Estimating
Cash Flows |
Cash outflows associated with a capital budgeting proposal may take many forms, but here are a few typical cash outflows:
It is possible that cash outflows can occur in any year of the equipment's life (overhaul of a machine's engine four years after purchasing a new machine, for example). However, virtually all of the cash outflows will typically occur at the time of the asset's purchase. (The time of purchase is typically referred to as "year 0" since "year 1" is one year after the purchase date, etc..)
Two comments should be made regarding the cash outflows.
Fixed assets are frequently purchased in order to reduce the costs of the company - that is, there are savings associated with the purchase of the new asset. These savings may be in any of several areas. For example:
However, by reducing the company's cost, purchase of the machine will tend to increase the company's taxable income. In other words, the company may not get to keep all of the savings associated with buying and using the new machine - the government will take some of it away in the form of higher taxes. We are interested in knowing how much of the savings we get to keep (after paying the higher taxes).
There are two ways of calculating these after-tax cash inflows: a long way and a short way. We'll cover the long way (to help explain what's going on) but suggest using the short way (because it's easier).
The long way to calculate after-tax cash inflows
Let's assume that purchase of a new fixed asset (cost = $30,000, useful life = 5 years) will allow the company to save $10,000 in costs annually. For the sake of illustration, let's also assume that the company is in the 30% tax bracket and uses straight-line depreciation.
Here are the changes to the company, on both an accounting and a cash flow basis, for each year:
Accounting Basis | Cash Flow Basis | |
Change in Sales | $0 | $0 |
- Change in Costs | ($10,000) | ($10,000) |
Change in EBDT* | $10,000 | $10,000 |
- Change in Depreciation | $6,000 | $0 |
Change in Taxable Income | $4,000 | $10,000 |
- Change in Taxes (@30%) | $1,200 | $1,200 |
Change in Net Income | $2,800 | $8,800 |
+ Addback of Change in Depreciation | $6,000 | $0 |
Change in After-tax Cash Flow | $8,800 | $8,800 |
* EBDT = earnings before depreciation and taxes
Notice that:
There is a difference of $6,000 between the two columns' values for change in net income ($2,800 vs. $8,800). This difference is due to the fact that depreciation of $6,000 is subtracted in the accounting column but not in the cash flow column. It is the cash flow of $8,800 that we are looking for. (Notice in the cash flow column that we save $10,000, pay $1,200 of this in the form of higher taxes, and get to keep the remaining $8,800.)
We could calculate this amount as we have done in the cash flow column, but notice that this means that we must also calculate the accounting column in order to determine the amount of taxes to be paid. So most analysts who use this method simply calculate the numbers in the accounting column, then add back the change in depreciation to the change in net income (as show above). This allows us to move relatively quickly to the $8,800 after-tax cash flow that we are looking for.
The short way to calculate after-tax cash inflows
Let's now look at a shorter, and easier, way to calculate the $8,800 cash flow determined above.
We will separate the calculations into two parts:
Adding the two effects together, we have:
Cash Inflow = savings * (1 - tax rate) + change in depreciation * tax rate
Cash Inflow = $10,000 * (1 - 0.30) + $6,000 * 0.30
Cash Inflow = $7,000 + $1,800
Cash Inflow = $8,800So, if you just memorize this little equation, you'll find it fairly easy to calculate the project's cash inflow:
Cash Inflow = savings * (1 - tax rate) + change in depreciation * tax rate
Terminal cash flows
In addition to the "normal" cash inflows, there are a few "unusual" cash flows that occur in the last year of the project's life. These are typically called terminal cash flows because they occur at the termination, or end, of the project's life.
These terminal cash flows typically are:
These terminal cash flows are added to the normal cash inflow for the last year of the project's life.
For more details, follow this link on sunk costs.
- If the discount rate includes an inflation premium (as it almost always will), then the cash flows should reflect the impact of inflation as well.
- If the cash flows do not include the impact of inflation, then the inflation rate should be deducted from the discount rate.
For more details, follow this link on how to treat inflation in a capital budgeting analysis.
The answer is "no". The whole purpose of conducting a capital budgeting analysis is to see if the operating cash flows are large enough to repay us for (1) the amount of money spent for the asset (i.e., the initial investment), (2) our financing cost, and (3) an extra return to cover the risk inherent in our estimates of future cash flows (i.e., the risk premium). The financial costs are captured in the hurdle rate and do not need to be considered again by showing the individual payments on the debt or financing vehicle.
For more details, read this section on cash flows associated with financing the project.
Related Topics
Managing Risk of Cash Flow Estimates in Capital Budgeting Decisions