Chapter 9 – Incremental Cash Flow

1. Chapter 9 – Incremental Cash Flow • Learning Objectives • Understand the importance of cash flow • Calculate the operating cash flow • Produce a Sources and Uses of Cash • Understand the relationship of the three financial statements • Calculate depreciation and cost recovery • Estimate cash flow for capital budgeting decisions

2. Three Financial Statements • Income Statement – Measure of performance over a specific time • Statement of Financial Position or Balance Sheet – Listing of all assets, liabilities, and ownership claims • Sources and Uses of Cash or Statement of Cash Flow – Where dollars came from and where dollars were spent

3. Income Statement • Income Statement bottom line is net income • Net income is not cash flow • Accrual Accounting – timing of cash and recording of economic transaction different • Noncash items – depreciation for example • Want operating cash flow (OCF) • Use modified income statement • Interest expense is not part of OCF • OCF = EBIT + Depreciation - Taxes

4. Balance Sheet • The Balance Sheet Categories • Cash Account • Key element is change in cash over the period • Cash includes money, checking accounts, etc. • Working Capital Accounts • Current Assets and Current Liabilities • Assets and Liabilities typically converted to cash or paid over the business cycle • Long-Term Debt • Owner’s Accounts • Snapshot of company at a specific point in time

5. Sources and Uses of Cash • Statement of Cash Flow or Sources and Uses of Cash • Cash flow from business operations • Cash flow from financing • From Owners (residual claims) • From Lenders (fixed claims) • Cash flow for capital spending • Purchase of capital equipment • Recapture cash from sale of assets • Ties to the change in Cash Account over the period

6. Accounting Relationship • Accounting Identity in two forms • Assets ≡ Liabilities + Owner’s Equity • Cash Flow from Assets ≡ Cash Flow to Creditors + Cash Flow to Owners • Work through components, pages 266-267 • Building the Cash Flow Identity • Cash Flow from Assets = Operating Cash Flow – Increases in Net Working Capital – Increases in Capital Spending

7. Accounting Relationship • Continued Building the Cash Flow Identity • Cash Flow to/from Creditors • Interest paid on debt – shows up in this section not in operating cash flow • Any repayment of principal on debt claims • New borrowed funds are from (negative to lenders) • Cash Flow to Owners • Dividend Payments • Any retirement of common stock • New shares issued are funds from (negative to owners)

8. Cash Flow Identity to Sources and Uses of Cash • Once the components of the cash flow identity are calculated… • Convert the information into the Statement of Cash Flow or Sources and Uses of Cash • The change in the cash account is the “bottom line” of this statement • Three Categories • Operating Activities • Investing Activities • Financing Activities

9. Estimating Incremental Cash Flow • Objective – Estimate future cash flow of a project (for decision making) • Only Incremental Cash Flow used in decision • Sunk Costs – Do not use • Erosion Costs – Must account for lost sales of old products when new product introduced • Synergy Gains – 2 + 2 = 5 • Working Capital – new projects require working capital, must include in cash flow • Capital Expenditures – Usually large up front cash flow out • Depreciation and cost recovery on divesting assets

10. Capital Spending and Depreciation • Capital Spending for a project is usually an up front cash outflow • It is expensed on the income statement over time via depreciation • Depreciation is not a cash flow • Deprecation impacts cash flow through reduction in taxes, a real cash flow • Different Types • Straight line depreciation • Modified Accelerated Cost Recovery System (MACRS)

11. Capital Spending and Depreciation • Depreciation example for Cogswell Cola • Bottling Machine – Initial cost is $1,500,00 • Include installation costs, another $150,000 • Property class for MACRS is 7 years • Annual depreciation expense • Year 1 = $1,650,000 x 0.1429 = $235,785 • Year 2 = $1.650,000 x 0.2449 = $404,085 • … • Year 8 = $1,650,000 x 0.0445 = $73,425 • Table 9.5 page 275 for all eight years

12. Disposal of Capital Equipment • When a capital asset is disposed of by a company it can result in cash flow • Fully depreciated assets: cash flow is sale price minus taxes • When asset is not fully depreciated • Determine current “book value” of asset • Difference between sales price and book value is the gain or loss on disposal • Tax a gain and tax credit on a loss • Cash flow is sales price – tax on gain (or + credit on loss) • Example 9.3 College Doughnuts Disposal

13. Projected Cash Flow for Project • Putting all the elements together on incremental cash flow for decision making on a project • Initial Investment (typically capital spending and increases in working capital) • Annual operating cash flow • Disposal of equipment • Decrease in working capital at conclusion of project • Use Incremental Cash Flow with • NPV Model • IRR Model • Example Pulsar Cola Project – Table 9.8

14. Homework • Problems 5 through 10 – Accounting Relationship • Problem 12 – Erosion Costs • Problem 16 – Depreciation • Problem 18 – Cost Recovery • Problem 20 – Incremental Cash Flow