Unit 4: Cash Management (Current asset management, Budgeting, Inventory)

To do an engineering economic analysis, the method to calculate the interest rate

payable on a loan must be kept in mind. The nominal interest is not always the
correct interest rate to use. It all depends on the frequency of the compounding of
the interest rate. The effective interest should always be used. For this reason, a
discussion of effective interest is included in this unit.

To do an engineering economic analysis, the calculation should always be done with

after-tax cash flow. Because depreciation and the interest payable on a loan is tax
deductible, it would change the cash flow. The NPV calculated with before-tax cash
flow will differ significantly from the NPV calculated with after-tax cash flow. The
after-tax calculations are therefore of the utmost importance to make good decisions.
It is included in this unit because of its importance.

Learning outcomes

After studying this unit, you should be able to:

• Examine the role and importance of the different current assets of a company
that need to be managed (cash budget, accounts receivable, credit policy, etc).

• Determine the usefulness of the financial statements, balance sheet and cash flow
statement in a company.

• Discuss the advantages and disadvantages of stock keeping.

• Explain the consequences of lack of cooperation between inventory management

and the other divisions in the company.

• Discuss the role and responsibility of the financial manager.

• Perform the after-tax cash flow calculations for project selection.

• Explain the use of effective interest rate in engineering economic analysis.

Reading:

To complete this unit, study different sections in conjunction with listed chapters in
the prescribed textbook as illustrated in the following table:

Financial Risk and Uncertainty Chapter 10 pages 360-376

Open Rubric
Effective Interest Chapter 3 pages 80-86

Depreciation and Corporate taxes Chapter 8 pages 270-305 (excluding

paragraph 3.2)

1. INTRODUCTION

Current Asset Management is all about managing the cash in the company by
ensuring that the following is in place:
• enough cash to pay your suppliers.
• enough cash to pay for the operations of the company.
• enough cash for investments that are anticipated.
• an affordable credit policy.
It is important for every company to plan its cash flow (cost and revenue). This plan
culminates in what we call the budget. When an engineering economic analysis is
done, the final cash flow should be after tax has been paid. The influence of tax on
the cash flow can change the final outcome of the analysis.

The nominal interest rate cannot always be used as such. The frequency of the
compounding of the interest per period gives rise to effective interest. Only effective
interest rates can be compared. It is therefore a requirement that the effective
interest rate should be used in calculations.

2. MANAGEMENT OF CURRENT ASSETS

2.1. Operating Cash Flows

This represents those cash flows related to the production and sales of goods or
services (Operating Activities). This data is retrieved from the cash flow statement.

2.2. Financing Activities

The procurement of capital for production purposes must be paid for. There are a
number of financial instruments that can be used to pay for this investment. They
are:
• Retained earnings
• Loans
 • Common and preferred stock
• Bonds

Inclusion of these financial instruments into the capital structure of a company will
influence the risk with regard to investors’ perception of the altered capital structure
and it will also influence the operating leverage of the company.

2.3. Investing Activities

Investment activities include transactions such as:

• purchasing new fixed assets,
• reselling old equipment, and
• buying and selling financial assets.

2.4. The Cash Flow Statement

The cash flow statement demonstrates if a company is generating enough cash to

pay its debt obligations, and fund the operating expenses and anticipated
investments. Most companies become insolvent because of bad cash flow
management. The cash flow budget should make enough provision for unforeseen
happenings in the economy and the market it is serving.

The cash flow statement will explain the following:

• The assumptions made about future business
• Future investments
• Credit granted and receivables
• Provisions made
• Reasons for bad debt

2.5. Accounts Receivable

Any company should have a credit policy. Not all the company`s clients pay on
receiving the goods. The company should therefore have a credit policy stating that
a client must pay its account for example within 30 days and interest can be added
after this period. The maximum amount of credit per client can also be part of the
credit policy.
2.6. Credit Analysis

The company must determine the influence its credit policy has on its profitability.
The following questions must be asked:

• Does the policy contribute too much bad debt?

• What is the influence on the profit margin of the company?
• Does the present credit policy give the company a competitive edge?
• What percentage of sales is tied up in credit?
• What is the cost of the credit for the company?
NB: Credit standards must be available to evaluate the financial strength and
creditworthiness a customer must exhibit in order to qualify for credit. The National
Credit Act 34 of 2005 volume 489 governs the provisioning of credit. Google the Act
and discuss the implications of the Act for the provisioning of credit to a company’s
customers.

To view an example of a Cash Flow Statement, refer to table 11.10, Page 588 in
the prescribed textbook.

3. MANAGEMENT OF INVENTORIES

3.1. Inventories Classification

Inventories can be classified as:

• Supplies are components manufactured and supplied by outside contractors.

• Raw material required to produce products.
• Work-in-process is products still in the manufacturing process and after
completion will be moved to the supplies section.
• Finished products that are ready to be despatched to clients.

Inventory levels depend heavily upon sales. Inventory ties up capital and therefore
inventory levels should be very carefully managed. If the inventory levels are too
high in relation to the production rate, capital is tied up in the inventory and this
influences the profitability of the production line and therefore the company.

3.2. Inventory Management Goals

The goals of inventory management are:

• To ensure that the inventories needed to sustain operations are available. If

inventory levels are too low it will cause the production facility to either come
to a standstill or they will have to produce at lower levels with consequences
for the profitability of the company. If inventory levels are too high then the
inventory ties up capital that can be used somewhere else.

