Hi, I’m having a little trouble with a slight complexity of this initial cash flow that I’m perhaps overanalysing.
- The purchase price of the new superliner, Pacific Dream, is $37 million. The purchase transaction will occur today and, as explained in paragraph 16, it will be partially funded with $7 million cash. To determine the tax-approved depreciation of Pacific Dream one needs to refer to the Australian Tax Office (ATO) Taxation Ruling TR2000/18 to determine the effective life. Superliners such as Pacific Dream are classified under the „Ships and steamers‟ category of „Water Transport‟ and therefore qualifies for an effective life of 20 years.
Obviously a capital budgeting analysis is funded by a combination of debt and equity, the optimal amount of which is decided by the firm. But when recording the initial cash flows, how would I reflect the above paragraph solely with reference to initial cash flows? Not sure if the 7 million cash needs to be incorporated in any way or if I just include -37,000,000 and what do I do with the depreciation at this point, if any? Thank you heaps.
If your asset value is $37 million, that value will be depreciated 20 years (37 / 20 = 1.85). That depreciation must be included in the income statement to correctly calculate the tax payment (taxes affect cash flows).
$37 million investment will be distributed this way: $37 million as investment cash outflow (Cash flow of investment activities), and $30 million financing cash inflow (Cash flow from financing activities). The net amount is $7 million which is the amount the company will pay with equity.
The free cash flow will be the sum of operational, investing and financing cash flows. As you see, you will use $7 million as initial cash outflow, however, don’t forget to include the debt payments into the financing cash flow through the life of the loan, this will reduce your operational cash flow and give a cash flow according to that small intial net cash outflow for the company.
Thank you for your detailed response, but I’m now incredibly confused. My tutor replied to my email and said that I just record the -37,000,000 at the beginning and ignore the 7 million because financing cash flows are not be included in the capital budgeting analysis? Like, what? lol He said the only pertinent asset that needs to be captured is the -37,000,000 because we are later going to sell that asset and we need the value of the asset recorded to see if the CB analysis is worth it (determined by later calculating the NPV etc)
Your tutor is right. Sorry for not being clear. Capital budgeting does not consider financing decisions, it evaluates if a project is profitable or not without consider whether it is financed by a combination of debt and equity or solely equity. In this case debt must not be accounted and use $37 million as initial cash outflow.
What I said in my previous response is other kind of analysis where financing cash flows are considered (for example to calculate APV or Adjusted Present Value). Interest expense is tax deductible so you will save income taxes and hence increase final cash flow (interest tax shield). Some books analyze as I said, however, CFAI curriculum does not. Be sure that CFAI is correct and your tutor aswell.
Hi - thank you for your clarification. I appreciate it greatly. I’ve been having trouble with just two more areas of the capital budgeting analysis and I was wondering if you could shed some light on wher exactly to include these cash flows and the applicable tax effects:
Firstly,
- Australian Galaxy Cruises policy is to have the world‟s youngest fleet so they plan to sell Pacific Dream after 10 years. By sticking to a strict four-year maintenance overhaul, Australian Galaxy Cruises ensures its fleet is kept in excellent condition which also maximises each liner‟s salvage value. The maintenance overhaul will cost $5.22 million in year 4 and $3 million in year 8. The maintenance overhaul expenses are classified as an allowable tax deduction when paid. The overhaul means the cash sales in year four and year eight are reduced to only 75% of annual cash sales. During the maintenance overhaul in year 4 and year 8, Pacific Dream‟s annual operating costs (with the exception of food and beverage) remain at the same level, regardless of whether it is removed from service for maintenance or not. Food and beverage costs are reduced to only 75% of annual food and beverage costs.
So this is what I have worked out:
Applying the fundamental principle that the capital budgeting analysis takes into account only those cash flows that are incremental… The annual cash flows in year 4 are 37 million and in year 8 34.6 million, so assuming they will exhibit a a 25% reduction, these reductions will be -$9250000 and -8650000 respectively - these are the sales we are losing, correct? So for year 4, do I just do: 5220000 - 9250000 = -4030000 … does this mean that we are making a net loss due to the maintenace cost in year 4?
Do I just go on to calculate the relevant tax effect, so we would get a tax benefit
(-4030000 x 0.3) = +1209000 so my cash flow for year 4 in this part would be Maintenance costs: -4030000
Tax effect on maintenance expense: +$1209000 And do the same thing for year 8 with the different sales? Or am I completely off-track?
Just the last paragraph that I’m having difficulty with:
- Australian Galaxy Cruises‟ call centre that is based in rented premises in Adelaide will have to be expanded with the addition of Pacific Dream. The current annual call centre operating costs consist of $730,000 in rent and $690,000 in salary and wages. Steven has told James that if the call centre does expand, it must relocate to cheaper premises. John has negotiated with a property developer for a larger building on the outskirts of Adelaide that will suit the expanded call centre at an annual rental cost of $670,000. The salary and wages associated with the expanded call centre will increase to $892,000 per annum compared to the figure at the current call centre. The timing of rent payments for the Adelaide call centre occurs at the end of each year.
So calculating the incremental cost of the salary and wages expense appears to be straightforward: 892000 - 690000 = $-202000 p.a
relevant tax deduction = -202000 x 0.3 = $+60600
But because the rent goes down from 730,000 to 670,000, how do I incorporate this decrease since it is not incremental but very much a part of the project? Do I subtract this from somewhere else or do I calculate some sort of unique tax effect? Just stuck on that part. Thank you so much for your time, I appreciate it immensely.
About the planes:
You discounted sales well (-25% in year 4 and 8)
The maintenance of 5.22 is tax deductible as you said earlier, so you must account it as an expense in order to calculate your income tax. It would be - 5.22 - 9.25 = -14.47 incremental expense, Tax shield = 14.47 x (0.3) = 4.34
About the rent and wages:
incremental salary and wages = -2.02 (expense increased)
incremental builing rent = +0.6 (expense decreased, it is a save)
Please, note that incremental cash flow does not necessarily means “increase” in absolute terms of an amount, it can be savings of costs, loss of income, higher costs or higher incomes. Incremental means change in cash flows.
Coming back to the problem, net costs = -1.42, so your tax deduction is 1.42 x (0.3) = 0.43
Effect in net income of increased costs = -1.42 + 0.43 = -0.99
Hope this helps