# Chapter 12: Developing Project Cash Flows

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1 Chapter 12: Developing Project Cash Flows Cost and Benefit Estimating Income Statement Cash Flow Statement How to handle working capital How to handle financing After-Tax Cash Flow Analysis Approach 1: Cash Flows based on Income Statement Approach 2: Traditional Method of Net Cash Flow Table Generalized Cash Flow Approach EIN Fall 23 Cost Estimating Need estimates since we are making current decisions on future costs Type of Estimate Rough estimates Semi-detailed estimates Detailed estimates Comments Used for high-level planning. The intent is to quantify and consider the order of magnitude of the numbers involved. (Errors between 3% to +6%.) Used for budget purposes at a project s conceptual or preliminary design stages. (Errors between 15% to +2%) Used during a project s detailed design and contract bidding phases. These estimates involve the most time and resources to develop. (Errors between 3% to +5%) Will play a role in sensitivity analysis, risk, and uncertainty EIN Fall 23

2 Cost Estimating It can be difficult to make good estimates. Compare the cost of an estimate with its expected accuracy Estimate Cost Low Medium High Accuracy EIN Fall 23 Cost Estimating "Per Unit" Estimating Model Uses a per unit factor such as a cost per person Works well for rough or order-of-magnitude type estimates, and is commonly used in the construction industry Note this model does not account for economies of scale (lower per unit costs for larger quantities) "Segmenting" Estimating Model An estimate is decomposed into its individual components Estimates made at lower levels, then these estimates are added together Work Breakdown Structure Common for large processes, products, or projects Spreadsheets can be very useful with this subject matter EIN Fall 23

3 Cost Indices The U.S. Federal government publishes cost index data through the Department of Commerce Bureau of Statistics The Statistical Abstract of the United States publishes cost indexes for labor, construction, and materials Best-known example is the consumer price index (CPI), a measure of inflation The measure is scaled, so it is only the relative values of any two measures that are meaningful For example, in 192, the measure was about 2; in 1997 it was about 16. The conclusion is that one would have to spend 16/2 or 8 times as much in 1997 as in 192 for the same consumables Cost indices work in the same way as price indices Cost indices are dimensionless EIN Fall 23 Cost Indices 18 US Urban CPI, Jan. of each year EIN Fall 23

4 Power Sizing Model Power Sizing Model Cost of equipment A / Cost of equipment B = [Size or capacity of equipment A / Size or capacity of B] x A generalization of the cost index model The power sizing model scales up or scales down previously known costs, accounting for economies of scale that are common in industrial plant and equipment costs It does not adjust for changes in cost over time Example (Estimate the cost of a new heat exchanger) We paid \$5, for a 1 ft 2 heat exchanger 5 years ago We need a 25 ft 2 heat exchanger today Heat exchangers with this capacity range have x =.55 The Heat Exchanger Cost Index (HECI) was 136 five years ago, and is 1487 today EIN Fall 23 Example: Power Sizing and Cost Indexing Power sizing formula A for today and B for five years ago, x =.55 Cost of 25 ft 2 heat exchanger = 5(25/1).55 = \$82,8 We have only adjusted so far for a change in size. We must still adjust for a change in costs over time Cost index formula Equipment Cost today / Equipment Cost 5 years ago = Index Value today/index value 5 years ago Equipment cost today (1487/136) 82,8 = \$94,3 EIN Fall 23

5 Estimating Benefits For the most part, we can use the same approach to estimate benefits as to estimate costs: Fixed and variable benefits Recurring and non-recurring benefits Incremental benefits Life-cycle benefits Rough, semi-detailed, and detailed benefit estimates Difficulties in estimation Segmentation and index models Major differences between benefit and cost estimation: Costs are most likely to be underestimated Benefits are most likely to be overestimated Costs tend to occur in the near future Benefits tend to occur further in the future than costs EIN Fall 23 Example Year Economic Analysis Before and After Taxes Giuliano s Pizza plans to spend \$3, on a used truck for the shipping and receiving department of its local warehouse. Estimated life = 5 years. Estimated savings per year = \$8 Estimated salvage value = \$75. Giuliano s is in the 34% tax bracket SL depreciation = (3-75)/5 = \$45 per year Before Tax Cash Flows SL deprec. Taxable Income (a) (b) 34% Income taxes: -.34 (c) After Tax Cash Flows (a) + (d) (a) (b) (c) (d) (e) -\$3 -\$ \$119 \$ \$ \$ \$ SV(or MV) = BV = \$ EIN Fall 23