• To hold the costs of ordering and carrying inventories to the lowest possible
level.

3.3. Inventory Costs

Typical costs associated with inventory are:

• Carrying costs.
Inventory consists of material for manufacturing of items and completed items.
This material and completed items represent capital locked up that could have
been used to finance other projects or activities. One would therefore strive to
keep inventory levels at a safe level.
• Ordering and receiving costs.
To order inventory, mainly material and sub-components, implies administrative
costs as well as transport costs. The delivery time of stock is a very important
factor with regard to deciding when to place orders for replenishment of stock.
• Cost incurred if the manufacturing process runs out of stock.
The stock levels must be monitored very carefully. If there is a too high level of
inventory, capital is locked in unnecessarily (this is also called bonding). If the
stock levels are insufficient to support the manufacturing process, it will have a
serious influence on the profit of the company. The production process is
operating below capacity, too few items are manufactured and the process
becomes a loss-making project.

3.4. Inventory Control Systems

As already mentioned, the stock levels must be monitored very accurately. If there is
a too high level of inventory, capital is locked down unnecessarily. If the stock levels
are insufficient to support the manufacturing process, it will have a serious influence
on the profit of the company.

Inventory control systems depend a lot on the type and nature of the production
process as well as the technology available to the company. It can run from
uncomplicated to very complicated systems. The cost to operate these systems must
also be kept in mind. A system can be very efficient but too expensive for the nature
of the company`s business. The following are different inventory systems:

Red-line method

Inventory items are stocked in a bin and a red line around the inside indicates the
point when a replacement order must be placed to replenish the stock.

Two-bin method

Inventory items are stocked in two bins and when the working bin is empty this is the
point when a replacement order must be placed to replenish the stock.

Computerised Systems

A good inventory control system is dynamic and not static.

A computerised inventory control system starts with an inventory count in memory.

As withdrawals are made, they are recorded by the computer, and the inventory
balance is revised. When the reorder point is reached, the computer will either
automatically place an order or issue a message that a new order must be placed.
When the stock is replenished, the computer will revise the stock level.

Just-in-Time Systems

The just-in-time system delivery of components is tied to the speed of the production
line, and components are generally delivered only a few hours before they are
required to be used in the production process.

This system reduces the need to carry large inventories, but it requires a great deal
of coordination between the manufacturer and its suppliers, both in the timing of
deliveries and the quality of the components. The basic requirement of quality is
paramount because a few rejected components can disrupt the manufacturing
process.

Outsourcing

Outsourcing is the practice of purchasing components rather than making them in-
house. Outsourcing is often combined with the just-in-time method.

4. BUDGETING

4.1. Definition of a Budget

A budget is an estimation of revenue and expenses over a future period of time and
can be re-evaluated when the management of a company is of the opinion that the
business environment has changed or the strategic analysis requires a change. In
companies a budget is an internal document used by management and is often not
required by external parties.

4.2. Characteristics of a Budget

• Budgeting involves current investments in which benefits are expected to be

received beyond one year in the future. The use of one year is arbitrary.
Investments in assets with a project life less than one year should be
accommodated in the working capital domain. There can be an overlap. A new
distribution system may include a new warehouse and an investment in
inventory.

• Budgeting also involves the following:

o The development of investment proposals.
o Estimates of cash flows for the proposals.
o The analysis and evaluation of cash flows.
o The selection and ranking of projects based upon an acceptance criterion.
o Risk analysis.
o Selection of proposals that fit into a strategic framework of the company.
o Financing the capital budget.
o Portfolio management and re-evaluation of projects on a continuous basis.
• Elements contained in a budget. Depending upon the company involved, projects
can emanate from a variety of sources. Projects can be classified into different
categories:
o New products.
o Expansion of existing product range.
o Replacement of existing equipment.
o Research and development.
o Government legislation.
o Exploration.
• Project evaluation for budgeting purposes
The proper evaluation of projects is critical due to the following:
o Over-investment in capital projects results in higher costs.
o Under-investment may result in the company losing market share due to the
production of inferior products or not having sufficient capacity to meet
demand.
o The investment decision results in a loss of flexibility. Once a company invests
in a project, the company is committed to the project for many years to come.

4.3. Nature of Budgetary Procedure

A formal process for planning through the use of estimated financial and accounting
data is known as budgeting and it is as follows:
• The budget is a carefully prepared estimate of future business operations based
on management`s expectations of the conditions that are likely to hold in the
economy and the industry.
• Since the budgeting process generally focuses on profitability, and since cost
determination is an important factor in the determination of income, reliable future
cost estimates are a prerequisite to the preparation of a useful budget plan. The
more accurate a forecast is, the better the budget process will be for
management planning.
• Planning for future business operations may be in terms of operational or
period/project planning. Planning for material and direct labour requirements and
other expenses of operations for the coming year would constitute operational
planning.
• Budgets assist management in the planning, coordination and control of the
various business functions of sales, production and administration.
• Timing the availability of capital assets.
Companies must forecast demand and plan increased capacity to be in a position
to capitalise on the increased demand in the future. Since the acquisition of
capital assets can involve lengthy delivery times and to be available, this factor
has obvious implications for purchasing agents and plant managers.

