Chapter 9 – Incremental Cash Flow  Learning Objectives  Understand the importance of cash flow  Calculate the operating cash flow  Produce a Sources and Uses of Cash  Understand the relationship of the three financial statements  Calculate depreciation and cost recovery  Estimate cash flow for capital budgeting decisions

Three Financial Statements  Income Statement – Measure of performance over a specific time  Statement of Financial Position or Balance Sheet – Listing of all assets, liabilities, and ownership claims  Sources and Uses of Cash or Statement of Cash Flow – Where dollars came from and where dollars were spent

Income Statement  Income Statement bottom line is net income  Net income is not cash flow  Accrual Accounting – timing of cash and recording of economic transaction different  Noncash items – depreciation for example  Want operating cash flow (OCF)  Use modified income statement  Interest expense is not part of OCF  OCF = EBIT + Depreciation - Taxes

Balance Sheet  The Balance Sheet Categories  Cash Account  Key element is change in cash over the period  Cash includes money, checking accounts, etc.  Working Capital Accounts  Current Assets and Current Liabilities  Assets and Liabilities typically converted to cash or paid over the business cycle  Long-Term Debt  Owner’s Accounts  Snapshot of company at a specific point in time

Sources and Uses of Cash  Statement of Cash Flow or Sources and Uses of Cash  Cash flow from business operations  Cash flow from financing  From Owners (residual claims)  From Lenders (fixed claims)  Cash flow for capital spending  Purchase of capital equipment  Recapture cash from sale of assets  Ties to the change in Cash Account over the period

Accounting Relationship  Accounting Identity in two forms  Assets ≡ Liabilities + Owner’s Equity  Cash Flow from Assets ≡ Cash Flow to Creditors + Cash Flow to Owners  Work through components, pages  Building the Cash Flow Identity  Cash Flow from Assets = Operating Cash Flow – Increases in Net Working Capital – Increases in Capital Spending

Accounting Relationship  Continued Building the Cash Flow Identity  Cash Flow to/from Creditors  Interest paid on debt – shows up in this section not in operating cash flow  Any repayment of principal on debt claims  New borrowed funds are from (negative to lenders)  Cash Flow to Owners  Dividend Payments  Any retirement of common stock  New shares issued are funds from (negative to owners)

Cash Flow Identity to Sources and Uses of Cash  Once the components of the cash flow identity are calculated…  Convert the information into the Statement of Cash Flow or Sources and Uses of Cash  The change in the cash account is the “bottom line” of this statement  Three Categories  Operating Activities  Investing Activities  Financing Activities

Estimating Incremental Cash Flow  Objective – Estimate future cash flow of a project (for decision making)  Only Incremental Cash Flow used in decision  Sunk Costs – Do not use  Erosion Costs – Must account for lost sales of old products when new product introduced  Synergy Gains – = 5  Working Capital – new projects require working capital, must include in cash flow  Capital Expenditures – Usually large up front cash flow out  Depreciation and cost recovery on divesting assets

Capital Spending and Depreciation  Capital Spending for a project is usually an up front cash outflow  It is expensed on the income statement over time via depreciation  Depreciation is not a cash flow  Deprecation impacts cash flow through reduction in taxes, a real cash flow  Different Types  Straight line depreciation  Modified Accelerated Cost Recovery System (MACRS)

Capital Spending and Depreciation  Depreciation example for Cogswell Cola  Bottling Machine – Initial cost is $1,500,00  Include installation costs, another $150,000  Property class for MACRS is 7 years  Annual depreciation expense  Year 1 = $1,650,000 x = $235,785  Year 2 = $1.650,000 x = $404,085  …  Year 8 = $1,650,000 x = $73,425  Table 9.5 page 275 for all eight years

Disposal of Capital Equipment  When a capital asset is disposed of by a company it can result in cash flow  Fully depreciated assets: cash flow is sale price minus taxes  When asset is not fully depreciated  Determine current “book value” of asset  Difference between sales price and book value is the gain or loss on disposal  Tax a gain and tax credit on a loss  Cash flow is sales price – tax on gain (or + credit on loss)  Example 9.3 College Doughnuts Disposal

Projected Cash Flow for Project  Putting all the elements together on incremental cash flow for decision making on a project  Initial Investment (typically capital spending and increases in working capital)  Annual operating cash flow  Disposal of equipment  Decrease in working capital at conclusion of project  Use Incremental Cash Flow with  NPV Model  IRR Model  Example Pulsar Cola Project – Table 9.8

Homework  Problems 5 through 10 – Accounting Relationship  Problem 12 – Erosion Costs  Problem 16 – Depreciation  Problem 18 – Cost Recovery  Problem 20 – Incremental Cash Flow