Net Income Versus Cash Flow Lecture No.24 Professor C. S. Park Fundamentals of Engineering Economics Copyright © 2005

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

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

Allowed depreciation expenses (not cash flow) Capital Expenditure versus Depreciation Expenses 1 2 3 4 5 6 7 8 Capital expenditure (actual cash flow) $28,000 1 2 3 4 7 6 7 8 $1,250 $3,500 $2,500 $2,500 $2,500 $4,000 $4,900 $6,850 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? 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 2nd year. Company A can invest $1 million in year 1, while Company B has nothing to invest during the same period. Company A Company B Year 1 Net income Cash flow $1,000,000 1,000,000 Year 2 2,000,000

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

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