Raising Funds

Asset expansion involves substantial expenditures. A company contemplating a

major capital expenditure programme may need to arrange its financing several
years in advance to make sure the funds are available when required. The capital
structure is of utmost importance in these decisions. The amount of debt in the
capital structure depends on the profitability of the company. If profit is marginal,
then debt in the capital structure should be as low as possible to avoid default in
paying interest.

4.4. The Classification of Budgets

Operating budgets are classified under the following two categories:

Static or Fixed Budgets

The static or fixed budget is based upon a single expected volume of business
activity. The fixed budget will be prepared from a relatively constant set of figures,
using data for the sales and expenses for a single definite estimated volume.

Flexible Budgets

The flexible budget is based on a series of possible volumes, all considered within
the range of probability.

Whether a budget is static or flexible, it is always desirable to have all manufacturing

overhead costs, selling and administrative expenses grouped into fixed, variable and
semi-variable classifications, so that when making comparisons of the budget with
the actual figures, management can evaluate to what extent the variations in costs or
income were attributable to changes in volume and what variations were attributable
to other causes.

4.5. Advantages of using Budgets

The following are advantages of budgeting:

• Preparation of budgets forces management to engage in planning. The objectives

of the company have to be defined and stated in financial terms.
• The use of budgets lends itself to coordinating the activities of the various
segments of the business.
• Budgets provide an instrument for control.
• The techniques used in budgeting force management to examine the uses of
resources with the result that a more efficient use of resources may result.
• The use of budgets results in a management that is cost conscious and sensitive
before funds are committed.
• When a budget has been set realistically and in collaboration with all levels, the
budget can be a powerful tool for motivating employees to meet the budget
objectives for costs and revenues.

4.6. The Budget process

The following steps for budgeting:
1. Generate proposal.
2. Obtain estimates of revenues, expenditures and resources.
3. Coordinate these estimates in light of the objectives of top management.
4. Analyse and select projects.
5. Communicate the budget to responsible managers.
6. Implement the budget plan.
7. Report interim progress toward budgeted objectives.

The process begins by establishing assumptions for the upcoming budget period.
These assumptions are related to projected sales, cost trends and any other
economic entities that might be important in this company`s environment. Specific
factors that might be affecting potential expenses are addressed and monitored.
Development of the sales budget is most often the starting point. Subsequent
expense budgets can only then be derived knowing the future cash flows. Every
division, department and different subsidiaries develop their own budgets.

All budgets are rolled up into the master budget that includes financial statements,
estimated cash inflows, outflows and financing plans.

Finally, top management reviews the budget and it is then submitted for approval to
the directors.

4.7. Limitations of Budgets

The following are budget limitations:
• A budget is an estimate.
Budgets are normally developed for three years. All the data in the budget are
estimates. They are determined either by computer analogies or by previous
experience. The budget is also developed to ensure a pre-determined
profitability. If there is no adherence to the budget, profitability of certain
projects can be negatively affected.
• The budgeting system should not take the place of management.
The management style of senior management can play a role in the final
outcome of the budget. The authoritarian manager or the aggressive manager
will always make sure that their pet projects are financed optimally.
• Benefits to be derived from the use of budgets will only be as good as the
effort expended to establish the budget. The financial control within the
company should be such that deviations from the budget are immediately
attended to and remedial action taken.

4.8. Capital Budgeting

• Capital budgeting is the analysis and evaluation of investment projects that

normally produce benefits over a number of years.

• Capital budgeting involves the entire process of planning expenditures whose

returns are expected to extend beyond one year.

Types of investment projects

 • Replacement/Maintenance of infrastructure.

• Replacement cost reduction.

• Expansion of existing products.

• Expansion of existing markets.

• Expansion into new products or markets.

• Safety or environmental projects.

• Research and development.

4.9. Long-term effects

The following are long-term effects of capital budgets:

• Commitment into the future.

Capital expenditures are usually large sums of money. Once it is invested, the
money cannot be recovered if it was the wrong decision.
• Asset expansion is fundamentally related to future sales.
Capital expenditure, by definition, always takes place over more than one year.
Capital is invested with only one objective in mind, and that is to produce more of an
item or a new project to increase profit and create wealth.
• An erroneous forecast can result in serious consequences for the company.

4.10 Examples of Capital Budget Decisions

Example 1: Problem Statement:

Increase capacity of factory.

Possible alternatives:
Identify all possible alternatives to increase the production
capacity.

Example 2: Problem Statement:

Increase product range.

Possible alternatives:
Identify all possible alternatives to increase the product range.

5. EVALUATION OF ALTERNATIVES ON AN AFTER-TAX BASIS

Depreciation and the interest payable on a loan is tax deductible. The NPV before
tax will be different from the NPV after tax. Calculation of the NPV with before-tax
cash flow will most probably give a different result and the wrong decision can be
made.
5.1. Definition of Depreciation

Depreciation is an accounting concept that establishes an annual deduction against

before-tax income such that the effect of use and time on an asset`s value can be
reflected in a company`s financial statements.

In engineering economic analysis we exclusively use the concept of accounting

depreciation because it provides a basis for determining the income taxes
associated with any project.

5.2. Concepts for After-tax Calculations

The following concepts are associated with tax calculations:

Market value

This is what will be paid by a willing buyer to a willing seller for a property where
each has equal advantage and is under no compulsion to buy or sell.

Because of the structure of depreciation, the market value can differ substantially
from the book value. A building tends to increase in market value but it decreases as
depreciation charges are taken. A computer station may have a market value lower
than the book value.

