EMGT 502

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EMGT 502

• 21 September 2006

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Today

• Cash Flow Estimation
• Are we thinking projects???
• HW Walton Medical Laboratory text pg 266-7
• Next week postponement

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Cash Flows

• Today we will discuss where we get the CFs below
• Lots of accounting information
• The trick is estimation of relevant CFs

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The Basic Idea

• Assess project-specific costs costs that would
  not be incurred if the project is not undertaken
• Assess project specific benefits financial and
  otherwise, if possible - benefits that would not
  be realized if the project is not undertaken
• Use the numbers in the NPV calculation(s)

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Cash Flows

• Issues
• Opportunity Costs for
• Opportunity Costs for Fixed Assets
• Product Life Cycles
• Production Costs
• Revenues f (Volume, Price Structure)
• Taxes

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More Issues

• Its more than Operating Income (Revenues less
  Operating Expenses)
• The issue is CASH FLOWS, which is not necessarily
  the same as Net Income (NI)
• Net inflows/outflows that are presumed to be lost
  if the project in question is not undertaken

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Relevant Cash Flows

• Relevant CFs are directly attributable to the
  project under consideration
• Can be incremental outflows or a CF eliminated
• Can be incremental inflows or a CF outflow
  avoided
• Irrelevant CFs occur independent of the project
  at hand

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Special-Case CFs

• Sunk Costs
• Dont Count
• Indirect Costs
• Shared, may be difficult to determine
• Overhead is one example
• Joint Costs
• Shared costs between activities changing one
  activity does not affect others costs

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Between-Project Costs

• Consider Joint-Cost projects as single-project
  sets of the component projects
• A intuitive algorithm
• Calculate the individual NPVs of projects with
  shared costs
• Calculate the combined NPV of the set of
  positive-NPV component projects
• If both NPVs are positive, proceed

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Benefits and Other Issues

• Indirect Benefits obvious analogy to indirect
  costs can be overflow benefits
• Issues associated with suppliers of capital
• Interest expense(s) is not considered as an
  outflow instead, the impact on k may be
  considered, partially via the income stat.
• Opportunity costs

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3 Pieces of Accounting Info

• Income Statement
• Project-specific revenues and expenses
• Balance Sheet
• Changes in affected balance sheet accounts are
  estimated
• Cash Flow Statement
• Life of the project, salvage values, depreciation

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Please Keep in Mind (!!)

• Our objective here is two-fold
• Present an overview of accounting data and issues
  so we know enough to communicate and understand
  financial statements
• Use the overview to focus on cash-flow estimation
  and income-statements
• This is not meant to replace a full-blown
  accounting discussion

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Income Statement

• From Revenues to Net Income (NI)
• Posting of Revenues and Costs is a key issue
• Accrual versus Cash basis for accounting purposes
• Revenues and expenses are recognized when a
  transaction constructively occurs rather than
  when cash changes hands

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Income Statement Line Items

• Sales/Revenues
• Expenses
• Cost of Sales, Marketing and Administrative,
  Interest Expense, Other Items
• Depreciation
• Taxes
• Special Items
• N/I

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Public-Sector Depr

• Depreciation works (essentially) the same way in
  both private and public sectors
• Method is key for both
• Straight line vs Accelerated Depreciation
• Accelerated Depreciation schedule(s)
• MACRS Table 8.4, page 239 in the text

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Balance Sheet

• Acquisition
• Land, plant and equipment
• Balance Sheet assets
• Operations
• Short-term assets
• Disposition
• Nonland assets are depreciated over their
  accounting lives

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Balance Sheet Items

• Assets
• Current
• Fixed
• Liabilities
• Delineated by time
• Equity
• ? Assets-LiabilitiesOwners Equity (O/E)

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Public Sector A-L O/E Story

• The concept of O/E is clear in the private sector
  almost regardless of ownership structure
• In the public sector, maybe not so clear
• Often resources are grouped in funds
• Fund A Fund L Fund Balance aka Net Assets
  can be thought of as public Equity

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Public Sector B/S

• Fixed assets are likely to be property and
  equipment, much like a firm
• Current assets (C/A) are similar
• Cash
• A/R
• Inventory
• Current Liabilities similar too
• A/P
• Wages payable

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More Pub. Sect./Non-Profit

• According to GASB, a Non-Profit
• Receives contributions from providers not
  expecting equal/positive return(s)
• Goals do not include profitability
• No formal ownership interest

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Non Profits

• Donations often come with strings attached that
  is, uses of funds are restricted
• Separate funds and sub-entities to control
  restricted funds
• Financial statements prepared for each sub-entity
  or fund
• Different categories of restricted assets

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Non-Profit Fund Accounting

• Organization finances divided among funds
• O/E section contains fund balances no owners
• Internal control reporting purposes
• Restricted, partially/temporarily restricted,
  unrestricted funds
• Each fund is a separate accounting entity

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State and Local Governments

• GASB Government Accounting Standards Board
• Modified Accrual Accounting
• Funds
• Governmental funds
• Proprietary funds
• Trust or agency funds

