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

2. 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.

3. Types of Cash Flow Elements in Project Analysis Differential or incremental cash flow: cash flow due asset

4. 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

5. 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

6. 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%

7. 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?

8. 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.

9. 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%

10. (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

11. Step 3 – Create an Income Statement1 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

12. Step 4 – Develop a Cash Flow Statement1 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

13. An Excel Worksheet

14. Investment & Salvage Value
Example 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

15. 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

16. Question (b): Yes, Accept the Project !
Is this investment justifiable at a MARR of 15%?
PW(15%) = -$148, $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

17. 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%

18. 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

19. 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.

20. 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

21. Table 9.4
Additional
entries related
to debt financing

22. 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

23. 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

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

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

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

27. 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.

29. Example 9.4 Applying Specific Inflation Rates

30. 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. 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.