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Cash Flow Analysis

Supplemental Reading, Chapter 2, 3, and 4 in


Newnan, D., Whittaker, J., Eschenbach, T., and Lavelle, J. (2018). Engineering Economic
Analysis (4th Canadian edition). Oxford University Press.

ENG 3000
© Nish Balakrishnan, 2020
Learning Objectives
• Assess when a problem is “cost based” vs. “flow based”.
• Be able to identify problems that can be solved using “flow” based
analysis.
• Correctly model cash flows in a cash flow diagram and draw a cash
flow diagram for a given word problem.
• Solve a variety of cash flows for their present values.
• Be able to correctly map a cash flow to other equivalent flows.
• Be able to go from a cash flow back into a word problem.
Flow Based Problems
• So far, problems have been solved by modelling the time value of
money:
• Discounting and Interest based problems (Module 3)
• Simple problems can be easily communicated via text:
• Involve very simple elements: 1 line per variable or statement, few lines for a
simple problem
• Example: An engineering company who has a WACC of 5% is deciding on the
profitability of a project. A new engineer preps a report and shows that the overall
cost of a project is $10,000 and is expected to return $13,000 5 years later. Is
this profitable?
• Complex problems - more numbers to keep track of and more
timelines:
• Involve simple elements, maybe a line or two per variable, but some lines may
cause you to have to do multiple calculations
Flow Based Problems
Example 1: Your company is looking to store an overstock of old tooling and
other supplies. The options are to buy a set of shipping containers at a cost of
$20,000 (with an expected life of 20 years with a salvage value of $1000 at the
end) or you can pay a rental rate of $150 per year, with an initial fee of $300
(damage deposit) that's returned at the 20 year mark.

Example 2: An engineering Company who has a WACC of 4.5% is deciding on


the profitability of a project. A new Engineer preps a report and shows that the
return schedule is: $3000 next year, $2000 2 years later, $4000 4 years later,
and $27,000 9 years later. There is an upfront cost to the project that you don't
know yet. If you want to make $10k on the project on top of your WACC, what
would be the maximum you could pay up front?
Flow Based Problems
• Flow based approaches look at problems that evolve over time:
• flows of cash into and out of projects, analysis of timing of the flows and costs to
compare options
• Highly useful for project analysis, where costs are knownUseful for
long term modelling where the time value of money can dominate
decisions.
• Typically, much riskier than cost-based approaches based on issues
in previous lecture.
• Use a cash flow diagram to summarize data and provide further
options for analysis.
Cash Flow Diagrams
• Simple way to represent cash flowing out (negative) and cash flowing
in (positive):
• Lets you easily model a problem to then apply one of the available analysis
techniques to it.
• Allows you to transform a problem from one cash flow to an equivalent one.

Simple Example: An engineering company


who has a WACC of 5% is deciding on the
profitability of a project. A new engineer
preps a report and shows that the overall
cost of a project is $10,000 and is expected
to return $13,000 5 years later. Is this
profitable?
Cash Flow Diagrams
• Lets you also look at more complicated options and even compare
flows:
• Your company is looking to store an overstock of old tooling and other supplies. The options
are to buy a set of shipping containers at a cost of $20,000 (with an expected life of 10 years
with a salvage value of $1000 at the end) or you can pay a rental rate of $120 per year, with
an initial fee of $300 (damage deposit) that's returned at the 10 year mark.
How to Solve Cash Flow Diagrams:
• Easy to look at a diagram like this and assume the value: $300 -
$300, and $120 x 20 years. However this is far from accurate:

• A simple way of resolving this diagram is to determine what the NPV


(Net Present Value is): what is the value of X to make these two
equivalent?
How to Solve Cash Flow Diagrams:
• This can be done fairly easily:

• Can be done by simply by finding the present value of each item:


• PV of $300 at year zero is $300.
• PV of $300 at year 20 is $300(1+i)-20
• PV of $120 series can be done with the same process, but one payment at a time
• Quite a tedious process…
Cash Flow Solving Tricks
• Basic key to solving cash flows – superposition of flows

• Now, how do we solve these?


Cash Flows - Single Transactions:
• As shown previously, each year, discount is applied at a rate of (1+i)
where i is the discount rate chosen for analysis
• General relation is:
F = P(1+i)N
where i is the discount rate (per year) and N is the number of years, P is the present
value, and F is the future value
• Conversely:
P = F(1+i)-N
• This is often written in cash flow analysis in the format: (X, i, N)
• (F/P, i, N) where i is the interest rate and N is the number of periods
• (P/F, i, N) where i is the interest rate and N is the number of periods
• Values can also be determined from a table (see appendix of
textbook), computed, or done using a financial calculator.
Cash Flows - Annuities:
• An annuity is a regular payment (once per period) over a period of
time. Ex. Monthly car payments, Mortgage.
• As shown previously, each year, discount is applied at a rate of (1+i),
where i is the discount rate chosen for analysis, however to do each
one separately can take a while. General relation is:
P = A(1+i)-1 + A(1+i)-2 + ... A(1+i)-N
P = A [(1+i)-1 + (1+i)-2 + ... (1+i)-N ]
*Insert Math here*
Cash Flows - Annuities:

