Cash Flow Statement

Presented by Anita Singhal 1

Capital Budgeting Statement
 Statement of outlay of funds- Estimation of
costs and benefits involved
 Long-term investment so forecast of incomes
and expenditures over the period of the
investment
 Typically for a minimum of 5-7 years and
beyond
 Forecast total sales, all expenses and the
profit expected every year

Presented by Anita Singhal 2

Costs and Benefits – Basic
Principles
 Cash Flow Principle
 Incremental Principle
 Long-term funds Principle
 Post-tax principle

Presented by Anita Singhal 3

Cash Flow Principle
 Costs and benefits measured in terms of
actual cash-flow
 Costs are cash outflows
 Benefits are cash inflows
 This is different from the normal P&L a/c
 P&L a/c is prepared on the basis of
accounting principles
 Main feature is that Depreciation and other
non-cash benefits are added back to profits
as they do not involve cash outflow
Presented by Anita Singhal 4
Cash Flow Principle
 cash flow approach takes cognisance of the time
when cash exchanges hand, whereas the
accounting approach ignores it.
 Under the usual accounting practices, revenue is
recognised as being generated when the product is
sold, not when cash is collected from the sale.
Thus, revenue may remain a paper figure for
months and years before payment is received.
 In the same way, expenditure is recognised as
being made when incurred and not when actual
payment is made.

5
Depreciation
 In capital budgeting decisions, cash flows
have to be considered net of taxes.
 Since in capital expenditure decision, we are
using the Cash Flow Approach, depreciation is
included in the calculation of net benefits, as
it is a non-cash item.
 However, depreciation is deductible
expenditure in the determination of taxable
income. Thus we first deduct depreciation
from cash inflows, then calculate tax on
income, and finally add back depreciation.
6
Incremental Principle
 Cash flows measured in incremental
terms
 That means only those cash flows
relevant to the project under
consideration to be included
 Consider all incidental effects
 Ignore sunk costs
 Question allocation of overhead costs
 Only include incremental overhead costs -
not allocated overhead costs
Presented by Anita Singhal 7
Incremental Principle
 Consider all incremental effects.
 In addition to direct cash flows of the project, all its incidental
effects on the rest of the firm must be considered.
 For eg, a project may enhance the profitability of some other
existing activity if it has a complimentary relationship with it, or
it may detract fro the profitability if it has a competitive
relationship with it.
 Ignore sunk costs.
 Sunk costs represent past outlays which cannot be recovered, so
they have to be ignored.
 For example, if the company has purchased a new land for Rs 5
crores, before even deciding on whether to undertake production
of a new product, then this is a sunk cost and cannot be charged
to the project as it is not directly associated with it

8
Incremental Principle
 Include opportunity costs.
 If the project requires the use of some resources, already
available with the firm, then the opportunity cost of these
resources should be charged to the project.
 for eg, if a project requires the use of a vacant piece of land
within the factory premises, then the cost of this land represents
a sunk cost and is irrelevant for the decision in that sense.
However, the project should be charged with the opportunity
cost of this land, which is its rent.

 Question the allocation of Overhead Costs.

 Costs which are only indirectly related to a product are called
Overhead Costs, like general administrative expenses,
managerial salaries etc.
 These overhead costs are normally allocated to various products
on some basis like machine hours, floor space, labour hours etc.

9
Example 1
 ABC Equipments is considering utilising
a plot of land which it had purchased at
Rs.15 lacs, 2 years back to construct its
warehouse, at a cost of Rs.2.5 Lacs. It
is presently being rented out at an
annual rent of Rs.1,00,000.
 Cost of land – Rs.15 lacs - sunk cost
 Annual rent – Rs. 1 lac – opportunity
cost
10
Long-term funds Principle
 View the project from long-term funds
point of view.
 This means that the project will be
purely funded from long-term sources
of funds
 Long-term sources of funds are – equity
capital, preference capital, debentures
and loans from banks
 Cost of long term funds will be taken
when evaluating the investment
Presented by Anita Singhal 11
proposal
Post-tax principle
 All cash flows should be accounted for
after tax payments
 Taxes paid should be deducted from all
cash flows

