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Project Cash Flow Analysis

Lecture No. 27
Professor C. S. Park
Fundamentals of Engineering Economics
Copyright © 2005

1
Elements of Investment Decision
• Identification of Investment Opportunities
• Generation of Cash Flows
• Measures of Investment Worth
• Project Selection Our focus in this
chapter is to
• Project Implementation develop the format
of after-tax cash
• Project-Control/Post-Audit flow statements.

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

3
Cash Flows from Operating Activities
Approach 1 Approach 2
Income Statement Approach Direct Cash Flow Approach
Operating revenues Operating revenues
Cost of goods sold - Cost of goods sold
Depreciation
Operating expenses - Operating expenses
Interest expenses - Interest expenses
Taxable income
Income taxes - Income taxes
Net income Cash flow from operation
+ Depreciation

4
A Typical Format used for Presenting Cash Flow
Statement
Cash flow statement
Operating
+ Net income
activities
+Depreciation
Income statement
Revenues -Capital investment +
Expenses + Proceeds from sales of
Cost of goods sold depreciable assets
Depreciation - Gains tax Investing
Debt interest - Investments in working activities
Operating expenses capital
Taxable income + Working capital recovery +
Income taxes
Net income + Borrowed funds Financing
-Repayment of principal activities

Net cash flow

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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%

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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?
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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.

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• (a) Step 1: Depreciation Calculation
– Cost Base = $125,000
– Recovery Period = 7-year MACRS
MACRS Depreciation Allowed
N Rate Amount Depreciation Amount
1 14.29% $17,863 $17,863
2 24.49% $30,613 $30,613
3 17.49% $21,863 $21,863
4 12.49% $15,613 $15,613
5 8.93% $11,150 $5,575
6 8.92% $11,150 0
7 8.93% $11,150 0
8 4.46% $5,575 0

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(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
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Step 3 – Create an Income Statement

Income 0 1 2 3 4 5
Statement
Revenues $100,00 $100,00 $100,00 $100,00 $100,00
0 0 0 0 0
Expenses:
Labor 20,000 20,000 20,000 20,000 20,000
Material 12,000 12,000 12,000 12,000 12,000
Overhead 8,000 8,000 8,000 8,000 8,000
Depreciation 17,863 30,613 21,863 15,613 5,581
Taxable Income $42,137 $29,387 $38,137 $44,387 $54,419
Income Taxes (40%) 16,855 11,755 15,255 17,755 21,768
Net Income $25,282 $17,632 $22,882 $26,632 $32,651
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Step 4 – Develop a Cash Flow Statement
Cash Flow Statement 0 1 2 3 4 5

Operating Activities:

Net Income $25,28 $17,63 $22,88 $26,63 $32,651


2 2 2 2
Depreciation 17,863 30,613 21,863 15,613 5,581

Investment Activities:

Investment (125,000)

Working capital (23,331) 23,331

Salvage 50,000

Gains Tax (6,613)

Net Cash Flow ($148,331) $43,145 $48,245 $44,745 $42,245 $104,950

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An Excel Worksheet

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Example 9.1 - Net Cash Flow Table Generated by
Traditional Method Using Approach 2
A B C D E F G H I J
Year Investment & Revenue Labor Expenses Overhead Depreciation Taxable Income Net Cash
End Salvage Value Materials Income Taxes Flow
0 -$125,000 -$125,000
-23,331
1 $100,000 20,000 12,000 8,000 $17,863 42,137 16,855 $43,145

2 100,000 20,000 12,000 8,000 30,613 29,387 11,755 $48,245


3 100,000 20,000 12,000 8,000 21,863 38,137 15,255 $44,745
4 100,000 20,000 12,000 8,000 15,613 44,387 17,755 $42,245

5 100,000 20,000 12,000 8,000 5,581 54,419 21,678 $38,232

50,000* 16,525 6,613 $43,387


23,331 23,331

*Salvage value Note that


H = C-D-E-F-G Information required to
I = 0.4 * H calculate the income taxes
J= B+C-D-E-F-I