Residual value

The salvage or residual value is an asset`s estimated value at the end of its tax life.
The eventual salvage value of an asset must be estimated when the depreciation
schedule for the asset is established. If this estimate subsequently proves to be
inaccurate, the necessary adjustment must be made.

Cost basis (First cost, unadjusted basis)

The cost of acquiring an asset (purchase price), including normal cost of making the
asset serviceable. The cost basis generally includes the actual cost of an asset
and all other incidental expenses, such as freight, site preparation and
installation. This total cost, rather than the cost of the asset only, must be the
depreciation basis charged as an expense over an asset`s tax life.

Adjusted cost basis

This is used after some depreciation has been charged.

Book value

This refers to the worth of a property as shown on the accounting records of a

company. It is ordinarily taken to mean the original cost of the property less all
amounts that have been charged as:

k (1≥k≥n); where k denotes the end of year.

Tax life (Recovery period)

This refers to the period of time over which depreciation deductions are used to
offset taxable income in determining the income tax to be paid.

The Receiver of Revenue publishes guidelines on lives for categories of assets

known as asset depreciation ranges (ADR). These guidelines specify a range of lives
for different classes of assets based on historical data, and taxpayers are free to
choose a depreciable life within the specified range for a given asset.

Useful life

The period of time an asset is kept in productive use in a trade or business.

What can be depreciated?

Tangible or intangible property can be depreciated if it meets the following criteria:

• It must be used in business or held for the production of income.

• It must have a determinable life, and the life must be longer than one year.
• It must be something that wears out, decays, gets used up, becomes
obsolete, or loses value from natural causes.
• If an asset has no definitive service life, the asset cannot be depreciated (you
cannot depreciate land).
5.3. Depreciation Methods

The following methods are used to calculate depreciation:

5.3.1. The Straight-line Method

Definition: The straight-line depreciation method assumes that a constant

amount is depreciated each year over the tax life of the asset.

Calculation of straight-line depreciation

Formula:

Example:
First cost/Cost basis = R100 000
Tax life of project = 5 years
Residual value (t = 5 years) = R20 000

Depreciation = 100 000 – 20 000 = R16 000 per year for 5

years as illustrated in table 4.1.

Table 4.1: Cash flow for a straight-line depreciation

Year(t) Depreciation Book value

beginning
of the year
0 100 000
1 16 000 84 000
2 16 000 68 000
3 16 000 52 000
4 16 000 36 000
5 16 000 20 000

Residual value at
end of tax life

5.3.2. The Declining Balance Method (Constant Percentage Method)

Definition: In the declining balance method it is assumed that the annual

cost of depreciation is a fixed percentage of the book value at
the beginning of the year.
 The ratio of the depreciation in any one year to the book value
at the beginning of the year is constant through the tax life of
the asset. As the book value of an asset decreases through
time, so too does the size of the depreciation change.

Example: First cost/Cost basis = R100 000

Tax life of project = 5 years
Depreciation = 200% Declining balance method

Table 4.2. Cash flow for declining balance depreciation

Year(t) Depreciation Book value

beginning
of the year
0 100 000
1 40 000 60 000
2 24 000 36 000
3 14 400 21600
4 8640 12960
5 5184 7776

Depreciation =  (Book Residual value

value beginning of the year) at end of tax life

Residual Value and Book Value

If a residual value is estimated for the asset, this estimated residual value is
not used in the declining balance depreciation method to calculate the annual
depreciation.
Note. The book value can never be smaller than the residual
value.

Whenever the book value approaches the residual value,

the claiming of any further depreciation must be terminated
at that stage.
 If the rate of depreciation is not going to equate the book
value and the residual value at the end of the tax life, the
rate of depreciation should be increased.

Figure 4.1 below illustrates a scenario where the book value is

greater than the residual value.

Case 1: Book value > Residual value

Book
Boo value Optimal depreciation rate
Too slow a depreciation rate

Book Value end of tax

Excess Tax Paid
Residual Value

Tax life
Depreciation rate too slow

Figure 4.1: Book value > Residual value

When Bn > R and T → tax life, switch from declining balance method to straight-line
depreciation method at n`

Figure 4.2 illustrates a scenario where the book value is less than the residual value.

Case 2:
Book value < Residual value

Optimal depreciation rate

Book
value Too fast the depreciation rate

Residual Value

Tax Deficit
Book Value end of tax life

Tax life

Figure 4.2: Book value < Residual value

Depreciation rate too fast
When Bn > R and T → tax life terminates depreciation process or depreciates at a
slower rate by changing over to the straight-line method.

Example: Cost basis = R40 000

Tax life = 10 years
Residual value = R10 000
Depreciation = 200% Declining balance method.

Table 4.3: Illustrates depreciation if a residual value is specified

Year Depreciation Book value
beginning of the
year
1 8 000 40 000
2 6 400 32 000
3 5 120 25 600
4 4 096 20 480
5 3 276.8 16 384
6 2 621.44 13 107.2
7 485.76 10 485.76
(2 097.15) 10 000

Note: Book value for year 7 would be less than the residual value of
R10 000, if the full depreciation of R2 097.15 had been claimed.
We adjust the depreciation for year 7 to R485.76, making the
book value R10 000. The moment the book value reaches the
residual value of R10 000, the deduction of depreciation must
be terminated. The book value may not reach values beyond
the residual value. The depreciation calculations reach its final
conclusion after 7 years although the tax life is 10 years. The
residual value will be deducted from the market value at the end
of the project life to determine the taxable income.