Presented by Anita Singhal 12

Initial Investment
 Relevant cash outflows
 Occurring at time zero
 Capital expenditure – cost of asset
 If replacement, after tax proceeds of
sale of previous asset also considered
 Installation costs to be included
 All other incidental expenses peculiar to
this project to be included
13
 Change in net Working Capital
 Net working capital = current assets –
current liabilities
 Upon purchase of new asset – lead to
increase in current assets to support higher
sales
 Increase in current assets – outflow of cash
 Increase in current liabilities – inflow of cash
 Difference between the two – changes in net
wkg. Cap.
 If change is negative – inflow
 When change is positive - outflow 14
Working Capital Principle
 Working capital contributes another important
ingredient of cash flow stream, which is
directly related to an investment proposal.
 The term working capital is used here in a net
sense, that is current assets minus current
liabilities.
 If an investment is expected to increase
sales, there will be an increase in current
assets in the form of cash, inventory,
debtors, bills receivables etc
15
Working Capital Principle
 But part of this increase will be offset by an
increase in current liabilities, such as creditors
and bills payable.
 Obviously, the sum equal to the difference
between the two, will be needed to carry out
the investment proposal.
 Sometimes it may constitute a significant part
of the total investment in the project.

16
Working Capital Principle
 The additional net working capital forms part
of the initial cash outlay.
 However, this additional net working capital
will be returned to the firm at the end of the
projects life. Thus, this recovery of net
working capital becomes part of the cash
inflow stream in the terminal year.
 The initial investment in this net working
capital and the subsequent recovery of the
same, do not cancel each other out due to
the time value of money.
17
Terminal Cash Flow
 Cash flow resulting from termination and liquidation
of a project at the end of its economic life
 Final year of project
 Also called salvage value
 Consider cash flow received
 Account for capital gains tax if any
 Or for tax credit on capital loss i.e. loss on sale of
capital asset is allowed to be deducted from a gain
on sale of capital asset resulting on savings of tax
paid on capital gains.

18
Example 2
 The machine cost Rs.10,00,000 5 years back
 Today it’s book value is Rs.250,000.
 Sold for Rs.1,00,000
 Long-term capital gains tax – 20%
 Capital loss = 2.5-1 = Rs.1.5 lacs
 Net benefit to the firm = 0.2* 1.5 =
Rs.30,000
 Total sale proceeds = 1,00,000 + 30,000 =
Rs.1.3 lacs
19
CALCULATION OF CAPITAL GAIN/LOSS

BOOK VALUE OF ASSET 250000

SALE VALUE 100000

LOSS ON SALE 150000

OFFSET AGAINST CAPITAL GAINS

20
HYPOTHETICAL SITUATION

PROFIT ON SALE OF ASSET 300000

CAPITAL GAINS TAX 0.2

TAX INCIDENCE 60000

CONSIDERING CAPITAL LOSS OFFSET

CAPITAL GAIN 300000

CAPITAL LOSS 150000

NET CAPITAL GAIN 150000

CAPITAL GAINS TAX 0.2

TAX INCIDENCE 30000

DIFFERENCE IN TAX PAYABLE 30000

21
Cash Flows for Replacement
Decisions
 When a machine is to be replaced by a
new machine of the same type.
 The existing machine has some more
useful life
 Consider costs and benefits associated
with this decision

22
Replacement – initial
investment
 Cost of new Asset +
 net working capital required for new
asset
 Less
 After tax salvage value of old asset +
 Net working capital required for old asset

23
Replacement – operating cash
flows
 Operating cash inflows from new asset
 Less:
 Operating cash inflows from the old asset,
had it not been replaced

24
Replacement – terminal cash
flow
 After tax salvage value of new asset +
 Recovery of net working capital
associated with new asset
 Less
 After tax salvage value of old asset had it
not been replaced +
 Recovery of net working capital associated
with old asset
25