its
accumulated depreciation.

The two reasons we need to deal with depreciation when doing capital
budgeting problems are:

The tax flow implications from the annual operating cash flow (OCF) and
The gain or loss at disposal of a capital asset.

Powerpoint Templates
Page 15
 Straight-line Depreciation vs. MACRS
Modified Accelerated Cost Recovery System

• The annual depreciation expense is calculated by dividing the

initial cost plus installation minus the expected residual value
(at termination) equally over the expected productive life of
the asset.
• The annual depreciation expenses are the same for each year. If
you were to graph the expense on the y-axis and time on the x-
axis, you would observe a straight-line (horizontal) over the life of
the asset.

• MACRS rates are established by the federal government. Since 1981

MACRS (originally ACRS) has allowed for firms to accelerate the
depreciation write-off in early years of the asset’s life.
• These rates are set up based on various asset categories (class-lives).

• The assets are fully depreciated over the asset life class and there is no
anticipated residual value for tax purposes.

Powerpoint Templates
Page 16
 MACRS
Modified Accelerated Cost Recovery System

Powerpoint Templates
Page 17
 MACRS
Modified Accelerated Cost Recovery System

Powerpoint Templates
Page 18
 MACRS
Modified Accelerated Cost Recovery System

Example: MACRS Depreciation

The Grand Junction Furniture Company has just bought some specialty tools to be
used in the manufacture of high-end furniture. The cost of the equipment is $400,000
with an additional $30,000 for installation. If the company has a marginal tax rate of
30%, compare its annual tax savings that would be realized from using MACRS
depreciation rates.

Example: MACRS depreciation (Answer)

According to Table, Specialty tools falls under a 3-year class asset with rates in Years 1-4 of
33.33%, 44.45%, 14.81%, and 7.41% respectively.
Depreciable basis = Cost + Installation = $400,000 + $30,000 = $430,000
The annual depreciation expenses (i.e. annual rate x depreciation basis of $430,000)are
shown below:
MACRS
Year rate Dep. Exp
1 33.33% $143,319
2 44.45% $191,135
3 14.81% $ 63,683
4 7.41% $ 31,863
Total 100.00% $430,000
Powerpoint Templates
Page 19
 MACRS
Modified Accelerated Cost Recovery System

Example: MACRS depreciation (Answer)

Each year’s depreciation expense is deducted from revenue, along
with other expenses to determine taxable income. So the
depreciation expense times the tax rate gives you the reduction in
annual taxes (a tax shield).
Year One: $143,319 x 0.30 = $42,996 (rounded to nearest $)
Year Two: $191,135 x 0.30 = $57,341
Year Three: $63,683 x 0.30 = $19,105
Year Four: $31,863 x 0.30 = $9,559
Under straight-line each year is the same,
$430,000 / 3 x 0.30 = $43,000
In both cases the total tax shield is $129,000 but with MACRS you get
more of the tax shield in the first two years.
Powerpoint Templates
Page 20
 Cash Flow and the Disposal of Capital Equipment

When a depreciable asset is sold, the cash inflow that results can be higher
than, equal to, or lower than the actual selling price of the asset, depending on
whether it was sold above (taxable gain), at (zero-gain) or below (tax credit) book
value.

Note:
If Selling Price > BV Cash Inflow = Selling Price less tax

If Selling Price < BV Cash Inflow = Selling Price + tax credit

If Selling Price = BV Cash Inflow = Selling Price

Powerpoint Templates
Page 21
Cash Flow and the Disposal of Capital Equipment

Let’s say that the manager of the Grand Junction Furniture Company decides to dispose of the
specialty tools, acquired 2 years ago at a cost of $430,000 (including installation), to another
firm for $125,000. How much of an after-tax cash flow will result, assuming that the tools were
being depreciated based on the 3-year MACRS rates and the company’s marginal tax rate is
35%

Solution

Depreciable basis = $430,000

Year 1 depreciation rate = 33.33%
Year 2 depreciation rate = 44.45%
Total depreciation taken so far = $430,000 × (33.33% + 44.45%) = $334, 454
Book Value = Depreciable basis – Accumulated depreciation

Book Value = $430,000 – $334,454 = $95,546

Powerpoint Templates
Page 22
Cash Flow and the Disposal of Capital Equipment

Selling price = $125,000 > Book Value Taxable gain on the sale

Taxable gain = $125,000-$95,546=$29,454

After-tax Salvage Value = Selling Price – (Tax rate × Taxable gain )

=$125,000 – .35 × ($29,454)

=$125,000-$10,308.9=$114,691.1

After-tax Salvage Value = $114,691.1

Powerpoint Templates
Page 23