1. 1 Chapter 9 Project Cash Flow Analysis

2. 2 Project Cost Elements Cost data is required to prepare external reports (historical cost data) make decisions (current or estimated future cost data) prepare planning budgets (historical, current or estimated cost data)

3. 3 Classifying Costs for Manufacturing Environments

4. 4 Manufacturing Costs Direct materials: any material used in final product Direct labor: labor cost in fabrication of a product Manufacturing Overhead: indirect material, indirect labor, maintenance and repairs, heat and light, tax, depreciation, insurance, premium Non-manufacturing Costs: operating and marketing costs Overhead: heat and light, tax, depreciation associated with selling and administrative functions Marketing: Overhead, advertising, sales travel, shipping, sales commissions, sales salaries Administrative functions: executive and organizational cost related with management (accounting, public relations, secretarial support)

5. 5 Classifying Costs for Financial Statements Matching Concept: The costs incurred to generate particular revenue should be recognized as expenses in the same period that the revenue is recognized. Period costs: Those costs that are charged to expenses in the period in which the expenses are incurred. Assumption: the associated benefits are received in the same period as the expenses are incurred. Ex: all general and administrative expenses, selling expenses, insurance, income-tax expenses. Period costs appear on the income statement as expenses in the time period in which they occur. Product costs: Those costs that are matched against revenues on a product basis. Consist of costs involved in the purchase or manufacturing of goods. Ex: direct material, direct labor, manufacturing overhead. Product costs appear in the financial statements when the inventory or final product is sold, not when the product is manufactured.

6. 6 Classifying Costs for Financial Statements

7. 7 Cost Classification for Predicting Cost Behavior Cost behavior describes how a cost item responds to changes in the level of business activity. Volume index: The unit measure used to define “volume”. May be based on production inputs or outputs.  Automobile – “miles” driven  Generating plant – “kWh” produced  Stamping machine – “parts” stamped Cost Behaviors Fixed costs Variable costs Mixed costs Average unit costs

8. 8 Fixed Costs Def: The costs of providing a company’s basic operating capacity Cost behavior: Remain constant over the relevant range Ex: building rents, depreciation, salaries, annual insurance for a car

9. 9 Variable Costs Def: Costs that vary depending on the level of production or sales Cost behavior: Increase or decrease proportionally according to the level of volume Ex: direct material and labor cost, gasoline cost for a car Unit sales price-Unit variable cost=Unit contribution margin

10. 10 Mixed Costs  Def: a cost with both fixed and variable elements  Cost Behavior: y = a + bx, where “a” is a fixed cost  Typical examples: cost of electric power (lighting/heating/ac – fixed; power consumption by operating equipment – variable), depreciation cost for a car Total cost Operating Volume, X a 0

11. 11 Average Unit Cost Def: activity cost per unit basis Cost Behaviors:  Fixed cost per unit varies with changes in volume.  Variable cost per unit of volume is a constant.

12. 12 Practice Problem You have 3000 units to produce. Total labor cost = $20,000 Total material cost = $25,000 Total overhead cost = $15,000 Total fixed cost = $40,000 Average cost per unit= ($100,000)/3,000 = $33.33/unit

13. 13 Contribution Margin/Break-Even Sales Volume  Unit contribution margin  Unit contribution margin = unit sales price – unit variable cost  Contribution margin  Contribution margin = total sales revenue – total variable costs  Break-even sales volume: The volume where the total expenses become equal to the total sales revenue. unit sales price*V = fixed costs + unit variable cost*V unit sales price*V - unit variable cost*V = fixed costs

14. 14 Example 9.1 Break-Even Sales Volume Monthly break-even point: Number of units to be sold to make $50,000 profit before tax:

15. 15 Cost-Volume-Profit Graph

16. 16 Why Do We Use Cash Flow in Project Evaluation? Company ACompany B Year 1Net income Cash flow $1,000,000 1,000,000 $1,000,000 0 Year 2Net income Cash flow 1,000,000 2,000,000 Example: Both companies (A & B) have the same amount of net income and cash sum over 2 years, but Company A returns $1 million cash yearly, while Company B returns $2 million at the end of 2 nd year. Company A can invest $1 million in year 1, while Company B has nothing to invest during the same period.

17. 17 What Income Tax Rate Should be Used in Project Analysis? Regular Business Project Revenues Expenses $200,000 $130,000 $40,000 $20,000 Taxable Income Income Taxes $70,000 $12,500 $20,000 ?

