Chapter 17
Managerial Accounting
Cash Flows in Capital
Budgeting Decisions
Prepared by Diane Tanner
University of North Florida
Cash Flows in Capital Budgeting
• Only incremental amounts are considered
• Two categories of cash flows
• Operating activities
• Activities which occur as a result of business
operations during the year
• Found on the income statement
• Investing activities
• Acquisition of long-term assets
• Cash received from sale of long-term assets
Investing Cash Flows
in Capital Budgeting
 Two primary investing cash flows
 Purchase of investment assets at year 0
 Cash from the sale of long-term assets
 Salvage value is an expected cash flow
 If sold at the end of the useful life for the salvage
value, no gain or loss will occur
Accrual Vs. Cash Basis
Operations can be based on:
Cash Basis
Provides:
• Cash inflows
• Cash outflows
Accrual Basis
Provides:
• Amounts earned
• Amounts incurred
An indicator of real profits
Capital Budgeting Assumptions
 Assume all revenue is received in the period
earned
 i.e., Revenue = cash inflows
 Assume that all expenses are paid in the same
period incurred
 i.e., All expenses = cash outflows
 Non-cash items that are never paid nor received
 Depreciation expense
 Amortization expense
 Gains on disposal of long-term assets
 Losses on disposal of long-term assets
Indirect Method of Calculating
Operating Cash Flows
 Begin with accrual basis net income
 Remove items that are not cash flows
 Add
 Noncash expenses (e.g., depreciation, amortization)
 Losses from disposition of long-term assets
 Subtract
 Gains from disposition of long-term assets
Note that basic accruals and deferrals need
not be adjusted because of the assumptions
made in capital budgeting.
Direct Method of Calculating
Operating Cash Flows
 Also known as the shield method
 Calculating cash basis net income
 Omit all non-cash amounts
 Income taxes will be based on cash basis income
before taxes
 Add/subtract the tax shields
Tax Shields
 Tax savings/costs due to reporting expenses that have
no cash flow effect
 Four common tax shields
 Depreciation tax shield
 Depreciation expense × tax rate
 Amortization tax shield
 Amortization expense × tax rate
 Loss tax shield
 Loss on disposal × tax rate
 Gain negative tax shield
 Gain on disposal × tax rate
Tax savings due to
reporting an
expense that does
not use cash
Additional tax cost
due to reporting a
revenue that does
not generate cash
Depreciation tax shield = Depreciation expense x income tax rate
Operating Cash Flows – Indirect Method
FiCo is deciding whether to purchase equipment with a cost of $74,000, an estimated
residual value of $6,000, and an estimated life of 8 years. FinTru predicts the
equipment will reduce annual payroll costs to $360,000 from the current level of
$423,000. Cash operating expenses related to the new equipment are expected to be
$41,200 per year. FiCo’s cost of capital is 7.4%, its required rate of return is 8.8%,
and its income tax rate is 31%. Calculate annual incremental operating cash flows.
Incremental payroll cost savings ($423,000 - $360,000)
Incremental cash operating expenses
Incremental depreciation ($74,000 - $6,000)/8
Income before taxes
Income taxes expense (31% x $13,300)
Incremental net income
Add depreciation
Operating cash flows
$63,000
(41,200)
(8,500)
13,300
(4,123)
9,177
8,500
$17,677
9
Operating Cash Flows – Shield Method
10
FiCo is deciding whether to purchase equipment with a cost of $74,000, an estimated
residual value of $6,000, and an estimated life of 8 years. FinTru predicts the
equipment will reduce annual payroll costs to $360,000 from the current level of
$423,000. Cash operating expenses related to the new equipment are expected to be
$41,200 per year. FiCo’s cost of capital is 7.4%, its required rate of return is 8.8%,
and its income tax rate is 31%. Calculate annual incremental operating cash flows.
Incremental payroll cost savings
Incremental cash operating expenses
Incremental depreciation
Income before taxes
Income taxes expense
Incremental net income
Add depreciation
Operating cash flows
$63,000 $63,000
(41,200) (41,200)
(8,500)
-13,300 21,800
(4,123) (6,758)
9,177
15,042 Cash basis income
2,635
8,500
$17,677 $17,677
Depreciation tax shield = $8,500 x 31% = $2,635
Tax savings:
$6,758 - $4,123 = $2,635
The End
11