6 Economic Analysis Before and After Taxes Before Taxes: Cash flows in (a) have IRR = 15.69% After Taxes: Cash flows in (e) have IRR = 1.55% Important Notes Columns (b) and (c) are used for calculating the cash flow for income taxes!! They are not cash flows!!! Do not include these when calculating the after tax cash flow A minus ( ) represents a disbursement of money; a plus (+) represents the receipt of money Conclusion Before-tax analysis is only a starting point Income taxes are a major disbursement that cannot be ignored Only the after-tax ROR (or any equivalent worth measure) is a meaningful value EIN Fall 23 Estimating the After-Tax Rate of Return Example. You invest \$1, and get a return of \$1,. You are in the 28% tax bracket, so U.S. takes \$28, leaving you with \$72. After-tax ROR = (1 Incremental tax rate) (Before-tax ROR) Before-tax ROR = 1% After-tax ROR after taxes = 7.8% = (1.28) ROR before taxes Estimating after-tax ROR for nondepreciable assets Previous Example: After-tax ROR = (1.34)(15.69%) = 1.36% This is close towhat we found before (1.55%) There is no shortcut method to compute the after-tax ROR from the before-tax ROR. Even for nondepreciable assets, the above formula is just a rough approximation Estimating After-Tax MARR (Before-tax MARR)[(1 - effective income tax rate)] after-tax MARR EIN Fall 23

7 Example Working Capital Example (Inventory, No Depreciation) A firm is losing sales because it cannot always make quick deliveries. By investing an extra \$2, in inventory it is believed that the beforetax profit of the firm will be \$1, more the first year. The second year before-tax extra profit will be \$1,5. The extra profit is then expected to go up \$5 more each year. The investment in extra inventory may be recovered at the end of a four-year analysis period by selling it and not replenishing the inventory. Assuming an incremental tax rate is 39%, we wish to find the ROR before taxes, and the ROR after taxes. Working capital amount carried in cash, accounts receivable, and inventory that is available to meet daily operating needs Treat working capital investments just like capital expenditures except that no depreciation is allowed The investment in working capital is often assumed to be returned in full at the end of the project EIN Fall 23 Example Working Capital Year Before Tax Cash Flow SL deprec. Taxable Income (a) (b) Before taxes: CFS (a) has IRR = 8.5% After taxes: CFS (e) has IRR = 5.24%. Can you calculate before-tax and after-tax PW? 34% Income taxes: -.34 (c) After Tax Cash Flow (a) + (d) (a) (b) (c) (d) (e) -\$2, -\$2, 1 1, \$1, -\$ , ,5 -\$ , , -\$ ,5 +2, ,5 -\$975 1,525 +2, Key point: Inventory is not considered a depreciable asset, even though its value to the owner may decrease over time EIN Fall 23

8 Types of Cash Flow Elements EIN Fall 23 Cash Flows from Operating Activities Approach 1 Income Statement Approach Operating revenues Cost of goods sold Depreciation Operating expenses Interest expenses Taxable income Income taxes Net income + Depreciation Approach 2 Direct Cash Flow Approach Operating revenues - Cost of goods sold - Operating expenses - Interest expenses - Income taxes Cash flow from operation EIN Fall 23

9 Cash Flow Element Operating activities: Gross income Cost savings Manufacturing expenses O&M cost Operating income Interest expenses Income taxes Investing activities: Capital investment Salvage value Investment in working capital Working capital release Gains taxes Financing activities: Borrowed funds Principal repayments Other Terms Used in Business Gross revenue, Sales revenue, Gross profit, Operating revenue Cost reduction Cost of goods sold, Cost of revenue Operating expenses Operating profit, Gross margin Interest payments, Debt cost Income taxes owed, Tax credits received Purchase of new equipment, Capital expenditure Net selling price, Disposal value, Resale value Working capital requirement Working capital recovery Capital gains taxes, Ordinary gains taxes Borrowed amounts, Loan amount Loan repayment EIN Fall 23 Determining the Cash Flow Statement Income statement Revenues Expenses Cost of goods sold Depreciation Debt interest Operating expenses Taxable income Income taxes Net income Cash flow statement + Net income +Depreciation -Capital investment + Proceeds from sales of depreciable assets - Gains tax - Investments in working capital + Working capital recovery + Borrowed funds -Repayment of principal Net Cash Flow Operating activities + Investing activities + Financing activities EIN Fall 23

