Post on 17-Jan-2016
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Developing Project Cash Flow Statement
Lecture No. 23Chapter 9Fundamentals of Engineering EconomicsCopyright © 2008
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A Typical Format Used in Presenting a Net Cash Flow Statement
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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)
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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.
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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
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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%
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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
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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
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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
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Step 4: Develop the Cash Flow Statement
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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
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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.
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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
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Cash Flow Statement (Table 9.3)
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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
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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
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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.
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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.
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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.
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Example 9.4 Effects of Inflation on Projects with Depreciable Assets
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Cash Flow Statement (Table 9.4)
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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%
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Cash Flow Statement (Table 9.5)
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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.