CHAPTER 2

QUESTIONS

2.1 A simplified hypothetical Accounting Income Statement for XYZ Company is given below.

Income Statement for XYZ Company, Year End 31 December 2002

$ millions

Sales $45,000
Cost of goods sold 14,000
Other expenses 350
Selling, general and administrative expenses 12,455
Depreciation 2,500
Earnings before interest and taxes (EBIT) 15,695
Interest expense 495
Taxable income 15,200
Tax payable @ 30% 4,560
Net income (after tax) 10,640

Further information:

Sales: It is reasonable to assume that approximately 50% of sales are on credit. The credit terms are
90 days. For simplicity, assume all the credit customers take the full 90 days to pay.

Cost of goods sold: In addition to the cost of goods sold given in the table, inventories increased
$60 million in this year.

Selling, general, administrative, and other expenses: The XYZ Company has 90 days to pay on all
accounts and the company takes full advantage of this facility.

(a) What is the difference between the ‘sales’ in this financial statement and in what would
be recorded as a project’s cash flow? What is the cash inflow from sales for XYZ?
(b) How are the ‘cost of goods sold’ recorded in financial statements? Can the cost of goods
sold and its cash flows be easily reconciled? Is it really necessary to reconcile these two
in order to arrive at cash outflow related to cost of goods sold for project cash flow
analysis?
(c) What is the cash flow related to the ‘selling, general, administrative, and other expenses’
of XYZ?
(d) Distinguish between ‘accounting depreciation’ and ‘tax-allowable depreciation’ and
explain why only tax allowable depreciation has implications for project cash flows.
(e) What is ‘EBIT’ and why it is not used in project cash flows?
(f) Why is ‘interest expense’ and its tax savings not included in project cash flow analysis?
(g) In the context of project cash flow analysis, define ‘taxable income’.
(h) Define ‘tax payable’ in the context of project cash flow analysis.
(i) Define ‘net income’.
(j) Derive the year’s cash flow from the XYZ income statement after considering the points
discussed in the answers to previous parts.

2.2 Kajukotuwa corporation is considering the purchase of a new item of equipment to replace
the current one. The new equipment will cost $100,000 and requires $7,000 in installation
costs. It will be depreciated using the straight line method over a five-year period. The old
equipment was purchased for $40,000 five years ago. It was being depreciated using the
 straight line method using a 5-year economic life. The old machine’s market value today is
$45,000. As a result of the proposed replacement the corporation’s investment in working
capital is expected to increase by $12,000. The tax rate is 30%.

(a) Calculate the book value of the old machine.

(b) Calculate the taxes, if any, attributable to the sale of the old machine.
(c) Determine the initial investment associated with the proposed equipment replacement.

ANSWERS

Answer to Q 2.1

XYZ Reconciliation of income and cash flow

(a) Cash sales:
In accrual accounting systems, ‘sales’ represent the dollar value of the goods that have been sold
within the given accounting period. It does not necessarily mean that the firm received that amount
of cash. All the cash for the credit sales will not be received within the accounting income year. In
this question, 50% of the sales are on credit and all these customers take the full 90 days to pay. If
we assume a 365-day year, the actual cash inflow from sales will then be:

(45,000 * 275/365) + (90/365 * 45,000 * 0.5) = $39,452

Note that even the credit sales will receive cash after 90 days, hence both cash and credit sales
within the first 275 days will realize cash within the year. This component is represented by,
(45,000 * 275/365). Only 50% of the next 90 days sales will be cash sales, and the credit sales will
not realize cash within the year. This component is represented by (90/365 * 45,000 * 0.5).

(b) Cost of Goods Sold – Cash outflow:

In the financial statements, accountants try to match the cost of producing the goods with the
revenues from the sale. Otherwise, it will show that the business is making a loss. For example,
suppose the company produced $500 worth of goods in period 1 and they are then sold in period 2
for $950. If these are recorded for period 1 and 2, respectively, it will show that the business made a
loss in period 1 and a profit in period 2. That is somewhat misleading. Therefore, financial
statements normally show $500 as an expense in period 2 when the goods are sold. This accounting
practice is generally known as accrual accounting system. The $500 cost of goods sold is shown in
the accounting statements as an investment in inventories or an increase in inventories in period 1.
In period 2, when that amount is sold out, the inventories will be decreased by that amount.

It is quite difficult to reconcile cash flow and cost of goods sold from the summary accounting
reports. The net accounting measurement of inventory change will depend upon whether the
measurement system is ‘first-in-first-out’ or ‘last-in-last-out’, and on just how the actual inventories
are valued.

In a real project planning situation, estimating the cash outlay for cost of goods sold is quite
straightforward. You will have forecasts for expected sales units, expected selling prices, and
expected production costs. You would simply develop cash flow statements by netting out the
expected cash inflows and outflows from the given projections. The only use you would make of
accounting type reports is in the lay out of your calculations.

In this question, there is no adequate information to accurately estimate the cash flow of the cost of
goods sold. For the calculation purposes (required in the last part (j) of this question), we assume
that the cash outflow of the cost of goods sold is estimated as 12,450.

( c) Selling, general, administrative, and other expenses:

These expenses are actual costs of the project and must be included in a project’s cash flow. In
financial statements, these are subject to accrual accounting treatments. Since the XYZ company
has 90 days to pay and the company takes full advantage of this, the cash outflow will be:

(350 + 12,455) * 275/365 = $9,648.

