2024/02/13
Financial Management 332
CALCULATION OF
RELEVANT
CASH FLOWS
Economic and Management Sciences | EyeNzululwazi ngoQoqosho noLawulo | Ekonomiese en Bestuurswetenskappe
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Learning outcomes
By the end of this component, you should be able to:
• Justify why cash flows (not profits) are relevant to capital investment
decisions;
• Explain how tax considerations and depreciation for tax purposes
affect capital budgeting decisions;
• Distinguish between relevant cash flows for replacement and
expansion projects
• Calculate the components of project cash flow:
• Initial investment
• Operating cash flows
• Terminal cash flow
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Introduction
• Objective: Forecast CASH FLOWS associated with a capital
investment project
• Considers a single project within a firm
• Estimate the cash flows that are expected to result from
accepting to invest in a project
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Introduction
Capital investment: Investing large sums of money in a project with
expectation of generating future cash flows that will be sufficient to
warrant the initial investment
➢ Before managers acquire new capital assets, they need to be sure
investment will yield positive NPV
•
Main focus of capital budgeting?
Process of evaluating projects
Need to focus on calculating cash flows
➢ Required to evaluate capital investments to determine if they
contribute to shareholders’ wealth maximisation
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Difference between profit & cash flows
When investigating financial feasibility:
▪ Information required often from Statement of Profit or Loss
▪ Focus only placed on cash flow of project, NOT profit
▪ Reason: profit represents accounting item calculated based on
accounting guidelines
▪ Profit does not necessarily represent cash flow
Another distinction between profit and cash flow:
▪ Profits calculated for certain period of time
▪ Cash flows determined on specific point in time (when cash is
physically received or spent)
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Estimating relevant cash flows
Relevant cash flows:
▪ Cash flow that leads to change in overall future cash flows
▪ Direct consequence of accepting a project
▪ Incremental cash flows
Evaluation of expansion activities:
▪ Focus placed on cash flows associated with new project
Evaluation of replacement activities:
▪ Comparison between:
Current cash flow and
▪ Cash flow after replacement took place
▪
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Estimating relevant cash flows
Sunk costs
▪ Unrecoverable past costs
▪ Excluded when determining project’s incremental
contribution to overall cash flow of business
Opportunity costs
▪ Value of most valuable alternative given up if
investment is undertaken
▪ Included as part of relevant cost
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Estimating relevant cash flows
Finance costs
▪ Already included in company’s cost of capital
▪ Excluded when calculating relevant cash flows
Inflation and tax
▪ After-tax cash flows
▪ Company tax (27%); VAT (15%); Capital gains
inclusion (80%)
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Components of cash flows
• Initial investment
• Operating cash flow
• Terminal cash flow
Operating cash flows
+R8 000 +R10 000 +R12 000 +R14 000
+R16 000
Terminal cash flow
+R15 000
T1
T2
T3
T4
T5
- R40 000
Initial investment
Distinction between replacement and expansion projects
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Calculating the initial investment
Include ALL costs required before production / sales from
project can proceed
Total up-front costs (installed cost)
▪ Cost of investment (land, building, equipment)
▪ Shipping, transport and installation costs
▪ Training costs of employees
Any change in net working capital resulting from project
represents a cash flow
Calculated on an after-tax basis (VAT should be included)
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Calculating the operating cash flows
Capital investment:
• Represents investment in fixed assets required for operating
activities
• Utilising assets will generate cash flows
After initial investment is made:
• Series of cash flows usually generated over the project
lifetime
Major objective:
• Identify projects in which sufficient cash inflows will be
generated to justify initial investment
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Calculating the terminal cash flow
• Cash flows that relate only to the final stage of the
project lifetime
• Realised upon termination of the project
Three common categories:
▪ Estimated after-tax sales proceeds from old/existing
asset
▪ Shut-down costs (removal, repairs)
▪ Recovery of the NWC investment made at beginning
of project lifetime (as part of the initial investment)
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Calculating the relevant cash flow for an
expansion project
• Expansion project:
•
•
Additional capital investment
Expected to increase existing level of operations
• Focus placed on the cash flows associated with the
new project
• Need to consider potential impact on cash flow from
existing projects
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Initial investment for expansion project
Relevant cash flow determined by considering:
• additional cash flows
• that will result from new project
Total cost of the new asset
(xxxx)
Purchasing price
(xxx)
+Shipping and installation cost (xxx)
±Change in net working capital
(xxxx)
Initial investment
(xxxx)
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Operating cash flow for expansion project
• Need to convert profit from the SPL to cash flow
• Starting point:
EBIT = Profit before finance cost and tax
• Recalculate tax based on EBIT to determine NOPAT
• Add back depreciation; amortisation
Income
− Expenses
EBITDA
− Depreciation
EBIT
− Taxes
NOPAT
+ Depreciation
Annual operating cash flows
NEW
xxx
(xxx)
xxx
(xxx)
xxx
(xxx)
xxx
xxx
xxx
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Terminal cash flow for expansion project
After-tax sales proceeds:
• Determine proceeds from selling the asset (sales proceeds
minus removal cost, etc.)
