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CMA Exam Part 2, Section E - Incremental Cash Flows Example - YouTube
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incremental analysis now if we go back
[3]
to the beginning when we were talking
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about
[4]
relevant cash flows and we had
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differential cash flows and incremental
[8]
cash flows
[9]
those incremental cash flows were the
[10]
cash flows that were difference between
[13]
doing something and essentially doing
[16]
nothing
[17]
and so this idea of incremental analysis
[20]
and doing something or doing nothing
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being our two choices
[24]
is something that we can use to help
[25]
make decisions from a capital budgeting
[27]
perspective and the most common example
[30]
and the one that you'd be most likely to
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have to know has to do with deciding
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whether or not to replace an old asset
[36]
with a newer asset because our choices
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are do nothing
[40]
continue to operate with the existing
[42]
assets that we have or
[44]
the incremental cash flows would be
[45]
connected to the new replacement
[47]
asset and so what we're doing in a
[50]
situation like this is calculating the
[52]
difference in the cash flows between
[54]
doing nothing keeping the old asset or
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doing something
[58]
and replacing that older asset and so
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what we need to be doing in this
[62]
situation is identify
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what the relevant cash flows are and
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those are the cash flows that are
[68]
different between
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keeping the old asset and getting the
[72]
new asset and so
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what we're going to do is we're going to
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kind of walk through this theoretically
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and then we'll do it with an example
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where we
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have all of the numbers that go through
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this so just kind of thinking about the
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situation where we have
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an old asset that we can keep
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or we can buy a new asset what are those
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relevant cash flows well we have the
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after tax salvage value of the old
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asset if we buy the new asset because if
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we buy the new asset
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we'll be able to sell the old asset and
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so that would be
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a cash flow connected to the decision to
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buy the new asset
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and then kind of looking at the other
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end of the project
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at the end of this new assets life it
[113]
will have a salvage value
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and so what is the after-tax salvage
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value of that new asset at the end of
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its useful life we then also have this
[122]
whole issue about depreciation because
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the old asset might have some
[125]
depreciable life left
[126]
and the new asset would have some
[128]
depreciation connected to it and so
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we need to have the difference between
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that depreciation tax yield for
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the new asset and the old asset if that
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old
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asset still would have been depreciated
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that'll be a difference
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in the cash flows between the two
[143]
options and also if the old asset
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would have had a salvage value at the
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end of its life if not replaced
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then the loss of that after-tax salvage
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value at the end of the
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old assets life because it would be sold
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now
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if the new asset is purchased and then
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finally
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any difference in any after tax
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operating cash flows
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that would result from the new asset
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whether we're selling more and having
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more income whether it's more efficient
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and we have reduced operating
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expenses whatever that difference is in
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the operating cash flows
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connected to the old asset or the new
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asset
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so what we're going to do is we're going
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to set up an example here and read all
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the information then we're going to go
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through these five cash flows and
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calculate
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what the relevant cash flows are for
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each of the these kind of ones that
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we've identified here so here's our
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information
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wannabe companies considering replacing
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an old manually controlled plastic
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extrusion machine with a
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computer-controlled extrusion machine
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management estimates output could be
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increased and labor costs would
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would be reduced with the new machine so
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that before tax operating cash flow
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would be would increase by
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ninety thousand dollars per year
[212]
wannabes cost of capital is twelve
[214]
percent
[215]
its effective tax rate on operating
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income is forty percent and its capital
[219]
gains tax rate is thirty percent
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well here we have two different tax
[223]
rates
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and this doesn't make the question more
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difficult
