Chapter 8 - Pearson Learning Solutions

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340 PART THREE Long-Term Investment Decisionsinflows for each year for both the proposed and the present machine. Because theproposed machine is depreciated over 6 years, the analysis must be performedover the 6-year period to capture fully the tax effect of its year-6 depreciation. Theresulting operating cash inflows are shown in the final row of Table 8.8 for eachmachine. The $8,000 year-6 operating cash inflow for the proposed machineresults solely from the tax benefit of its year-6 depreciation deduction.Interpreting the Term IncrementalThe final step in estimating the operating cash inflows for a proposed replacementproject is to calculate the incremental (relevant) cash inflows. Incremental operatingcash inflows are needed, because our concern is only with the change inoperating cash inflows that result from the proposed project. Clearly, if this werean expansion project, the project’s cash flows would be the incremental cash flows.ExampleTable 8.9 demonstrates the calculation of Powell Corporation’s incremental (relevant)operating cash inflows for each year. The estimates of operating cashinflows developed in Table 8.8 appear in columns 1 and 2. Column 2 values representthe amount of operating cash inflows that Powell Corporation will receiveif it does not replace the present machine. If the proposed machine replaces thepresent machine, the firm’s operating cash inflows for each year will be thoseshown in column 1. Subtracting the present machine’s operating cash inflowsfrom the proposed machine’s operating cash inflows, we get the incremental operatingcash inflows for each year, shown in column 3. These cash flows representthe amounts by which each respective year’s cash inflows will increase as a resultof the replacement. For example, in year 1, Powell Corporation’s cash inflowswould increase by $26,480 if the proposed project were undertaken. Clearly,these are the relevant inflows to be considered when evaluating the benefits ofmaking a capital expenditure for the proposed machine.TABLE 8.9Incremental (Relevant) Operating Cash Inflowsfor Powell CorporationOperating cash inflowsIncremental (relevant)Proposed machine a Present machine a [(1) (2)]Year (1) (2) (3)1 $164,000 $137,520 $26,4802 183,200 125,520 57,6803 162,400 106,800 55,6004 151,200 90,000 61,2005 151,200 78,000 73,2006 8,000 0 8,000a From final row for respective machine in Table 8.8.2008935971Principles of Managerial Finance, Brief Fifth Edition, by Lawrence J. Gitman. Copyright © 2009 by Lawrence J. Gitman. Published by Prentice Hall.
CHAPTER 8 Capital Budgeting Cash Flows 341REVIEW QUESTIONS8–13 How does depreciation enter into the calculation of operating cashinflows? How does the income statement format in Table 8.7 relate toEquation 3.4 (on page 104) for finding operating cash flow (OCF)?8–14 How are the incremental (relevant) operating cash inflows that are associatedwith a replacement decision calculated?LG68.5 Finding the Terminal Cash FlowTerminal cash flow is the cash flow resulting from termination and liquidation ofa project at the end of its economic life. It represents the after-tax cash flow,exclusive of operating cash inflows, that occurs in the final year of the project.When it applies, this flow can significantly affect the capital expenditure decision.Terminal cash flow can be calculated for replacement projects by using the basicformat presented in Table 8.10.Proceeds from Sale of AssetsThe proceeds from sale of the new and the old asset, often called “salvage value,”represent the amount net of any removal or cleanup costs expected upon terminationof the project. For replacement projects, proceeds from both the new assetand the old asset must be considered. For expansion and renewal types of capitalexpenditures, the proceeds from the old asset are zero. Of course, it is notunusual for the value of an asset to be zero at the termination of a project.Taxes on Sale of AssetsEarlier we calculated the tax on sale of old asset (as part of finding the initialinvestment). Similarly, taxes must be considered on the terminal sale of both thenew and the old asset for replacement projects and on only the new asset in otherTABLE 8.10The Basic Format for DeterminingTerminal Cash Flow2008935971After-tax proceeds from sale of new asset Proceeds from sale of new asset Tax on sale of new asset After-tax proceeds from sale of old asset Proceeds from sale of old asset Tax on sale of old asset Change in net working capitalTerminal cash flowPrinciples of Managerial Finance, Brief Fifth Edition, by Lawrence J. Gitman. Copyright © 2009 by Lawrence J. Gitman. Published by Prentice Hall.
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Chapter 8 - Pearson Learning Solutions

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