18. 18 Before Undertaking Project After Undertaking Project The Effect of Project Gross revenue$200,000$240,000$40,000 Expenses130,000150,00020,000 Taxable income$70,000$90,000$20,000 Income taxes$12,500$18,850$6,350 Average tax rate 17.86% 20.94% 31.75% This is the tax rate that should be used in project evaluation. Income Tax Rate to be Used in Project Analysis The tax rate to use is the rate that applies to the additional taxable income projected in the economic analysis. Tax rate table

19. 19 BeforeAfterIncremental Taxable income$70,000$90,000$20,000 Income taxes12,50018,8506,350 Average tax rate17.86%20.94% Incremental tax rate31.75% 0.25($5,000/$20,000) + 0.34($15,000/$20,000) = 31.75% $75,000

20. 20 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.

21. 21 Types of Cash Flow Elements in Project Analysis

22. 22 A Typical Format used for Presenting Cash Flow Statement

23. 23 Cash Flows from Operating Activities  Cash flows from operation:  Sales revenues  Cost of goods sold  Operating expenses  Income taxes  How to estimate the cash flows from operation:  Cash flows from operation = net income + non-cash expenses (depreciation and amortization)

24. 24 Cash Flows from Investing Activities  Investment in physical assets  Should be capitalized (depreciated).  Investment in working capital  Investment in working capital refers to the investment made in non-depreciable assets, such as cash, accounts receivable, and inventory that is available to meet day-to-day operating needs.  Should be treated as capital expenditures, but no depreciation deduction is allowed.  Any recovery of working capital at the end of project life has no tax consequences.

25. 25 Cash Flows from Financing Activities  Cash flows from financing activities:  The amount of borrowing  The repayment of principal  Treatment of interest expenses:  Interest payments are tax-deductible expenses, so they are classified as operating, not financing activities

26. 26 Example 9.2 Cash Flow Statement with Only Operating and Investing Activities  Project Nature: Purchase of a new milling machine  Financial Data:  Investment activities:  Capital expenditure (milling machine): $162,000  Project life: 5 years  Salvage value: $45,000  Investment in working capital: $25,000, which will be recovered in full at the end of year 5  Operating activities:  Annual operating revenue: $175,000  Annual operating expenses:  Labor: $60,000  Materials: $20,000  Overhead: $10,000  Accounting Data:  Depreciation method: 7-year MACRS  Income tax rate; 40%  MARR after tax: 15%

27. MACRS Depreciation Schedules for Personal Property with Half-Year Convention

28. 28 n MACRS Rate Depreciation AmountBook Value 114.29%$23,143$138,857 224.49%$39,673$99,184 317.49%$28,338$70,845 412.49%$20,242$50,604 58.93% / 2$14,458 /2 = $7,229$43,375 6--- 7--- 8--- Step 1: Depreciation Calculation Cost basis = $162,000

29. 29  Salvage value = $45,000  Book Value (year 5) = Cost Basis – Total Depreciation = $162,000 - $118,625 = $ 43,375  Taxable gains = Salvage Value – Book Value = $45,000 - $43,375 = $1,625  Gains tax = (Taxable Gains)(Tax Rate) = $1,625 (0.40) = $650 Step 2: Gains (Losses) Associated with Asset Disposal

30. 30  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. Step 3: Consideration of Working Capital Investments $25,000 05 1 23 4 0 5

31. 31 Step 4: Develop the Cash Flow Statement

32. 32 0 1234 5 $25,000 Years $25,000 Working capital recovery cycles 0 12345 $60,257 $66,869 $62,335 $59,097 $98,242 Working capital recovery $25,000 $162,000 Investment in physical assets $25,000 Investment in working capital $25,000 Cash Flow Diagram including Working Capital

33. 33 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.

34. 34 End of Year Beginning Balance Interest Payment Principal Payment Ending Balance 1 $64,800 (64,800*12%) $7,776 (17,976-7,776) $10,200 (64,800*1.12-17,976) $54,600 2 54,600 (54,600*12%) 6,552 (17,976-6,552) 11,424 (54,600*1.12-17,976) 43,176 3 5,18112,79530,381 4 3,64614,33016,051 5 1,92616,0510 Amount financed: $64,800, or 50% of the total capital expenditure Financing rate: 12% per year Annual installment: $17,976 or, A = $64,800(A/P, 12%, 5) $17,976 Example 9.3 Cash Flow Statement with Financing Activities

35. 35 Remember! $5,000 A = $235.37 0 1 2 3 4 5 6 7 22 23 24 i = 1% per month Interest payment = ? Principal payment = ?