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it adds another step in the calculations
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perhaps what this means is
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if we have any efficiencies either
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increased revenue or
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or decreased expenses that increase in
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ninety thousand dollars per year
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that's going to be taxed at a 40 tax
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rate
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but the sale of the old asset the sale
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of the new asset at the end
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that's going to be taxed at a 30 tax
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rate so the tax adjustment is still the
[251]
same
[253]
it's just that we have two different tax
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rates one for operating
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and one for capital gains okay so just
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another
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item it doesn't make it more difficult
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just one more thing that we need to pay
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attention to
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so the original cost of the existing
[265]
machine was eighty thousand we have
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installation costs freight and insurance
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the expected salvage value at the end of
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the useful life
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and both are depreciated on the
[274]
straight-line method
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the existing machine had a five-year use
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or a 10-year useful life the new machine
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has a
[279]
five-year useful life so those are the
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amounts that we have connected to
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each of these options continuing the
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existing machines expected useful life
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at the time of its purchase was ten
[290]
years
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and it's been in service for seven years
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okay so it has three years left
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it could be sold now for five thousand
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however if the older machine is kept
[299]
assume that it will
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not be sold at the end of its expected
[302]
useful life which would occur in year
[303]
three of the incremental capital budget
[305]
analysis
[306]
instead assume the old machine would
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continue to be used for current
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production through year five
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of the incremental capital budget
[313]
analysis assume that at the end of year
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five the old machine could be sold
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for five hundred dollars all this means
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is we're going to continue to use the
[320]
existing machine
[323]
after its depreciation period has ended
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it had a 10-year useful life when we
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purchased it it's going to be
[328]
depreciated over 10 years using the
[330]
straight-line method
[331]
but if we don't buy the new machine
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we're going to continue to use that
[336]
asset for the next five years
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two years after its original useful life
[341]
has ended which is
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perfectly normal perfectly reasonable
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assuming the asset is still
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functional so our question is simple if
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the new machine is purchased
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what will be the net present value of
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the new machine
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and so what we have to do is go through
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these five cash flows
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and determine what is that incremental
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cash flow connected to
[360]
the decision to purchase the new machine
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so the first item
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the after tax salvage value of the old
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asset if and when the new asset is
[368]
purchased
[369]
okay so if we purchase the new asset can
[371]
be sold for five thousand dollars now
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it's been in service for seven years
[375]
straight line depreciation has been
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eight thousand five hundred dollars per
[378]
year
[378]
so 59 500 has been depreciated
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the original cost was 85 000 if we take
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into account all of the
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other costs in addition to the cost of
[388]
the machine itself
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um so the
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tax basis is twenty five thousand five
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hundred so we would have a twenty
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thousand
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five hundred dollar loss and the thirty
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percent capital tax
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capital gain tax rate our savings due to
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the loss would be six thousand one
[405]
hundred fifty dollars
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so if we buy the new machine
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and we sell the old machine the cash
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inflow from the old machine
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is eleven thousand five hundred dollars
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five thousand dollars
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cash that we got from it and six
[424]
thousand one hundred and fifty dollars
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in reduced taxes
[428]
because of the capital loss that we had
[429]
on the sale
[431]
of that old asset okay so that's our
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first cash flow we got 11
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150. now the second cash flow is the
[437]
after tax salvage value of the new asset
[440]
at the end of its useful life okay it
[442]
can be sold for ten thousand dollars at
[444]
the end of its useful at the end of its
[446]
life in year five
[447]
at that point the tax basis will be zero
[449]
so we'll have a ten thousand dollar gain
[452]
we have that thirty percent capital gain
[453]
tax rate pay three thousand dollars in
[456]
taxes so
[457]
the after after tax cash received from
[460]
the sale of the new asset
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at the end of year five seven thousand
[464]
dollars
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okay so that's what we've got so far now
[468]
the third
[470]
item is a little bit more involved it's