• Compare to book value to determine total profit/loss
• Calculate taxes:
• Capital gains tax
• Accounting tax
asset…..
After-tax proceeds from sale of old
asset
NEW
xxxx
asset…..
Proceeds from sale of old
asset
xxx
± Tax on sale of old
asset
asset…..
xxx
± Change in net working capital
Terminal cash flow
(xxxx)
(xxxx)
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CLASS EXAMPLE
CASH FLOW
PROBLEM 1
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Calculating the relevant cash flow for a
replacement project
• Additional
capital
investment
compared
to proceeds from existing investment
➢ Expected
to result in a
existing level of operations
change
from
the
• Focus placed on the difference in cash flows
generated with the new project compared to
the existing project (incremental cash flows)
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Initial investment for replacement project
• Not sufficient to focus only on cash flows associated with
new asset
• Also need to consider what effect removal of existing asset
has on company’s cash flows
Total cost of new asset
Purchasing price
+Shipping and installation cost
±Change in net working capital
(xxxx)
(xxx)
(xxx)
–After-tax proceeds sale of old asset
Proceeds from sale of old asset
xxx
±Tax on sale of old asset
xxx
±Change in net working capital
Incremental initial investment
(xxxx)
xxxx
(xxxx)
(xxxx)
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Operating cash flow for replacement project
• Comparison between the after-tax operating cash flows
generated by the existing and new projects:
Income
Income
− Expenses − Expenses
EBITDA
EBITDA
− Depreciation
− Depreciation
EBIT
EBIT
− Taxes
− Taxes
NOPAT
NOPAT
+ Depreciation
+ Depreciation
Annual operating
cash
flows
Annual
operating
cash
NEW
xxx
(xxx)
xxx
(xxx)
xxx
(xxx)
xxx
xxx
xxx
flows
OLD
xxx
(xxx)
xxx
(xxx)
xxx
(xxx)
xxx
xxx
xxx
• Incremental after-tax cash flows shows if:
➢ Replacement (new asset) cuts costs or
➢ Provides higher income than old asset
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Terminal cash flow for replacement project
• Relevant cash flow is incremental terminal cash flow
• Calculations for both the new and old asset required
After-tax proceeds from sale of old
newasset
asset
newasset
asset
Proceeds from sale of old
xxx
new
asset
± Tax on sale of old
asset
xxx
± Change in net working capital
(xxxx)
Terminal cash flow
(xxxx)
oldasset
asset
After-tax proceeds from sale of old
Proceeds from sale of old
oldasset
asset
xxx
± Tax on sale of old
oldasset
asset
xxx
± Change in net working capital
Terminal cash flow
xxxx
xxxx
(xxxx)
(xxxx)
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Capital gains tax
• Provision for capital gains tax not necessary when assets are
sold at prices less than their original cost prices
• Is possible, however, that an asset can be sold at price in
excess of not only its book value, but also in excess of its
original purchase price
• In such a situation, transaction will also be exposed to capital
gains tax
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Tax calculations
NB: Unless specified otherwise
• Value added tax (VAT) = 15%
• Corporate tax rate = 27%
• Capital gains tax inclusion rate = 80%
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CLASS EXAMPLE
CASH FLOW
PROBLEM 2
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Conclusion
• The focus should be placed on cash flows, and not profit,
when capital projects are appraised.
• Sunk costs and additional financing costs should not be
included when determining a project’s relevant cash flows.
• In contrast, opportunity costs, inflation and taxes should be
included when estimating a project’s relevant cash flows.
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Conclusion
• Although the procedure differs slightly when estimating cash
flows for an expansion project and a replacement project,
projects usually consist of three types of cash flows, namely:
• Initial investment;
• Operating cash flows during the life of the project; and
• A terminal cash flow.
• In those cases where assets are sold for more than their
original cost price, the resulting capital gain will be taxable.
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