INDR 202 - Chapter 10

INDR  202

ENGINEERING  ECONOMICS

CHAPTER  10

PROJECT  CASH-­FLOW  ANALYSIS

SPRING  2015

PROJECT  CASH-­FLOW  ANALYSIS

PROJECT  COST  ELEMENTS

MANUFACTURING  COSTS

Direct Materials Direct Labor

Manufacturing Overhead

Maintenance, repair, heat, light, tax, depreciation

NONMANUFACTURING  COSTS

Operating  Costs

MANUFACTURING  COSTS

Cost  of Finished   Goods Manufacturing   Costs Purchase  of Raw  Materials RAW   MATERIALS   WAREHOUSE Inventory  of Raw  Materials FACTORY Inventory  of Work  in  Process

FINISHED   GOODS   WAREHOUSE CONSUMERS Cost  of  

PROJECT  COST  ELEMENTS

MATCHING  PRINCIPLE

Costs  incurred  to  generate  particular  revenue  are  recognized  as   expenses  in  the  same  period  as  the  revenue  is  recognized.

PERIOD  COSTS

matched  against  periods,  immediate expenses,  executive salaries,  insurance and income-­tax expenses,  appear on  the income statement in  the period in  

which they occur

PRODUCT  COSTS

COST  BEHAVIOR

Fixed Costs

(providing basic operating capacity;;

constant over relevant range)

Variable Costs

(dependent on production level;;

increasing/decreasing with volume)

AVERAGE  UNIT  COST

fixed  cost  per  unit   varying  with  volume

constant  variable   cost  per  unit

𝐾 + 𝑐𝑥

𝑥

=

𝐾

PROJECT  EVALUATION

IDENTIFY  INVESTMENT  OPPORTUNITIES.

ESTIMATE  AFTER-­TAX  NET  CASH  FLOWS.

MEASURE  INVESTMENT  WORTH.

SELECT  A  PROJECT.

IMPLEMENT  SELECTED  PROJECT.

CASH  FLOWS  VS.  NET  INCOME

Net income

is an accounting measure of a firm’s

profitability, ignoring actual timing of cash flows.

Cash flow

analysis incorporates the time value of

money.

Company  A Company  B

Year  1 Net  income

Cash  flow

$1,000,000

$1,000,000

$1,000,000

$0

Year  2 Net  income

Cash  flow

$1,000,000

$1,000,000

$1,000,000

CASH  FLOW  FROM  OPERATION  =  NET  INCOME  +  DEPRECIATION

OPERATING  ACTIVITIES

CURRENT  SALES  REVENUES

COST  OF  GOODS  SOLD

OPERATING  EXPENSES

0 1 2 3 4 5 6 7 8

$28,000 Capital  expenditure_{(actual  cash  flow)}

$4,000

$6,850 $4,900

$3,500 $2,500 $2,500 $2,500 $1,250

Allowed  depreciation  expenses (not  actual  cash  flows)

0 1 2 3 4 5 6 7 8

Item Income Gross  income  (revenues) $50,000 Expenses

Cost  of  goods  sold Depreciation

Operating  expenses

$20,000 $4,000 $6,000

Taxable  income $20,000

Taxes  (40%) $8,000

Net  income $12,000

Cash  Flow $50,000

-­$20,000

-­$6,000

-­$8,000

All sales  &  expenses  except  depreciation  paid  in 1st _year

$20,000 $0 $50,000 $40,000 $30,000 $20,000 $10,000 Net  income Depreciation Income  taxes Operating  expenses

Cost  of  goods  sold

Net cash  flow $16,000 Gross income $50,000 $6,000 $8,000 $4,000 $12,000

Assuming  revenues  are  received  &  expenses  are  paid  in  cash:

Net  cash  flow  =  Net  income  +  Noncash  expense  (i.e.,  depreciation)

Before   Undertaking   Project After   Undertaking   Project Project   Effect

Gross  revenue $200,000 $240,000 $40,000

Expenses $130,000 $150,000 $20,000

Taxable  income $70,000 $90,000 $20,000

Income  taxes $12,500 $18,850 $6,350

Average  tax  rate 17.86% 20.94% 31.75%

rate to be used in evaluating the project in isolation from the rest of operations

Before After Incremental

Taxable  income $70,000 $90,000 $20,000

Income  taxes $12,500 $18,850 $6,350

Average  tax  rate 17.86% 20.94%

Incremental  tax  rate 31.75%

25%

$5,000

$20,000

+ 34%

$15,000

$20,000

= 31.75%

$20,000  incremental taxable  income  from

the  project

Marginal  tax  rate 15% 25% 34%

Regular  income  from  operation

$0 $20,000 $40,000 $60,000 $80,000 $100,000

$5,000

at  25% $15,000at  34%

INVESTING  ACTIVITIES

SALVAGE  VALUE

ORIGINAL  INVESTMENT

WORKING-­CAPITAL  INVESTMENT

Working capital: amount carried in cash, accounts receivable, inventory available to meet day-­to-­day operating activities

