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    FINS1613: Business Finance: Semester 1, 2017 Section III: Capital Budgeting The Indirect Method

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    Howard Qin
    The document provides an example of using the indirect method to calculate incremental cash flows for a capital budgeting project over multiple years. In Year 0, capital expenditures are deducted from operating earnings to determine cash flows. In Year 1, depreciation is added back to operating earnings to calculate cash flows. Working capital changes between revenues and expenses are considered. Finally, after-tax salvage values from asset sales are included in cash flows. The example illustrates how to systematically apply these adjustments each year to reconcile operating earnings with cash flows using the indirect method.

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    FINS1613: Business Finance: Semester 1, 2017 Section III: Capital Budgeting The Indirect Method

    Uploaded by

    Howard Qin
    39 views7 pages
    The document provides an example of using the indirect method to calculate incremental cash flows for a capital budgeting project over multiple years. In Year 0, capital expenditures are deducted from operating earnings to determine cash flows. In Year 1, depreciation is added back to operating earnings to calculate cash flows. Working capital changes between revenues and expenses are considered. Finally, after-tax salvage values from asset sales are included in cash flows. The example illustrates how to systematically apply these adjustments each year to reconcile operating earnings with cash flows using the indirect method.

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    FINS1613 h/w QUESTION

    Original Title

    Indirect Method Lecture Problem

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    The document provides an example of using the indirect method to calculate incremental cash flows for a capital budgeting project over multiple years. In Year 0, capital expenditures are deducted from operating earnings to determine cash flows. In Year 1, depreciation is added back to operating earnings to calculate cash flows. Working capital changes between revenues and expenses are considered. Finally, after-tax salvage values from asset sales are included in cash flows. The example illustrates how to systematically apply these adjustments each year to reconcile operating earnings with cash flows using the indirect method.

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    39 views7 pages

    FINS1613: Business Finance: Semester 1, 2017 Section III: Capital Budgeting The Indirect Method

    Uploaded by

    Howard Qin
    The document provides an example of using the indirect method to calculate incremental cash flows for a capital budgeting project over multiple years. In Year 0, capital expenditures are deducted from operating earnings to determine cash flows. In Year 1, depreciation is added back to operating earnings to calculate cash flows. Working capital changes between revenues and expenses are considered. Finally, after-tax salvage values from asset sales are included in cash flows. The example illustrates how to systematically apply these adjustments each year to reconcile operating earnings with cash flows using the indirect method.

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    © All Rights Reserved
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    of 7

    FINS1613: Business Finance

    Semester 1, 2017

    Section III: Capital Budgeting


    The Indirect Method

    A thorough understanding of the relationships among the balance sheet, income statement, and
    cash flow statement can be developed by following the financial events of a firm over a fiscal year.
    This problem illustrates how each pro forma incremental financial statement relates to sales,
    purchases, capital expenditures, depreciation, taxes, and working capital items, such as
    inventories, accounts receivable, and accounts payable.

    For each year listed below, prepare the incremental balance sheet, incremental operating income
    statement, and incremental cash flow statement.

    Year 0 (Capital Expenditures)

    A project begins its life with a $5,000 cash allocation from the firm. This entire amount will be
    used to buy manufacturing equipment with a useful life of 10-years that will be depreciated at
    prime cost.

    


    Year 1 (Depreciation)

    During the fiscal year, the firm expects to sell 600 finished products at a price of $8.00 each.
    The raw materials required are expected to cost $2.50 per each. At the end of the fiscal year,
    the firm will depreciate the manufacturing equipment and pay taxes.

    … SKIPPING FORWARD SEVERAL YEARS…

    Year 7a (Working Capital)

    The firm’s balance sheet at the end of year 6 is provided in the worksheets. In year 7, the
    following events will happen:
    (A) The firm expects to buy inventory for 200 items at a price $25 each, paying the supplier
    in cash.
    (B) During the fiscal year, the firm expects to sell 130 finished products at a price of $32
    each. Of these, 80 are sold in cash and 50 by credit.
    (C) The firm expects to make a cash payment of $2,160 on raw materials previously
    purchased from suppliers on credit.
    (D) At the end of the fiscal year, the firm will pay taxes.


