Chapter 9
Project Cash Flow Analysis
1
General Cost Terms
2

Manufacturing Costs
Direct materials
Materials used in the final product.
Direct labor
Labor costs that goes to fabrication of a product.
Manufacturing Overhead
In particular, indirect materials, indirect labor, maintenance and repairs on production
equipment, heat and light, property taxes, depreciation, insurance on manufacturing
facilities, and overtime payment.

Non-manufacturing Costs
Overhead
Heat and light, property taxes, depreciation, and similar items associated with selling
and administrative functions.
Marketing
Advertising, shipping, sales travel, sales commissions, and sales salaries.
Administrative
Executive compensation, general accounting, public relations, and secretarial support.
3
COST FLOWS AND CLASSIFICATIONS IN
MANUFACTURING COMPANY
4

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 charged to expenses in the period
in which the expenses are incurred. Examples of periodic costs are all
general and administrative expenses, selling expenses, insurance,
and income tax expenses. Therefore, advertising costs, executive
salaries, sales commissions, public relations costs, and other nonmanufacturing costs would all be period cost. Such costs are not
related to the production and flow of manufactured goods, but deducted
from revenue in the income statement.

Product costs: Those costs involved in the purchase or manufacturing
of goods. In the case of manufactured costs consist of direct materials,
direct labor, and manufacturing overhead. Product costs are not
viewed as expenses; rather they are the cost of creating inventory.
Thus, product costs are considered an asset until goods are sold.
5
Cost Classification for Predicting Cost
Behavior

Volume index
Operating cost respond in some
way to changes in its operating
volume.

Cost Behaviors
Fixed costs
Variable costs
Mixed costs
In the car case, Depreciation,
occur from passage of time
(fixed portion) and also More
miles are driven a year, loses its
Market value (variable portion),
cost of electrical power (lighting,
number of machine hours
worked).

Average unit costs
6
Volume Index

Definition: The unit measure
used to define “volume” Based
on production inputs (tons of
coal processed, direct labor
hours used, or machine hours
worked).

Examples:
 Automobile – “miles” driven
 Electricity Generating plant
– “kWh” produced
 Stamping machine – “parts”
stamped
7
Fixed Costs



Definition: The costs of providing
a company’s basic operating
capacity are known as its fixed
costs or capacity costs. Must
have a relatively wide span of
output for which costs are
expected remain constant.
Fixed cost do not change within
a given time period although
volume may change. For car
example, the annual insurance,
property tax, license fee.
Cost behavior: Remain constant
over the relevant range.
8
Variable Costs

Definition:
Costs that vary depending
on the level of production
or sales. In manufacturing,
direct labor and material
costs are major variable
costs.

Cost behavior:
Increase or decrease
proportionally according
to the level of volume
9
Practice Problem






You have 3000 units to produce.
Total labor cost = $20,000
Total material cost = $25,000
Total overhead cost = $15,000
Total fixed cost = $40,000
What is the average cost per unit?
Average cost = ($100,000)/3,000 = $33.33/unit
10
Project Cash Flow Analysis
11
Developing Project 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
12
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 Revenues: $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%
13
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?
14
When Projects Require Working Capital
Investments

Working capital represents the amount carried in cash,
accounts receivable, and inventory that are needed for the
operation of the project

Working Capital includes the stocks of finished and semifinished goods that will be economically consumed in the near
future or will be made into a finished consumer good in the
near future.

How to treat working capital investments: just like a capital
expenditure except that no depreciation is allowed.
15
(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
$ 5,581
6
8.92 %
$11,150
0
7
8.93 %
$11,150
0
8
4.46 %
$5,575
0
16
(a) Step 2: Gains (Losses) associated with
Asset Disposal
• Salvage value = $50,000
• Book Value (year 5) = Cost Base – Total Depreciation
= $125,000 - $ 91,533
= $ 33,467
• Taxable gains = Salvage Value – Book Value
= $50,000 - $ 33,467
= $16,533
• Gains taxes = (Taxable Gains) (Tax Rate)
= $16,533 x (0.40)
= $6,613
17
Step 3 – Create an Income Statement
1
2
$100,000
$100,000
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
3
4
$100,000 $100,000
5
$100,000
Expenses:
Overhead
Depreciation
Taxable Income
Income Taxes (40%)
Net Income
18
Step 4 – Develop a Cash Flow Statement
Cash Flow
Statement
0
1
2
3
4
Net Income
$25,282
$17,632
$22,882 $26,632
Depreciation
17,863
30,613
21,863
5
Operating
Activities:
15,613
$32,651
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
19
20
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
21
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)
= $31,423 > 0
$48,245
$43,145
$44,745 $42,245
0
1
2
3
4
5
Years

Yes, Accept the Project !
$148,331
22
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%
23
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
24