fm 3 notes by narain

7/30/2019 Fm 3 notes by narain

1/14

Narain

Cost Benefit measurement

Profit is not a theoretical superior basis ofmeasurement

Cash Flow is considered to be the superiorbasis of measurement

Is not affected by the Accounting conventions

Objective and verifiable

Cash Flow models can also be taken atdifferent levels of analysis

Operating Free Cash Flow

Free Cash Flow to Equity


2/14

Narain

Cash Flows of the Project

Aftertax incremental operating cash flows

Only the cash flows which are incremental in natureand directly attributable to the project are relevant

Net of tax effect

tax liability or tax shield

Depreciation & Amortisation non cash items butaffects taxes

Indirect overheads ignore if not affected by the

project

Effect on other projects consider with the projectsflows

Opportunity costs consider with the project flows


3/14

Narain

Cash Flows of the Project

Financial charges ignore in the project flows

Investment & Financing decisions are

considered separately

Avoids double counting as these charges are

reflected in the hurdle rate

Changes in working capital consider with

the project flows Only changes are considered

Need arise because account books are kept on

accrual basis


4/14

Narain

Proforma Cash Flow Statement

1. Cash flow from operations

Profit before tax

+ Depreciation & other non-cash items

+ Interest & other non-operating items- Income tax paid

- Increase in Working Capital

2. Cash flow from investing

Cash paid to acquire Fixed AssetCash received for disposing Fixed Asset

3. Cash flow from financing

Interest/Dividend paid

Capital funds raised


5/14

Narain

Cash flow computation

With the help of following projected Income Statement,calculate the cash inflow:

Net Sales Revenue 475000

Cost of goods sold 200000

General expenses 100000

Depreciation 50000 350000

Profit before interest and taxes 125000

Interest 25000

Profit before tax 100000

Tax @30% 30000

Profit after tax 70000


6/14

Narain

Cash flow computations

The cost of a new plant is Rs. 5,00,000. Ithas an estimated life of 5 years after

which it would be disposed off (scrapvalue is nil). Profit before depreciation,interest and taxes (PBIT) is estimated tobe Rs. 1,75,000 p.a.

Find out the yearly cash flow from the plant,if tax rate is assumed to be 30% anddepreciation is provided on straight line

basis.


7/14

Narain

Cash flow computations

ABC Ltd. is evaluating a capital budgetingproposal for which relevant figures are asfollows:

Compute cash flows for the relevant periodassuming written down method of providing

depreciation.

Cost of Plant Rs. 11,00,000Installation cost Rs. 3,400

Economic life 7 years

Scrap value Rs. 30,000

Profit before depreciation and tax Rs. 5,00,000Tax rate 30%


8/14

Narain

Illustration 1

A company will create a computer facility at thecost of Rs. 2 lac. The annual maintenancecost shall be Rs. 20,000. After 5 years the

system will be phased out. The expectedscrap value is Rs. 40,000. The project grosscash inflows are expected to be:

Compute the cash flows for the project if taxrate is 30% and depreciation is provided at

60% WDV.

1st yr 2nd yr 3rd yr 4th yr 5th yr

50,000 80,000 1,00,000 80,000 60,000


9/14

Narain

Illustration 2

A firm is using a two year old machine that waspurchased for Rs. 70,000. The remaining life is 5years. Depreciation rate is 40%.

Firm is considering its replacement with a newmachine costing Rs. 1,40,000 which would be used for5 years. The installation charges will be Rs. 10,000.The increase in the working capital requirement will beRs. 20,000 as a result of using the new machine. The

firm is subject to income tax rate of 35% and capitalgains tax rate of 30%.

Determine the initial cash flow if salvage value of existingmachine is (a) 80,000 (b) 60,000 (c) 50,000 (d)20,000.


10/14

Narain

Illustration 3

A machine has a book value of Rs. 90,000. andremaining life of 5 years. It is depreciable @20%. Its present salvage value is its book

value but nil after 5 years.

It can be replaced with a new machine worthRs. 4,00,000. It will have a salvage value of

Rs. 2,50,000 after 5 years. The new machinewill save Rs. 1,00,000 p.a. in manufacturingcosts. It will depreciate @ 33.33%. The taxrate is 35%.

Determine the post tax incremental cash flow.


11/14

Narain

Exercise

A machine purchased for Rs. 96,000 has a bookvalue of Rs. 24,000 and remaining life of 4years. It is depreciable @ 50%. Its present

salvage value is Rs. 20,000 but nil after 4years.

It can be replaced with a new machine worth

Rs. 1,30,000. It will have a salvage value ofRs. 8,000 after 4 years. The new machine willsave Rs. 60,000 in manufacturing costs. Itwill depreciate @ 40%. The tax rate is 35%.

Determine the post tax incremental cash flow.


12/14

IllustrationFind incremental CFAT from the following information:

Purchase price of the new asset 10,00,000Installation costs 2,00,000

Increase in working capital in year zero 2,50,000

Scrap value of the new asset after 4 years 3,50,000

Annual revenues from new asset 21,50,000

Annual cash expenses on new asset 9,50,000

Current book value of old asset 4,00,000

Present scrap value of old asset 5,00,000

Annual revenue from old asset 19,25,000

Annual cash expenses on old asset 11,25,000

Planning period 4 years

Depreciation on new asset 20%

Depreciation on old asset 25%

Tax rate 30%


13/14

Exercise

A company is considering to install a machine costing Rs.5,00,000 with an additional investment of Rs. 1,50,000 forits installation. The salvage value at the end of year 10 is

estimated at Rs. 2,50,000. The machine is estimated togenerate a sales revenue of Rs. 20,00,000 in the first yearand the sales are expected to grow at 5% p.a. for theremaining life of the machine. The profit after tax isexpected at 10% of the sales while the working capitalrequirement are expected to be 5% of the sales.

Compute the cash flows assuming SLM depreciation andadditional working capital is required at the beginning ofeach year and is fully salvageable.


14/14

Narain

Solution

Initial investment outlay Rs. 7,50,000

First Year CFAT Rs. 2,35,000

Second Year CFAT Rs. 2,44,750

Third Year CFAT

Rs. 2,54,987

Fourth Year CFAT Rs. 2,65,737

Fifth Year CFAT Rs. 2,77,024

Sixth Year CFAT Rs. 2,88,875

Seventh Year CFAT Rs. 3,01,319

Eighth Year CFAT Rs. 3,14,385

Ninth Year CFAT Rs. 3,28,104

Tenth Year CFAT

Rs. 7,55,396

fm 3 notes by narain

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