Illustration 2 : XYZ Ltd is considering a new investment project about which the following
information is available.
(i) The total outlay on the project will be ` 100 lacks. This consists of `60 lacks on plant
and equipment and `40 lacks on gross working capital. The entire outlay will be incurred
at the beginning of the project.
(ii) The project will be financed with `40 lacks of equity capital; `30 lacks of long term debt
(in the form of debentures); ` 20 lacks of short-term bank borrowings, and ` 10 lacks of
trade credit. This means that `70 lacks of long term finds (equity + long term debt) will
be applied towards plant and equipment (` 60 lacks) and working capital margin (`10
lacks) – working capital margin is defined as the contribution of long term funds towards
working capital. The interest rate on debentures will be 15 percent and the interest rate
on short-term borrowings will be 18 percent.
© The Institute of Chartered Accountants of India
Financial Management
6.8
(iii) The life of the project is expected to be 5 years and the plant and equipment would fetch
a salvage value of ` 20 lacks. The liquidation value of working capital will be equal to
`10 lacks.
(iv) The project will increase the revenues of the firm by ` 80 lacks per year. The increase in
operating expenses on account of the project will be `35.0 lacks per year. (This includes
all items of expenses other than depreciation, interest, and taxes). The effective tax rate
will be 50 percent.
(v) Plant and equipment will be depreciated at the rate of 331/3 percent per year as per the
written down value method. So, the depreciation charges will be :
` (in lacs)
First year 20.0
Second year 13.3
Third year 8.9
Fourth year 5.9
Fifth year 4.0
Given the above details, you are required to work out the post-tax, incremental cash flows
relating to long-term funds.
Solution
Cash Flows for the New Project
` (in lacs)
Years
0 1 2 3 4 5
(a) Plant and equipment (60.0)
(b) Working capital margin (10.0)
(c) Revenues 80.0 80.0 80.0 80.0 80.0
(d) Operating Costs 35.0 35.0 35.0 35.0 35.0
(e) Depreciation 20.0 13.33 8.89 5.93 3.95
(f) Interest on short-term bank borrowings 3.6 3.6 3.6 3.6 3.6
(g) Interest on debentures 4.5 4.5 4.5 4.5 4.5
(h) Profit before tax 16.90 23.57 28.01 30.97 32.95
(i) Tax 8.45 11.79 14.01 15.49 16.48
(j) Profit after tax 8.45 11.78 14.00 15.48 16.47
(k) Net salvage value of plant and equipment 20.0
(l) Net recovery working capital margin 10.0
(m) Initial Investment [(a) + (b)] (70.0)
© The Institute of Chartered Accountants of India
Investment Decisions
6.9
(n) Operating cash inflows
[(j) +(e) + (g) (1–T)] 30.70 27.36 25.14 23.66 22.67
(o) Terminal cash flow
[(k) + (l) ] 30.00
(p) Net cash flow.
[(m) + (n) + (o) ] (70.0) 30.70 27.36 25.14 23.66 52.67
Working Notes (with explanations):
(i) The initial investment, occurring at the end of year 0, is ` 70 lacs. This represents the
commitment of long-term funds to the project. The operating cash inflow, relating to longterm
funds, at the end of year 1 is ` 30.7 lacs.
That is,
Profit after tax + Depreciation + Interest on debentures (1 – tax )
` 8.45 lacs + `20 lacs + ` 4.5 lacs (1 – 0.50)
The operating cash inflows for the subsequent years have been calculated similarly.
(ii) The terminal cash flow relating to long-term funds is equal to :
Net Salvage value of plant and equipment + Net recovery of working capital margin
When the project is terminated, its liquidation value will be equal to:
Net Salvage value of plant and equipment + Net recovery of working capital
The first component belongs to the suppliers of long-term funds. The second component
is applied to repay the current liabilities and recover the working capital margin.
in the yellow color highlighted, why interest on debentures is added. it is an expense and we pay it to deb. holders, why it is again an inflow. dep is non cash exp so added. why deb int. is added.
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