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

2. 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. 3 Types of Cash Flow Elements in Project Analysis Differential or incremental cash flow: cash flow due asset

4. 4 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

5. 5 A Typical Format used for Presenting Cash Flow Statement Income statement Revenues Expenses Cost of goods sold Depreciation Debt interest Operating expenses Taxable income Income taxes Net income 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 Investing activities Financing activities + +

6. 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. 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. 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. 9 (a) Step 1: Depreciation Calculation –Cost Base = $125,000 –Recovery Period = 7-year MACRS N MACRS Rate Depreciation Amount Allowed Depreciation Amount 114.29%$17,863 224.49%$30,613 317.49%$21,863 412.49%$15,613 58.93%$11,150$5,575 68.92%$11,1500 78.93%$11,1500 84.46%$5,5750

10. 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. 11 Income Statement 012345 Revenues$100,00 0 Expenses: Labor20,000 Material12,000 Overhead8,000 Depreciation17,86330,61321,86315,6135,581 Taxable Income$42,137$29,387$38,137$44,387$54,419 Income Taxes (40%)16,85511,75515,25517,75521,768 Net Income$25,282$17,632$22,882$26,632$32,651 Step 3 – Create an Income Statement

12. 12 Step 4 – Develop a Cash Flow Statement Cash Flow Statement 012345 Operating Activities: Net Income$25,28 2 $17,63 2 $22,88 2 $26,63 2 $32,651 Depreciation17,86330,61321,86315,6135,581 Investment Activities: Investment(125,000) Working capital(23,331)23,331 Salvage50,000 Gains Tax(6,613) Net Cash Flow ($148,331)$43,145$48,245$44,745$42,245$104,950

13. 13 An Excel Worksheet

14. 14 Example 9.1 - Net Cash Flow Table Generated by Traditional Method Using Approach 2 ABCDEFGHIJ Year End Investment & Salvage Value RevenueLaborExpenses Materials OverheadDepreciationTaxable Income Income Taxes Net Cash Flow 0-$125,000 -23,331 -$125,000 1$100,00020,00012,0008,000$17,86342,13716,855$43,145 2100,00020,00012,0008,00030,61329,38711,755$48,245 3100,00020,00012,0008,00021,86338,13715,255$44,745 4100,00020,00012,0008,00015,61344,38717,755$42,245 5100,00020,00012,0008,0005,58154,41921,678$38,232 50,000* 23,331 16,5256,613$43,387 23,331 Information required to calculate the income taxes *Salvage value Note that H = C-D-E-F-G I = 0.4 * H J= B+C-D-E-F-I

15. 15 Cash Flow Diagram including Working Capital 0 1234 5 $23,331 Years $23,331 Working capital recovery cycles 0 12345 $43,145 $48,245 $44,745 $42,245 $81,619 Working capital recovery $23,331 $125,000 Investment in physical assets $23,331 Investment in working capital $23,331

16. 16 Question (b): Is this investment justifiable at a MARR of 15%? PW(15%) = -$148,331 + +$43,145(P/F, 15%, 1) +.... + $104,950 (P/F, 15%, 5) = $31,420 > 0  Yes, Accept the Project ! 0 12345 $148,331 $43,145 $48,245 $44,745 $42,245 $104,950 Years

17. 17 Question (C): IRR AB 1PeriodCash Flow 20($148,331) 3143,145 4248,245 5344,745 6442,245 75104,950 =IRR(B2:B7,0.10) IRR = 22.55%

18. 18 Rate of Return Analysis (IRR = 22.55%) n = 0n =1n = 2n = 3n = 4n = 5 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-$148,331$43,145$48,245$44,745$42,245$104,950 Project Balance -$148,331-$138,635-$121,652-$104,339-$85,6220

19. 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. 20 Loan Repayment Schedule (Example 9.2) End of Year Beginning Balance Interest Payment Principal Payment Ending Balance 1$62,500$6,250$10,237$52,263 252,2635,22611,26141,002 3 4,10012,38728,615 4 2,86113,62614,989 5 1,49914,9880 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) $16,487

21. 21 Additional entries related to debt financing Table 9.4

22. 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 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

23. 23 Effects of Inflation on Project Cash Flows 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 Note: Depreciation expenses are based on historical costs and always expressed in actual dollars

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

25. 25 ItemEffects of Inflation Loan repaymentsBorrowers repay historical loan amounts with dollars of decreased purchasing power, reducing the debt-financing cost.

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

27. 27 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.

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29. 29 Example 9.4 Applying Specific Inflation Rates

30. 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 0123401234 -$30,000 13,570 15,860 13,358 13,626 -$30,000 12,336 13,108 10,036 9,307 IRR 31.34% 19.40%

31. 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.

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