1. 1 Developing Project Cash Flow Statement Lecture No. 23 Chapter 9 Fundamentals of Engineering Economics Copyright © 2008

2. 2 A Typical Format Used in Presenting a Net Cash Flow Statement

3. 3 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)

4. 4 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 carrying raw-material inventories.  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.

5. 5 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

6. 6 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%

7. 7 n MACRS Rate Depreciation Amount Allowed Depreciation Amount 114.29%$23,143 224.49%$39,673 317.49%$28,338 412.49%$20,242 58.93%$14,458$7,229 68.92%$14,4500 78.93%$14,4580 84.46%$7,2290 Step 1: Depreciation Calculation Cost basis = $162,000

8. 8  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 taxes = (Taxable Gains)(Tax Rate) = $1,625 (0.40) = $650 Step 2: Gains (Losses) Associated with Asset Disposal

9. 9  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

10. 10 Step 4: Develop the Cash Flow Statement

11. 11 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

12. 12 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.

13. 13 End of Year Beginning Balance Interest Payment Principal Payment Ending Balance 1$64,800$7,776$10,200$54,600 254,6006,55211,42443,176 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

14. 14 Cash Flow Statement (Table 9.3)

15. 15 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 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

16. 16 Effects of Inflation on Project Cash Flows – (1) Depreciation Expenses Note: Depreciation expenses are based on historical costs and always expressed in actual dollars 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

17. 17 Effects of Inflation on Project Cash Flows – (2) Interest Expenses ItemEffects of Inflation Loan repayments Borrowers repay historical loan amounts with dollars of decreased purchasing power, reducing the debt-financing cost.

18. 18 Effects of Inflation on Project Cash Flows – (3) Working Capital ItemEffects of Inflation Working capital requirement Known as working capital drain, the cost of working capital increases in an inflationary environment, as additional cash must be invested to maintain new price levels.

19. 19 Effects of Inflation on Project Cash Flows – (4) Profitability ItemEffects 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.

20. 20 Example 9.4 Effects of Inflation on Projects with Depreciable Assets

21. 21 Cash Flow Statement (Table 9.4)

22. 22 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 = 21.90%

23. 23 Cash Flow Statement (Table 9.5)

24. 24 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.