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
Our focus in this
Project Selection
chapter is to
develop the format
Project Implementation
of after-tax cash
flow statements.
Project-Control/Post-Audit
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
Income Statement Approach
Operating revenues
Cost of goods sold
Depreciation
Operating expenses
Interest expenses
Taxable income
Income taxes
Net income
+ Depreciation
Approach 2
Direct Cash Flow Approach
Operating revenues
- Cost of goods sold
- Operating expenses
- Interest expenses
- Income taxes
Cash flow from operation
4
A Typical Format used for Presenting Cash Flow
Statement
Cash flow statement
+ Net income
+Depreciation
Income statement
Revenues
Expenses
Cost of goods sold
Depreciation
Debt interest
Operating expenses
Taxable income
Income taxes
Net income
-Capital investment
+ Proceeds from sales of
depreciable assets
- Gains tax
- Investments in working
capital
+ Working capital recovery
+ Borrowed funds
-Repayment of principal
Operating
activities
+
Investing
activities
+
Financing
activities
Net cash flow
5
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%
6
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?
7
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.
8
• (a) Step 1: Depreciation Calculation
– Cost Base = $125,000
– Recovery Period = 7-year MACRS
N
MACRS
Rate
Depreciation
Amount
Allowed
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
9
(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
10
Step 3 – Create an Income Statement
1
2
3
4
5
$100,00
0
$100,00
0
$100,00
0
$100,00
0
$100,00
0
Labor
20,000
20,000
20,000
20,000
20,000
Material
12,000
12,000
12,000
12,000
12,000
8,000
8,000
8,000
8,000
8,000
17,863
30,613
21,863
15,613
5,581
$42,137
$29,387
$38,137
$44,387
$54,419
16,855
11,755
15,255
17,755
21,768
$25,282
$17,632
$22,882
$26,632
$32,651
Income
Statement
Revenues
0
Expenses:
Overhead
Depreciation
Taxable Income
Income Taxes (40%)
Net Income
11
Step 4 – Develop a Cash Flow Statement
Cash Flow Statement
0
1
2
3
4
5
Net Income
$25,28
2
$17,63
2
$22,88
2
$26,63
2
$32,651
Depreciation
17,863
30,613
21,863
15,613
5,581
Operating Activities:
Investment Activities:
Investment
Working capital
(125,000)
(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
12
An Excel Worksheet
13
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
End
Investment &
Salvage Value
Revenue
Labor
Expenses
Materials
Overhead
Depreciation
Taxable
Income
Income
Taxes
Net Cash
Flow
0
-$125,000
-23,331
-$125,000
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
16,525
6,613
$43,387
23,331
50,000*
23,331
*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
14
Cash Flow Diagram including Working Capital
$23,331
$43,145
0
1
$48,245 $44,745
2
3
$125,000 Investment in
physical assets
$23,331 Investment in
working capital
Working capital
recovery
$81,619
$42,245
4
5
$23,331
$23,331
0
$23,331
1
$23,331
2
3
4
5
Years
Working capital recovery cycles
15
Question (b):

Is this investment justifiable
at a MARR of 15%?
$104,950

PW(15%) = -$148,331 +
+$43,145(P/F, 15%, 1) + . . .
. + $104,950 (P/F, 15%, 5)
= $31,420 > 0
 Yes, Accept the Project !
$48,245
$43,145
$44,745 $42,245
0
1
2
3
4
5
Years
$148,331
16
Question (C): IRR
1
A
Period
2
0
B
Cash Flow
($148,331)
3
1
43,145
4
2
48,245
5
3
44,745
6
4
42,245
7
5
104,950
=IRR(B2:B7,0.10)
IRR = 22.55%
17
Rate of Return Analysis (IRR = 22.55%)
n=0
Beginning
Balance
n =1
n=2
n=3
-$148,331 -$138,635 -$121,652
Return on
Investment
(interest)
-$33,449
-$31,262
-$27,432
$43,145
$48,245
$44,745
Payment
-$148,331
Project
Balance
-$148,331 -$138,635 -$121,652 -$104,339
n=4
n=5
-$104,339
-$85,622
-$23,528
-$19,328
$42,245 $104,950
-$85,622
0
18
When Projects are Financed with Borrowed
Funds


Key issue: Interest
payment is a taxdeductible 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.
19
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
Year
Beginning
Balance
Interest
Payment
Principal
Payment
Ending
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
20
Table 9.4
Additional
entries related
to debt financing
21
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.

