L27: Project Cash Flow Analysis

(c) 2001 Contemporary Engineering Economics

1www.izmirekonomi.edu.tr

L27: Project Cash Flow Analysis

ECON 320 Engineering EconomicsMahmut Ali GOKCEIndustrial Systems EngineeringComputer Sciences

www.izmirekonomi.edu.tr

Elements of Investment Decision

• Identification of Investment Opportunities

• Generation of Cash Flows

• Measures of Investment Worth

• Project Selection

• Project Implementation

• Project-Control/Post-Audit

Our focus in this chapter is to

develop the format of after-tax cash flow statements.


Types of Cash Flow Elements in Project Analysis


Approach 1

Income Statement Approach

Approach 2

Direct Cash Flow Approach

Operating revenues

Cost of goods sold

Depreciation

Operating expenses

Interest expenses

Taxable income

Income taxes

Net income

+ Depreciation

Operating revenues

- Cost of goods sold

- Operating expenses

- Interest expenses

- Income taxes

Cash flow from operation

Cash Flows from Operating Activities


A Typical Format used for Presenting Cash Flow Statement

Income statement Revenues Expenses Cost of goods sold Depreciation Debt interest Operating expensesTaxable incomeIncome taxesNet income

Cash flow statement

+ Net income+Depreciation

-Capital investment+ Proceeds from sales of depreciable assets- Gains tax- Investments in working capital+ Working capital recovery

+ Borrowed funds-Repayment of principal Net cash flow

Operatingactivities

Investing activities

Financingactivities

+

+


Example 9.1 When Projects Require only Operating and Investing Activities

• Project Nature: Installation of a new computer control system • Financial Data:

– Investment: $125,000– Project life: 5 years– Working capital investment: $23,331– Salvage value: $50,000– Annual labor savings: $100,000– Annual additional expenses:

• Labor: $20,000• Material: $12,000• Overhead: $8,000

– Depreciation Method: 7-year MACRS– Income tax rate: 40%– MARR: 15%


Questions

• (a) Develop the project’s cash flows over its project life.

• (b) Is this project justifiable at a MARR of 15%?

• (c) What is the internal rate of return of this project?


When Projects Require Working Capital Investments

Working capital means the amount carried in cash, accounts receivable, and inventory that is available to meet day-to-day operating needs. How to treat working capital investments: just like a capital expenditure except that no depreciation is allowed.


• (a) Step 1: Depreciation Calculation– Cost Base = $125,000– Recovery Period = 7-year MACRS

N

MACRS Rate

Depreciation Amount

Allowed Depreciation Amount

1 14.29% $17,863 $17,863

2 24.49% $30,613 $30,613

3 17.49% $21,863 $21,863

4 12.49% $15,613 $15,613

5 8.93% $11,150 $5,575

6 8.92% $11,150 0

7 8.93% $11,150 0

8 4.46% $5,575 0


(a) Step 2: Gains (Losses) associated with Asset Disposal

• Salvage value = $50,000• Book Value (year 5) = Cost Base – Total Depreciation

= $125,000 - $ 91,525= $ 33,475

• Taxable gains = Salvage Value – Book Value= $50,000 - $ 33,475= $16,525

• Gains taxes = (Taxable Gains)(Tax Rate)= $16,525 (0.40)= $6,610


Income Statement

0 1 2 3 4 5

Revenues $100,000

$100,000

$100,000

$100,000

$100,000

Expenses:

Labor 20,000 20,000 20,000 20,000 20,000

Material 12,000 12,000 12,000 12,000 12,000

Overhead 8,000 8,000 8,000 8,000 8,000

Depreciation 17,863 30,613 21,863 15,613 5,581

Taxable Income $42,137 $29,387 $38,137 $44,387 $54,419

Income Taxes (40%) 16,855 11,755 15,255 17,755 21,768

Net Income $25,282 $17,632 $22,882 $26,632 $32,651

Step 3 – Create an Income Statement


Step 4 – Develop a Cash Flow Statement

Cash Flow Statement 0 1 2 3 4 5

Operating Activities:

Net Income $25,282 $17,632

$22,882

$26,632

$32,651

Depreciation 17,863 30,613 21,863 15,613 5,581

Investment Activities:

Investment (125,000)

Working capital (23,331) 23,331

Salvage 50,000

Gains Tax (6,613)

Net Cash Flow ($148,331) $43,145 $48,245 $44,745 $42,245 $104,950


An Excel Worksheet

Table 9.1


Example 9.1 - Net Cash Flow Table Generated by Traditional Method Using Approach 2