10 Example 12.1 Operating and Investing Activities Only Project Nature: Installation of a new computer control system Financial Data: Investment: \$125, Project life: 5 years Salvage value: \$5, Annual labor savings: \$1, Annual additional expenses: Labor: \$2,, Material: \$12,, Overhead: \$8, Depreciation Method: 7-year MACRS Income tax rate: 4% MARR: 15% Questions: 1. Develop the project s cash flows over its project life 2. Is this project justifiable at a MARR of 15%? 3. What is the internal rate of return of this project? EIN Fall 23 Step 1: Depreciation Calculations Cost Basis = \$125, Recovery Period = 7-year MACRS N MACRS Rate Depreciation Amount Allowed Depreciation Amount % \$17,863 \$17, % \$3,613 \$3, % \$21,863 \$21, % \$15,613 \$15, % \$11,15 \$5, % 8.93% \$11,15 \$11,15 With half-year convention % \$5,575 EIN Fall 23

11 Step 2: Gains (Losses) with Asset Disposal Salvage value = \$5, Book Value (year 5) = Cost Basis Total Depreciation = \$125, - \$ 91,525 = \$ 33,475 Taxable gains = Salvage Value Book Value = \$5, - \$ 33,475 = \$16,525 Gains taxes = (Taxable Gains)(Tax Rate) = \$16,525 (.4) = \$6,61 EIN Fall 23 Example 12.1 Income Statement Income Statement Revenues \$1, \$1, \$1, \$1, \$1, Expenses: Labor 2, 2, 2, 2, 2, Material 12, 12, 12, 12, 12, Overhead 8, 8, 8, 8, 8, Depreciation 17,863 3,613 21,863 15,613 5,581 Taxable Income \$42,137 \$29,387 \$38,137 \$44,387 \$54,419 Income Taxes (4%) 16,855 11,755 15,255 17,755 21,768 Net Income \$25,282 \$17,632 \$22,882 \$26,632 \$32,651 EIN Fall 23

12 Example 12.1 Cash Flow Statement Cash Flow Statement Operating Activities: Net Income \$25,282 \$17,632 \$22,882 \$26,632 \$32,651 Depreciation 17,863 3,613 21,863 15,613 5,581 Investment Activities: Investment (125,) Salvage 5, Gains Tax (6,613) Net Cash Flow (\$125,) \$43,145 \$48,245 \$44,745 \$42,245 \$81,619 EIN Fall 23 Ex 12.1 Net Cash Flow Table (Traditional Method) A B C D E F G H Before-Tax Cash Flows Year End Investment & Salvage Value Revenue Labor Material Overhead Depreciation Taxable Income Income Taxes After-Tax Cash Flow -\$125, -\$125, 1 \$1, -4, \$17,863 42,137-16,855 \$43, , -4, 3,613 29,387-11,755 \$48, , -4, 21,863 38,137-15,255 \$44, , -4, 15,613 44,387-17,755 \$42, , -4, 5,581 54,419-21,678 \$38,232 5,* BV = 33,475 16,525-6,613 \$43,387 *Salvage value Note that F = B+C+D-E G =.4 * F H= B+C+D+G Information required to calculate the income taxes EIN Fall 23

13 Example 12.1 Additional Questions 2. Project Justified at MARR = 15%? PW(15%) = -\$125, + +\$43,145(P/F, 15%, 1) \$81,62 (P/F, 15%, 5) = \$43,151 > Yes, Accept the Project! \$81,619 \$48,245 \$44,745 \$42,245 \$43, Years 3. Determine the project s IRR At i = 25% PW(25%) = \$7,351 At i = 3% PW (3%) = -\$6,124 IRR = 27.61% > 15%, Accept!! \$125, EIN Fall 23 Projects Requiring Working Capital Working capital amount carried in cash, accounts receivable, and inventory that is available to meet daily operating needs Treat working capital investments just like capital expenditures except that no depreciation is allowed (Example 12.2) Price (revenue) per unit Unit variable manufacturing costs Labor Material Overhead Monthly volume Finished goods inventory to maintain Raw materials inventory to maintain Accounts payable Accounts receivable \$1 \$2 \$1.2 \$ units 2 month supply 1 month supply 3 days 6 days EIN Fall 23