Investment in physical assets yields depreciation allowance,

FINANCING  ACTIVITIES

BORROWED  FUNDS

Revenues Expenses

Cost  of  goods  sold Depreciation Debt  interest Operating  expenses Taxable  income Income  taxes NET  INCOME INCOME  STATEMENT

+  Net  income +  Depreciation

-­ Capital  investment

+  Proceeds  from  sales  of   depreciable   assets

-­ Gains  tax

-­ Investments  in  working   capital

+  Working-­capital  recovery

+  Borrowed  funds -­ Principal  payments

CASH  FLOW  STATEMENT

INCREMENTAL  CASH  FLOWS

Operating Activities

Investing Activities

EXAMPLE  4:  NEW  MILLING  MACHINE

Machine cost: $150,000

Modification cost: $12,000

Service life: 5 years

Salvage value: $45,000

Depreciation: 7-­year MACRS

Additional  revenues: $175,000/year

EXAMPLE  4:  NEW  MILLING  MACHINE

STEP  1.  DEPRECIATION

7-­year  MACRS  &  Cost  Basis  =  $162,000

Year Depreciation  _Rate Depreciation  _Amount Book  Value

1 14.286% $23,143 $138,857

2 24.490% $39,673 $99,184

3 17.493% $28,338 $70,845

4 12.495% $20,242 $50,604

EXAMPLE  4:  NEW  MILLING  MACHINE

STEP  2. GAINS  TAX

Taxable  Gains   = Salvage  Value  – Book  Value

=  $45,000  -­ $43,375  =  $1,625

Gains  Tax

=  (Tax  Rate)(Taxable  Gains)

EXAMPLE  4:  NEW  MILLING  MACHINE

STEP  3.  INCOME  STATEMENT

1 2 3 4 5

Revenue $175,000 $175,000 $175,000 $175,000 $175,000 Expenses:

EXAMPLE  4:  NEW  MILLING  MACHINE

STEP  4.  CASH  FLOW  STATEMENT

0 1 2 3 4 5

OPERATING

Net  Income $37,114 $27,196 $33,997 $38,855 $46,663

Depreciation $23,143 $39,673 $28,338 $20,242 $7,229

INVESTMENT

Investment -­$162,000

Salvage  Value $45,000

EXAMPLE  4:  NEW  MILLING  MACHINE

CASH  FLOW  DIAGRAM  &  PRESENT  WORTH

0 1 2 3 4 5

$60,257 $66,869 $62,335 _{$59,097 $98,242}

Working-­capital recovery

$25,000

$162,000

$25,000 Investment  in working  capital

Investment  in

physical  assets

𝑃𝑊 15% = $52,008 > 0

NEGATIVE  TAXABLE  INCOME

TAX  SAVINGS  from  negative  taxable  income  (project  loss)

Regular  

Business Project Combined  Operation Taxable  Income

Income  Taxes  (35%)

$100M

$35M

-­$10M

-­$3.5M

$90M

$31.5M

FINANCING  ACTIVITIES

Interest Payments

Tax-­deductible expenses

Borrowed Funds & Principal Payments

NOT affect taxes

EXAMPLE  4:  NEW  MILLING  MACHINE

End  of   Year

Beginning Balance

Interest  

Payment PaymentPrincipal   _BalanceEnding   1 $64,800 $7,776 $10,200 $54,600 2 $54,600 $6,552 $11,424 $43,176 3 $43,176 $5,181 $12,795 $30,381 4 $30,381 $3,646 $14,330 $16,051

Amount  financed:

$64,800

Financing  rate:

12%  per  year

1 2 3 4 5

Revenue $175,000 $175,000 $175,000 $175,000 $175,000 Expenses:

Labor $60,000 $60,000 $60,000 $60,000 $60,000 Material $20,000 $20,000 $20,000 $20,000 $20,000 Overhead $10,000 $10,000 $10,000 $10,000 $10,000 Debt  Interest $7,776 $6,552 $5,181 $3,646 $1,926 Depreciation $23,143 $39,673 $28,338 $20,242 $7,229 Taxable  Income $54,081 $38,775 $51,481 $61,112 $75,845 Income  Taxes $21,632 $15,510 $20,592 $24,445 $30,338

