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

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

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

Calculation on Depreciation

4. From following income statement of project determine annual cash flow for the company.

Solution

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:

Calculation of Depreciation:

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

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

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. 13,00,000

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.

• 4+8+6+2 = 20

Depreciation year wise:

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

Calculation of Cash inflow from old machine

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.

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.

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

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

New Machine Depreciation calculation

Old Machine Depreciation calculation

Calculation of incremental Depreciation

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

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

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:

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

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

Calculation of subsequent incremental annual cash inflow

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

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.

Depreciation on new expenditure incurred in year 1 = Rs. 2,00,000 / 5 = Rs. 40,000

Depreciation on new expenditure incurred in year 4 = Rs. 2,00,000 / 5 = Rs. 40,000

In 4th and 5th year Depreciation amount will be Rs. 40,000 + Rs. 40,000 = Rs. 80,000 ( expenditure has been incurred in year 1 and 4 ).

Depreciation on planned expenditure of year 3 = Rs. 1,60,000 / 5 = Rs. 32,000

Depreciation on planned expenditure of year 5 = Rs. 1,60,000 / 5 = Rs. 32,000

In 5th year Depreciation amount will be Rs. 32,000 + Rs. 32,000 = Rs. 64,000 (expenditure of year 3 and 5 both should be considered.)