14 Example 12.2 Working Capital Requirements During year 1 Sales Income /Expense Reported \$1, (1, units) Actual cash Received/paid \$83,333 Difference -\$16,666 Expenses \$4, (1, units) \$46,665 (11,667 units) +\$6665 Income taxes \$16,855 \$16,855 Net amount \$43,145 \$19,814 -\$23,333 This differential amount must be invested at the beginning of the year EIN Fall 23 Ex 12.3 Cash Flow Statement with Working Capital Item related to working capital investment EIN Fall 23

15 Ex 12.3 Cash Flow Diagram with Working Capital \$23,331 \$43,145 \$48,245 \$44,745 \$81,619 \$42,245 Working capital recovery \$125, Investment in physical assets \$23,331 \$23,331 Investment in working capital \$23,331 Years Working capital recovery cycles EIN Fall 23 Projects Financed with Borrowed Funds Key Issue Interest payment is a tax-deductible expense What Needs to be Done Once loan repayment schedule is known, determine the interest payment portion of the annual (or periodic) installment What about the Principal Payment? Since the amount of borrowing is NOT viewed as income to the borrower, the repayment of principal is NOT viewed as expenses either NO tax effect EIN Fall 23

16 Example 12.4 Financing (Borrowing) Amount financed: \$62,5, or 5% of total capital expenditure Financing rate: 1% per year Annual installment: A = \$62,5(A/P, 1%, 5), or \$16,487 End of Year 1 Beginning Balance \$62,5 Interest Payment \$6,25 Principal Payment \$1,237 Ending Balance \$52, ,263 5,226 11,261 41,2 3 41,2 4,1 12,387 28, ,615 2,861 13,626 14, ,989 1,499 14,988 \$16,487 EIN Fall 23 Example 12.4 Financing (Borrowing) Items related to financing activities EIN Fall 23

17 Projects with Negative Taxable Income Negative taxable income (on a project) means you can reduce your total taxable income from by the amount of the loss, which results in a tax savings Regular Business Project Combined Operation Taxable income \$1M (1M) \$9M Income taxes (35%) \$35M Tax Savings? \$31.5M Tax Savings = \$35M - \$31.5M = \$3.5M Or (1M)(.35) = -\$3.5M EIN Fall 23 When to Use: Generalized Cash Flow Approach When undertaking a project does not change a company s marginal tax rate Pros The cash flows can be generated more quickly Cons The process is less intuitive and not commonly understood by business people EIN Fall 23

18 Example 12.8 Investing activities Operating activities Financing activities EIN Fall 23 Extra Example 12-1 Certain new machinery when placed in service is estimated to cost \$18,. It is expected to reduce net annual operating expenses by \$36, per year for 1 years and to have a \$3, MV at the end of the tenth year. Assume the firm is in the federal taxable income bracket of \$335, to \$1,,, and the state income tax rate is 6%. This machinery is in the MACRS five-year property class. (a) Develop the before-tax and after-tax cash flows. (b) Calculate the before-tax and after-tax IRR. (c) Calculate the after-tax PW (after-tax MARR = 1% per year). EIN Fall 23

19 Extra Example 12-1 Solution EIN Fall 23 Extra Example 12-2 An engineering consulting firm can purchase a fully configured CAD workstation for \$2,. It is estimated that the useful life of the workstation is seven years, and its MV in seven years should be \$2,. Operating expenses are estimated to be \$4 per eight-hour workday, and maintenance will be performed under contract for \$8, per year. The MACRS property class is five years, and the effective income tax rate is 4%. As an alternative, sufficient computer time can be leased from a service company at an annual cost of \$2,. If the after-tax MARR is 1% per year, how many workdays per year must the workstation be needed in order to justify leasing it? (Assume a maximum of 25 workdays per year!!) EIN Fall 23

20 Extra Example 12-2 Solution EIN Fall 23

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