For capital budgeting problems, the terminal year after tax non operating cash flows: TNOCF: Salt + NWCInv - T (Salt - Bt) I can’t intuitively understand this. I get that you add back the NWInc. But if Sal represents the market value and B represents the Book value, why are you subtracting your gain less taxes from your market value? Is it just to recognizea tax on your gain and take that away from the current market value? Can someone help reason this out so that this is not just something that has to be memorized. Thanks.
The last piece of the equation is just subtracing taxes paid on gains from the sale. Read it this way: Cash from sale of fixed assets + net working capital - taxes paid on the gain from sale of fixed assets [i.e. tax rate x (market value-book value)]. You only pay taxes on the gain from the sale, not on the entire sale amount.
don’t look at it as market value. Look at it as cash flows. So at the end of a project, you get your NWC back, and you get to sell off your equipment (Sal). Selling that equipment creates taxes if its over book value (its a gain), so therefore the cash you get at the end of the day is whatever you sold it for minus the taxes you owe.
Getting back NWCInv is the unrealistic part for me.
Remember your level one balance mantra for NWC. - Source of cash/Use of Cash. Your just selling the old asset, adjusting your cash, and then taxing any gains on the sale. - Formulas are intuitive.
this makes perfect sense. nwc back plus cash you make minus the tax on the gains. thanks everyone.
What about the outlay for a replacement project: NWCI+fixed capital-Sal0+T(Sal0-B0)? What is the origin of that?
Same idea really. Net working capital and fixed investment for the project minus the salvage value of what you’re replacing. For example, if you’re replacing a machine, the old machine probably has some kind of value (even if its just for scrap metal) and the proceeds from selling it will offset some of your investment costs. The last piece is just adding back the tax that you pay on the gains from selling the old asset.
So do you ever get back NWC when you set up a replacement project? i.e. outlay = FCInv. +NWCInv(new equipment) - NWCInv(legacy equipment) - Sal0 +T(Sal0-B0) Say the first fixed asset required some WC, and when you sell that puppy to buy the new model you get back that WC but you have to expend an additional amount for WC associated with the new model. I suppose that’s why it’s “net” working capital… the problem should say the replacement of the equipment would require an “additional” amount of WC.
How about OCF formula?
I have seen two variations in the answers:
CF=(S-C-D)(1-t) + D
CF=(S-C)(1-t) + tD
I don’t really get when you need to add back just D or tD!
Algebraically, these are equivalent to each other.
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