A Q/A Session

Sir, I am having great difficulty in understanding where shall issuance of loans be written in Cash Flow Statement. In the book it mentions that collection and issuance of loans should be written in the Investing section but then it says that issuance and redemption of long term debts should be written in the Financing section.Arent loans long term debts?

=> I understand your concern. It's easy to misunderstand these concepts. So, read the following carefully. In general, if an activity affects income statement, it is an operating activity; if it affects the long-term assets of a company, it is an investing activity, and if it affects long-term  liabilities and equity, then it is a financing activity.  

Simplistically, the activities related to generation of funds for running a company are financing activities. Once a company has the funds, it may use the funds in investing activities. Read more...

Investing Activity:
1. Purchase and sale of long-term assets.
2. Purchase and sale of instruments (stocks, bonds, etc.) of other companies.
2. Making loans (lending money to an individual or a company) and getting back the principal (NOT the interest, as it is accounted for in the operating activity section) of a loan made earlier.

Financing Activity:
1. Receiving money from owners (by issuing shares) or creditors (by borrowing in form of bonds/notes etc.).
2. Making payments to the owners (in form of dividends) or the creditors (returning the borrowed money e.g. redemption of bonds).
3. Purchase or sale of own shares (also called treasury stock or capital stock).

Sir, I have a question related to chapter 10, FIN254. I am not clear with the question of problem 13. How should I proceed in problem 13? What should be the steps?

=> First you need to calculate annual depreciation expense, then the after tax salvage (as book value at the end of the project would be zero, total salvage value would be the gain and you would need to deduct tax from the gain to get to after tax salvage). Yearly savings of 130,000 is equivalent to pretax earnings [Sales – Costs(without dep. exp)]. You may use the “Tax Shield Approach” to find OCF.

Sir, I am having a confusion in Problem: 14 of Chapter 10.What do we mean by 'reduce working capital by $ 125,000 (this is a one time reduction)'?Where do we place this NWC figure in the calculations?Is it recovered at the end of the project life?

=> This is very much similar to the earlier question (Problem 13). Accepting this project means that we will reduce overall NWC of the firm by $125,000 (remember, incremental cash flow?). This reduction in NWC is a cash inflow for this project at Year 0. This reduction in NWC implies that when the project ends, we will have to increase NWC for the firm again. So, at the end of the project, we will have a cash outflow to restore the NWC to its level before the project. We also must include the aftertax salvage value at the end of the project. 

Sir, you said about Pretax OCF in the class. If I want to calculate OCF, then I have to deduct taxes from the pretax ocf. Is my concept is right sir?

=> You are right! Tax is applied on earnings, not on cash flows. Since we disregard interest expense when evaluating a project, OCF = Net Income + Dep. Exp. = (EBIT - Taxes) + Dep. Exp. So, OCF + Taxes (which is Pretax OCF) = EBIT + Dep. Exp. Now you calculate taxes on EBIT, then deduct taxes from pretax OCF to get OCF.