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7/27/2019 Financial Management I_Chapter 7
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Financial Management 1
BBPW3103Chapter 7
Cash Flow of Capital Budgeting
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Guidelines In estimating Cash Flowfor Capital Budgeting
It is an additional cash flow
Involves the change of cash flow in a project
Suppose that Project A will increased the cashsales revenue from RM1 million to RM1.5million.
So, only RM0.5 million will take into account
as change of cash flow
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Guidelines In estimating Cash Flowfor Capital Budgeting (Cont.)
It takes into account the effects of taxation The cash flow that must take into account is the cash
flow after tax For example : If the tax 30% and total cash flow is
RM1 million. So, only RM700,000 will takes intoaccount
Does not take into account the effect offinancing In estimating cash flow, these costs are not takes into
account especially interest costs of financing The effects of this financing had been taken into
account when the cost of capital is used to discount
the cash flow. If it is taken into account, the effect of this financing
is taken into account twice.
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Guidelines In estimating Cash Flowfor Capital Budgeting (Cont.)
Guidelines to estimate cash flow of capitalbudgeting Disregard Sunk Cost : Sunk Cost is the cost that has
been spent that does not influences the decision onaccepting / rejecting a project. This sunk cost doesnot take into account in calculating of cash flow. Forexample, research laboratory
Do Not Disregard Opportunity Cost : Opportunity cost
can be defined as the cash flow that could had beenobtained if the project under consideration. This costshould into account as cash outflow due to decreasethe company cash flow. For example, rental income
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Guidelines In estimating Cash Flowfor Capital Budgeting (Cont.)
Guidelines to estimate cash flow of capitalbudgeting (Cont.)
Do Not Disregard Side Effect : Refer to effect of
accepting the projects. For example, the effect ofproducing new product such as increasing the cashoutflow
There are 3 types of cash flow based on the
time occurs Initial Outlay (IO)
Operating Cash Flow (OCF)
Terminal Cash Flow (TCF)
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Guidelines In estimating Cash Flowfor Capital Budgeting (Cont.)
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Initial Outflow
Is the total cash outflow at the beginningof the project occur.
There are a few main items that areinvolved in the estimating of IO
Cost of purchasing, installing and transportingthat are involved for the new asset
Change to the net working capital
Sales revenue after tax for the old assets thatmust be sold if the project is accepted
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Cost of Purchasing, Installing andTransporting New Assets
Only cost that be spent to enable theproject to be operational will be takes intoaccount
The cost that not involved directly such assunk cost must didnt take into account
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Changes To Net Working Capital
NWC is differences of current assets and currentliabilities
NWC = Current Assets Current Liabilities Example : The opening of new factory is expected to
increase the level of account payable by RM500,000, theaccount receivable by RM800,000, the level of inventoryby RM400,000 and the level of short term loans byRM100,000.
The change of NWC is
= Acc. Receivable + Inventory - Acc. Payable- Short Term Loans= RM800,000 + RM400,000 RM500,000
RM100,000= RM600,000
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Revenue From Sale of Old AssetsAfter Tax
A new project may need the company to replaceold asset by buy new assets
The sales of old assets will generate cash inflow
to the company and this cash flow must betaxed.
Tax is imposed on the components of capitalgains only and not the entire revenue from the
sale of the assets Capital gain is the surplus of selling from asset
book value
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Revenue From Sale of Old AssetsAfter Tax (Cont.)
There are several equation that must be considered thatis: Sales Revenue
= Selling Price Increase in Tax
Increase in Tax= Tax Rate x Capital Gain
Capital Gain
= Selling Price Book Value
Book Value
= Original Price Accumulated Depreciation Accumulated Depreciation
= Annual Depreciation x Year of Used
Annual Depreciation
= Original Cost Lifetime
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Revenue From Sale of Old AssetsAfter Tax (Cont.)
Example 7.1 : Project A involves thereplacement of an old grinding machinewith a new grinding machine. The old
grinding machine was bought at the priceof RM250,000 3 years ago and has alifetime of 5 years. What is the salesrevenue of the asset after tax if this old
machine can be sold at the price ofRM120,000 now and the marginal tax rateis 30%?
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Revenue From Sale of Old AssetsAfter Tax (Cont.)
Obtain the book value of the old asset
Accumulated Depreciation
= (RM250,000 5 years) x 3 years
= RM150,000
Net Book Value
= Original Price Accumulated Depreciation
= RM250,000 RM150,000
= RM100,000
Obtain the capital gain
= Selling Price Book Value
= RM120,000 RM100,000
= RM20,000
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Revenue From Sale of Old AssetsAfter Tax (Cont.)
Obtain the effect of taxation
= Surplus x Tax Rate
= RM20,000 x 30%
= RM6,000
Define the sales revenue after tax
= Selling Price Increase in Tax
= RM120,000 RM6,000
= RM114,000
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Revenue From Sale of Old AssetsAfter Tax (Cont.)