Taxable
income
Income
taxes
(35%)
Handling Project Loss
Regular
Business
Project
Combined
Operation
$100M
(10M)
$90M
$35M
?
$31.5M
Tax savings
Tax Savings = $35M - $31.5M
= $3.5M
Or (10M)(0.35) = -$3.5M
22
Effects of Inflation on Project Cash Flows
Item
Depreciation
expense
Effects of Inflation
Depreciation expense is
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
23
Item
Salvage value
Effects of Inflation
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
Working capital
requirement
Effects of Inflation
Known as working capital
drain, the cost of working
capital increases in an
inflationary environment.
26
Item
Rate of Return
and NPW
Effects of Inflation
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.
27
A
1
7
8
9
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
B
C
D
E
F
G
H
Example 9.3 Cash Flow Statement for the Automated Machining Center Project
Income Statement
Inflation Rate
1
2
3
4
5
5%
$ 105,000
$ 110,250
$ 115,763
$ 121,551
$ 127,628
5%
5%
5%
21,000
12,600
8,400
17,863
22,050
13,230
8,820
30,613
23,153
13,892
9,261
21,863
24,310
14,586
9,724
15,613
25,526
15,315
10,210
5,581
Taxable Income
Income Taxes (40%)
$ 45,137
18,055
$ 35,537
14,215
$ 47,595
19,038
$ 57,317
22,927
$ 70,996
28,398
Net Income
$ 27,082
$ 21,322
$ 28,557
$ 34,390
$ 42,598
27,082
17,863
21,322
30,613
28,557
21,863
34,390
15,613
42,598
5,581
(1,351)
63,814
(12,139)
28,361
Revenues
Expenses:
Labor
Material
Overhead
Depreciation
0
Cash Flow Statement
Operating Activities:
Net Income
Depreciation
Investment Activities:
Investment
Salvage
Gains Tax
Working Capital
Net Cash Flow
(in actual dollars)
(125,000)
5%
5%
(23,331)
(1,167)
$ (148,331) $ 43,778
(1,225)
$ 50,710
(1,287)
$ 49,133
$ 48,652
$ 128,215
28
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
Revenues
Expenses:
Labor
Material
Overhead
Depreciation
0
6%
1
2
3
4
5
$106,000 $112,360 $119,102 $ 126,248 $ 133,823
5%
4%
5%
21,000
12,480
8,400
17,863
22,050
12,979
8,820
30,613
23,153
13,498
9,261
21,863
24,310
14,038
9,724
15,613
25,526
14,600
10,210
5,581
Taxable Income
Income Taxes (40%)
$ 46,257 $ 37,898 $ 51,327 $ 62,562 $ 77,906
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
Depreciation
Investment Activities:
Investment
Salvage
Gains Tax
Working Capital
Net Cash Flow
(in actual dollars)
27,754
17,863
22,739
30,613
30,796
21,863
37,537
15,613
46,744
5,581
(1,351)
57,964
(9,799)
28,361
(125,000)
3%
5%
(23,331)
(1,167)
(1,225)
(1,287)
$ (148,331) $ 44,450 $ 52,127 $ 51,372 $ 51,799 $ 128,851
29
Rate of Return Analysis under Inflation
_
f  10%


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:
i' 
1 i
_
1
1 f
1  0.3134

1
1  0.10
 19.40%
n
0
1
2
3
4
IRR
Net cash
flows in
actual
dollars
-$30,000
13,570
15,860
13,358
13,626
31.34%
Net cash
flows in
constant
dollars
-$30,000
12,336
13,108
10,036
9,307
19.40%
30
Decision Criterion


If you use 31.34% as your IRR, you should
use a market interest rate (or inflationadjusted MARR) to make an accept and
reject decision.
If you use 19.40% as your IRR, you should
use an inflation-free interest rate (inflationfree MARR) to make an accept and reject
decision.
31
Input
Tax Rate(%) =
MARR(%) =
Output
PW(i) =
IRR(%) =
40
15
0
1
2
3
$37,761
33.74%
4
5
6
Income Statement
Revenues (savings)
Expenses:
Depreciation
$38,780
$38,780
$38,780
$38,780
$38,780
$38,780
9,817
16,825
12,016
8,581
6,135
3,064
Taxable Income
Income Taxes (40%)
$28,963
11,585
$21,955
8,782
$26,764
10,706
$30,199
12,080
$32,645
13,058
$35,716
14,286
Net Income
$17,378
$13,173
$16,059
$18,120
$19,587
$21,430
Cash Flow Statement
Operating Activities:
Net Income
Depreciation
Investment Activities:
Investment
Salvage
Gains Tax
Net Cash Flow
$
$
$
17,378 $
9,817 $
13,173 $
16,825 $
16,059 $
12,016 $
18,120 $
8,581 $
19,587 $
6,135 $
21,430
3,064
$
$
3,500
3,505
(68,701)
($68,701)
$27,195
$29,998
$28,074
$26,700
$25,722
$31,499
32