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Cash Flows Advantages And Disadvantages Accounting Essay

INTRODUCTION

"Cash Flows" implies movement of cash in and out of non-cash items. Receipt of cash from a non-cash item is termed as cash inflow while cash payment in respect of such items as cash outflow. For example, purchase of machinery by paying cash is cash outflow while sale proceeds received from sale of machinery is cash inflow. Other examples of cash flows include collection of cash from debtors, payments to creditors, payments to employees, receipt of dividend, interest payments, etc.

Cash flows exclude movements between items that constitute cash or cash equivalents because these components are part of cash management of an enterprise rather than part of its operating, investing, or financing activities. Cash management includes the investment of excess cash in cash equivalents. Hence, purchase of marketable securities or short-term investments which constitutes cash equivalents is not considered while preparing cash flow statements.

This paper solves a numerical problem given in the question and discusses about the effect of Capital Consumption Allowance (CCA) on the cash flow of an organization which is done through two sections entitled `A' and `B' respectively.


- A -

NUMERICAL PROBLEM

QUESTION:

The LSC Corporation is considering investing in a new piece of machinery that will cost the firm £100,000. It will remain operational for eight years, and will be scrapped at the end of the eighth year. It will generate annual revenues of £70,000 over that period, and will incur annual costs of £50,000 over the same period. Its salvage value at the end of the eight years is £5,000.

The company's cost of capital is 10 per cent and the firm has a tax rate of 36 per cent

  1. Calculate the total present value of the project's cash flows.

  2. Calculate the project's Net Present Value. Should LSC Corporation invest in this project?

LSC Corporation Cash Flow Statement

Year

Cost

Revenues

Expenses

Earnings After Tax

CCA for Year

0

(100,000)

       

1

 

70,000

(50,000)

12,800

10,000

2

 

70,000

(50,000)

12,800

18,000

3

 

70,000

(50,000)

12,800

14,400

4

 

70,000

(50,000)

12,800

11,520

5

 

70,000

(50,000)

12,800

9,216

6

 

70,000

(50,000)

12,800

7,373

7

 

70,000

(50,000)

12,800

5,898

8

 

70,000

(50,000)

12,800

4,718

Notes: CCA: Capital Consumption Allowance

SOLUTION:

The Cash Flow Statement is required to find out the present value and the net present value of an asset. The net cash flow not only includes the cash inflows, but also the cash outflows of a business concern.

Net Cash Flows = Cash Inflows + Cash Outflows

Cash Inflow includes all the revenues of the firm which is £70,000 over a period of 8 years and salvage value of £5,000 at the end of the eighth year as per the question given. On the other hand, Cash Outflow includes all the expenses incurred by the firm and the corporate tax to be paid by the firm. According to the question, an amount of £50,000 has been incurred by the firm over a period of 8 years as expense while the amount of corporate tax to be paid is not given. The tax of a year is to be paid in its succeeding year. To find out the amount of corporate tax to be paid for the 8 years can be found out using the following formulae:

Revenue - Expenses = Profit before Tax (Gross Profit)

Profit before tax * Tax @ Given rate = Corporate tax

When the amount of Corporate Tax is deducted from the amount of Gross Profit, we get the Net Profit or Profit after Tax:

Profit before tax - Corporate Tax = Profit after Tax (Net Profit)

But according to the question given, the firm is provided with an amount of Capital Consumption Allowance (CCA) each year, over this period of 8 years. This CCA has an effect on the taxation purpose. We have a tax relief of given CCA in each year.

Revenue - Expenses - CCA = Profit before Tax

YEAR

0

1

2

3

4

5

6

7

8

9

INVESTMENT (in £)

100,000

                 

REVENUE (in £)

 

70,000

70,000

70,000

70,000

70,000

70,000

70,000

70,000

 

EXPENSES (in £)

 

50,000

50,000

50,000

50,000

50,000

50,000

50,000

50,000

 

GROSS PROFIT (in £)

 

20,000

20,000

20,000

20,000

20,000

20,000

20,000

20,000

 

CCA (in £)

 

10,000

18,000

14,400

11,520

9,216

7,373

5,898

4,718

 

PBT (in £)

 

10,000

2,0000

5,600

8,480

10,784

12,627

14,102

15,282

 

CT @36% (in £)

   

3,600

720

2,016

3,052.8

3,882.24

4,545.72

5,076.72

5,502

PAT(in £)

 

20,000

16,400

19,280

17,984

16,947

16,118

15,454

14,923

-5,502

SALVAGE VALUE (in £)

               

5,000

 

NCF (in £)

 

20,000

16,400

19,280

17,984

16,947

16,118

15,454

19,923

-5,502

PV FACTOR

 

0.909

0.826

0.751

0.683

0.621

0.564

0.513

0.467

0.424

PRESENT VALUE (in £)

 

18,180

13,546.4

14,479.3

12,283.1

10,524.21

9,090.417

7,928.046

9,304.172

-2,332.64

TOTAL PRESENT VALUE (in £)=

∑PRESENT VALUES = 93,003

NET PRESENT VALUE (in £)=

TOTAL PRESENT VALUES - INVESTMENT = 93,003 - 100,000 = -6,997


CONCLUSION

Total present value of the project's cash flow = £93,003

Net Present value of the project's cash flow =93,003 - 100,000 = £-6,997

As the NPV is a negative figure, we can conclude that it is not wise for the LSC Corporation to invest in this project.


- B -

EFFECT OF CAPITAL CONSUMPTION ALLOWANCE ON CASH FLOW OF A FIRM

"Cash Flows" implies movement of cash in and out of non-cash items. Receipt of cash from a non-cash item is termed as cash inflow while cash payment in respect of such items as cash outflow. For example, purchase of machinery by paying cash is cash outflow while sale proceeds received from sale of machinery is cash inflow. Other examples of cash flows include collection of cash from debtors, payments to creditors, payments to employees, receipt of dividend, interest payments, etc.

A cash flow statement shows inflow and outflow of cash and cash equivalents from various activities a firm during a specific period. The primary objective of the cash flow statement is to provide useful information of cash flows (inflows and outflows) of an enterprise during a particular period under various heads, i.e. operating activities, investing activities and financing activities.

According to the Canada Revenue Agency, Capital Consumption Allowance (CCA) is "a tax deduction that Canadian tax laws allow a business to claim for the loss in value of capital assets due to wear and tear or obsolescence". (http://sbinfocanada.about.com/) It measures the amount of expenditure that an organization needs to undertake in order to maintain, as opposed to grow its productivity.


CONCLUSION

Capital Consumption allowance is non-cash item which is to be treated as an incremental cash flow. It decreases a firm's net profit and thus, lowers its tax bill for the year. Due to CCA, the firm has more cash in hand at the end of the year than it would have had without expensing depreciation. Thus, we can conclude that CCA has a positive impact on Cash Flow of a firm by decreasing the amount of corporate tax actually to be paid.

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