Hi, can someone please explain: 1. Why is the loss on sale of equipment considered a cash inflow 2. Why is the present value of additional depreciation expense on new equipment (as compared to depreciation on old equipment) considered an operating inflow.
- It’s not so much a cash inflow as a way of reconciling the balance sheet movements by way of cash movements. See this thread for some examples:
http://www.analystforum.com/forums/cfa-forums/cfa-level-ii-forum/91329563
- Is there a specific example you can point to? Basically you are adding back Depreciation tax savings.
I am looking at Schweser reading 25, question 11. I still don’t get how: 1. a loss is an inflow. 2. additional depreciation is an inflow. if we are paying more depreciation on the new equipment, is it not an outflow.
I find it easier to think in terms of reconciling balance sheet movements. If ending ppe is 2mm and beginning ppe is 1mm and I sold a ppe asset for a loss of 500k during the period, what must have been my Fixed Capital Investment in that period? For my beginning and ending ppe amounts to line up, I must have invested 1.5mm in Fixed Capital during the period otherwise my reported ppe would be wrong. To calculate that number i do ending ppe - beginning ppe - gain on sale (here I am subtracting a loss so adding it back). This doesn’t mean that the loss is an inflow in the real world, but rather I am just trying figure out the cash I invested in Fixed Capital.
- okay so am i correct in saying that for part 1, a loss on sale is an inflow in the sense that it increases Fixed Capital Investment? 2. by the same thinking, am i correct in saying that for part 2, depreciation is considered an operating inflow since it increases operating cash flows?
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No, it doesn’t increase FCInv, you are trying to determine what FCInv is from the balance sheet accounts, so you are just doing the arithmetic to get there. In the example i posted, the FCInv is 1.5mm, but if I just looked at my balance sheet accounts, i would think it’s only 1mm (ending PPE - beginning PPE). To calculate my overall FCInv i have to account for gains/losses on sales as well so i can reconcile the balance sheet accounts (i.e. i have to ask myself what are the changes that go into the ending and beginning PPE balances). So i wouldn’t think of this as inflows/outflows, but in terms of figuring out where the cash has gone, mathmetically.
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Just the tax shield of Depreciation increases operating cash flows, but otherwise since Depreciation is a non-cash charge it doesn’t affect operating cash flows. The equations are about the math behind accounting for cash movements.
When you sell something you get cash; that’s the inflow.
If you’re using the indirect method to calculate CFO, then you’d add back depreciation.
ro424 thanks for your input, but i’m still confused. s2000, are you able to explain 1. and 2. further?
The notion of cash inflow is exactly what it means. Here’s a simple example:
Carrying value of PPE = X
Sale of PPE = Y
IF:
- Y < X = LOSS on IS
- Y > X = GAIN on IS
Investment Cashflow = Y (no matter what gets recorded on the BS, you already spent money on this item at T = -10 and now you’re getting a peice of it back at T= 0)
FCInv = CapEx - Sale of Y (cash proceeds of Y, not gain/(loss)
If the sale happened in the period of analysis, then the ending balance would be smaller than the begining balance (all else equal) which would reflect the removal of the sold PPE (Y from above). Essentially the PPE was replaced on the BS with cash and the difference recorded as a Gain/(loss) in the IS (RE).
Suppose that you buy a machine for $50,000 cash; that’ll be a $50,000 cash outflow from investing on your statement of cash flows.
A year later, you’ve depreciated it by $10,000 (so its book value is $40,000), and you sell it for $35,000 cash. You’ll show a $5,000 loss on your _ income statement _ ($35,000 – $40,000 = -$5,000), but you’ll show a $35,000 cash inflow from investing on your _ statement of cash flows _.
Recall your Level I CFO, Indirect Method. (If you’ve forgotten, here’s an article I wrote on it: http://financialexamhelp123.com/cfo-indirect-method/.) If you’re estimating your cash flows by estimating net income, then using the indirect method to get from net income to CFO, you’ll add back depreciation; it’s a non-cash expense, so you add it back to get CFO. It isn’t that the depreciation is a cash inflow; it’s that it’s offsetting a non-cash expense in net income, so you have to add it back.
galli and s2000, i get completely your explanations, thanks. but you are both referring to reading 36 (Free cash flow valuation). My previous questions, relate to reading 25 (Capital Budgeting), in particular replacement decision analysis. 1. Referring to the replacement project analysis example in Schweser (reading 25), they have initial investment outlay = FC + NWC - proceeds of sale of old maching + (1-t)*(loss on sale of old machine). So why is the loss on sale of old maching a cash inflow?
- Again referring to the replacement project analysis, why is (new machine depreciation - old machine depreciation)*T, considered a cash inflow?
The loss isn’t a cash inflow. The proceeds are a cash inflow (reducing the initial investment), any taxes you have to pay on a gain on the sale are a cash outflow (increasing the initial investment), and any taxes you save on a loss are a cash inflow (reducing the investment). I believe that your formula as written is incorrect.
Suppose that the book value of the old machine is $10,000, and your incremental tax rate is 30%. If you sell it for $12,000, you have a cash inflow of $12,000, reducing your initial outlay by $12,000, but you have additional taxes of $600 (= 30% × ($12,000 – $10,000)), increasing your initial outlay by $600. If, instead, you sell it for $9,000, you have a cash inflow of $9,000, reducing your initial outlay by $9,000, and you have tax savings of $300 (= 30% × ($10,000 – $9,000)), further decreasing your initial outlay by $300.
In computing the cash flows from the original project (e.g., using the old machine), you calculated the net income as (sales – costs – depreciation)(1 – T), then added back depreciation because it’s a non-cash expense. (This is just the indirect method for CFO.) For the new project, you’re doing the same thing. The irritant is that in calculating the incremental cash flows for the new project, they don’t go through the algebra; that’s what’s confusing you. Here it is:
Original:
CF = (S – C – D)(1 – T) + D
= (S – C)(1 – T) – D(1 – T) + D
= (S – C)(1 – T) – D + DT + D
= (S – C)(1 – T) + DT
Incremental:
ΔCF = (ΔS – ΔC – ΔD)(1 – T) + ΔD
= (ΔS – ΔC)(1 – T) – ΔD(1 – T) + ΔD
= (ΔS – ΔC)(1 – T) – ΔD + ΔDT + ΔD
= (ΔS – ΔC)(1 – T) + ΔDT
thank you s2000, get it completely.
Cool!