• This is often written in cash flow analysis in the format: (X, i, N)


• (A/P, i, N) where i is the interest rate and N is the number of periods
• (P/A, i, N) where i is the interest rate and N is the number of periods
• Values can also be determined from a table (see appendix of textbook),
computed, or done using a financial calculator.
• P/A is sometimes called the series present worth factor
• A/P is sometimes called the capital recovery factor
Cash Flows – Series Payments:
• A series payment is an annuity that changes over time (i.e. $200 per
year for the next 20 years with an increase in rate of $10 per year
over the term).
• Commonly come in three forms: Arithmetic, Geometric and Real.
• Arithmetic series - yearly $ value increase or decrease for an annuity. Typically
have a base annuity (i.e. $200 per year, increasing by $10 per year).
• Geometric Series - yearly % increase or decrease for an annuity. Typically have a
base annuity (i.e. $200 per year, increasing by 2% per year)
• Real Series - unpredictable increase or decrease in an annuity. Usually populated
from real data or complex service agreements. Can often be approximated using
an annuity or another series (think about inflation/interest)
• First two can be solved explicitly (a formula for a solution) or
discretely (Excel or other spreadsheet software)
Cash Flows – Arithmetic Gradient:
• General case: take out the base annuity (A) from the gradient, and
determine the yearly gradient increase (G):
Cash Flows – Arithmetic Gradient:
• General Solution to convert gradient to annuity:

• This is often written in cash flow analysis in the format: (X, i, N)


• (A/G, i, N) where i is the interest rate and N is the number of periods
• (G/A, i, N) where i is the interest rate and N is the number of periods
• Values can also be determined from a table (see appendix of textbook),
computed, or done using a financial calculator.
• Note: these factors convert to an annuity, so for a present value,
would need A/P There are also equivalent P/G and G/P factors
Cash Flows – Arithmetic Gradient:
• Example (with i = 5%) – Equation Based
Cash Flows – Arithmetic Gradient:
• Example (with i = 5%) – Factor Based
Cash Flows – Geometric Gradient:

• Take out the base annuity (A ) from the gradient, and determine the
yearly gradient increase (g) in % per year.
• Follow steps in textbook to determine factor
• Factors in tables don’t typically account for % gradients:
• Would need a separate table for each variation in g
• In most cases (N < 5) easier to treat as discrete payments and use
P/F factor. In larger cases - use excel or similar software
Cash Flows – Geometric Gradient:

• Example steps in excel if i = 5%:


• Set column A to the year
• Set cell B1 to annuity face value ($200)
• Set cell B2 to "=B1*(1+g)“, substituting g for the % increase, apply to all cells
below
• Set cell C1 to present value "=B1*((1+i)^-A1)" apply to all cells below, substituting
i for the discount rate, apply to all cells below.
Cash Flows – Geometric Gradient:
Cash Flows – Solving Approach:
• So far there are multiple types of flows that we have looked at, the
superposition of which can make nearly any cash flow:
• Single Payments, (P/F, i, N) and (F/P, i, N)
• Annuities, (A/P, i, N) and (P/A, i, N)
• Arithmetic Gradients, (P/G, i, N), (A/G, i, N), and (G/A, i, N)
• Other things (geometric gradients, real cost series payments etc…)
• For a given (general) cash flow:
• Break it down in to each of the factors above
• Each of these types of flows are converted to a single value at year 0 (present
value)
• Values can be added and the total sum can be determined – Net Present Value
• If positive, the project results in money gained, if negative the project costs
money. DEPENDS ON DISCOUNT RATE USED.
Cash Flows – Solving Approach:
Example:

Note: If i was 0%, what would the NPV be?


Cash Flow Example Problems:
Problem 1: Your company is looking to store an overstock of old tooling and other
supplies. The options are to buy a shipping container at a cost of $2000 (with an
expected life of 20 years with a salvage value of $100 at the end) or you can pay a
rental rate of $120 per year, with an initial fee of $300 (damage deposit) that's
returned at the 20 year mark. Your company uses a WACC of 5%.
Cash Flow Example Problems:
Problem 1: Your company is looking to store an overstock of old tooling and other
supplies. The options are to buy a shipping container at a cost of $2000 (with an
expected life of 20 years with a salvage value of $100 at the end) or you can pay a
rental rate of $120 per year, with an initial fee of $300 (damage deposit) that's
returned at the 20 year mark. Your company uses a WACC of 5%.

