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Capital Budgeting

 Self-Paced Overview

Net Cash Flows

Net Cash Flows are the cash flows every year after a project is adopted.

 
  −  
  =  
  =  
  +  
  =  

ΔProjected Earnings Before Taxes and Depreciation
ΔDepreciation
Change in Taxable Earnings (1−Tax Rate)
Earnings After Taxes
ΔDepreciation
Net Cash Flows

 
  −  
  =  
  =  
  +  
  =  

ΔEBTD
ΔDEPR
ΔEBT(1−t)
EAT
ΔDEPR
NCF

– or –

ΔEBTD − ΔDEPR = ΔEBT(1−t) = EAT + ΔDEPR = NCF

Projected change in earnings before taxes and depreciation arises from costs savings or added returns to the company.

Example 1:

Your company is evaluating the purchase of a new project with a depreciable base of $100,000, expected economic life of 4 years and change in earnings before taxes and depreciation of $45,000 year 1, $20,000 year 2, $25,000 year 3 and $35,000 year 4. Assume straightline depreciation and a 20% tax rate.

Yr ΔEBTD ΔDEPR = ΔEBT(1−t) = EAT + ΔDEPR = NCF
1 $45,000 $25,000 = $20,000(.8) = $16,000 + $25,000 = $41,000
2 $20,000 $25,000 = −$5,000(.8) = −$4,000 + $25,000 = $21,000
3 $25,000 $25,000 = $0(.8) = $0 + $25,000 = $25,000
4 $35,000 $25,000 = $10,000(.8) = $8,000 + $25,000 = $33,000

The depreciation in this example is $25,000 per year. ($100,000 ÷ 4)

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