5.3.3. Depreciation Recapture and Capital Loss

Definition: Depreciation recapture

Occurs when a depreciable asset is sold for more than the

Formula: current book value.

Depreciation recapture = Selling price – Book value

The amount is treated as ordinary taxable income in the year of

asset disposal.

Definition: Capital loss

Occurs when a depreciable asset is disposed of for less than its

Formula: current book value.

Capital loss = Book value – Selling price

This provides a tax saving in the year of replacement.

5.3.4. The After-tax MARR Value

Formula:

After-tax analysis can be performed by exactly the same methods (PW, FW, AE,
IRR) as before-tax analysis. The only difference is that after-tax cash flows must be
used in place of before-tax cash flows, and the calculation of a measure of merit is
based on an after-tax MARR.

Alternative template to facilitate the computation of after-tax cash flows

Figure 4.3 illustrates an alternative template to calculate the after-tax cash flow.
0 1 2 N-1 N
1. Market/Salvage value

2. Net Investment

3. Revenue (Sales income)

4. Expenses (Disbursements)

5. EBIT

6. Interest on loan
7. Depreciation

8. Book value (Residual value)

9. Taxable income

10. Income tax

11. Income after tax

12. Loan payment

13. Balance of loan outstanding

14. ATCF

2. Net Investment (equity) = Total investment-Total value of the loan

5. Book value (residual value) = Book value at end of tax life or end of project.

9. Taxable income = EBIT-interest on loan-depreciation.

Taxable income year n = EBIT + salvage value-interest on loan-depreciation-residual

value.

11. Net cash flow = EBIT + salvage value-taxes-loan payment-balance of loan

outstanding

Figure 4.3: Illustrates alternative template to calculate after-tax cash flow

Example: Straight-line depreciation

A lathe can be purchased new for R18 000. It will have a 4-year
useful life. Reductions in operating costs from the machine will
be R8 000 (savings) per year.

Before-tax MARR = 10%

Effective tax rate = 40%
Tax life = 3 years
Residual value (t = 5years) = R3 000
Salvage value (t = 8 years) = R3 000

MARR (After tax) = MARR (Before tax)(1-Tax rate)

= 10%(1 – 0.40)
= 6%

0 1 2 3 4
1. Salvage value 3 000
2. Net Investment -18 000
3. Revenue
4. Expenses
5. EBIT 8 000 8 000 8 000 8 000 Salvage
6 Interest on loan value +
EBIT-
7. Depreciation 5 000 5 000 5 000
residual
EBIT-
8. Residual value 3 000 value
depreciation
9. Taxable income 3 000 3 000 3 000 5 000
10. Income tax -1 2 00 -1 200 -1 2 00 -2 000
11. Income after tax -6 800 6 800 6 800 8 000
12. Loan payment (Taxable income) (tax rate)
13. Balance of loan
14. ATCF -18 000 -6 800 6 800 6 800 8 000

NPV = - 18 000 + 6 800(P/A,6,3) + 8 000(P/F,6,4)

= - 18 000 + 6 800(2.6730) +8 000(0.7921)

= + 6513.2

Example: Declining balance method without a specified residual

value.
Normally with the declining balance method there is no
residual value specified. The book value at the end of the
tax life will then be the residual value.

An automatic lathe can be purchased new for R18 000. It will

have a 5-year useful life. Reductions in operating costs from the
machine will be R8 000 per year.
Before-tax MARR = 10%
Effective tax rate = 40%
Tax life = 3 years
Residual value = not specified
Market value (t = 5 years) = R5 000
Depreciation = 200% Declining balance method
MARR (After tax) = MARR (Before tax)(1-Tax rate)
= 10% (1 – 0.40)
200% declining = 6%
method
2
= = 0.6666
3
Tax life 3
years 0 1 2 3 4 5
1. Salvage value 5 000
2. Net Investment -18 000
3. Revenue
4. Expenses
(18 000)(0.6666)
5. EBIT 8 000 8 000 8 000 8 000 8 000
4.2. Interest on loan
4.3. Depreciation 11 998.8 3 996.79 1 336.13
4.4. Residual value (18 000-11 998.8)(0.6666) 668.28
6. Taxable income -3 998.88 4 003.27 6 663.87 8 000 12 331.72
7. Income tax +1599.55 -1 601.30 -2 665.54 -3 200 -4932.68
8. Income after tax -18 000 9 599.55 6 398.7 5 334.46 4 800 8 067.32
9. Loan payment
10. Balance of loan
11. ATCF -18 000 9 599.55 6 398.7 5 334.46 4 800 8 067.32

NPV = -18 000 + 9 599.55(P/F,6,1) +6 398.7(P/F,6,2)

+ 5 334.46(P/F,6,3) + 4 800(P/F,6,4)
+ 8 067.32(P/F,6,5)

= -18 000 + 9 599.55(0.9434) +6 398.7(0.8900)

+ 5 334.46(0.8396) + 4 800(0.7921)
+ 8 067.32(0.7473)
=11 060.64
The NPV > 0 therefore the project is economically viable.

Example: Declining balance method and a specified residual

value. When a residual value is specified, the

depreciation must stop. The book value may not
be smaller than the specified residual value.

An automatic lathe can be purchased new for R180 000. It will

have a 5-year useful life. Reductions in operating costs from the
machine will be R80 000 per year. Depreciation is the 200%
declining balance method. The tax life = 5 years. The residual
 value is R30 000.Tax rate = 40%.

