Before managers can draw a time line to be used for capital budgeting decisions, they must identify investing activities and calculate operating activities. This chapter provides a very brief review of identifying cash flows and preparing the statement of cash flows using the indirect method. The chapter also introduces the concept of tax shields which are used to shelter income from income taxes. You may need to resurrect your financial accounting text if you do not have a solid understanding of cash flows.

 


Accrual Vs. Cash Basis


While investing cash flows are generally easy to identify, operating cash flows must often be calculated. Under the accrual basis of accounting, operating activities are reported on the income statement. Amounts in the operating activities section of the statement of cash flows represent the same activities as those on an income statement, but on a cash basis. The conversion of accrual basis net income to cash basis income is performed using the indirect method in the same manner as you learned in financial accounting. In fact, it is somewhat easier to use the indirect method for capital budgeting because of the following assumptions that simplify the conversion of accrual basis income to cash basis income:

1.    Assume all revenues are received in cash in the same year as earned.

2.    Assume all expenses are paid in cash in the same period as incurred.

These assumptions allow you to omit adjustments for accruals and deferrals that generally result from adjusting journal entries, such as recognizing receivables and payables.

 


Incremental Amounts


Only incremental cash flows--those that are relevant--are considered when analyzing capital budgeting projects. Incremental amounts are those that differ between decisions. Non-incremental amounts are not useful and are not used in capital budgeting analysis.

 


Calculating Operating Cash Flows


There are two approaches to calculate operating cash flows. The first approach is called the indirect approach. It begins with net income which is then converted to operating cash flows. The second approach is called the direct method, also known as the shield method, when performing capital budgeting. The direct method involves determining the individual operating cash inflows and outflows, which are then combined together to determine operating cash flows.

 


Income Taxes


All business entities in the U.S. must file income tax returns and pay income taxes on their accrual basis income. The amount on which a company pays income taxes is referred to as income before taxes. While the tax rate structure is complicated with different rates assessed at different income levels, a single effective income tax rate is assumed in capital budgeting. The tax rate is multiplied by the company's taxable income. This calculation determines the amount of 'income tax expense' and is the amount the company must pay to the Internal Revenue Service for income taxes for a year.1

 


Calculating Incremental Net Income


Net income estimates often differ each year during the useful life of a capital investment. Revenue may differ due to changes in selling prices or units expected to be sold. Costs may differ between years due to inflation, activity levels, or other factors. For this reason, net income must be calculated separately for each year for which the proposed investment is expected to generate future benefits. 

 

To determine annual incremental accrual basis net income, perform the following steps: 

Step 1: Determine the incremental operating revenue  by comparing the revenue that is expected if the capital budgeting investment is undertaken with the current revenue. Increases in revenue cause profits to increase. Decreases in revenue cause profits to decrease. Amounts that reduce profit are shown with parentheses to denote a negative effect.

 

Step 2: Determine the incremental operating costs and cost savings. Increases in costs cause profits to decrease, so they should be shown with parentheses. Because cost savings decrease expenses, which in turn, increases profit, they are displayed as positive amounts.

Note: The cost of purchasing a capital asset is never an operating cash flow because the acquisition cost impacts multiple accounting periods and is not immediately expensed. Purchases of capital assets are investing activities and must be capitalized, and their cost allocated over the periods the assets will provide benefits.

Step 3: Calculate depreciation on the proposed capital investment. Because the incremental depreciation expense decreases profit, it should be shown with parentheses. Straight-line depreciation is the same amount each year over the asset's useful life. Double-declining balance will differ from year to year because it is an accelerated method.

 

Step 4: Mathematically combine (add or subtract) the incremental expenses with the incremental revenue to obtain incremental income before taxes, also known as taxable income.

 

Step 5: Calculate income tax expense by multiplying income before taxes (step 4) by the  effective income tax rate,

 

Step 6: Subtract income tax expense from income before taxes to determine net income. If income before taxes is a negative amount (a loss before taxes) for a particular year, the negative income tax expense amount will actually be a tax savings because if the investment is accepted, the company will combine its regular operations with operations related to the newly acquired asset, which causes the company's overall income tax expense to be lower. While income tax expense is a cost and requires parentheses to signify it as a negative amount, tax savings amounts increase profits, so they are shown as positive amounts.


Using the Indirect Method to Determine Operating Cash Flows


Some components of the net income calculation are not cash flows. These non-cash flow amounts must be removed in order to arrive at net operating cash flows. Because of the first two assumptions addressed earlier in this chapter, there will be no adjustments due to accounts receivable, payables, and most other accruals and deferrals that create timing differences between cash and accrual basis amounts. However, there are four amounts that are often included on the income statement that are non-cash amounts that must be removed:

1.    Depreciation expense

2.    Amortization expense

3.    Gain on disposal of long-term assets

4.    Loss on disposal of long-term assets

These four items never create or use cash, though GAAP requires reporting them on the income statement. To convert net income to cash basis income, you must remove all non-cash flow amounts. The removal by adding or subtracting is based on whether the item caused net income to increase or decrease during the year.

