CFAi Reading 25 Q 12 EBIT and After tax operating Cash Flow

CFA Level II Corporate Finance
#1

#next_pages_container { width: 5px; hight: 5px; position: absolute; top: -100px; left: -100px; z-index: 2147483647 !important; } Hi Everyone,

In the Question 12 Reading 25 (Capital Budgeting) p.67-68,

We are asked about the After Tax Operating Cash Flow so we have the choice between these 2 formulas:

(1) CF = (S - C - D) x (1-T) + D

(2) CF = (S - C) x (1-T) + T x D

According to the wording we know:

FCinv = $100

Dep = $50 because (2 years straigth line deprectiation with no Salvage value)

EBIT for year 1 and 2 = $ 50

WACC= 12% ; Ke = 12%

The solution given on page 80 gives:

(2) CF = (S - C - D) x (1-T) + D

CF = 50 x ( 1 - 0.3) + 50

CF = 85 (each year)

Do they consider that EBIT = S - C - D ?

I stupidely used the other formula (1) CF = (S - C) x (1- T) + TD

CF = 50 x 0.7 + 0.3 x 50 = 50 that is wrong.

With the information given, Can we use the first formula ?

#2

Howdy!

Yes.

Yes.

#3

(1) CF = (S - C - D) x (1-T) + D

= (S-C)(1-T) -D(1-T) + D

= (S-C)(1-T)+DT

same as (2)

(2) CF = (S - C) x (1-T) + T x D

#4

#next_pages_container { width: 5px; hight: 5px; position: absolute; top: -100px; left: -100px; z-index: 2147483647 !important; } thanks for your quick answers

#5

I decided not to mention that, primarily because the focus of the question was whether you could use the first formula if you were given EBIT, but not S & C separately; in that case, you cannot use the second formula.

You are correct: they’re algebraically equivalent, so if you have S, C, D, and T given, you can use either with equal satisfaction.

#6

_________

That’s what I thought:

I started plugin the values using the second formula and realized I was wrong. At first I did not understand why as the two formulas are equivalent. I also thought about something I read in other chapters (in the equity part), that argued that EBIT was a bad proxy to estimate CF, but in this case it seems that we can just plug EBIT for S - C - D

Anyway thanks to both of you for your explanations!

-Phil