    Year 7b (After-Tax Salvage)


    Assume that, concurrent with the end of fiscal year 7, the firm sells the manufacturing
    equipment for $3,000.
    Questions:

    1. In year 0, how can you use the amount of capital expenditures to adjust incremental
    operating earnings and find incremental cash flows?

    

    

    

    

    


    2. In year 1, how can you use the amount of depreciation to adjust incremental operating
    earnings to find incremental cash flows?

    

    

    

    

    


    3. Define net working capital as:


    Net Working Capital = Accounts Receivable + Inventory - Accounts Payable,
    where all amounts are book values. In year 7a, how does what happens to net working
    capital over a fiscal year reflect the difference between incremental operating earnings
    and incremental cash flows?

    

    

    

    

    


    4. In year 7b, how can you use the amount of after-tax salvage to adjust incremental
    operating earnings to find incremental cash flows?

    

    

    

    

    


    5. Combine your answers from questions 1 through 4 to derive the indirect method:
    Year 0

    Income Statement Cash Flow Statement

    Incremental revenues Operating activities


    Incremental costs Incremental cash collected from revenues
    Incremental depreciation Incremental cash payments from expenses
    Earnings before interest and taxes (EBIT) Incremental taxes (30% of EBIT)
    Incremental taxes (30%) Cash provided by operating activities
    Incremental earnings
    Investment activities
    Incremental capital expenditures
    Incremental after-tax salvage
    Cash from investing activities

    Incremental cash flow

    Balance Sheet (End of Year, Incremental Values)

    Assets Liabilities
    Cash Accounts payable
    Accounts receivable Other liabilities
    Inventories
    Net property, plant, & equipment Total liabilities

    Shareholder’s equity

    Total assets Total liabilities and shareholder’s equity


    Year 1

    Income Statement Cash Flow Statement

    Incremental revenues Operating activities


    Incremental costs Incremental cash collected from revenues
    Incremental depreciation Incremental cash payments from expenses
    Earnings before interest and taxes (EBIT) Incremental taxes (30% of EBIT)
    Incremental taxes (30%) Cash provided by operating activities
    Incremental earnings
    Investment activities
    Incremental capital expenditures
    Incremental after-tax salvage
    Cash from investing activities

    Incremental cash flow

    Balance Sheet (End of Year, Incremental Values)

    Assets Liabilities
    Cash Accounts payable
    Accounts receivable Other liabilities
    Inventories
    Net property, plant, & equipment Total liabilities

    Shareholder’s equity

    Total assets Total liabilities and shareholder’s equity


    Year 6

    Balance Sheet (End of Year, Incremental Values)

    Assets Liabilities
    Cash 6,000 Accounts payable 3,900
    Accounts receivable 1,200 Other liabilities
    Inventories 4,600
    Net property, plant, & equipment 2,000 Total liabilities 3,900

    Shareholder’s equity 9,900

    Total assets 13,800 Total liabilities and shareholder’s equity 13,800


    Year 7

    Income Statement Cash Flow Statement

    Incremental revenues Operating activities


    Incremental costs Incremental cash collected from revenues
    Incremental depreciation Incremental cash payments from expenses
    Earnings before interest and taxes (EBIT) Incremental taxes (30% of EBIT)
    Incremental taxes (30%) Cash provided by operating activities
    Incremental earnings
    Investment activities
    Incremental capital expenditures
    Incremental after-tax salvage
    Cash from investing activities

    Incremental cash flow

    Balance Sheet (End of Year, Incremental Values)

    Assets Liabilities
    Cash Accounts payable
    Accounts receivable Other liabilities
    Inventories
    Net property, plant, & equipment Total liabilities

    Shareholder’s equity

    Total assets Total liabilities and shareholder’s equity


    Year 7: After-tax Salvage Worksheet

    Accounting gain and tax computation Cash flows


    Sale price Sale price
    Book value Taxes (30% of capital gain)
    Capital Gain After-tax salvage
    Taxes (30%)

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