A B C D E F G H I J

Year End

Investment & Salvage Value

Revenue Labor Expenses Materials

Overhead Depreciation Taxable Income

Income Taxes

Net Cash Flow

0 -$125,000

-23,331

-$125,000

1 $100,000 20,000 12,000 8,000 $17,863 42,137 16,855 $43,145

2 100,000 20,000 12,000 8,000 30,613 29,387 11,755 $48,245

3 100,000 20,000 12,000 8,000 21,863 38,137 15,255 $44,745

4 100,000 20,000 12,000 8,000 15,613 44,387 17,755 $42,245

5 100,000 20,000 12,000 8,000 5,581 54,419 21,678 $38,232

50,000*

23,331

16,525 6,613 $43,387

23,331

Information required tocalculate the income taxes

*Salvage value Note thatH = C-D-E-F-GI = 0.4 * HJ= B+C-D-E-F-I

k


Cash Flow Diagram including Working Capital

0 1 2 3 4 5

$23,331Years

$23,331

Working capital recovery cycles

0 1 2 3 4 5

$43,145$48,245 $44,745

$42,245$81,619

Working capitalrecovery

$23,331

$125,000 Investment in physical assets

$23,331 Investment inworking capital

$23,331

$23,331


Question (b): Is this investment justifiable

at a MARR of 15%?

PW(15%) = -$148,331 + +$43,145(P/F, 15%, 1) + . . . . + $104,950 (P/F, 15%, 5)

= $31,420 > 0 Yes, Accept the Project !

0

1 2 3 4 5

$148,331

$43,145

$48,245 $44,745 $42,245

$104,950

Years


Question (C): IRR

A B

1 Period Cash Flow

2 0 ($148,331)

3 1 43,145

4 2 48,245

5 3 44,745

6 4 42,245

7 5 104,950

=IRR(B2:B7,0.10)

IRR = 22.55%


Rate of Return Analysis (IRR = 22.55%)

n = 0 n =1 n = 2 n = 3 n = 4 n = 5

Beginning

Balance

-$148,331 -$138,635 -$121,652 -$104,339 -$85,622

Return on

Investment

(interest)

-$33,449 -$31,262 -$27,432 -$23,528 -$19,328

Payment -$148,331 $43,145 $48,245 $44,745 $42,245 $104,950

Project

Balance

-$148,331 -$138,635 -$121,652 -$104,339 -$85,622 0


When Projects are Financed with Borrowed Funds Key issue: Interest

payment is a tax-deductible expense.

What Needs to Be Done: Once a loan repayment schedule is known, separate the interest payments from the annual installments.

What about Principal Payments? As the amount of borrowing is NOT viewed as income to the borrower, the repayments of principal are NOT viewed as expenses either– NO tax effect.


Loan Repayment Schedule (Example 9.2)

End of

Year

Beginning

Balance

Interest Payment

Principal Payment

Ending

Balance

1 $62,500 $6,250 $10,237 $52,263

2 52,263 5,226 11,261 41,002

3 41,002 4,100 12,387 28,615

4 28,615 2,861 13,626 14,989

5 14,989 1,499 14,988 0

Amount financed: $62,500, or 50% of total capital expenditureFinancing rate: 10% per yearAnnual installment: $16,487 or, A = $62,500(A/P, 10%, 5)

$16,487


Additionalentries related

to debt financing

Table 9.4

Net income+depreciation-principal repayment=net cahs flow


When Projects Results in Negative Taxable Income Negative taxable

income (project loss) means you can reduce your taxable income from regular business operation by the amount of loss, which results in a tax savings.

Handling Project Loss

Regular Business

Project Combined Operation

Taxable income

Income taxes (35%)

$100M

$35M

(10M)

?

$90M

$31.5M

Tax Savings = $35M - $31.5M = $3.5MOr (10M)(0.35) = -$3.5M

Tax savings


Effects of Inflation on Project Cash Flows

Item Effects of Inflation

Depreciation expense

Depreciation expense is charged to taxable income in dollars of declining values; taxable income is overstated, resulting in higher taxes

Note: Depreciation expenses are based on historical costs andalways expressed in actual dollars



Salvage value Inflated salvage value combined with book values based on historical costs results in higher taxable gains.



Loan repayments

Borrowers repay historical loan amounts with dollars of decreased purchasing power, reducing the debt-financing cost.



Working capital requirement

Known as working capital drain, the cost of working capital increases in an inflationary environment.



Rate of Return and NPW

Unless revenues are sufficiently increased to keep pace with inflation, tax effects and/or a working capital drain result in lower rate of return or lower NPW.


