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Chapter 9 Project cash flow analysis

Understanding project cost elements Why use cash flow in economic analysis Income-tax rate to use in economic analysis Incremental cash flows from undertaking a project Developing project cash flow statements Effects of inflation on project cash flows

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Chapter 9 Project cash flow analysis

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  1. Understanding project cost elements Why use cash flow in economic analysis Income-tax rate to use in economic analysis Incremental cash flows from undertaking a project Developing project cash flow statements Effects of inflation on project cash flows Discount rate to be used in after-tax economic analysis: cost of capital Chapter 9Project cash flow analysis

  2. General cost terms Manufacturing costs • direct materials • direct labor • mfg. overhead Non-manufacturing costs • overhead • marketing • administrative

  3. Classifying costs for financial statements Matching concept: the costs incurred to generate particular revenue should be recognized as expenses in the same period that the revenue is recognized Period costs: those costs that are matched against revenues on a time period basis Product costs: those costs that are matched against revenues on a product basis

  4. Cost classification for predicting cost behavior Volume index: the unit measure used to define “volume”, e.g. automobile miles driven, generating plant kWh produced, stamping machine parts stamped Fixed costs: The costs of providing a company’s basic operating capacity – remain constant over the relevant range. Variable costs: Costs that vary depending on the level of production or sales – increase or decrease proportionally according to the volume. Mixed costs: semi-variable, e.g. depreciation Average unit costs: activity cost per unit basis, including fixed cost that varies with changes in volume & variable cost that is constant per unit of volume.

  5. Cost classification example You have 3,000 units to produce Labor cost = $20,000 Material cost = $25,000 Overhead cost = $15,000 Fixed cost = $40,000 What is the average cost per unit? Average cost = ($100,000)/3,000 = $33.33/unit

  6. $20,000 incremental taxable income due to undertaking project Regular income from operation $5,000 at 25% $15,000 at 34% Marginal tax rate 15% 25% 34% $100,000 $0 $20,000 $40,000 $60,000 $80,000 Income tax rate to use in project analysis? Average tax rate 17.86% 20.94%31.75% 0.25($5,000/$20,000) + 0.34($15,000/$20,000) = 31.75%

  7. 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

  8. Ex 9.1: When projects require only operating & investing activities • Project: 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% • Questions: • Develop the project’s cash flows over its project life. • Is this project justifiable at a MARR of 15%? • What is the internal rate of return of this project? Working capital means the amount carried in cash, accounts receivable & inventory that is available to meet day-to-day operating needs Treat working capital investments just like a capital expenditure except that no depreciation is allowed.

  9. Ex 9.1a: Step 1 – Depreciation calculation Cost base = $125,000 Recovery = 7-year MACRS

  10. Ex 9.1a: Step 2 – Gains (losses) associated w/ asset disposal Salvage value = $50,000 Book value (year 5) = cost base – 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. Ex 9.1a: Step 3 – Create an income statement

  12. Ex 9.1a: Step 4 – Develop a cash-flow statement

  13. Ex 9.1a: Net cash flow table generated by alternative approach *Salvage value Information required to calculate the income taxes Note that: H = C – D – E – F – G I = 0.4  H J = B + C – D – E – F – I

  14. Ex 9.1a: 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

  15. $104,950 $48,245 $44,745 $42,245 $43,145 0 1 2 3 4 5 Years $148,331 Ex 9.1b: 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 !

  16. Ex 9.1c: IRR Solve using Excel: =IRR(B2:B7,0.10) or trial & error … IRR = 22.55%

  17. Ex 9.1c: check rate of return analysis (IRR = 22.55%)

  18. 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

  19. Ex 9.2: Loan repayment schedule 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

  20. Ex 9.2: Effect on income, cash flow & NPW Additional entries related to debt financing PW(15%) = –$85,351 + $29,158(P/F, 15%, 1) + . . . . + $89,063 (P/F, 15%, 5) = $44,439 > $31,420

  21. Negative taxable income (project loss) means you can reduce your taxable income from regular business operationby the amount of loss, which results in a tax savings. Handling project loss When projects result in negative taxable income Tax savings Tax savings = $35M - $31.5M = $3.5M or (10M)(0.35) = -$3.5M

  22. Effects of inflation on project cash flows Depreciation expense is charged to taxable income in dollars of declining values; taxable income is overstated, resulting in higher taxes (Depreciation expenses are based on historical costs & always expressed in actual dollars) Inflated salvage value combined with book values based on historical costs results in higher taxable gains. Loan repayments: Borrowers repay historical loan amounts with dollars of decreased purchasing power, reducing the debt-financing cost. Known as “working capital drain”, the cost of working capital increases in an inflationary environment. Rate of return & NPW: Unless revenues are sufficiently increased to keep pace with inflation, tax effects and/or a working capital drain result in a lower rate of return or lower NPW.

  23. i – f i’ = i + f Ex 9.3: effects of inflation i = 0.15 + 0.05 + (0.15)(0.05) = 20.75% PW(20.75%) = $23,441 vs. $31,420 w/o inflation IRR = 22.20% vs. 22.55% w/o inflation > 20.75% i’ = 16.38% (inflation free rate of return) > MARR of 15% Decline in PW of $31,420 – $23,441 = $7,979 is due to income-tax considerations & working capital drains Recall that: i =i′ + f + f i′

  24. Ex 9.4: Applying specific inflation rates

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