L24: Net Income Versus Cash Flow ECON 320 Engineering Economics Mahmut Ali GOKCE Industrial Systems Engineering Computer Sciences

Taxable Income and Income Taxes Gross Income Expenses Cost of goods sold (revenues) Depreciation Operating expenses Taxable income Income taxes Net income Item

Example 8.8- Net Income Calculation ItemAmount Gross income (revenue)$50,000 Expenses Cost of goods sold Depreciation Operating expenses 20,000 4,000 6,000 Taxable income20,000 Taxes (40%)8,000 Net income$12,000

Capital Expenditure versus Depreciation Expenses $4,000 $6,850 $4,900 $3,500$2,500 $1,250 $28,000 Capital expenditure (actual cash flow) Allowed depreciation expenses (not cash flow)

Cash Flow vs. Net Income Net income : Net income is an accounting means of measuring a firm’s profitability based on the matching concept. Costs become expenses as they are matched against revenue. The actual timing of cash inflows and outflows are ignored. Cash flow : Considering the time value of money, it is better to receive cash now than later, because cash can be invested to earn more money. So, cash flows are more relevant data to use in project evaluation.

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.

Example 8.9 – Cash Flow versus Net Income ItemIncomeCash Flow Gross income (revenue$50,000 Expenses Cost of goods sold Depreciation Operating expenses 20,000 4,000 6, ,000 -6,000 Taxable income20,000 Taxes (40%)8,000-8,000 Net income$12,000 Net cash flow$16,000

Net income versus net cash flow $0 $50,000 $40,000 $30,000 $20,000 $10,000 $8,000 $6,000 $20,000 Net income Depreciation Income taxes Operating expenses Cost of goods sold Net cash flow Gross revenue $4,000 $12,000 Net cash flows = Net income + non-cash expense (depreciation)