 

Because a gain is a revenue, it is added on the income statement to determine net income. To remove it, you must subtract the gain from net income to determine operating cash flows. You must add depreciation expense, amortization expense, and any losses to net income because they were each subtracted when net income was determined.

 

Net income

- Gain on disposal of long-term assets

+ Depreciation expense

+ Amortization expense

+ Loss on disposal of long-term assets

= Operating cash flows

 


Using the Direct (Shield) Method to Determine Operating Cash Flows


The second approach used to determine operating cash flows involves creating a cash basis income statement, and then adding the tax savings resulting from non-cash amounts. The tax savings is called a tax shield and can result from any non-cash amount reported on the income statement. Tax shields in capital budgeting result from depreciation, amortization, and losses. Gains also create shields, however, they are negative shields that cause extra taxes to be paid. While other amounts generate shields, they are beyond the scope of this chapter.

 

Depreciation Expense

Depreciation expense is not a cash flow. Recall the journal entry to record depreciation:

Depreciation expenses.......................xxx

    Accumulated depreciation....................xxx

Note that neither part of the journal entry affects the Cash account. As such, depreciation is considered a non-cash expense because there is no cash involved in recording depreciation. Because it is an expense, it is subtracted on the income statement, which in turn reduces taxable income. When taxable income is smaller, the cash paid for income taxes is smaller. Depreciation, therefore, creates a tax savings, called the depreciation tax shield. A separate tax shield occurs for each year in which depreciation is reported.

 

        Depreciation tax shield = [Depreciation expense] x [Income tax rate]

 

Amortization Expense

Amortization expense is another non-cash flow expense. Recall the journal entry to record the amortization of intangible assets:

Amortization expenses................................xxx

    Patent, Trademark, Franchise, etc.................xxx

Amortization is a non-cash expense because there is no cash involved in recording amortization. Just like depreciation, it reduces taxable income, reduces taxes to be paid, and results in a smaller cash outflow to pay for income taxes. Amortization, therefore, creates a tax savings, called the amortization tax shield.

 

       Amortization tax shield = [Amortization expense] x [Income tax rate]

 

Gains and Losses on the Disposal of Long-Term Assets

Gains and losses on the disposal of long-term assets are also non-cash amounts that appear on the income statement. While there is often a cash flow associated with the sale of a long-term asset, the amount on any gain or loss is based on the difference between the cash selling price and the book value of the asset being disposed of.

 

Gains increase income, as they are a special type of revenue. Losses decrease income, as they are a special type of expense. As a result, gains translate into larger income tax expense, while losses decrease income taxes. A gain creates additional income tax expense and is called a gain tax shield which is always negative. A loss creates a tax savings and is called a loss tax shield.

 

Gain tax shield = [Gain on disposal] x [Income tax rate]

Loss tax shield = [Loss on disposal] x [Income tax rate]

 

 

Calculating Operating Cash Flows

If the shield method is used to calculate operating cash flows, you must begin with cash basis income and add the tax shield amounts to arrive at operating cash flows.

 

Cash basis net income

- Gain tax shield (negative shield)

+ Depreciation tax shield

+ Amortization tax shield

+ Loss tax shield                          

= Operating cash flows

 


Investing Cash Flows


Investing activities are those involving cash paid or received for long-term assets. In most capital budgeting problems, you will have two investing cash flows:

1. The initial cost of acquisition of the new asset at the beginning of the useful life

2. The salvage value of the proposed acquisition at the end of its useful life

If an old asset is being replaced and is being sold (as opposed to being thrown out in a dumpster), you will have an additional investing activity---the cash inflow for the selling price of the asset. Most likely the old asset will be sold on the same day the new asset is acquired.

 

Because investing activities are not operating activities, they are never reported on the income statement, and as such, have no income tax effect. Only revenues and expenses have an income tax effect. 


A Few Reminders........


When determining incremental cash flows, consider the impact on the entire company. Your calculations of net income and operating cash flows are incremental, meaning they represent the difference in cash flows if the capital budgeting project is undertaken compared to cash flows if the project is rejected. A company planning a capital investment will already have other revenues and costs related to its regular operations.

 

Be sure to remember that the purchase of a capital asset is an investing activity, not an operating activity. As such, the acquisition cost is not an expense on the income statement.
 


