Analyzing Project Cash Flows, Lecture notes of Accounting

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Chapter 12

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Analyzing Project Cash Flows

Principles Applied in This Chapter ^ Principle 3: Cash Flows Are the Source of

Value.

^ Principle 5: Individuals Respond to Incentives.

Guidelines for Forecasting IncrementalCash Flows ^ Sunk Costs

(such as market research) and

overhead costs

(such as utilities expenses) are not incremental cash flows.  Account for positive and negative

synergistic effects

and

opportunity costs.

Guidelines for Forecasting IncrementalCash Flows ^ Work in

Working Capital Requirement ^ Need for additional working capital arises as cash inflows andoutflows are often mismatched.  Ignore

Financing Costs ^ They are accounted for in the discount rate used to discountcash flows.

Forecasting Project Cash Flows

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^ Four Step Procedure for calculating cash flows1.^

Depreciation expense

2.^

Change in working capital required

3.^

Change in capital expenditures

4.^

Calculate Free Cash Flows for project

Depreciation Expense, Taxes and Cash Flow Depreciation expenses is subtracted while calculating the firm’staxable income.However, depreciation is a not a cash expense.Therefore, depreciation must be added back into net operatingincome when calculating cash flows.

Depreciation Expense, Taxes and Cash Flow Example Consider a firm that purchased an equipment for$500,000 and incurred an additional $50,000 for shipping andinstallation.The equipment is expected to last 10 years and have a salvagevalue of $25,000?What is the annual depreciation expense?

Depreciation Expense, Taxes and Cash Flow Annual Depreciation expense= (Cost of equipment + Shipping & Installation Expense –Expected salvage value)

÷^ (Life of the equipment)

= ($500,000 + $50,000 - $25,000)

÷^ (10)

=^ $52,

Working Capital If the firm is able to finance some or all of its inventories usingtrade credits, this will offset the cash outflow. Thus the netincrease is given by:

Working Capital

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^ Increase working capital is a cash outflow ^ Will working capital requirements drop when the projectends?^ ^

If “Yes,” we have a cash inflow at the end of the project

Free Cash Flow

Step 4: Calculating a Project’s Free Cash Flow

The Problem ^ Crockett Clothing Company has analyzed investing in a newsewing machine assuming $360,000 annual revenue.^ ^

Checkpoint 12. ^ The firm

’s management wants to know the impact of a decrease in expected revenues from $360,000 to $240,000per year.  What would be the project’s operating cash flow under therevised revenue estimate?

Step 1: Picture the Problem

This is the information given to us:^ Equipment

$2,00,

Project life

5 years

Salvage Value

-

Depreciation expense

$40,000 per year

Cash Operating Expenses

-$5,000 per year

Revenues

$240,000 per year

Growth rate for revenues

0%

Cost of goods sold/Revenues

60%

Investment in Net operating workingcapital

-$78,

Required rate of return

20%

Tax rate

30%

Step 2: Decide on a Solution Strategy ^ We need to calculate the operating cash flows