36. 36 Solution

37. 37 Cash Flow Statement (Table 9.3) Read the example from the book!

38. 38 When Project 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 ProjectCombined Operation Taxable income Income taxes (35%) $100M $35M (10M) ? $90M $31.5M Tax Savings = $35M - $31.5M = $3.5M Or (10M)(0.35) = -$3.5M Tax savings

39. 39 Effects of Inflation on Project Cash Flows ItemEffects of Inflation Depreciation expense Depreciation expense is charged to taxable income in dollars of declining values; taxable income is overstated, resulting in higher taxes Salvage value Inflated salvage value combined with book values based on historical costs results in higher taxable gains. Note: Depreciation expenses are based on historical costs and always expressed in actual dollars

40. 40 ItemEffects of Inflation 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. Effects of Inflation on Project Cash Flows

41. 41 Example 9.4 Effects of Inflation on Projects with Depreciable Assets (General inflation rate = 5%)

42. 42 Cash Flow Statement (Table 9.4) Read the example from the book!

43. 43 Example 9.5 Applying Specific Inflation Rates Cash Flow ItemInflation Rate  Revenue6%  Labor5%  Materials4%  Overhead5%  Salvage value3%  Working capital5%  General inflation rate = 6%  Inflation-free interest rate = 15%  Market interest rate = i’ + f + i’f = 21.90%

44. 44 Cash Flow Statement (Table 9.5) Read the example from the book!

45. 45 Decision Rules  If you use 41.15% (which was calculated based on the cash flows in actual dollars) as your IRR, you should use a market interest rate (21.90%) to make an accept and reject decision.  If you use 33.16% (which was obtained based on the cash flows in constant dollars) as your IRR, you should use an inflation-free interest rate (15%) to make an accept and reject decision.  33.16% = (41.15%-6%)/(1+6%) = (i-f)/(1+f)

46. 46 Example A farmer will purchase a land for $10,000 and farming equipment for $5,000. His starting working capital for the business will be $1,000. The farming equipment has 10- years life and will be depreciated using straight-line method with no salvage value. The expected income is $5,000 every year and annual operating cost is estimated to be $500. He has to pay $600 property tax on land every year, an expense which is tax deductible. He is subject to an income tax rate of 40%. What is the farmer’s prospective annual rate of return from this investment after taxes?

47. 47 Solution Income Statement Income5,000 Operating cost 500 Property tax 600 Depreciation 500 Taxable income3,400 Income tax@40%1,360 Net income2,040 Cash flow=Net income + Depreciation = $2,540

48. 48 Solution 5,000 10,000 1,000 2,540 …………………. 1,000 0 12 10

49. 49 Solution PW=-16,000+2,540(P/A,i,10)+1,000(P/F,i,10) PW(10%)=-16,000+2,540  6.1446+1,000  0.3855=-7.216 PW(9%)=-16,000+2,540  6.4177+1,000  0.4224=723.358 Interpolation: i=9+723.358/(723.358+7.216)=9.99%

50. 50 Summary Identifying and estimating relevant project cash flows is perhaps the most challenging aspect of engineering economic analysis. All cash flows can be organized into one of the following three categories: 1. Operating activities. 2. Investing activities 3. Financing activities.

51. 51 Cash Items 1. New investment and disposal of existing assets 2. Salvage value (or net selling price) 3. Working capital 4. Working capital release 5. Cash revenues/savings 6. Manufacturing, operating, and maintenance costs. 7. Interest and loan payments 8. Taxes and tax credits

52. 52 Non-cash items 1. Depreciation expenses 2. Amortization expenses The income statement approach is typically used in organizing project cash flows. This approach groups cash flows according to whether they are operating, investing, or financing functions.

53. 53 U.S. Corporate Tax Rate (2005) Taxable income 0-$50,000 $50,001-$75,000 $75,001-$100,000 $100,001-$335,000 $335,001-$10,000,000 $10,000,001-$15,000,000 $15,000,001-$18,333,333 $18,333,334 and Up Tax rate 15% 25% 34% 39% 34% 35% 38% 35% Tax computation $0 + 0.15(D) $7,500 + 0.25 (D) $13,750 + 0.34(D) $22,250 + 0.39 (D) $113,900 + 0.34 (D) $3,400,000 + 0.35 (D) $5,150,000 + 0.38 (D) $6,416,666 + 0.35 (D) (D) denotes the taxable income in excess of the lower bound of each tax bracket