[472]
the difference between the depreciation
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tax yield for the new asset and the
[475]
depreciation tax yield for the old asset
[479]
okay what that difference is going to be
[482]
so
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on the old machine it would have been
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eight thousand five hundred dollars per
[485]
year
[485]
for years one two and three and then
[488]
nothing for years four and five okay
[492]
the new machine is going to be a hundred
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and sixty-five thousand dollar total
[496]
cost
[496]
five years thirty three thousand dollars
[499]
per year so the difference in the
[500]
depreciation tax well
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the difference in the depreciation
[503]
expense
[505]
is thirty three thousand dollars minus
[507]
eight thousand five hundred
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so twenty four thousand five hundred
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dollars in years one two and three
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and then thirty three thousand dollars
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in year four and five
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and those differences in depreciation
[519]
expense
[520]
need to be multiplied by forty percent
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so the difference the difference in the
[526]
depreciation tax yield is
[528]
nine thousand eight hundred dollars in
[530]
years one two and three
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and then thirteen thousand two hundred
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dollars in years four and five
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okay now the fourth difference that we
[540]
need to look at if the
[541]
old asset would have had a salvage value
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at the end of its life if not replaced
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the loss of that after-tax salvage value
[548]
at the end of the old assets life if it
[549]
is sold now
[550]
and the new asset is purchased so what
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we're saying here is this
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if we buy the new asset we're selling
[556]
the old asset right now
[559]
we already calculated the cash inflow
[560]
from that but
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if we sell the old asset right now we
[565]
don't get
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to sell it in five years in three years
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when it was over when
[570]
it ended its useful life so we're giving
[572]
up
[573]
that future cash flow of selling the old
[575]
asset in the future
[577]
in exchange for selling the old asset
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now so we need to calculate what it is
[581]
we're giving up because
[582]
we're giving we're getting the cash from
[585]
selling it now
[587]
but we are giving up the cash from
[590]
selling it later
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so the salvage value of the old machine
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if it were kept and used and sold at the
[595]
end of year five would be 500
[597]
would be fully depreciated for tax
[599]
purposes and so
[600]
we would have to pay taxes on that 500
[604]
capital gain 30 capital gain tax rate
[607]
150
[608]
in taxes so we have a 350
[611]
negative cash flow in year five because
[614]
this is the cash we would not
[617]
get in year five if the new machine is
[619]
purchased this is cash given up
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in year five if we purchase it
[626]
if we purchase the new asset now this is
[629]
offset quite a bit by the cash we get if
[631]
we sell the old machine right now
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but we're looking at the difference and
[636]
so we've got what we sell it for now
[638]
and what we're giving up later and
[641]
finally the easiest one really is that
[644]
operating cash flow that we have each
[646]
year and we know what it is it's 90 000
[649]
per year we have to pay taxes on it at
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40 so that takes us down to 54
[654]
000 is our after tax cash flow for that
[658]
and that's
[658]
every year now what we do next is we can
[661]
put all of those
[662]
amounts into our table we've got our
[664]
investment in year zero of 165
[666]
000 we have the after tax cash flow from
[668]
the sale of the old machine
[670]
we then have the depreciation tax yield
[674]
difference each of those years 9 800 for
[676]
the first three years and then 13
[678]
200. the operating cash flow we have
[680]
that lost
[682]
350 dollars by not selling the out the
[684]
old asset at the end
[686]
we have the seven thousand dollar sale
[689]
of the asset at the end
[690]
we get the net cash flows each year we
[692]
take the present value of each of those
[694]
at twelve percent because that was our
[695]
required return
[697]
and we get the discounted cash flows for
[700]
each year individually but we do have to
[702]
take and
[702]
add all of those together we add all of
[705]
those net
[706]
all those individual cash flows together
[708]
we get a net present value of eighty
[709]
four thousand
[711]
ten dollars so
[714]
if wannabe company purchases the new
[717]
machine
[720]
they're gonna have an eighty four
[721]
thousand ten dollar net present
[723]
net present value from that decision so
[726]
then that present value is gonna
[727]
increase
[727]
by eighty four thousand ten 10 if they
[730]
purchased the new machine
[732]
now we could have done this
[736]
another way instead of focusing on the
[739]
differences between
[741]
keeping the old asset and buying the new
[742]
asset we could have done
[744]
what are the next five years cash flows
[746]
if we keep the old machine
[750]
and what are the five-year cash flows if
[752]
we buy the new machine
[756]
and compare those differences compare
[758]
the total of the
[759]
current machine the total of the new
[761]
machine and compare the differences we
[763]
would get 84
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000 10 but what we've done here is
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instead of making
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two full calculations we've made one
[770]
full calculation by looking at the
[772]
difference those
[773]
incremental cash flows from the decision
[775]
of purchasing the new machine
[777]
compared to the decision of not
[780]
purchasing the new machine or
[781]
essentially
[782]
doing nothing so a lot of numbers here
[785]
this example is probably bigger than
[788]
what you would have certainly in a
[789]
multiple choice question
[790]
maybe if you got something about this on
[792]
a problem it would get
[793]
kind of close to this but you're just
[796]
identifying what are the different
[798]
cash flows between the two options and
[800]
if you did get a big problem like this
[802]
in one of the problems the good news is
[805]
you get points for everything you do
[807]
correctly so if you did this whole
[809]
table of cash flows you made this whole
[811]
table here and you got one of those
[812]
numbers wrong
[814]
you miscalculated or you didn't take
[816]
into account that
[817]
what they give up by selling the machine
[819]
now the old machine now instead of
[821]
selling the old machine at the end at
[822]
350
[824]
you'd get 95 of the points
[829]
okay so you get points in the problems
[831]
for doing everything
[832]
correctly and so don't worry about one
[834]
out of twenty numbers maybe being wrong
[836]
you've done
[836]
absolutely brilliantly on that question
[838]
you can get ninety-five percent of the
[840]
points
[841]
and that's a that's a good result okay
[843]
so
[844]
incremental analysis making it or using
[846]
it to make the decision about whether or
[848]
not we should keep the old machine
[850]
or whether or not we should invest in
[851]
that new machine and we've done the
[852]
analysis here
[853]
by looking at the cash flows that are
[855]
different
[856]
between the two options those
[858]
incremental cash flows and using that
[861]
to make our decision
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