Y BTCF Depre- Book

ciation value
0 - 180 000 Only R2 400 can be claimed as
1 80 000 - 60 000 120 000 depreciation in year 4 to bring the
2 80 000 - 36 000 54 000 book value to R30 000 that is equal
3 80 000 - 21 600 32 400 to the stated residual value
4 80 000 - 2 400 30 000
- (12 960) (23 328)
5 80 000 30 000

MV 50 000 30 000

If subtracted from 32 4000 book value

the residual value will be less than R30
000
0 1 2 3 4 5
1. Market/Salvage value 50 000

2. Net investment -180 000

3. Revenue
4. Expenses
5. EBIT 80 000 80 000 80 000 80 000 80 000
6. Interest on loan
7. Depreciation 60 000 36 000 21 600 2 400
8.Residual value 30 000
9. Taxable income 20 000 44 000 58 400 77 600 100 000
7. Income tax 8 000 17 600 23 360 31 040 40 000
10. Income after tax -180 000 72 000 62 400 56 640 48 960 90 000
11. Loan payment
12. Balance of loan
13. ATCF -180 000 72 000 62 400 56 640 48 960 90 000

The book value can only be reduced by the annual depreciation value until it
equals the residual value of R30 000. The book value can never be lower than
the specified residual value.
Example: Evaluation of financing methods using after-tax cash flow

Index Engineering is an engineering company near

Johannesburg that manufactures items for the military.
Management is considering buying a multi-spindle lathe
costing R250 000. This machine could save the company R80
000 per year over the project life of 5 years. The purchase of
the lathe will be financed by R90 000 from own funds and the
balance by obtaining a loan of R160 000. The interest payable
on the loan is 15% and the loan is paid back over a period of 4
years. According to the Receiver of Revenue the tax life for
this category of machine is 8 years and the residual value (t=8
years) is R50 000. The lathe will sell for R80 000 at the end of
the 5th year. The company pays 40% tax. The depreciation
method to be used is the straight-line method. The before-tax
MARR is 10%. Make a recommendation as to whether the
lathe should be procured.

Before-tax MARR = 10%

Effective tax rate = 40%
Tax life = 8 years
Residual value = R50 000
Market value (t = 5 years) = R80 000

MARR (After tax) = MARR (Before tax)(1-Tax rate)

= 10%(1 – 0.40)
= 6%

Annual loan payment = 160 000(A/P,15,4)

= 56 048

0 1 2 3 4 5
1. Salvage value 80 000
2. Net Investment -90 000
3. Revenue
4. Expenses
5. EBIT 80 000 80 000 80 000 80 000 80 000
6. Interest on loan 24 002 19 195 13 667 7 311
7. Depreciation 25 000 25 000 25 000 25 000 25 000 8.
Residual value 200 000
9. Taxable income 30 998 35 805 41 333 47 689 65 000
. Income tax -12 399 -14 332 -16 533 -19 075 -26 000
11. Income after tax -90 000 67 601 65 668 63 467 60 925 134 000
12. Loan payment 56 048 56 048 56 048 56 048
13. Balance of loan
14. ATCF -90 000 11 553 9 620 7 419 4 877 134 000
Annual interest:

Iy1 = 56 048(P/A,15,4)0.15 = 24 002

Iy2 = 56 048(P/A,15,3)0.15 = 19 195
Iy3 = 56 048(P/A,15,2)0.15 = 13 667
Iy4 = 56048(P/A,15,1)0.15 = 7311

Depreciation = 190 000 – 10 000 = 22 500

8

NPV = - 90 000 +11 553(P/F,6,1) +9 620(P/F,6,2)

+7 419(P/F,6,3) +4 877(P/F,6,4)
+ 134 000(P/F,6,5)

= - 90 000 +11 553(0.9434) +9 620(0.89)

+7 419(0.8396) +4 877(0.7921)
+ 134 000(0.7473)

= + 39 691.16

The NPV > 0 therefore the project is economically viable.

Example: Straight-line depreciation and tax life shorter than project life:

Tax life = 4 years

Project life = 8 years
Depreciation = Straight-line depreciation
Tax rate = 20%
Residual value = R30 000
80000 − 30000
Depreciation = = 12500
4

Y BTCF Depre- Book Taxable

ciation value income
0 - 80 000
 1 18 000 12 500 67 500 5 500
2 18 000 12 500 55 000 5 500
3 18 000 12 500 42 500 5 500
4 18 000 12 500 30 000 5 500
5 18 000 18 000
6 18 000 18 000
7 18 000 18 000
8 18 000 18 000
MV 25 000 30 000 -5 000 Market value - Residual value

25 000-30 000=-5 000

Example: Straight-line depreciation and tax life equal to project life:

Tax life = 8 years
80000 − 30000
Depreciation = = 6250
8

Y BTCF Depre- Book Taxable

ciation value income
0 - 80 000
1 18 000 6 250 73 750 11 750
2 18 000 6 250 67 500 11 750
3 18 000 6 250 61 250 11 750
4 18 000 6 250 55 000 11 750
5 18 000 6 250 48 750 11 750
6 18 000 6 250 42 500 11 750
7 18 000 6 250 36 250 11 750
8 18 000 6 250 30 000 11 750
MV 25 000 30 000 -5 000 Market value - Residual value

