11.3 Finding the Operating Cash Inflows

LG 5 11.3 Finding the Operating Cash Inflows

The benefits expected from a capital expenditure or “project” are embodied in its operating cash inflows, which are incremental after-tax cash inflows. In this sec- tion, we use the income statement format to develop clear definitions of the terms after-tax, cash inflows, and incremental.

INTERPRETING THE TERM AFTER-TAX Benefits expected to result from proposed capital expenditures must be measured

on an after-tax basis because the firm will not have the use of any benefits until it has satisfied the government’s tax claims. These claims depend on the firm’s tax- able income, so deducting taxes before making comparisons between proposed investments is necessary for consistency when evaluating capital expenditure

CHAPTER 11

Capital Budgeting Cash Flows

INTERPRETING THE TERM CASH INFLOWS All benefits expected from a proposed project must be measured on a cash flow

basis. Cash inflows represent dollars that can be spent, not merely “accounting profits.” There is a simple technique for converting after-tax net profits into operating cash inflows. The basic calculation requires adding depreciation and any other noncash charges (amortization and depletion) deducted as expenses on the firm’s income statement back to net profits after taxes. Because deprecia- tion is commonly found on income statements, it is the only noncash charge we consider.

Example 11.6 3 Powell Corporation’s estimates of its revenue and expenses (excluding deprecia- tion and interest), with and without the proposed new machine described in

Example 11.5, are given in Table 11.4. Note that both the expected usable life of the proposed machine and the remaining usable life of the present machine are 5 years. The amount to be depreciated with the proposed machine is calculated by sum- ming the purchase price of $380,000 and the installation costs of $20,000. The proposed machine is to be depreciated under MACRS using a 5-year recovery

period. 4 The resulting depreciation on this machine for each of the 6 years, as well as the remaining 3 years of depreciation (years 4, 5, and 6) on the present machine, are calculated in Table 11.5 (see page 440). 5

The operating cash inflows each year can be calculated by using the income statement format shown in Table 11.6 (see page 440). Note that we exclude interest because we are focusing purely on the “investment decision.” The interest is relevant to the “financing decision,” which is separately considered. Because we exclude interest expense, “earnings before interest and taxes” (EBIT) is equivalent to “net profits before taxes,” and the calculation of “operating cash inflow” in

Powell Corporation’s Revenue and Expenses (Excluding Depreciation TA B L E 1 1 . 4

and Interest) for Proposed and Present Machines

With proposed machine With present machine

Expenses Revenue

Expenses

(excl. depr. and int.) Year

(excl. depr. and int.)

4. As noted in Chapter 4, it takes n+1 years to depreciate an n-year class asset under current tax law. Therefore, MACRS percentages are given for each of 6 years for use in depreciating an asset with a 5-year recovery period.

5. It is important to recognize that, although both machines will provide 5 years of use, the proposed new machine will be depreciated over the 6-year period, whereas the present machine, as noted in the preceding example, has been depreciated over 3 years and therefore has remaining only its final 3 years (years 4, 5, and 6) of depreciation (12%,

PART 5

Long-Term Investment Decisions

Depreciation Expense for Proposed and Present Machines

TA B L E 1 1 . 5

for Powell Corporation

Applicable MACRS depreciation Depreciation

Cost

percentages (from Table 4.2)

With proposed machine

With present machine

12% (year-4 depreciation)

12 (year-5 depreciation)

12,000 4 Because the present machine is at the end of the third year of its cost 5 recovery at the time the analysis is performed, it has only the final 3 6 years of depreciation (as noted above) still applicable.

5 (year-6 depreciation)

Total

$69,600 a

a The total $69,600 represents the book value of the present machine at the end of the third year, as calculated in Example 11.5.

Table 11.6 is equivalent to “operating cash flow (OCF)” (defined in Equation 4.3, on page 122). Simply stated, the income statement format calculates OCF.

Substituting the data from Tables 11.4 and 11.5 into this format and assuming

a 40% tax rate, we get Table 11.7. It demonstrates the calculation of operating cash inflows for each year for both the proposed and the present machine. Because the proposed machine is depreciated over 6 years, the analysis must be performed

Calculation of Operating Cash Inflows

TA B L E 1 1 . 6

Using the Income Statement Format

Revenue - Expenses (excluding depreciation and interest)

Earnings before depreciation, interest, and taxes (EBDIT) - Depreciation Earnings before interest and taxes (EBIT)

- Taxes (rate = T)

Net operating profit after taxes 3NOPAT = EBIT * (1 - T)4

+ Depreciation

Operating cash inflows (same as OCF in Equation 4.3)

