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Financial Management
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
Particulars Amount (Rs.)
EBDT /PBDT 2,75,000 Less: Depreciation (1,00,000)
PBT /EBT 1,75,000
Less Tax @ 40 % of EBT/PBT
(70,000)
PAT/EAT 1,05,000
Add: Depreciation 1,00,000
Cash flow 2,05,000
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 Particulars Amount (Rs.)
EBDT /PBDT 4,00,000
Less: Depreciation (2,10,000)
PBT /EBT 1,90,000
Less Tax @ 40 % of EBT/PBT
(76,000)
PAT/EAT 1,14,000
Add: Depreciation 2,10,000
Cash flow 3,24,000
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
Year 1 (Rs.)
Year 2(Rs.)
Year 3(Rs.)
Year 4(Rs.) PBDT 3,00,000 3,00,000 3,00,000 3,00,000
Less
Depreciati on
(2,00,00 0)
(1,60,00 0)
(1,28,00 0)
(1,02,40 0)
PBT 1,00,000 1,40,000 1,72,000 1,97,600 Less Tax
@30 % of PBT
(30,000) (42,000) (51,600) (59,280)
PAT 70,000 98,000 1,20,400 1,38,320 Add
Depreciati on
2,00,000 1,60,000 1,28,000 1,02,400
Cash Flow 2,70,000 2,58,000 2,48,000 2,40,720 Terminal
Cash Flow
Rs.
4,37,880
Calculation on Depreciation
Year 1(Rs.)
Year 2(Rs.) Year 3(Rs.) Year 4(Rs.) Year 5(Rs.) WDV 10,00,000 10,00,000-
2,00,000 = 8,00,000
8,00,000 –1,60,000
= 6,40,000
6,40,000 - 1,28,000 = 5,12,000
5,12,000- 1,02,400 = 4,09,600 Depreciati
on
20 % of 10,00,000
= 2,00,000
20 % of 8,00,000 = 1,60,000
20 % of Rs. 6,40,000
= Rs. 1,28,000
20 % of 5,12,000 = 1,02,400
4. From following income statement of project determine annual cash flow for the company.
Income Statement of the Project Net Sales revenue 7,70,000
- Cost of Goods Sold (3,00,000) - General Expenses (1,50,000) - Depreciation (70,000) Profit before interest
and taxes
2,50,000
- Interest (50,000)
Profit before tax 2,00,000
- Tax@ 30% (60,000)
Profit after tax 1,40,000
Solution
Cash flow of the Project Net Sales revenue 7,70,000 - Cost of Goods Sold (3,00,000) - General Expenses (1,50,000) - Depreciation (70,000) Profit before interest
and taxes
2,50,000
- Tax@ 30% (75,000) Profit after tax 1,75,000 Add: Depreciation 70,000
Cash Flow 2,45,000
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:
Particulars Year 1 (Rs.) Year 2(Rs.) Year 3(Rs.) Year 4(Rs.) Sales in units 100000
units
110000 units
121000 units
133100 units Selling Price
per unit (Rs)
20 20 20 20
Total Sales 20,00,000 22,00,000 24,20,000 26,62,000 less: Variable
cost (VC/unit
× no. of units)
(10,00,000) (11,00,000) (12,10,000) (13,31,000)
less: Fixed cost
(3,00,000) (3,00,000) (3,00,000) (3,00,000) EBDT 7,00,000 8,00,000 9,10,000 10,31,000 Less
:Depreciation
(5,00,000) (3,75,000) (2,81,250) (2,10,937.5) EBT 2,00,000 4,25,000 6,28,750 8,20,062.5 less: Tax @30
% of EBT
(60,000) (1,27,500) (1,88,625) (2,46,018.75) PAT 1,40,000 2,97,500 4,40,125 5,74,043.75 Add:
Depreciation
5,00,000 3,75,000 2,81,250 2,10,937.5 Annual Cash
Inflow
6,40,000 6,72,500 7,21,375 7,84,981.25 Terminal Cash
inflow
Rs.
5,39,843.75
Calculation of Depreciation:
Year 1(Rs.)
Year 2(Rs.) Year 3(Rs.) Year 4(Rs.) Year 5(Rs.) WDV 20,00,000 20,00,000-
5,00,000 = 15,00,000
15,00,000 –3,75,000
= 11,25,000
11,25,000 - 2,81,250 = 8,43,750
8,43,750- 2,10,937.5
=
6,32,812.5 (WDV at the time of
disposal) Depreciati
on
25 % of 20,00,000
25 % of 15,00,000
= 3,75,000
25 % of Rs. 11,25,000 = Rs.
