CMA Study Group

Help with calculation of cashflow for final year.

  • 1.  Help with calculation of cashflow for final year.

    Posted 17 days ago


    Dear All,

    I need some help with the calculation of cash flows. I am confused with depreciation tax shield calculation and also the net of tax on gain calculation. I have an unclear understanding of the entire formula. I have added a question with the answer. Would be great if you could help!


     Carl Corporation is considering a $1,000,000 investment that will have a three-year life. Working capital of $250,000 will be required at the beginning of the project. At the end of the project, the equipment will be sold for an estimated $400,000. Carl Corporation's required rate of return is 10%. The company expects annual cash flow of $400,000. Carl Corporation's tax rate is 40%. The equipment will be depreciated over a three-year period for tax purposes, and the depreciation rates for tax purposes (MACRS) are as follows:



        Year                    Depreciation rate


           1                               33.33%

           2                               44.45%

           3                               14.61%

           4                                7.41%

    Present value factors are as follows:




    Year PV of $1

      PV of an Annuity







    10%      10%       11% 11%12%12%
    1.90909.90909.89286.90909.90909.89286
    2.8264581162.79719.73554.71252

    .69005

    3.75132.73119.71178.48685.44371

    .40183


    4.6830165873  .63552.16986.10245

    .03735


    What is the cash flow in the final year?

    The answer:

    The final year's cash flow consists of:

            

                    Operating cash flow                  $240,000

                    Depreciation   Tax Shield          59,240

                    Proceeds from sale,

                    net of tax on gain:

                    $400,000-.4*(400,000-74100)    269,640

                    Released working capital           250,000

                    Total cash flow                            818,880

    Could you explain the answer? Thank you!


    Regards,

    Nanditha James




  • 2.  RE: Help with calculation of cashflow for final year.

    Posted 16 days ago
    Hello Nandita,

    the answer you have provided is the correct one or what you have calculated?

    Before calculation of depreciation tax shield, we need to understand Depreciation is non cash expenditure and why it is included in capital budgeting because it reduces the taxes that we need to pay.( Saves/reduces cash outflow)

    Also always calculate depreciation tax shield and Net gain/loss on sale separately. If you keep the items separate, it will be much clearer and you will not get confused.

    Depreciation tax shield ( Tax saved) = Depreciation for the year X Corporate Tax rate
                                                              = 1,000,000 X 7.41% X 40% = 29,640

    Net again on Sale = Book value less Actual sale value.... Please note in capital budgeting, always consider the book value as tax basis value of the asset at the time/year of sale. In this case, the tax basis is of the asset is 0 ( Zero) because the asset is fully depreciated at the end of the project. And then the asset is sold for $400,000. Hence entire $400,000 is a gain and since it is a gain, you have to pay tax on it, which is 40%. Hence only 60% is your cash flow. $400,000 X 60% = $240,000

    Hence 29,640 + 240,000 = 269,640

    You should not take the additional the 59,640 what you have shown in the answer.

    Hence the answer should be $240,000 ( Operating cash flow) + 269,640 ( As above) + 250,000 ( working capital)= $759,640

    If the question asks for PV of the cash flows, then we would further discount this value by the PV factor for $1 as provided in the table, which is .68301

    Let me know if this is clear.

    Thanks,
    Kiran



    ------------------------------
    Kiran S Kulkarni
    BENGALURU
    India
    ------------------------------



  • 3.  RE: Help with calculation of cashflow for final year.

    Posted 15 days ago
    Hi Kiran,
    The answer was provided. Thank you for your explanation. I understand now.
    Could you also explain how to find the operating cash flow value? I would really appreciate that.

    Thank you
    Nanditha James

    ------------------------------
    Nanditha James
    Student
    BANGALORE
    India
    ------------------------------



  • 4.  RE: Help with calculation of cashflow for final year.

    Posted 15 days ago
    Sorry please ignore the previous message. I confused it with another question. I have understood everything.
    Thank you

    ------------------------------
    Nanditha James
    Student
    BANGALORE
    India
    ------------------------------



  • 5.  RE: Help with calculation of cashflow for final year.

    Posted 16 days ago
    Hi Nanditha,

    Two things are required to find net cash inflow resulting from sale of an asset.

    1. Sales value of asset
    2. Tax on Capital gains from sale of asset

    Net cashflow from sale of asset = Sales value - tax on capital gains

    Sales value is already given in the que. ($ 400,000)

    Tax = (Sales value - Book value) * 40%
          =  (400,000 - 74,100) * 40%
          = $ 130,360

    Net cashflow from sale of asset = 400,000 - 130,360
                                                       = $ 269,640

    Hope this helps

    ------------------------------
    Chirag Patel
    None
    Pune MH
    India
    ------------------------------



  • 6.  RE: Help with calculation of cashflow for final year.

    Posted 15 days ago
    Thank you, Chirag for breaking it down clearly.

    Thanks a lot!
    Nanditha James

    ------------------------------
    Nanditha James
    Student
    BANGALORE
    India
    ------------------------------