1

Developing Project Cash Flow Statement

Lecture No. 23Chapter 9Fundamentals of Engineering EconomicsCopyright © 2008

2

A Typical Format Used in Presenting a Net Cash Flow Statement

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

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

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

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

n

MACRS Rate

Depreciation Amount

Allowed Depreciation Amount

1 14.29% $23,143 $23,143

2 24.49% $39,673 $39,673

3 17.49% $28,338 $28,338

4 12.49% $20,242 $20,242

5 8.93% $14,458 $7,229

6 8.92% $14,450 0

7 8.93% $14,458 0

8 4.46% $7,229 0

Step 1: Depreciation CalculationCost basis = $162,000

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

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

0 51 2 3 4

$25,000

0

$25,000 $25,000

5

10

Step 4: Develop the Cash Flow Statement

11

0 1 2 3 4 5

$25,000Years

$25,000

Working capital recovery cycles

0 1 2 3 4 5

$60,257$66,869 $62,335

$59,097$98,242

Working capitalrecovery

$25,000

$162,000 Investment in physical assets

$25,000 Investment inworking capital

$25,000

$25,000

Cash Flow Diagram including Working Capital

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

End of

Year

Beginning

Balance

Interest Payment

Principal Payment

Ending

Balance

1 $64,800 $7,776 $10,200 $54,600

2 54,600 6,552 11,424 43,176

3 43,176 5,181 12,795 30,381

4 30,381 3,646 14,330 16,051

5 16,051 1,926 16,051 0

Amount financed: $64,800, or 50% of the total capital expenditureFinancing rate: 12% per yearAnnual installment: $17,976 or, A = $64,800(A/P, 12%, 5)

$17,976

Example 9.3 Cash Flow Statement with Financing Activities

14

Cash Flow Statement (Table 9.3)

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

Project Combined Operation

Taxable income

Income taxes (35%)

$100M

$35M

(10M)

?

$90M

$31.5M

Tax Savings = $35M - $31.5M = $3.5MOr (10M)(0.35) = -$3.5M

Tax savings

16

Effects of Inflation on Project Cash Flows – (1) Depreciation Expenses

Note: Depreciation expenses are based on historical costs andalways expressed in actual dollars

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

17

Effects of Inflation on Project Cash Flows – (2) Interest Expenses

Item Effects of Inflation

Loan repayments

Borrowers repay historical loan amounts with dollars of decreased purchasing power, reducing the debt-financing cost.

18

Effects of Inflation on Project Cash Flows – (3) Working Capital

Item Effects 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

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

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.

20

Example 9.4 Effects of Inflation on Projects with Depreciable Assets

21

Cash Flow Statement (Table 9.4)

22

Example 9.5 Applying Specific Inflation Rates

Cash Flow Item Inflation RateRevenue 6%Labor 5%Materials 4%Overhead 5%Salvage value 3%Working capital 5%

General inflation rate = 6%Inflation-free interest rate = 15%Market interest rate = 21.90%

23

Cash Flow Statement (Table 9.5)

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.