25 000-30 000=-5 000

Example: Straight-line depreciation and tax life longer than project life:

Project life = 6 years

Tax life = 8 years

80000 − 30000
Depreciation = = 6250
8

Y BTCF Depre- Book Taxable

ciation value income
0 - 80 000
1 18 000 6 250 73 750 11 750
2 18 000 6 250 67 500 11 750
3 18 000 6 250 61 250 11 750
4 18 000 6 250 55 000 11 750
5 18 000 6 250 48 750 11 750
6 18 000 6 250 42 500 11 750
MV 25 000 42 500 -17 500 Market value - Residual value

25 000-42 500= -17 500

New residual value at end of project life of 6 year

Self-test Calculations 4.1

First cost: R75 000
Savings per year: R10 000
Project life: 6 years
Tax life: 10 years
Tax rate: 40%
Residual value: R0
Loan: R 25 000
Interest on loan: 12%
Payback period: 2 years
Market value end of project life: R30 000
Depreciation method: 200% declining balance method.
Before-tax MARR = 33.3333%

Question
4.1.1 By calculating the NPV after tax, determine if this project is economically
viable.

Scenario 2
First cost: R75 000
Savings per year: R10 000
Project life: 6 years
Tax life: 10 years
Tax rate: 40%
Residual value: R25 000
Loan: R25 000
Interest on loan: 12%
Payback period: 2 years
Market value end of project life: R30 000
Depreciation method: Straight-line depreciation method
Before-tax MARR = 33.3333%

Question
4.1.2 By calculating the NPV after tax, determine if this project is economically
viable.

Scenario 3
First cost: R75 000
Savings per year: R10 000
Project life: 6 years
Tax life: 4 years
Tax rate: 40%
Residual value: R25 000
Loan: R25 000
Interest on loan: 12%
Payback period: 2 years
Market value end of project life: R30 000
Depreciation method: Straight-line depreciation method.
Before-tax MARR = 33.3333%

Question
By calculating the NPV after tax, determine if this project is economically viable.

6. EFFECTIVE INTEREST RATE

Different nominal interest rates cannot be compared with each other. What is
necessary to know is the frequency of the compounding of the interest rates. One
bank advertises an investment with a rate of return of 13%. Another bank advertises
an investment with a rate of return of 13.43%. Bank number one quotes a nominal
interest. Bank number 2 quotes a compound interest rate. To make a decision where
to invest, one should first establish the frequency of the compounding. Once the
compounding interest rates are known, the investment decision can be made.

When a loan is negotiated, the financial institution will quote the nominal interest say
12%. They will also quote the frequency of the compounding of the interest rate.

The following three different cases can now occur:

1. The frequency of the cash flow is more than the frequency of the compounding of
the interest rate.

2. The frequency of the cash flow is the same as the frequency of the compounding
of the interest rate.

3. The frequency of the cash flow is less than the frequency of the compounding of
the interest rate.

6.1. Nominal Interest Rate

Nominal interest, is an interest rate that does not include any consideration of the
frequency of the compounding.
A nominal interest r, may be stated for any time period (1 year, 1 month)

% per time period t:

=12% per year

=1.5% per month x 24 months

=36% per 2-year period

None of these nominal rates make mention of the compounding frequency.

6.2. Effective Interest Rate

Effective interest rate is the actual rate that applies for a stated period of time. The
compounding of interest during the time period of the corresponding nominal rate is
accounted for by the effective interest rate.

Nominal interest rates with different compounding frequencies cannot be compared

directly but only by way of the effective interest rate.

An effective interest rate has the compounding frequency attached to the nominal
rate statement.

=r% per time period, frequency of compounding

=12% per year compounded monthly.

The timing of the cash flow must always coincide with the compounding of the
interest rate:

Options when calculating effective interest rate:

• Change the cash flow

• Change the interest rate

6.3. Calculating the Effective Interest Rate

6.3.1. Compounding frequency of interest is less than the frequency of the cash
flow.

Example: Nominal interest per year

The cash flow is quarterly and the interest rate is 12% compounded semi-
annually.

The time of the cash flow is not coinciding with the compounding of the
interest rate
 0 Q1 Q2 Q3 Q4

1 000 1 000 1 000 1 000

Bring cash flow in line with compounding frequency

0 SA1 SA2

2 000 2 000

NPV = 2000(P/A,6,2)

Interest rate per semi-annual period

6.3.2. Compounding frequency of interest and the frequency of the cash flow is the
same.

Case 2

The cash flow is quarterly and the interest rate is 12% compounded quarterly.

The time of the cash flow is the same as the frequency of the compounding of
the interest rate.

0 Q1 Q2 Q3 Q4

1 000 1 000 1 000 1 000

NPV = 1 000(P/A,3,4)

Interest rate per quarterly period

 6.3.3. Compounding frequency of interest is larger than the frequency of the cash
flow

The cash flow is semi-annual and the interest rate is 12% compounded quarterly.

The time of the cash flow is not coinciding with the compounding of the
interest rate.