What if the WACC is not right? what if it turns out to be closer to 10% or what if it's
closer to 1%?
Option A, i only affects the salvage, if i = 1% NPV increases to -$1918, if r = 10%
NPV decreases to -$1985.14
Option B, i affects the deposit and annuity, if i = 1% NPV decreases to -$2219.66, if i
= 10% NPV increases to -$1277.04
Example Problems
Take a quick break here to reflect on the techniques shown, and make
sure you understand the factors/steps before proceeding
Cash Flow Example Problems:
Simple Problem 1:
Cash Flow Example Problems:
Simple Problem 2:
Cash Flow Example Problems:
Simple Problem 3:
Cash Flow Example Problems:
Simple Problem 4: You deposit $500 in a credit union at the end of each year, for five
years. The credit union pays 5% interest, compounded annually. Immediately after the
fifth deposit, how much do you have in your account?
Cash Flow Example Problems:
Simple Problem 4: You deposit $500 in a credit union at the end of each year, for five
years. The credit union pays 5% interest, compounded annually. Immediately after the
fifth deposit, how much do you have in your account?
Cash Flow Example Problems:
Simple Problem 5: You want to buy some electronic equipment for $1,000. You decide to
to save a uniform amount at the end of each month so that you would have the required
$1,000 at the end of one year. The local credit union pays 6% interest, compounded
monthly. How much would you have to deposit each month?
Cash Flow Example Problems:
Simple Problem 6: On January 1st, you deposit $5,000 in a credit union that pays 8%
nominal annual interest, compounded quarterly. You wish to withdraw all the money in
five equal yearly sums, beginning December 31st of the first year. How much should you
withdraw each year?
Cash Flow Example Problems:
Simple Problem 7: Which one is better? $3000 today or the situation shown below, if rate
of return is 10%.
Cash Flow Example Problems:
Simple Problem 8: You have purchased a new car, and hope to set aside enough money
in a bank account to pay for the maintenance of the car for the first five years. It has been
estimated that the maintenance cost of a car is $120 per year increasing by $30 per year.
Assume the maintenance costs occur at the end of each year and that the bank pays 5%
interest. How much should you deposit in the bank, right now?
Cash Flow Example Problems:
Practical Problem 1: As part of a plant overhaul, you want to build a custom machine that
replaces several existing manufacturing steps. The machine would produce products with
a value of $20,000 per year, and requires a overhaul every 3 years at a cost of $10,000,
and a major overhaul (on top of the minor overhaul) every 6 years at a cost of $15,000.
The production supplies needed equate to a value of about $2000 a year. At the end of
it's useful service life, the machine is worth about $3000 in scrap metal. If your company
has a discount rate of 4%, what is the maximum cost you would pay for the machine (up
front) to have it be economically viable? Useful life: 10 years
Cash Flow Example Problems:
Practical Problem 1 – Continued:
Cash Flow Example Problems:
Practical Problem 2:

A) The #72 Bus in your city runs a regular route through the city. In a fairly typical day,
the bus does 30 runs of the same route with an average ridership of 20 riders per run.
The bus charges a fare of $2.95 per rider, and costs $700 a day to operate (maintenance
+ gas) and costs $150,000 to buy (over a 25 year service life). What is the NPV of
running the bus over it's 25 year service life if the WACC of the bus company is 4%?

B) The bus company tries a pilot project and determines that adding another bus to the
adds 30% more ridership to the route, and riders are willing to pay up to $3.25 for a more
frequent bus on the same route. How does this change the NPV if you assume all of the
other costs scale up based on the number of busses on a route?
Cash Flow Example Problems:
Practical Problem 2a: The #72 Bus in your city runs a regular route through the city. In a
fairly typical day, the bus does 30 runs of the same route with an average ridership of 20
riders per run. The bus charges a fare of $2.95 per rider, and costs $700 a day to operate
(maintenance + gas) and costs $150,000 to buy (over a 25 year service life). What is the
NPV of running the bus over it's 25 year service life if the WACC of the bus company is
4%?
Cash Flow Example Problems:
Practical Problem 2b: The bus company tries a pilot project and determines that adding
another bus to the adds 30% more ridership to the route, and riders are willing to pay up
to $3.25 for a more frequent bus on the same route. How does this change the NPV if
you assume all of the other costs scale up based on the number of busses on a route?
Cash Flow Example Problems:
Practical Problem 3: You have deemed that your current in house welding capabilities are
too expensive. They cost you $18,295 a year and typical your welders can handle all the
jobs you do in a year. You support your welding shop by paying about $2021 a year in
supplies with a $5145 overhaul every 5 years. A local welding shop has approached you
to offer their services at $15,251 a year for the next ten years with a maximum rate
increase of $2000 per year for the next year years after that. Alternatively, you can
upgrade your shop to use a robotic welding unit that costs $200,000 up front, and costs
only $2000 a year in supplies (and is warrantied fully for the next 20 years). If your
WACC is 5% which option presents the best NPV?
Cash Flow Summary

• By now you should be able to:


• Be able to identify problems that can be solved using “flow”
based analysis.
• Correctly model cash flows in a cash flow diagram and draw a
cash flow diagram for a given word problem.
• Solve a variety of cash flows for their present values.
• Be able to correctly map a cash flow to other equivalent flows.
• Be able to go from a cash flow back into a word problem.
Cash Flow Analysis

Module 3

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