CHAPTER 11

Capital Budgeting Cash Flows

TA B L E 1 1 . 7 Calculation of Operating Cash Inflows for Powell Corporation’s Proposed and Present Machines

Year 5 Year 6 With proposed machine

$2,520,000 $2,520,000 $ 0 ⫺ Expenses (excluding depreciation

Revenue a $2,520,000

2,300,000 Earnings before depreciation,

and interest) b 2,300,000

interest, and taxes

48,000 20,000 Earnings before interest and taxes

⫺ Depreciation c 80,000

$ 172,000 $ 172,000 - $20,000 ⫺ Taxes (rate, T = 40%)

68,800 - 8,000 Net operating profit after taxes

48,000 20,000 Operating cash inflows

⫹ Depreciation c 80,000

With present machine

$2,400,000 $2,250,000 $ 0 ⫺ Expenses (excluding depreciation

Revenue a $2,200,000

2,120,000 Earnings before depreciation,

and interest) b 1,990,000

interest, and taxes

0 0 0 Earnings before interest and taxes

⫺ Depreciation c 28,800

$ 150,000 $ 130,000 $ 0 ⫺ Taxes (rate, T = 40%)

52,000 Net operating profit after taxes

0 0 0 Operating cash inflows

⫹ Depreciation c 28,800

$ 90,000 $ 78,000 $ a From column 1 of Table 11.4.

b From column 2 of Table 11.4. c From column 3 of Table 11.5.

over the 6-year period to capture fully the tax effect of its year-6 depreciation. The resulting operating cash inflows are shown in the final row of Table 11.7 for each machine. The $8,000 year-6 operating cash inflow for the proposed machine results solely from the tax benefit of its year-6 depreciation deduction. 6

INTERPRETING THE TERM INCREMENTAL The final step in estimating the operating cash inflows for a proposed replacement

project is to calculate the incremental (relevant) cash inflows. Incremental operating cash inflows are needed because our concern is only with the change in operating cash inflows that result from the proposed project. Clearly, if this were an expansion project, the project’s cash flows would be the incremental cash flows.

6. Although here we have calculated the year-6 operating cash inflow for the proposed machine, this cash flow will

PART 5

Long-Term Investment Decisions

Incremental (Relevant) Operating Cash Inflows

TA B L E 1 1 . 8

for Powell Corporation

Operating cash inflows

Incremental (relevant) Proposed machine a Present machine a [(1) ⴚ (2)]

a From final row for respective machine in Table 11.7.

Example 11.7 3 Table 11.8 demonstrates the calculation of Powell Corporation’s incremental (rel- evant) operating cash inflows for each year. The estimates of operating cash

inflows developed in Table 11.7 appear in columns 1 and 2. Column 2 values rep- resent the amount of operating cash inflows that Powell Corporation will receive if it does not replace the present machine. If the proposed machine replaces the present machine, the firm’s operating cash inflows for each year will be those shown in column 1. Subtracting the present machine’s operating cash inflows from the proposed machine’s operating cash inflows, we get the incremental operating cash inflows for each year, shown in column 3. These cash flows repre- sent the amounts by which each respective year’s cash inflows will increase as a result of the replacement. For example, in year 1, Powell Corporation’s cash inflows would increase by $26,480 if the proposed project were undertaken. Clearly, these are the relevant inflows to be considered when evaluating the bene- fits of making a capital expenditure for the proposed machine. 7

7. The following equation can be used to calculate more directly the incremental cash inflow in year t, ICI t .

ICI t = 3¢EBDIT t * (1 - T) 4 + (¢D t * T) where

¢ EBDIT t = change in earnings before depreciation, interest, and taxes [revenues expenses -

(excl. depr. and int.)] in year t ¢ D t = change in depreciation expense in year t T= firm’s marginal tax rate

Applying this formula to the Powell Corporation data given in Tables 11.4 and 11.5 for year 3, we get the following values of variables:

¢ EBDIT 3 = ($2,520,000 - $2,300,000) - ($2,400,000 - $2,230,000) = $220,000 - $170,000 = $50,000 ¢ D 3 = $76,000 - $12,000 = $64,000

T = 0.40 Substituting into the equation yields

ICI 3 = 3$50,000 * (1 - 0.40)4 + ($64,000 * 0.40) = $30,000 + $25,600 = $55,600

CHAPTER 11

Capital Budgeting Cash Flows

6 REVIEW QUESTIONS 11–9 How does depreciation enter into the calculation of operating cash

inflows? How does the income statement format in Table 11.6 relate to Equation 4.3 (on page 122) for finding operating cash flow (OCF)?

11–10 How are the incremental (relevant) operating cash inflows that are asso- ciated with a replacement decision calculated?