25 % of 8,43,750=
= 5,00,000 2,81,250 2,10,937.5
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
Years Year 1 Year 2 Year 3 Year 4 Year 5 EBDT 60,000 65,000 68,000 70,000 70,000
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
Year 1 Year 2 Year 3 Year 4 Year 5 EBDT 60,000 65,000 68,000 70,000 70,000 Less:
Depreciation
(30,000) (30,000) (30,000) (30,000) (30,000) EBT 30,000 35,000 38,000 40,000 40,000 Less: Tax @
40 %
(12,000) (14,000) (15,200) (16,000) (16,000) PAT 18,000 21,000 22,800 24,000 24,000 ADD:
Depreciation
40,000 40,000 40,000 40,000 40,000 Annual Cash
Inflow
58,000 61,000 62,800 64,000 64,000 Terminal
Cash inflow
Rs. 70,000
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. 12,00,000 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:
Year 1 Year 2 Year 3 Year 4 Depreciation Rs.
12,00,000
× 4/20 = Rs.
2,40,000
Rs.
12,00,000
× 8/20 = Rs.
4,80,000
Rs.
12,00,000
× 6/20 = Rs.3,60,00
Rs.
12,00,000
× 2/20 = Rs.1,20,000
Calculation of Subsequent Cash inflow,
Incremental Cash inflow & Terminal Cash Inflow
Particulars Year 1(Rs.) Year 2(Rs.) Year 3(Rs.) Year 4(Rs.) Revenue 2500000 2500000 2500000 2500000 Less: Cash
expenses
(11,00,000) (11,00,000) (11,00,000) (11,00,000) EBDT 14,00,000 14,00,000 14,00,000 14,00,000 Less :
Depreciation
2,40,000 4,80,000 3,60,000 1,20,000 EBT 11,60,000 9,20,000 10,40,000 12,80,000 Less: Tax @ 30 % 3,48,000 2,76,000 3,12,000 3,84,000 PAT 8,12,000 6,44,000 7,28,000 8,96,000 Add: Depreciation 2,40,000 4,80,000 3,60,000 1,20,000 Annual cash
inflow from new machine
10,52,000 11,24,000 10,88,000 10,16,000
Less: Cash inflow of old asset
(4,92,500) (4,92,500) (4,92,500) (4,92,500) Incremental cash
inflow 559500 631500 595500 523500
Terminal Cash
inflow 7,20,000
Calculation of Cash inflow from old machine
Particulars Year 1 (Rs.) Year 2(Rs.) Year 3(Rs.) Year 4(Rs.) Revenue 19,50,000 19,50,000 19,50,000 19,50,000 Less: Cash
expenses
(12,00,000) (12,00,000) (12,00,000) (12,00,000) EBDT 6,50,000 6,50,000 6,50,000 6,50,000 Less :
Depreciation
(1,25,000) (1,25,000) (1,25,000) (1,25,000) EBT 5,25,000 5,25,000 5,25,000 5,25,000 Less: Tax @ 30 % (1,57,500) (1,57,500) (1,57,500) (1,57,500) PAT 3,67,500 3,67,500 3,67,500 3,67,500 Add: Depreciation 1,25,000 1,25,000 1,25,000 1,25,000 Annual cash
inflow from old machine
4,92,500 4,92,500 4,92,500 4,92,500
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
Particulars Year 1 Year 2 Year 3 Year 4 Year 5
Saving in cost (EBDT)
140000 140000 140000 140000 140000 Less:
Incremental Depreciatio n
(95,000) (71,250) (53,437) (40,078) (30,059)
EBT 45,000 68,750 86,563 99,922 109,941 Less:
Incremental Tax @ 30 %
(13,500) (20,625) (25,969) 29,977 32,982
Incremental PAT
31,500 48,125 60,594 69,946 76,959 Add:
Incremental Depreciatio n
95,000 71,250 53,437 40,078 30,059
Net Cash inflow
1,26,50 0
1,19,37 5
1,14,03 1
1,10,02 3
1,07,01 8
Terminal cash inflow
2,00,00 0
Terminal Cash inflow = Salvage value of new machine = Rs. 2,00,000 (Tax ignored as per the question)
New Machine Depreciation calculation
Year 1(Rs.)
Year 2(Rs.) Year 3(Rs.) Year 4(Rs.) Year 5(Rs.) WDV 5,00,000 5,00,000 –
1,25,000 =
3,75,000 - 93,750 = 2,81,250
2,81,250 – 70312.5 =
2,10,937.5 - 52,734 =
3,75,000 2,10,937.5 1,58,202 Depreciati
on
25 % of 5,00,000 = 1,25,000
25 % of 3,75,000 = 93,750
25 % of 2,81,250 = 70,312
25 % of 2,10,937 = 52,734
25 % of 1,58,202 = 39,551
Old Machine Depreciation calculation
Year 1(Rs.)
Year 2(Rs.) Year 3(Rs.) Year 4(Rs.)
Year 5(Rs.) WDV 1,20,000 1,20,000-
30,000= 90,000
90,000–22500 = 67500
67500 - 16,875= 50,625
50,625 - 12,656= 37,969 Depreciat
ion
25 % of 1,20,000
= 30,000
25 % of 90,000
= 22,500
25 % of 67,500 = 16,875
25 % of 50,625= 12,656
25 % of 37,969
=9,492
Calculation of incremental Depreciation
Year 1(Rs.)