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Cash Flow Diagram including Working Capital
$23,331 Working capital
recovery
$48,245 $44,745 $81,619
$43,145 $42,245

1 2 3 4 5
0
$125,000 Investment in
physical assets $23,331 $23,331
$23,331 Investment in
working capital
0 1 2 3 4 5

$23,331 Years
$23,331
Working capital recovery cycles

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Question (b):
 Is this investment justifiable
at a MARR of 15%?
$104,950

 PW(15%) = -$148,331 + $48,245 $44,745 $42,245


+$43,145(P/F, 15%, 1) + . . . $43,145
. + $104,950 (P/F, 15%, 5)
0
= $31,420 > 0
1 2 3 4 5
 Yes, Accept the Project !
Years

$148,331

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Question (C): IRR
A B
1 Period Cash Flow
2 0 ($148,331)
=IRR(B2:B7,0.10)
3 1 43,145
4 2 48,245
5 3 44,745 IRR = 22.55%
6 4 42,245
7 5 104,950

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Rate of Return Analysis (IRR = 22.55%)

n=0 n =1 n=2 n=3 n=4 n=5


Beginning -$148,331 -$138,635 -$121,652 -$104,339 -$85,622
Balance
Return on -$33,449 -$31,262 -$27,432 -$23,528 -$19,328
Investment
(interest)
Payment -$148,331 $43,145 $48,245 $44,745 $42,245 $104,950

Project -$148,331 -$138,635 -$121,652 -$104,339 -$85,622 0


Balance

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When Projects are Financed with Borrowed
Funds
 Key issue: Interest  What about Principal
payment is a tax- Payments? As the
deductible expense. amount of borrowing is
 What Needs to Be NOT viewed as income
Done: Once a loan to the borrower, the
repayment schedule is repayments of principal
known, separate the
interest payments from are NOT viewed as
the annual installments. expenses either– NO
tax effect.

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Loan Repayment Schedule (Example 9.2)
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)

End of Beginning Interest Principal Ending


Year Balance Payment Payment Balance
1 $62,500 $6,250 $10,237 $52,263
2 52,263 5,226 11,261 41,002
3 41,002 4,100 12,387 28,615
4 28,615 2,861 13,626 14,989
5 14,989 1,499 14,988 0

$16,487

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Table 9.4

Additional
entries related
to debt financing

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When Projects Results in Negative Taxable
Income
 Negative taxable  Handling Project Loss
income (project loss)
means you can
reduce your taxable Regular Project Combined
income from regular Business Operation
business operation Taxable $100M (10M) $90M
by the amount of income
loss, which results in Income $35M ? $31.5M
a tax savings. taxes
(35%) Tax savings

Tax Savings = $35M - $31.5M


= $3.5M
Or (10M)(0.35) = -$3.5M

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Effects of Inflation on Project Cash Flows

Item Effects of Inflation

Depreciation Depreciation expense is


expense 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

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Item Effects of Inflation

Salvage value Inflated salvage value


combined with book values
based on historical costs
results in higher taxable gains.

24
Item Effects of Inflation

Loan repayments Borrowers repay historical


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

25
Item Effects of Inflation

Working capital Known as working capital


requirement drain, the cost of working
capital increases in an
inflationary environment.

