Developing Project

Cash Flow
Statement
Lecture No. 23
Chapter 9
Fundamentals of Engineering Economics
Copyright © 2008

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A Typical Format Used in Presenting a
Net Cash Flow Statement

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Cash Flows from
Operating Activities
 Cash flows from operation:
 Sales revenues
 Cost of goods sold
 Operating expenses
 Income taxes
 How to estimate the cash flows from
operation:
 Cash flows from operation = net income + non-
cash expenses (depreciation and amortization)

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Cash Flows from Investing
Activities
 Investment in physical assets
 Should be capitalized (depreciated).
 Investment in working capital
 Investment in working capital refers to the
investment made in non-depreciable assets, such
as carrying raw-material inventories.
 Should be treated as capital expenditures, but no
depreciation deduction is allowed.
 Any recovery of working capital at the end of
project life has no tax consequences.

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Cash Flows from
Financing Activities
 Cash flows from financing activities:
 The amount of borrowing
 The repayment of principal
 Treatment of interest expenses:
 Interest payments are tax-deductible expenses,
so they are classified as operating, not financing
activities

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Example 9.2 Cash Flow
Statement with Only Operating
and
ProjectInvesting
Nature: Purchase of aActivities
new milling machine
 Financial Data:
 Investment activities:
 Capital expenditure (milling machine): $162,000
 Project life: 5 years
 Salvage value: $45,000
 Investment in working capital: $25,000, which will be recovered in full at the end of
year 5
 Operating activities:
 Annual operating revenue: $175,000
 Annual operating expenses:
 Labor: $60,000
 Materials: $20,000
 Overhead: $10,000
 Accounting Data:
 Depreciation method: 7-year MACRS
 Income tax rate; 40%
 MARR after tax: 15%

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Step 1: Depreciation
Calculation
Cost basis
MACRS = $162,000
Depreciation Allowed Depreciation
n Rate Amount Amount
1 14.29% $23,143 $23,143
2 24.49% $39,673 $39,673
3 17.49% $28,338 $28,338
4 12.49% $20,242 $20,242
5 8.93% $14,458 $7,229
6 8.92% $14,450 0
7 8.93% $14,458 0
8 4.46% $7,229 0

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Step 2: Gains (Losses)
Associated with Asset
Disposal
 Salvage value = $45,000
 Book Value (year 5) = Cost Basis – Total Depreciation
= $162,000 - $118,625
= $ 43,375
 Taxable gains = Salvage Value – Book Value
= $45,000 - $43,375
= $1,625
 Gains taxes = (Taxable Gains)(Tax Rate)
= $1,625 (0.40)
= $650

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Step 3: Consideration of
Working Capital Investments

0 1 2 3 4 5
 Working capital means $25,000 $25,000
the amount carried in
cash, accounts
receivable, and inventory $25,000
that is available to meet
day-to-day operating
needs. 0
 How to treat working 5
capital investments: just
like a capital expenditure
except that no
depreciation is allowed. $25,000

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Step 4: Develop the Cash
Flow Statement

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Cash Flow Diagram including
Working Capital
$25,000 Working capital
recovery
$66,869 $62,335 $98,242
$60,257 $59,097

0 1 2 3 4 5
$162,000 Investment in
physical assets $25,000 $25,000
$25,000 Investment in
working capital
0 1 2 3 4 5

$25,000 Years
$25,000
Working capital recovery cycles

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When Projects are
Financed with Borrowed
Funds
 Key issue: Interest  What about principal
payment is a tax- payments? As the
deductible expense. amount of borrowing is
 What needs to be NOT viewed as income
done: Once a loan to the borrower, the
repayment schedule is repayments of principal
known, separate the
interest payments from are NOT viewed as
the annual installments. expenses either– NO
tax effect.

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Example 9.3 Cash Flow
Statement with Financing
Activities
Amount financed: $64,800, or 50% of the total capital expenditure
Financing rate: 12% per year
Annual installment: $17,976 or, A = $64,800(A/P, 12%, 5)

End of Beginning Interest Principal Ending

Year Balance Payment Payment Balance
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
5 16,051 1,926 16,051 0

$17,976

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Cash Flow Statement (Table
9.3)

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When Projects Results in
Negative Taxable Income
 Negative taxable  Handling Project Loss
income (project loss)
means you can
reduce your taxable Regular Project Combined
income from regular Business Operation
business operation Taxable $100M (10M) $90M
by the amount of income
loss, which results in Income $35M ? $31.5M
a tax savings. taxes
(35%) Tax savings

Tax Savings = $35M - $31.5M

= $3.5M
Or (10M)(0.35) = -$3.5M

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Effects of Inflation on Project
Cash Flows – (1)
Depreciation Expenses
Item Effects of Inflation

Depreciation Depreciation expense is

expense 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

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Effects of Inflation on Project
Cash Flows – (2) Interest
Expenses
Item Effects of Inflation

Loan Borrowers repay historical

repayments loan amounts with dollars of
decreased purchasing
power, reducing the debt-
financing cost.

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Effects of Inflation on Project
Cash Flows – (3) Working
Capital
Item Effects of Inflation

Working capital Known as working capital

requirement drain, the cost of working
capital increases in an
inflationary environment, as
additional cash must be
invested to maintain new
price levels.

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Effects of Inflation on Project
Cash Flows – (4) Profitability
Item Effects of Inflation

Rate of Return Unless revenues are

and NPW sufficiently increased to keep
pace with inflation, tax
effects and/or a working
capital drain result in lower
rate of return or lower NPW.

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Example 9.4 Effects of
Inflation on Projects with
Depreciable Assets

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Cash Flow Statement
(Table 9.4)

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Example 9.5 Applying
Specific Inflation Rates
Cash Flow Item Inflation Rate
Revenue 6%
Labor 5%
Materials 4%
Overhead 5%
Salvage value 3%
Working capital 5%
General inflation rate = 6%
Inflation-free interest rate = 15%
Market interest rate = 21.90%

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Cash Flow Statement (Table
9.5)

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Decision Rules
 If you use 41.15% (which was calculated
based on the cash flows in actual dollars) as
your IRR, you should use a market interest
rate (21.90%) to make an accept and reject
decision.
 If you use 33.16% (which was obtained
based on the cash flows in constant dollars)
as your IRR, you should use an inflation-free
interest rate (15%) to make an accept and
reject decision.

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