Q1 Q2 Q3 Q4

0 SA1 SA2

1 000 1 000

Alternative calculation – Method 1 – Change interest rate – Effective

interest rate per semi-annual.
c 2
 r   0.06 
ia = 1 +  = 1 +  = 0.0609 = 6.09%
 m   2 

ia = Effective int erest per semi − annually period

r = Nominal interest for the period for which you want to calculate the
effective interest rate, in this example, semi-annually.

m = Frequency of compounding in the period for which you want to

calculate the effective interest rate.

c = interest period per payment period

NPV = 1 000(P/A,6.09,2)

 (1 + i )N − 1  (1.0609)2 − 1 
= A N 
= 1000 2 
= 1831.09
 i(1 + i )   0.0609(1.0609) 

Alternative calculation – Method 2 – Change cash flow to be quarterly.

Calculate the cash flow to be quarterly:

 0 Q1 Q2

A A

F = 1 000
The cash flow is semi-annual but because the interest is compounded quarterly
according to this method of calculation, the cash flow must be changed to quarterly
cash flow. When this is achieved, the cash flow and the compounding of the interest
will coincide at the same time. One semi-annual period is now considered and the
cash flow at the end of the semi-annual period is regarded as the future value of the
two quarterly cash flows to be calculated. The (A/F,i, n) formula is used to calculate
the quarterly cash flow. The two quarterly cash flows now become an annuity.

F=1 000

A=1 000(A/F,3,2) =1 000(0.4926) = 492.6 per quarter

NPV = 492.6(P/A,3,4) = 492.6(3.7171) = 1 831.04

Interest rate per quarter There are 4 quarters for the two semi-
annual periods

6.3.4. Continuous Compounding

Normally civil engineering projects are very large projects and the project time is
long. The Gautrain or excavating a tunnel are both expensive projects. The cash flow
for such projects takes place over very short periods. It can be daily or even hourly.
To calculate an NPV under these circumstances, continuous compounding of the
interest is used. The formula for continuous compounding is:

ia = e r − 1
This interest rate can be substituted in the discrete formula.

The NPV for an annuity if the interest is compounded on a continuous basis and the
discrete formula is used, would be:

r =12% nominal interest rate

A =5 000 per year

Project life =10 years

ia = er − 1 = e0.12 − 1 = 0.1274
 (1 + i )N − 1  (1.1274)10 − 1 
NPV = A N 
= 5000 10 
= 27415.49
 i(1 + i )   0.1274(1.1274) 

Activity 4.2: Self-test Calculations

Scenario 1: Effective Interest Rate

The cash flow is semi-annually and the frequency of compounding the interest
rate is annually 500 500 500 500

0 SA1 SA2 SA3 SA4

Questions.

4.2.1a Calculate the FV if i = 24% compounded annually.

4.2.1b Calculate the FV if i = 24% compounded monthly and n = 4.

4.2. 1c Calculate the FV if i = 24% compounded monthly and n = 24.

4.2.1d Calculate the FV if i = 24% compounded monthly and n = 8.

Scenario 2

5000 5000 5000 5000

0 y3 y6 y9 y12
4.2.2a Calculate the FV if i = 24% compounded monthly and n = 4.

4.2.2b Calculate the FV if i = 24% compounded monthly and n = 12.

Self-test Calculations: After-tax cash flow

Scenario 1

1. Your company received an order for a water pump to alleviate the drought in the
North West Province in South Africa. The estimated profit will be R45 000 per year.
Your company must purchase dedicated equipment to the value of R550 000. This
purchase will be financed with a loan of R250 000. The interest payable on the loan
is 12% and the loan will be repaid in three equal annual payments. The original
request was for delivery over a period of 10 years. The provincial government is
now negotiating with you to reduce the delivery period to 6 years.

Questions

4.2.3 Will you accept this order?

The following information is also available:

• Tax life: 10 years
• Depreciation method: 200% declining balance method.
• Residual value R125 000
• Effective tax rate: 40%
• Before tax MARR: 33.3333%
• Project life:10 years
• Market value end year 10: R50 000
• Market value end year 6: R200 000

Scenario 2
Index Engineering is doing business in the electronic business field. Index
Engineering received a request for a proposal to assemble a quality control
measurement device to be used in foundries to check for possible cracks in the
castings.
If this RFP is successful, Index Engineering will have to invest R350 000 in
equipment. The management of Index Engineering will need a loan of R150 000 at
an interest of 12% to be repaid in two equal annual payments.
The estimated annual profit before tax would be R125 000 per year.
The project life is for a period of 8 years.
It is company policy to use the 200% declining balance method or the straight-line
depreciation method, whichever is the most advantageous each year for the
company to calculate the depreciation. The tax life is 5 years and the residual value
is R50 000. The before-tax MARR=24.39%. The salvage value at t=5 years is
R75 000.The tax rate is 18%.
The management of Index Engineering uses the five-year payback as its criterion to
accept or reject projects and requested you to analyse the economic feasibility of the
project.
Question

4.2.4 Do a Net present value after-tax calculation to determine if Index Engineering

must accept this project according to their 5-year payback criteria.

Self–test Exercise
1a. Analyse the management of a capital budget of any company of your choice.
1b. Refer to section 3 in this unit to answer this question.
1c. Share your findings with your peers as directed by your lecturer.

2a. Evaluate the cash flow of any company of your choice in terms of its usefulness.
2b. Refer to section 2 in this unit to answer this question.
2c. Share your findings with your peers as directed by your lecturer.
Reflection on study unit 4

1.1. Describe what you have learned from study unit 4.

1.2. How does this concur with your experience in your working environment?

1.3. What can you take from this unit to develop your capabilities?

1.4. What contributions do you think you will now be able to make in your work area?
Think of lessons you acquired that you were not aware of before going through this unit.