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Item Effects of Inflation

Rate of Return Unless revenues are


and NPW 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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A B C D E F G H
1 Example 9.3 Cash Flow Statement for the Automated Machining Center Project
7
8 Income Statement
9 Inflation Rate 0 1 2 3 4 5
11
12 Revenues 5% $ 105,000 $ 110,250 $ 115,763 $ 121,551 $ 127,628
13 Expenses:
14 Labor 5% 21,000 22,050 23,153 24,310 25,526
15 Material 5% 12,600 13,230 13,892 14,586 15,315
16 Overhead 5% 8,400 8,820 9,261 9,724 10,210
17 Depreciation 17,863 30,613 21,863 15,613 5,581
18
19 Taxable Income $ 45,137 $ 35,537 $ 47,595 $ 57,317 $ 70,996
20 Income Taxes (40%) 18,055 14,215 19,038 22,927 28,398
21
22 Net Income $ 27,082 $ 21,322 $ 28,557 $ 34,390 $ 42,598
23
24 Cash Flow Statement
25
26 Operating Activities:
27 Net Income 27,082 21,322 28,557 34,390 42,598
28 Depreciation 17,863 30,613 21,863 15,613 5,581
29 Investment Activities:
30 Investment (125,000)
31 Salvage 5% 63,814
32 Gains Tax (12,139)
33 Working Capital 5% (23,331) (1,167) (1,225) (1,287) (1,351) 28,361
34
35 Net Cash Flow $ (148,331) $ 43,778 $ 50,710 $ 49,133 $ 48,652 $ 128,215
36 (in actual dollars)

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Example 9.4 Applying Specific Inflation Rates
Example 9.4 Cash Flow Statement for AMC Project under Inflation (Multiple Price Indices)

Income Statement
Inflation Rate 0 1 2 3 4 5

Revenues 6% $106,000 $112,360 $119,102 $ 126,248 $ 133,823


Expenses:
Labor 5% 21,000 22,050 23,153 24,310 25,526
Material 4% 12,480 12,979 13,498 14,038 14,600
Overhead 5% 8,400 8,820 9,261 9,724 10,210
Depreciation 17,863 30,613 21,863 15,613 5,581

Taxable Income $ 46,257 $ 37,898 $ 51,327 $ 62,562 $ 77,906


Income Taxes (40%) 18,503 15,159 20,531 25,025 31,162

Net Income $ 27,754 $ 22,739 $ 30,796 $ 37,537 $ 46,744

Cash Flow Statement

Operating Activities:
Net Income 27,754 22,739 30,796 37,537 46,744
Depreciation 17,863 30,613 21,863 15,613 5,581
Investment Activities:
Investment (125,000)
Salvage 3% 57,964
Gains Tax (9,799)
Working Capital 5% (23,331) (1,167) (1,225) (1,287) (1,351) 28,361

Net Cash Flow $ (148,331) $ 44,450 $ 52,127 $ 51,372 $ 51,799 $ 128,851


(in actual dollars)

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Rate of Return Analysis under Inflation
_
f  10%

 Principle:True (real) rate of Net cash Net cash


return should be based on flows in flows in
constant dollars. n actual constant
dollars dollars
 If the rate of return is
computed based on actual 0 -$30,000 -$30,000
dollars, the real rate of 1 13,570 12,336
return can be calculated 2 15,860 13,108
as: 3 13,358 10,036
1 i 4 13,626 9,307
i'  _ 1
1 f IRR 31.34% 19.40%
1  0.3134
 1
1  0.10
 19.40%

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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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Input Output
Tax Rate(%) = 40 PW(i) = $37,761
MARR(%) = 15 IRR(%) = 33.74%

0 1 2 3 4 5 6
Income Statement

Revenues (savings) $38,780 $38,780 $38,780 $38,780 $38,780 $38,780


Expenses:
Depreciation 9,817 16,825 12,016 8,581 6,135 3,064

Taxable Income $28,963 $21,955 $26,764 $30,199 $32,645 $35,716


Income Taxes (40%) 11,585 8,782 10,706 12,080 13,058 14,286

Net Income $17,378 $13,173 $16,059 $18,120 $19,587 $21,430

Cash Flow Statement


Operating Activities:
Net Income $ 17,378 $ 13,173 $ 16,059 $ 18,120 $ 19,587 $ 21,430
Depreciation $ 9,817 $ 16,825 $ 12,016 $ 8,581 $ 6,135 $ 3,064
Investment Activities:
Investment $ (68,701)
Salvage $ 3,500
Gains Tax $ 3,505

Net Cash Flow ($68,701) $27,195 $29,998 $28,074 $26,700 $25,722 $31,499

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