Contemporary Engineering Economics, 4 th edition, © 2007 Process of Developing Project Cash Flows Lecture No.38 Chapter 10 Contemporary Engineering Economics Copyright © 2006

Contemporary Engineering Economics, 4 th edition, © 2007 Chapter Opening Story – New Incentives for Being Green Carrier corporation has invested $250 million in developing a new energy efficient heat exchangers. The expected retail price of the system unit is about $4,236. The initial profit margin is about 7.45%, but there is no way of knowing how long Carrier will be able to sustain their desired profit margin. Under this circumstance, any project’s justification depends upon the ability to estimate potential cash flows.

Contemporary Engineering Economics, 4 th edition, © 2007  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. Elements of Investment Decision

Contemporary Engineering Economics, 4 th edition, © 2007 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. Cash Flow vs. Net Income

Contemporary Engineering Economics, 4 th edition, © 2007 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  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 year1, while Company B has nothing to invest during the same period.

Contemporary Engineering Economics, 4 th edition, © 2007 Gross Income Expenses Cost of goods sold (revenues) Depreciation Operating expenses Taxable income Income taxes Net income Item Net Income Calculation – A Starting Point of Cash Flow Estimation

Contemporary Engineering Economics, 4 th edition, © 2007 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 Example – Net Income Calculation Project description:  Purchased an equipment costing $28,000  Gross income: $50,000/yr  Cost of goods sold: $20,000/yr  Operating expenses: $6,000/yr Depreciation method – 7-year MACRS Income tax rate: 40% Determine the net income during the first year of operation

Contemporary Engineering Economics, 4 th edition, © $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) Capital Expenditure versus Depreciation Expenses

Contemporary Engineering Economics, 4 th edition, © 2007 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 Cash Flow versus Net Income

Contemporary Engineering Economics, 4 th edition, © 2007 $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) Estimating Net Cash Flow from Net Income

Contemporary Engineering Economics, 4 th edition, © 2007 Types of Cash Flow Elements in Project Analysis

Contemporary Engineering Economics, 4 th edition, © 2007 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 Operating revenues - Cost of goods sold - Operating expenses - Interest expenses - Income taxes Cash flow from operation Cash Flows from Operating Activities

Contemporary Engineering Economics, 4 th edition, © 2007 A Typical Format used for Presenting Cash Flow Statement