Walk Through Problem


Elco, Inc. is contemplating the purchase of a new piece of equipment for expansion. This acquisition would alleviate $8,000 per year in rental costs for the current machine. The following information pertains to the new equipment:

 

Initial cost of proposed new equipment $156,000
Estimated useful life 8 years
Estimated disposal value at end of useful life $20,000

 

Elco estimates the new equipment will cause revenues to increase from the current level of $300,000 to $360,000 per year. Cash operating expenses related to the increase in revenue are expected to be $24,000 per year. Elco uses straight-line depreciation. Elco’s required rate of return is 10%, and its income tax rate is 30%. The current machine has a zero book value and a zero salvage value. Calculate the annual incremental after-operating cash flows if the new equipment is purchased using the indirect method and the shield approach. 

Solution - Indirect Method

The indirect method requires that all non-cash amounts are removed from net income. You must first calculate accrual basis net income.

 

Step 1: Identify the incremental revenues i.e., the amount revenues will differ if the new equipment is acquired. Revenues will increase by $60,000:

 

        $360,000 - $300,000 = $60,000

 

Step 2: Identify the incremental expenses. Each cost should appear on a separate line in the analysis and be labeled respectively. There are 3 costs that will differ if the acquisition is made:

1. Cash operating expenses will increase by $24,000 which cause profits to decline. This decline in profit is shown in parentheses since it causes a decline in profit. 

2. Rental costs will be reduced, which create a cost savings of $8,000 per year. Savings increase profits so a positive number should be shown.

3. If the equipment is acquired, its cost will be allocated over the time period the asset is expected to generate economic resources. The depreciation calculation is:

       Depreciation expense = [Cost - Salvage value] / Estimated life

                                       = [$156,000 - $20,000] / 8 = $17,000 per year

 

Because depreciation expense decreases profits, display it with parentheses.

 

Step 3: The incremental revenue and the three incremental costs are listed and netted together, resulting in the calculation of income before taxes:

Increase in revenues

+$60,000

Increase in cash operating expenses

(24,000)

Reduction of rental costs

+8,000

Depreciation expense

(17,000)

Income before taxes

27,000

Step 4: The income tax rate of 30% is multiplied by income before taxes to determine income tax expense.  This amount decreases profits so it appears with parentheses as a negative amount.

 

30% x $27,000 = $8,100

 

Step 5: The income tax expense amount is subtracted from income before taxes to arrive at incremental net income.

Increase in revenues

+$60,000

Increase in cash operating expenses

(24,000)

Reduction of rental costs

+8,000

Depreciation expense

(17,000)

Income before taxes

27,000

Income tax expense

  (8,100)

Incremental net income

$18,900

Step 6: To convert net income to operating cash flows, remove the non-cash amounts. There is only one non-cash amount in this analysis---depreciation expense. Since depreciation expense was initially subtracted to determine net income, you must add it back to remove it.

 

Increase in revenues

+$60,000

Increase in cash operating expenses

(24,000)

Reduction of rental costs

+8,000

Depreciation expense

(17,000)

Income before taxes

27,000

Income tax expense

  (8,100)

Net income

18,900

Add back non-cash items: depreciation

+17,000

Cash flows from operations

$35,900

 

The company is expected to generate $35,900 from operating activities each year.

 

Solution - Direct/Shield Method

The shield method begins with cash-basis net income, and then adjusts for the income tax shield. It is calculated in a similar manner by determining incremental revenues and incremental expenses, but includes only those amounts that are cash flows.

 

Step 1: Incremental revenue, cash operating expenses, and rental costs are cash flow amounts. Depreciation is omitted since it is a non-cash item.

Increase in revenues

+$60,000

Increase in cash operating revenues

(24,000)

Reduction of rental costs

+8,000

Net cash flows before taxes

$44,000

Step 2: Calculate income tax expense based on the 'net cash flows before taxes' amount:

$44,000 x 30% = $13,200

 

Increase in revenues

+$60,000

Increase in cash operating expenses

(24,000)

Reduction of rental costs

+8,000

Net cash flows before taxes

44,000

Income tax expense

 (13,200)

Cash basis net income

$30,800

 

Step 3: Calculate the depreciation tax shield. The shield is calculated by multiplying depreciation expense for the year by the tax rate:

 

$17,000 x 30% = $5,100

This difference for which you must adjust is called the depreciation tax shield because in essence, it shields $17,000 of profits from income taxes.

Step 4: Add the tax shield to cash basis income. The amount of cash flows from operations is the same as calculated using the indirect method.

Increase in revenues

+$60,000

Increase in cash operating revenues

(24,000)

Reduction of rental costs

  +8,000

Net cash flow before taxes

44,000

Income tax expense

(13,200)

Cash basis net income

30,800

Depreciation tax shield

 +5,100

Cash flows from operations

$35,900

 

___________________

1 While there are some differences between income taxes expense and income taxes payable due to GAAP differing from the U.S. tax code, the discussion of differences is beyond the scope of this chapter.


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