L27: Project Cash Flow Analysis

1. L27: Project Cash Flow Analysis ECON 320 Engineering Economics Mahmut Ali GOKCE Industrial Systems Engineering Computer Sciences (c) 2001 Contemporary Engineering Economics

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. Types of Cash Flow Elements in Project Analysis

4. Cash Flows from Operating Activities

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

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. 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. 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. (a) Step 1: Depreciation Calculation • Cost Base = $125,000 • Recovery Period = 7-year MACRS

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. Step 3 – Create an Income Statement

12. Step 4 – Develop a Cash Flow Statement

13. An Excel Worksheet Table 9.1

14. Example 9.1 - Net Cash Flow Table Generated by Traditional Method Using Approach 2 *Salvage value Note that H = C-D-E-F-G I = 0.4 * H J= B+C-D-E-F-I Information required to calculate the income taxes

15. Cash Flow Diagram including Working Capital $23,331 Working capital recovery $44,745 $81,619 $48,245 $43,145 $42,245 1 2 3 4 5 0 $125,000 Investment in physical assets $23,331 $23,331 Investment in working capital $23,331 5 1 2 3 4 0 Years $23,331 $23,331 Working capital recovery cycles

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 ! $104,950 $48,245 $44,745 $42,245 $43,145 0 1 2 3 4 5 Years $148,331

17. Question (C): IRR =IRR(B2:B7,0.10) IRR = 22.55%

18. Rate of Return Analysis (IRR = 22.55%)

19. 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. When Projects are Financed with Borrowed Funds

20. 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) $16,487

21. Table 9.4 Net income+depreciation-principal repayment=net cahs flow Additional entries related to debt financing

22. 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 When Projects Results in Negative Taxable Income Tax savings Tax Savings = $35M - $31.5M = $3.5M Or (10M)(0.35) = -$3.5M

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

29. Example 9.4 Applying Specific Inflation Rates

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: IRR 31.34% 19.40%

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.