Year 2(Rs.)
Year 3(Rs.)
Year 4(Rs.)
Year 5 (Rs) Depreciation
of new machine
1,25,000 93,750 70,312 52,734 39,551
Less:
Depreciation of old machine
(30,000) (22,500) (16,875) (12,656) (9,492)
Incremental Depreciation
95,000 71,250 53,437 40,078 30,059
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 Rs.
Savings in maintenance 30,000 Saving in operation of 1,10,000
plant
EBDT 1,40,000
Less: Incremental Depreciation
(13,000)
EBT 1,27,000
Less: Tax @ 30 % (38,100)
PAT 88,900
Add: Incremental Depreciation
13,000 Net annual Cash inflow 1,01,900 Terminal cash inflow Rs. 10,000
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 Rs.
Incremental benefit (EBDT)
90,000 Less: Incremental
Depreciation
(10,000)
EBT 80,000
Less: Tax @ 30 % (24,000)
PAT 64,000
Add: Incremental Depreciation
10,000 Net annual Cash inflow 74,000 Terminal cash inflow Rs. 50,000
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:
Year 1 (Rs.)
Year 2(Rs.)
Year 3(Rs.)
Year 4(Rs.)
Year 5(Rs.) Existing
Machine
30,000 30,000 30,000 30,000 30,000 New
Machine
70,000 90,000 1,00,000 90,000 1,00,000
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
Case 1
Rs.1,20,000
Case 2
Rs.1,25,000
Case 3 Rs.90,000
Case 4 Rs.80,000 Cost of new
machine including installation cost
2,50,000 2,50,000 2,50,000 2,50,000
Less: Scrap value of old machine
(1,20,000) (1,25,000) (90,000) (80,000)
Add: increase in working capital
30,000 30,000 30,000 30,000
± Tax saving / paid on loss or gain on sale of old asset
(1,500) 0 (10,500) (13,500)
Incremental initial cash outflow
1,58,500 1,55,000 1,79,500 1,86,500
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
Case 1
Rs.1,20,000
Case 2
Rs.1,25,000
Case 3 Rs.90,000
Case 4 Rs.80,000 Book
value of old
1,25,000 1,25,000 1,25,000 1,25,000
machine Less : Scrap value of old
machine
(1,20,000) (1,25,000) (90,000) (80,000)
Capital gain / loss
5,000 loss 0 35,000 loss
45,000 loss Tax @
30 % on Capital gain / loss
1,500 0 10,500 13,500
Since, in Case I, III and IV, there is a capital loss. Hence, tax calculated on capital loss is subtracted from initial cash outflow.
Calculation of subsequent incremental annual cash inflow
Year 1 (Rs.)
Year 2 (Rs.)
Year 3 (Rs.)
Year 4 (Rs.)
Year 5 (Rs.) Cash inflow before
depreciation and taxes from new machine
70,000 90,000 1,00,00 0
90,000 1,00,000
Less: Cash inflow before (30,000) (30,000) (30,000) (30,000) (30,000)
depreciation and taxes from old machine Incremental Cash inflow before
depreciation and taxes
40,000 60,000 70,000 60,000 70,000
Less: Incremental depreciation
(25,000) (25,000) (25,000) (25,000) (25,000) EBT (Earning before tax) 15,000 35,000 45,000 35,000 45,000 Less: Tax @ 30 % (4,500) (10,500) (13,500) (10,500) (13,500)
PAT 10,500 24,500 31,500 24,500 31,500
Add : incremental depreciation
25,000 25,000 25,000 25,000 25,000 Incremental annual net
cash inflow
35,500 49,500 56,500 49,500 56,500 Terminal cash inflow
(Release of working capital at the end of 5th year)
30,000
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
Particulars Year 1 Year 2 Year 3 Year 4 Year 5 Savings in
annual
operating cost
70,000 70,000 70,000 70,000 70,000
Less: Tax @ 30
%
(21,000) (21,000) (21,000) (21,000) (21,000) Net Saving 49,000 49,000 49,000 49,000 49,000 Add:
expenditure not required
1,60,000 1,60,000
Less: new expenditure required
(2,00,000) (2,00,000)
Incremental tax saving
12,000 12,000 2,400 14,400 4,800 Net Cash inflow (1,39,000) 61,000 2,11,400 (1,36,600) 2,13,800
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.
Particulars Year 1 Year 2 Year 3 Year 4 Year 5 Depreciation
on new
expenditure
40,000 40,000 40,000 80,000 80,000
Tax saving @ 12,000 12,000 12,000 24,000 24,000
30 % (A)
Depreciation on planned expenditure
0 0 32,000 32,000 64,000
Tax saving @ 30 % (B)
0 0 9,600 9,600 19,200 Incremental
tax saving (A- B)
12,000 12,000 2,400 14,400 4,800
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.)