EXAMPLE  4:  NEW  MILLING  MACHINE

CASH  FLOW  STATEMENT

0 1 2 3 4 5

OPERATING

Net  Income $32,449 $23,265 $30,889 $36,667 $45,507

Depreciation $23,143 $39,673 $28,338 $20,242 $7,229

INVESTMENT

Investment -­$162,000

Salvage  Value $45,000

Gains  Tax -­$650

Working  Capital -­$25,000 $25,000

FINANCING

EXAMPLE  4:  NEW  MILLING  MACHINE

CASH  FLOW  DIAGRAM  &  PRESENT  WORTH

0 1 2 3 4 5

$45,392 $51,514 $46,432 _$42,579

$106,036

$122,200

𝑃𝑊 15% = $63,816 > 0

EFFECTS  OF  INFLATION

Depreciation

(in  actual  dollars)

Overstatement  of  taxable  income  &  higher  taxes

Salvage  Value

Higher  taxable  gains  from  inflated  salvage  value  &  book  values   based  on  historical  costs

Loan  Repayments

Debt-­financing  cost  reduced  by  repayment  of  historical  loan   amounts  in  dollars  of  decreased  purchasing  power

Working  Capital

Working-­capital  drain  through  increase  in  cost  of  working  capital   in  inflationary  environment

1 2 3 4 5

Revenue $175,000 $175,000 $175,000 $175,000 $175,000 Expenses:

Labor $60,000 $60,000 $60,000 $60,000 $60,000 Material $20,000 $20,000 $20,000 $20,000 $20,000 Overhead $10,000 $10,000 $10,000 $10,000 $10,000 Debt  Interest $7,776 $6,552 $5,181 $3,646 $1,926 Depreciation $23,143 $39,673 $28,338 $20,242 $7,229

EXAMPLE  4:  NEW  MILLING  MACHINE

1 2 3 4 5

Revenue $183,750 $192,938 $202,584 $212,714 $223,349 Expenses:

Labor $63,000 $66,150 $69,458 $72,930 $76,577 Material $21,000 $22,050 $23,153 $24,310 $25,526 Overhead $10,500 $11,025 $11,576 12,155 $12,763 Debt  Interest $7,776 $6,552 $5,181 $3,646 $1,926 Depreciation $23,143 $39,673 $28,338 $20,242 $7,229 Taxable  Income $58,331 $47,488 $64,879 $79,430 $99,329 Income  Taxes $23,332 $18,995 $25,952 $31,772 $39,732

EXAMPLE  4:  NEW  MILLING  MACHINE

0 1 2 3 4 5 Recovered $25,000 $26,250 $27,563 $28,941 $30,388 Required -­$25,000 -­$26,250 -­$27,563 -­$28,941 -­$30,388 $0 Balance -­$25,000 -­$1,250 -­$1,313 -­$1,378 -­$1,447 $30,388

EXAMPLE  4:  NEW  MILLING  MACHINE

WORKING  CAPITAL

SALVAGE  VALUE  &  GAINS  TAX

$45,000 1 + 0.05

;

= $57,433

CASH  FLOW  STATEMENT

0 1 2 3 4 5

OPERATING

Net  Income $34,999 $28,493 $38,927 $47,658 $59,597

Depreciation $23,143 $39,673 $28,338 $20,242 $7,229

INVESTMENT

Investment -­$162,000

Salvage  Value $57,433

Gains  Tax -­$5,623

Working  Capital -­$25,000 -­$1,250 -­$1,313 -­$1,378 -­$1,447 $30,388

FINANCING

EXAMPLE  4:  NEW  MILLING  MACHINE

CASH  FLOW  DIAGRAM  &  PRESENT  WORTH

0 1 2 3 4 5

$46,692 $55,429 $53,092 _$52,123

$132,974

$122,200

Inflation-­adjusted  MARR:

𝑖 = 𝑖

=

+ 𝑓̅ + 𝑖

=

𝑓̅

EXAMPLE  4:  NEW  MILLING  MACHINE

Rate  of  return  based  on  actual  dollars:  38.77%

38.77%  >  20.75%

Acceptable  Project

Real  (inflation-­free)  rate  of  return:

𝑖

=

=

𝑖 − 𝑓̅

1+𝑓̅

=

0.3877 − 0.05

1+0.05

= 32.16%

Costs in manufacturing environments are classified as

manufacturing

(e.g., material, labor, overhead, etc.) &

nonmanufacturing

costs (e.g., operating, marketing).

Costs are classified as

product

&

period

costs for valuing

inventories & determining deductible expenses.

Costs are classified as

fixed

,

variable

,

mixed

costs with

respect to their behavior.

Projects must be evaluated based on their cash flows

(NOT their net income).

Project cash items include investments in new assets,

disposal costs of existing assets, salvage (resale) values,

investment & recovery of working capital, revenues &

savings, manufacturing & operating costs, interest & loan

payments, taxes & tax credits.

Depreciation is a noncash item & must be added to net

income to find the net cash flow.

Cash flows are grouped as

operating

,

investing

,

financing

costs in the income statement.

Project cash flows may be stated in

actual

or

constant

dollars

& interest rates may be given as

market

or

real