CMA Study Group

calculation of annual expected cash flow

  • 1.  calculation of annual expected cash flow

    Posted 15 days ago
     Hi all,
    Can someone explain 
    1. Why after-tax advertisement expense is taken
    2. The annual expected cash flow. shouldn't the depreciation tax shield be added to the after-tax cash flow to arrive at the annual cash flow?
    I have included the question and answer as provided. 

    Right-Way Stores is a chain of home improvement stores with 150 locations. Right-Way has identified an attractive site for a new store and Jim Smith, Director of Financial Planning, has been asked to prepare an analysis and make a recommendation for or against opening this proposed new store. In preparing his analysis, Smith has determined that the land at the proposed site will cost $500,000 and the new store will cost $3.5 million to build. The building contractor requires full payment at the start of construction, and it will take one year to build the store. Right-Way will finance the purchase of the land and construction of the new building with a 40-year mortgage. The mortgage payment will be $118,000 payable annually at year end. Fixtures for the store are estimated to cost $100,000 and will be expensed. Inventory to stock the store is estimated to cost $100,000. Concerned about the possibility of rising prices, the company expects to purchase the fixtures and inventory at the start of construction. Advertising for the grand opening will be $50,000, paid to the advertising agency on retainer at the start of construction. The new store will begin operations one year after the start of construction. Right-Way will depreciate the building over 20 years on a straight-line basis, and is subject to a 35% tax rate. Right-Way uses a 12% hurdle rate to evaluate projects. The company expects to earn aftertax operating income from the new store of $1,200,000 per year. 
    REQUIRED: 
    1. What is Right-Way's total initial cash outflow? Show your calculations.
     2. Calculate the annual expected cash flow from the proposed new store. Show your calculations. 

    Answer provided :

      1. 500,000 + 3,500,000 +100,000 + 100,000 + (50,000 * (1-.35) = $4,232,500 million. 
    2. The scenario tells us that the after-tax operating income is $1,200,000. We find the depreciation expense by dividing the building cost into the depreciation period, $3,500,000 / 20 = $175,000 annual depreciation expense. Assuming the interest on the mortgage is not considered when we discount a cash flow, or it is included in (taken out to arrive at) the $1.2 million, and no change in working capital, we can calculate the Cash Flow three ways:

     a. Simply add the $1,200,000 and the $175,000 to get $1,375,000.

     b. Find total net income: $1,200,000 after tax operating income / 1-.35 = $1,846,150 taxable income. The tax on this is 646,154, getting us back to 1,200,000 net income. Add back the 175,000 depreciation to get $1,375,000.
     
    c. Use depreciation tax shield: Start with the $1,846,154 taxable income. Adding the 175,000 depreciation, we get before tax cash flow of $2,021,154. The tax on this is 707,404, but the depreciation tax shield is 61,250, resulting in 1,375,000 cash flow.   



  • 2.  RE: calculation of annual expected cash flow

    Posted 14 days ago
    Hi Nanditha,
    1. Why after-tax advertisement expense is taken?
    500,000 + 3,500,000 +100,000 + 100,000 + (50,000 * (1-.35) = $4,232,500 million.
    Out of this all the amounts (500,000 + 3,500,000 +100,000 + 100,000) are capital expenses or capital cash outflows. It goes to Balance sheet.

    but $50,000/- paid for advertisement is an expense so its tax deductible. As its an expense the company get tax shield (savings on Tax) . Even though they spend 50000/- they get a tax credit of (50000*35%) = 17500/-.  Eventually they spend only 32500/-

    2. The annual expected cash flow. shouldn't the depreciation tax shield be added to the after-tax cash flow to arrive at the annual cash flow?
    See operating Income means income after Depreciation. In the question it says Operating income after Tax. It means we have availed the benefit of Tax shield.  1.2 Million profit after tax it is . Here the main Non cash expense is Depreciation so we add back to Profit to arrive at cash flow.




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    Mohammed Nadeem
    Accountant
    Vi Sigma Apparel Group FZE
    Abu Dhabi
    United Arab Emirates
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  • 3.  RE: calculation of annual expected cash flow

    Posted 14 days ago
    Hello Nandita,

    1) Why after tax advertisement expense is taken? Because advertisement is a valid operating business expense and is tax deductible per IRS. Hence after tax amount is taken.
    2) For capital budgeting questions, keep it simple. After Tax Operating Income and depreciation keep it separate always ( Unless they give a split of Revenue,operationing cost and depreciation separately and ask you to calculate operating cash flow), when you are calculating NPV or annual cash flow. Operating income $1.2M is given so we take it as is. No change

    As I mentioned earlier, depreciation Tax shield ( Tax saved)= Depreciation amount X Tax rate= $175,000 X 35%= 61,250. This is correct.

    Thanks,
    Kiran





  • 4.  RE: calculation of annual expected cash flow

    Posted 12 days ago
    Hi Naser,

    You are correct

    Why isn't the tax benefit availed on the fixtures and rather capitalized? Since the problem clearly states its expensed.

    See fixtures come under the classification of Fixed asset. Of course its management's policy which asset to be capitalized or expensed out.

    But IRS (Internal Revenue Service) ie. the tax department wont permit you to expense it out. Why because the if you are recording a fixed asset as expense you are reducing the Tax revenue of Government. They permit you to take deduction as Depreciation across the life of the asset.

    Why isn't the tax benefit availed on the fixtures and rather capitalized? Since the problem clearly states its expensed.
    In simple words Fixtures are not a tax deductible expense.

    Hope this will help u.

    ------------------------------
    Mohammed Nadeem
    Accountant
    Vi Sigma Apparel Group FZE
    Abu Dhabi
    United Arab Emirates
    ------------------------------