Example 7.2 : Teguh company plans to purchase anew cement mixing machine, replacing the oldmachine. The old machine was purchased 6 yearsago at RM200,000 and was depreciated using the
straight line method for lifetimes of 10 years.If the company plans to replace this old machine, itcan be sold at the RM120,000. the price of the newmachine is RM300,000 while transporting cost is
RM20,000 and the installation cost is RM10,000.This machine will increase the raw materials byRM20,000 and the account payable increased byRM10,000. The tax rate is 30%. What is the initialoutlay for the machine.
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Revenue From Sale of Old AssetsAfter Tax (Cont.)
Change in Net Working Capital= Inventory Acc. Payable= RM20,000 RM10,000= RM10,000 (outflow)
Accumulated Depreciation= Original Price Lifetime x Used Time= (RM200,000 10 years) x 6 years= RM120,000
Net Book Value= Purchase Price Accumulated Depreciation= RM200,000 RM120,000= RM80,000
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Revenue From Sale of Old AssetsAfter Tax (Cont.)
Capital Gain= Selling Price Book Value= RM120,000 RM80,00= RM40,000
Increase in Tax= Capital Gaun x Tax Rate= RM40,000 x 30%= RM12,000
Sales Revenue After Tax= Selling Price Increase in Tax= RM120,000 RM12,000= RM108,000
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Revenue From Sale of Old AssetsAfter Tax (Cont.)
Initial Outlay
= New Machine Price
+ Transportation Cost
+ Installation Cost
Sale Revenue for Old Asset
= RM300,000 + RM20,000
+ RM10,000 RM108,000
= RM232,000
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Operating Cash Flow (Cont.)
Example 7.3 : Refer to the Teguh Companyinformation for the effect of this project on thelevel of sales, operating expenditure anddepreciation expenses.
The following are the information that has beenobtained The new machine will be used for 4 years and is
depreciated via straight line to the scrap value ofzero.
At the end of 4 years, this machine is expected to besold at the price of RM70,000. With this replacement,the company expected to increase the sales revenueby RM50,000 per year
At the same time, the case expenditure will reduce by
RM5,000 per year.
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Operating Cash Flow (Cont.)
Related Information
S = RM50,000
E = -RM5,000
Change of Depreciation
Old depreciation = RM50,000
New machine depreciation
= (RM300k + RM20K + RM10K) 4
= RM82,500
Change of depreciation
= RM82,500 RM50,000
= RM32,500
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Operating Cash Flow (Cont.)
The Operating Cash Flow
= (S -E -D)(1 t) + D
= [RM50,000 (-RM5,000) RM32,500](1 0.3) + RM32,500
= (RM50,000 + RM5,000 RM32,500)
(0.7) + RM32,500= RM48,250
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Terminal Cash Flow
Total cash flow at the end of the project
There are several items that related to the TCFthat is
Sales revenue after tax of new assetsThe cash flow receive for asset that has been soldmust be taxed.
For example, an asset in the project can be sold atthe price of RM100,000. So, the sales revenue after
tax is= Selling Price Increase in Tax
= RM100,000 (RM100,000 x 0.3)
= RM70,000
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Terminal Cash Flow (Cont.)
Other expenditure related with projecttermination.
The termination of a project involves a clean up cost,moving cost and refurbishment cost. The formula ofExpenditure After tax is
= Expenditure Tax
Suppose a project expected to involves of RM250,000for clean-up cost. If the tax rate is 30%, the clean-upexpenditure tax is
= RM250,000 (RM250,000 x 30%)
= RM250,000 RM75,000
= RM175,000
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Terminal Cash Flow (Cont.)
Regaining the original level of NetWorking Capital.NWC will be increase at the beginning of the
project
When the project is terminated, the company willreturn to its original position before the projectwas implemented
If the NWC increased in the beginning of the
project, the NWC will decrease to the originalposition.
If the NWC decreased in the beginning of theproject, the NWC will increase again to the originalposition
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Terminal Cash Flow (Cont.)
Regaining the original level of Net WorkingCapital.
Example 7.4 : Use the Teguh Company that is evaluating thereplacement of an old grinding machine with a new grinding
machine. Based on the information, the TFC of the project is
Sales revenue after tax of newmachine [RM120,000 (1 0.3)]
RM84,000
Other termination expenditure RM0
Regaining the level of net workingcapital
RM10,000
TCF RM94,000
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Application of Cash Flow for CapitalBudgeting in Decision Making
After the calculation made about IO, OCFand TCF, the company must to makedecision either to accept the project or not
based on PBP and NPV technique. Assumethe cost of capital is 12% and the targetedPBP is 3 years.
IO = RM232,000
OCF = RM48,250
TCF = RM94,000
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Application of Cash Flow for CapitalBudgeting in Decision Making (Cont.)
PBP Technique
The cumulative cash flow for the 3 years,
the PBP is RM144,750 that is less than theinitial cash outlay. So, the project must berejected.
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Application of Cash Flow for CapitalBudgeting in Decision Making (Cont.)
NPV Technique
The NPV value isRM25,680.75. So, theproject must be rejected.