LECTURE 3

CASH FLOW

Dyanne Brendalyn M. Cavero, MEng

 Cash Flow
• The sums of money recorded as receipts or
disbursements in a project’s financial records
• Can be drawn to help visualize and simplify
problems that have diverse receipts and
disbursements
• Examples: deposits to a bank, dividend interest
payments, loan payments, operating and
maintenance costs, and trade-in salvage on
equipment.
 Cash Flow
Purpose :
• To provide information about the cash inflows
and outflows of an entity during a period.
• To summarize the operating, investing, and
financing activities of the business.
• Helps users to assess a company’s liquidity,
financial flexibility, operating capabilities, and
risk.
 Cash Flow
Provides answers to the following important
questions:
- Where did cash come from?
- What was cash used for?
- What was the change in the cash balance?
 Cash Flow Standards
• The horizontal (time) axis is marked off in
equal increments, one per period, up to the
duration of the project.
• Receipts are represented by arrows directed
upward. Disbursements are represented by
arrows directed downward. The arrow length
is approximately proportional to the
magnitude of the cash flow.
 Cash Flow Standards
• Two or more transfers are in the same period
are placed end to end, and these may be
combined.
• Expenses incurred before t=0 are called sunk
costs which are not relevant to the problem
unless they have tax consequences in an after-
tax analysis.
 Cash Flow
Example :
Consider a mechanical device that will cost
P20,000 when purchased. Maintenance will
cost P1,000 each year. The device will generate
revenues of P5,000 each year for five years,
after which the salvage value is expected to be
P7,000.
Present the project’s cash flows in terms of
standard.
Cash Flow
 Cash Flow
Net cash flow = receipts – disbursements
=cash inflows –cash outflows
 Cash Flow
End of period – all cash flows are assumed to
occur at the end of an interest period (not end
of calendar year)
 Cash Flow Analysis
• Single payment cash flow
- can occur at the beginning of the time line
(designated as t=0), at the end of the time line
(designated as t=n), or any time in between.
 Cash Flow Analysis
• Uniform series cash flow
- consists of a series of equal transactions
starting at t=1 and ending at t=n. The symbol
A (representing an annual amount) is typically
given to the magnitude of each individual cash
flow
 Cash Flow Analysis
Uniform series cash flow
 Cash Flow Analysis
• Gradient series cash flow
- starts with a cash flow (typically with the
symbol G) at t=2 and increases by G each year
until t=n, at which the time the final cash flow
is (n-1)G. The value of the gradient at t=1 is
zero.
 Cash Flow Analysis
Gradient series cash flow
 Time Value of Money
• The funds placed in a secure investment will
increase in value in a way that depends on the
elapsed time and interest rate.
• The interest rate that is used in calculations is
known as the effective interest rate. If
compounding once a year, it is known as the
effective annual interest rate. However,
effective quarterly, monthly, or daily interest
rates are also used.
 Cash Flow Formulas
• Single Payment

n
FV  PV (1  i )

 1 
PV  FV  n 
 (1  i ) 
 Cash Flow Formulas
• Single Payment Example
An engineer received a bonus of $12,000 that
he will invest now. He wants to calculate the
equivalent value after 24 years, when he plans
to use all the resulting money as the down
payment on an island vacation home. Assume
a rate of return of 8% per year for each of the
24 years. Find the amount he can pay down.
 Cash Flow Formulas
• Uniform series cash flow
– Note :
The four uniform series formulas that involve A,
where A means :
• The cash flow occurs on consecutive interest periods
• The cash flow amount is the same in each period
 Cash flow formulas
• Uniform series cash flow (present worth)
n
 (1  i )  1 
PV  A  n 
 i (1  i ) 

 i (1  i ) n 
A  PV  n 
 (1  i )  1 
 Cash flow formulas
• Uniform series cash flow (future worth)

 i 
A  FV  n 
 (1  i )  1 

 (1  i ) n  1 
FV  A  
 i 
 Cash flow formulas
• Uniform series cash flow example
How much money should you be willing to pay
now for a guaranteed $600 per year for 9
years next year, at a rate of return of 16% per
year?
 Cash flow formulas
• Gradient series cash flow
– Arithmetic gradient
 (1  i ) n  1  G  (1  i ) n  1 n 
PV  A  n 
  n
 n
 i (1  i )  i  i (1  i ) (1  i ) 

– Conventional gradient
 (1  i ) n  1  G  (1  i ) n  1 n 
PV  A  n 
  n
 n 
 i (1  i )  i  i (1  i ) (1  i ) 
 Cash flow formulas
• Gradient series cash flow (example)
The highway department expects the cost of
maintenance for a piece of heavy construction
equipment to be $5,000 in year 1, to be
$5,500 in year 2, and to increase annually by
$500 through year 10. At an interest rate of
10% per year, determine the present worth of
10 years of maintenance costs.
 Cash flow formulas
• Gradient series cash flow
– Geometric gradient (cash flows that change
by a constant percentage)
– A1 = total cash flow in period 1
– g = rate of change per period (decimal form)
– i = interest rate per period
 Cash flow formulas
n
  1 g  
1    
  1 i  
PV  A1
 ig 
 
 
g i

1 n 
AG  n 
 i (1  i )  1 
 Cash flow formulas
 n 
P  A1  
 (1  i ) 
g i
 Cash flow formulas
• Gradient series cash flow (example)
A mechanical contractor has four employees
whose combined salaries through the end of
the year are $250,000. if he expects to give an
average raise of 5% each year, calculate the
present worth of the employee’s salaries over
the next 5years. Let i=12% per year.
 Basics of Gradients
• Arithmetic gradients consist of two parts : a uniform series
that has an A value equal to the amount of money in
period 1, and a gradient that has a value equal to the
change in cash flow between periods 1 and 2.
• For arithmetic gradients, the gradient factor is preceded by
a plus sign for increasing gradients and a minus sign for
decreasing gradients.
• Conventional arithmetic and geometric cash flows start
between periods 1 and 2, with the A value in each equation
equal to the magnitude of the cash flow in period 1 and
the P value in year 0.