Chapter 17

Cash Flows in Capital Budgeting Decisions - Operating and Investing


 

Cash basis accounting and accrual basis accounting each have their place in decision making. Because only cash flows can be invested, we use cash basis income when dealing with time value of money concepts. The income statement is where we find operating activities reported under the accrual basis of accounting, Amounts in the operating activities section of the statement of cash flows represent the same activities but on a cash basis. We must convert accrual basis net income to cash basis income before making capital budgeting decisions under the NPV and IRR methods.

 

Recall the amounts you used to calculate NPV and IRR were 'cash flow' amounts. They resulted from two types of business activities--operating cash flows and investing cash flows. This chapter provides a very brief review of the cash flow activities and the indirect method of the statement of cash flows. You may need to resurrect your financial accounting text if you do not have a solid understanding of cash flows.

 

Income Tax Concerns

All business entities in the U.S. must file income tax returns and pay taxes on income. The amount on which a company pays income taxes is referred to as 'Income before taxes' and results from subtracting all expenses from all revenues. While the tax rate structure is much more complicated with different rates for different amounts of profit, we will assume one marginal tax rate. That is, we will assume a flat tax rate to be multiplied by the company's income before taxes subtotal on its income statement. This calculation gives us 'income taxes payable' and is the amount the company must pay to the Internal Revenue Service for income taxes annually.

 

 

Incremental Amounts

Only relevant cash flows--those that are incremental--are considered when dealing with capital budgeting projects. Because amounts that are not incremental do not differ between decisions, they are not useful and are not used in the capital budgeting analysis.

 

 

Operating Cash Flows

There are two approaches to determining operating cash flows. The first approach is called the indirect approach. It requires calculating net income which is then converted back to operating cash flows using the indirect method. The second approach is called the shield approach. It involves creating an income statement on the cash basis, and then factoring the tax savings due to non-cash amounts.

 

The Indirect Approach

To determine operating cash flows under the indirect method, we begin with net income. Because you are estimating amounts that are expected to occur in the future, you must often draft an income statement first because no financial statements exist. The following steps are involved in determining operating cash flows: 

Step 1: Determine the incremental operating revenues. If you have multiple years, the revenue may differ each year due to inflation or changes in selling prices or units to be sold.

 

Step 2: Determine the incremental operating costs and cost savings. Increases in costs cause profits to decrease, so they should be shown with parentheses (a negative sign). Cost savings decrease expenses, so they create an increase in profit and are displayed with a plus sign. The cost of purchasing a capital asset is never part of the income statement because such acquisitions must be capitalized and their cost allocated over the periods the asset will benefit. Costs may change each year due to inflation, activity levels, or other factors.

 

Step 3: Calculate depreciation on the proposed capital investment and show it as an operating expense. Straight-line depreciation is the same amount each year over the assets useful life. Double-declining balance will differ because it is an accelerated method.

 

Step 4: Subtract incremental operating expenses from incremental revenue to get incremental operating income before taxes (i.e., subtract the amounts in steps 2 and 3 from the amount in step 1.) This subtotal for each year may differ each year due to inflation and other economic factors.

 

Step 5: Calculate income taxes expense by multiplying the effective income tax rate by 'income before taxes' from step 4.

 

Step 6: Subtract income taxes expense from operating income before taxes to determine net income. If income before taxes is a negative amount for one of the years, i.e., a loss before taxes, the income tax amount will be a tax savings because if the investment is accepted, the company will net its regular operations with the newly acquired operations which causes the taxes expense to be lower for the company as a whole. While income tax expenses are costs and require parentheses to signify them as a negative amount, tax savings amounts increase profits so they require a positive amount.

Net income is the result of using accrual basis income to determine revenues and expenses. Because time value of money methods such as NPV and IRR require cash basis income, you must convert net income to cash flows using the indirect method. This is the same concept as you learned in financial accounting. We make three assumptions to simplify the indirect method process:

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

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

3-    Assume annual operating cash flows occur at the end of the year.