(d) Depreciation:

There are two types of depreciations, none of which are cash flows. One is the ‘accounting
depreciation’. The other is the ‘tax-allowable depreciation’.

Accounting depreciation has nothing to do with project cash flows. It is an accounting journal entry.
It is an amortization of the initial cost of an asset. The amortization notion comes from the accrual
accounting matching principle. That is, the initial cost of an asset is expected to benefit the firm
over several years. Hence, the total initial cost is ‘spread’ over those future benefit years. The
annual amount of depreciation is only a notional amount. It does not represent the annual decline in
value of the asset, it does not measure the value of the asset used up, and it does not measure the
actual unit costs of the asset’s services.

For the purpose of financial statements of the firm, accounting depreciation is calculated in several
different ways, for example:

 The ‘life’ or ‘straight-line’ method allocates an equal amount of the initial cost to each year of
the asset’s life.
 The reducing balance method allocates a fixed percentage of the asset’s written down value in
each year.
 The ‘sum of the year’s digits’ method allocates a reducing proportion of the asset’s cost in
each year.
 The ‘units of production’ method allocates an amount on the basis of a ratio of the asset’s
expected productive capacity to each year of measured production.

All these methods attempt to allocate the initial cost of an asset over a number of accounting
periods.

Tax allowable depreciation has something to do with project cash flows as the tax payable will be
reduced by the tax deduction resulting from the tax-allowable depreciation. However, it is not the
depreciation itself, but the tax saving (or tax shield) from the tax allowable depreciation. For project
cash flows, we first deduct the tax allowable depreciation to arrive at the correct tax payment and
then add back the depreciation as it was not a cash outflow.

(e) Earnings before interest and taxes (EBIT):

In company accounting reports or financial statements, this section gives the firm’s operational
earnings. It is defined as the net benefits from operations before the deduction of financing charges
as interest, and the expense to government as taxes. The idea is to highlight the profitability of
operations, before the ‘non-operational’ costs are deducted. We do not use EBIT as a cash flow
measure in project analysis because it has deducted depreciation which is not a cash outflow, there
are timing differences related to various items, and it excludes taxes which are to be rightly charged
to the project as a cash outflow.

(f) Interest expenses:

Interest is return to providers of debt capital. It is an expense against the income generated to equity
holders, and as such is deducted in the determination of accounting profit. It is not included in
project cash flow analysis, because the discount rate employed in the project (NPV) analysis
accommodates the required returns to both equity and debt providers. Interest is tax deductible, and
therefore provides a tax shield for any investment. This benefit is also accounted in the discount
rate, as the rate employed in project analysis is an ‘after-tax’ rate.

(g) Taxable income:

Taxable income is defined by the relevant tax acts and does not necessarily mean the same thing as
accounting income or profit. Taxable income is notionally similar to accounting income, and
accounting procedures are used in its calculation, but its definition of ‘income’ and related
‘deductions’ are specific to taxing authority. In the project analysis, we need to employ the tax
definition of taxable income, as tax will be a cash outflow of the project.

(h) Tax payable:

This is the amount levied by the taxing authorities on the tax paying entity’s taxing base. In the
cases of project analysis of firms, the tax paying entity is the firm, and its taxing base is defined by
the relevant tax act as ‘taxable income’.

Tax payable is calculated a s a percentage of taxable income. The rate of corporate tax is usually a
fixed flat rate for every dollar of taxable income. In our example this is 30%. Tax rates for
individuals are usually set at varying rates, with the higher rates applied to higher taxable incomes.

In calculating the amount of tax payable, we apply relatively common tax definitions to both
taxable income and tax payable. However, taxation is a very volatile area, and tax rules are
constantly changing. In any situation where a project may be subject to particular and special tax
laws or rulings, you must seek expert tax advice. Even this may not be sufficient as tax laws can be
changed retrospectively or they can change from time to time after the project has commenced. The
best course to follow in this situation is to ensure that the project is not dependent upon tax savings
(or tax shields) for its success.

(i) Net income:

This is an accounting term which generally means the amount now available for division between
retained earnings and dividends. Usually, ‘net income’ refers to the income after deducting the cost
of goods sold, selling, general, administrative, and other expenses, depreciation, interest expenses
and taxes from the ‘net sales’. It is not a figure in the cash flow analysis of projects. It is
sometimes used in calculating the accounting rate of return, which we do not recommended for
project analysis.

(j)
Derivation of Cash Flows from XYZ Company’s Income Statement

Sales $39,452
- Cost of goods sold 12,450
- Selling, general, administrative, and other expenses 9,648
- Depreciation 2,500
= Taxable income 14,854
- Tax payable @ 30% 4,456
= Net income (after tax) 10,640
+ Depreciation 2,500
= Net cash flow 13,140

Answer to Q 2.2
Kajukotuwa Corporation Replacement Investment

a) Book Value of the Old Machine = Cost – Accumulated Depreciation

= 40,000 – (8,000 x 5) = 0
(Depreciation per year: $40,000 / 5 yrs = $8,000)

b) Taxes on Sale of Old machine = (Sale Proceeds – Book Value) x tax rate
= (45,000 – 0) x 0.30 = $13,500

c) Initial Investment associated with the Proposed Replacement:

Cost of new machine $100,000

+ Installation 7,000
- Proceeds from sale of old machine 45,000
+ Taxes on sale of old machine 13,500
+ Increase in net working capital 12,000
Initial Investment $87,500