Project Cash Flow Analysis Lecture No. 27 Professor C. S. Park Fundamentals of Engineering Economics Copyright © 2005

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 Differential or incremental cash flow: cash flow due asset

Cash Flows from Operating Activities 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 - Cost of goods sold - Operating expenses - Interest expenses - Income taxes Cash flow from operation

A Typical Format used for Presenting 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 Operating activities Income statement Revenues Expenses Cost of goods sold Depreciation Debt interest Operating expenses Taxable income Income taxes Net income + Investing activities + Financing activities

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.

Allowed Depreciation Amount (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 2 24.49% $30,613 3 17.49% $21,863 4 12.49% $15,613 5 8.93% $11,150 $5,575 6 8.92% 7 8 4.46%

(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

Step 3 – Create an Income Statement 1 2 3 4 5 Revenues $100,00 0 Expenses: Labor 20,000 Material 12,000 Overhead 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 4 – Develop a Cash Flow Statement 1 2 3 4 5 Operating Activities: Net Income $25,282 $17,63 2 $22,88 2 $26,63 2 $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

Investment & Salvage Value 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 -$125,000 -23,331 1 $100,000 20,000 12,000 8,000 $17,863 42,137 16,855 $43,145 2 100,000 30,613 29,387 11,755 $48,245 3 21,863 38,137 15,255 $44,745 4 15,613 44,387 17,755 $42,245 5 5,581 54,419 21,678 $38,232 50,000* 23,331 16,525 6,613 $43,387 *Salvage value Note that H = C-D-E-F-G I = 0.4 * H J= B+C-D-E-F-I Information required to calculate the income taxes

Working capital recovery cycles Cash Flow Diagram including Working Capital $23,331 Working capital recovery $44,745 $81,619 $48,245 $43,145 $42,245 1 2 3 4 5 $125,000 Investment in physical assets $23,331 $23,331 $23,331 Investment in working capital 1 2 3 4 5 Years $23,331 $23,331 Working capital recovery cycles

Question (b): Yes, Accept the Project ! 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 ! $104,950 $48,245 $44,745 $42,245 $43,145 1 2 3 4 5 Years $148,331

Question (C): IRR IRR = 22.55% A B 1 Period Cash Flow 2 ($148,331) 3 ($148,331) 3 43,145 4 48,245 5 44,745 6 42,245 7 104,950 =IRR(B2:B7,0.10) IRR = 22.55%

Rate of Return Analysis (IRR = 22.55%) 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 $43,145 $48,245 $44,745 $42,245 $104,950 Project

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) Amount financed: $62,500, or 50% of total capital expenditure Financing rate: 10% per year Annual installment: $16,487 or, A = $62,500(A/P, 10%, 5) End of Year Beginning Balance Interest Payment Principal Payment Ending 1 $62,500 $6,250 $10,237 $52,263 2 52,263 5,226 11,261 41,002 3 4,100 12,387 28,615 4 2,861 13,626 14,989 5 1,499 14,988 $16,487

Table 9.4 Additional entries related to debt financing

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

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 and always expressed in actual dollars

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

Item Effects of Inflation Loan repayments Borrowers repay historical loan amounts with dollars of decreased purchasing power, reducing the debt-financing cost.

Item Effects of Inflation Working capital requirement Known as working capital drain, the cost of working capital increases in an inflationary environment.

Item Effects of Inflation 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.

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 1 2 3 4 -$30,000 13,570 15,860 13,358 13,626 12,336 13,108 10,036 9,307 IRR 31.34% 19.40%

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.