178

91112131415161718192021222324

252627282930313233343536

A B C D E F G H

Example 9.3 Cash Flow Statement for the Automated Machining Center Project

Income StatementInflation Rate 0 1 2 3 4 5

Revenues 5% 105,000$ 110,250$ 115,763$ 121,551$ 127,628$ Expenses: Labor 5% 21,000 22,050 23,153 24,310 25,526 Material 5% 12,600 13,230 13,892 14,586 15,315 Overhead 5% 8,400 8,820 9,261 9,724 10,210 Depreciation 17,863 30,613 21,863 15,613 5,581

Taxable Income 45,137$ 35,537$ 47,595$ 57,317$ 70,996$ Income Taxes (40%) 18,055 14,215 19,038 22,927 28,398

Net Income 27,082$ 21,322$ 28,557$ 34,390$ 42,598$

Cash Flow Statement

Operating Activities: Net Income 27,082 21,322 28,557 34,390 42,598 Depreciation 17,863 30,613 21,863 15,613 5,581 Investment Activities: Investment (125,000) Salvage 5% 63,814 Gains Tax (12,139) Working Capital 5% (23,331) (1,167) (1,225) (1,287) (1,351) 28,361

Net Cash Flow (148,331)$ 43,778$ 50,710$ 49,133$ 48,652$ 128,215$ (in actual dollars)


Example 9.4 Cash Flow Statement for AMC Project under Inflation (Multiple Price Indices)

Income StatementInflation Rate 0 1 2 3 4 5

Revenues 6% 106,000$ 112,360$ 119,102$ 126,248$ 133,823$ Expenses: Labor 5% 21,000 22,050 23,153 24,310 25,526 Material 4% 12,480 12,979 13,498 14,038 14,600 Overhead 5% 8,400 8,820 9,261 9,724 10,210 Depreciation 17,863 30,613 21,863 15,613 5,581

Taxable Income 46,257$ 37,898$ 51,327$ 62,562$ 77,906$ Income Taxes (40%) 18,503 15,159 20,531 25,025 31,162

Net Income 27,754$ 22,739$ 30,796$ 37,537$ 46,744$

Cash Flow Statement

Operating Activities: Net Income 27,754 22,739 30,796 37,537 46,744 Depreciation 17,863 30,613 21,863 15,613 5,581 Investment Activities: Investment (125,000) Salvage 3% 57,964 Gains Tax (9,799) Working Capital 5% (23,331) (1,167) (1,225) (1,287) (1,351) 28,361

Net Cash Flow (148,331)$ 44,450$ 52,127$ 51,372$ 51,799$ 128,851$ (in actual dollars)

Example 9.4 Applying Specific Inflation Rates


Rate of Return Analysis under Inflation Principle:True (real) rate of

return should be based on constant dollars.

If the rate of return is computed based on actual dollars, the real rate of return can be calculated as:

n

Net cash flows in actual dollars

Net cash flows in constant dollars

0

1

2

3

4

-$30,000

13,570

15,860

13,358

13,626

-$30,000

12,336

13,108

10,036

9,307

IRR 31.34% 19.40%

ii

f'

.

..40%

_

1

11

1 0 3134

1 0 101

19

f_

10%


Decision Criterion

If you use 31.34% as your IRR, you should use a market interest rate (or inflation-adjusted MARR) to make an accept and reject decision.

If you use 19.40% as your IRR, you should use an inflation-free interest rate (inflation-free MARR) to make an accept and reject decision.


Input OutputTax Rate(%) = 40 PW(i) = $37,761

MARR(%) = 15 IRR(%) = 33.74%

0 1 2 3 4 5 6Income Statement

Revenues (savings) $38,780 $38,780 $38,780 $38,780 $38,780 $38,780Expenses: Depreciation 9,817 16,825 12,016 8,581 6,135 3,064

Taxable Income $28,963 $21,955 $26,764 $30,199 $32,645 $35,716Income Taxes (40%) 11,585 8,782 10,706 12,080 13,058 14,286

Net Income $17,378 $13,173 $16,059 $18,120 $19,587 $21,430

Cash Flow StatementOperating Activities: Net Income 17,378$ 13,173$ 16,059$ 18,120$ 19,587$ 21,430$ Depreciation 9,817$ 16,825$ 12,016$ 8,581$ 6,135$ 3,064$ Investment Activities: Investment (68,701)$ Salvage 3,500$ Gains Tax 3,505$

Net Cash Flow ($68,701) $27,195 $29,998 $28,074 $26,700 $25,722 $31,499

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L27: Project Cash Flow Analysis

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