Because of the first two assumptions, 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. There are only four amounts included on the income statement for which you must make an adjustment:

1-    Depreciation expense

2-    Amortization expense

3-    Gain on disposal of long term assets

4-    Loss on disposal of long term assets

These items appear on the income statement, but they never create or use cash flows. Because you are attempting to convert net income to cash basis income, you must remove all of these non-cash flow amounts. To remove these items, we look at whether they were initially added or subtracted in the calculation of net income. 

 

Because a gain is a revenue, it was added to determine net income. To remove it, you must subtract the gain from net income to determine cash flows. You must add the other three items to net income to remove them because they were each subtracted when net income was determined. This process removes the effects of these four amounts from the income statement when you subtract/add them because none of these amounts caused used or created any cash flows.

 

Tax Shield Approach

The second approach involves creating an income statement on the cash basis, and then factoring the tax savings due to non-cash amounts. The tax savings is called a tax shields and can result from any non-cash expense. The most common tax shields in capital budgeting result from depreciation and amortization, however a number of exist, which are reserved for more advanced courses. 

 

Depreciation expense is not a cash flow, however, it is reduces income taxes payable because it reduces taxable income, the amount on which income taxes are paid. Recall the journal entry to record depreciation:

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

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

It is considered a non-cash expense because there is no cash involved in recording depreciation. Because it is an expense, it is subtracted which in turn creates a smaller taxable income. Because taxable income is smaller, it reduces the related cash outflows for income taxes. Depreciation, therefore, creates a tax savings, called the depreciation tax shield.

 

        Depreciation tax shield = Depreciation expense for one period * tax rate

 

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

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

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

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

 

If the shield approach is taken, you must calculate cash basis income and add the tax shield amounts to arrive at operating cash flows.

 

 

Investing Cash Flows

Recall that investing activities include cash used to acquire long-term assets and cash received from disposing of 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, referred to as year and

2- The salvage value of the proposed asset 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 on the day of sale. Most likely the day of the sale of the old asset is the same day the new asset is being acquired. Cash received from selling the old asset must be shown separately from the cash paid to buy the new asset.

 

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. 

 

 

Sample Problem

Elpers, 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

Elpers 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. Elpers uses straight-line depreciation. Elper’s required rate of return is 10%, and its income tax rate is 30%. Calculate the incremental annual after-tax cash flow if the new equipment is purchased.   

 

Solution:

You must identify the incremental revenues first, i.e., the amount revenues are expected to change. Revenues will increase by $60,000 from the current level of $300,000.

 

Next identify the incremental expenses. Each cost should appear on a separate line in the analysis and be labeled. Cash operating expenses increase by $24,000 which cause profits to decline. Amounts which causes a decrease in profits require parentheses. 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.

 

Depreciation is a cost that appears on the income statement so you must calculate the amount using straight-line depreciation:

 

       [Cost - salvage value]  / Estimated life = [$156,000 - $20,000] / 8 = $17,000 per year

 

Because this expense decreases profits, show it with parentheses.

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

 

The result is income before taxes which is the basis on which to determine income tax expense. The tax rate of 30% is multiplied by income before taxes:

 

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

 

This amount decreases profits so it appears with parentheses as a negative amount.

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

 

To covert to cash flows, add back the non-cash amounts. There is only one in this analysis--depreciation expense. Cash flows from operations is $35,900.

 

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 other approach calculates cash basis income then adjusts for the tax effect. It is prepared in a similar manner by determining incremental revenues and incremental expenses, but includes only those that can be considered as cash flows. Depreciation is omitted since it is a non-cash item. Income taxes are calculated based on the Net cash flows before taxes amount:

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 operating income

$30,800

 Note that income tax is $13,200 under the cash basis and $8,100 under the accrual basis. The difference is due to deprecation expense which is an non-cash expense that reduces the amount on which a company must pay income taxes. 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. The shield is calculated by multiplying depreciation expense for the year by the tax rate:

 

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

 

Once the shield is added to cash flows from operations, it results in the same amount for cash flows from operations as the indirect approach.

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 operating income

30,800

Depreciation tax shield

  5,100

Cash flows from operations

$35,900

 

 

A few comments.............

When determining cash flows, consider the impact on the entire company. Your estimate of net income and operating cash flows is incremental, meaning it is the difference in profits if the capital budgeting project is undertaken. The company obviously has lots of other revenues and costs related to other parts of 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.
 


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