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Reference

• S. A. Finkler, Financial Management for Public,
  Health, and Not-for-Profit Organizations.
  Pearson, 2005.
• Many other sources

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Income Stat/Balance Sheet

• These are connected
• Accrual-based accounting numbers need to be
  converted to a cash-flow statement for capital
  budgeting purposes
• IS/BS timings are important
• Most assets are recognized as soon as acquired
• Revenues and cash expenses later

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Recognition of In and Outflows

• Basis
• Cash when money actually changes hands
• Accrual when contract is signed when
  goods/services are exchanged
• Modified Accrual time limit on accrual basis
  largely a government/not-for-profit entity
  accounting issue

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IS/BS

• Some items go from the BS to the IS as
  Depreciation Expense(s)
• Buildings, Equipment
• Some forms of cash investment are expensed
  immediately
• Training, Advertising

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IS/BS

• Some CF-type items start and stay on BS
• Cash, A/R, Inventory (I), A/P
• Some CF items start and stay on the IS
• Cash Revenues and Expenses
• Credit inflows and outflows go BS as A/R and A/P

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IS and Capital Budgeting

• The idea is we generate pro-forma income
  statements for individual projects
• The trick, of course, is estimating the I/S
  items, which are used to compute anticipated cash
  flows
• For now, we will assume we can know the future
  with some certainty

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Pro Forma IS

• These look a lot like conventional I/S
• They should be oriented toward project-specific
  revenues, costs, depreciation, interest payments,
  and the like
• The bottom line ? we must generate
  project-specific cash flows to evaluate a project!

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Whence Private I/S Line Items?

• Revenues? Projections, wild guesses
• Costs? Historical function of revenues,
  projections, wild guesses
• Depreciation? Should be doable
• Interest? Also doable
• Taxes Doable
• NWC Projections, but may be doable
• Cash Flows Dont forget the projections ..

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Costs

• Direct
• Materials
• Labor used to make items saleable
• Indirect
• Admin salaries
• Office and other supplies
• Selling expenses
• RD expenses

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Cash Flow Computation

• N/I
• Depreciation
• changes in NWC
• Current Assets Current Liabilities
• savings due to project
• Cash Flow

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Public-Sector Cash Flows

• 3 Main categories
• Cash from operating activities
• Cash from investments (buying/selling property,
  plant and equipment, stock)
• Cash from financing activities loans
• Big difference is in the investments category

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Public-Sector

• Project revenues may be either
• Non-cash items converted to monetary units
• Hard to do bound to be subjective
• May not be acceptable
• Savings
• Note that savings from a project is an explicit
  cash flow in the private sector too

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Example VM, Inc.

• Vous et Moi, Inc. expects new-project-related
  sales for the next 4 years (the life of the
  project) to increase at an annual rate of 15
  from todays level of 1m. Related cash expenses
  are 50 of sales. Credit sales average 60 days
  outstanding. No new fixed assets were acquired.
  See the associated Excel example.

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Yet More VM

• Inventory ---
• Suppose VM anticipates Inventory levels at 20
  of sales. What now?
• Inventory may be an important Cash Flow issue.
  Inventory may be both items sold and physical
  asset support. Initial investment made at time
  0. Losses generally occur, and should be
  considered.
• In this case, well consider inventory as a
  portion of the cash expense. For this particular
  example ..

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VM

• Suppose VM expects to lose 2 of inventory
  annually to shrinkage.
• Also, suppose VM expects to lose 10,000 upon
  liquidation of Inventory at the end of the 4-year
  projects life
• Back to the example

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Relevance

• Only cash flows and cash-flow statement items
  associated with events that are dependent on
  whether the project is undertaken should be
  considered
• I/S and B/S provide information for the Cash Flow
  statement, which is what we need for capital
  budgeting
• Usually projections have to be made

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Depreciation

• Keys are
• Life Category (Depreciation in (Life 1) years
  usually
• Rates from MACRSystem
• Can be recognized two ways
• As a pre-EBT outlay
• As a post N/I Tax-adjusted addition
• Book Value ?? Basis for tax purposes

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Next Example

• Socorro Investments (SI) is interested in
  expanding its capital budgeting analysis service
  to a second location in the middle Rio Grande
  Valley. Total expense for land, building, and
  equipment will be 1.1m. Of this, the land cost
  is 150K, the building cost is 600K, and
  equipment cost is 350K.

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More Next Example

• Assume SI will spend 50K on promotions and
  training associated with beginning operations 1
  January 07.
• 3K in accrued wages at opening

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Still More

• Operations First-Year Revenues of 1400K
  increasing at an annual rate of 5
• Wages of 700K, increasing an an average annual
  rate of 5
• A/R Increases by 10 of the increase in sales
  from a start of 10 of sales supplies maintained
  at 5 of sales, A/P at 5 of wages and operating
  expenses

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You Guessed It

• Equipment depreciated using 5-year MACRS
• Building depreciated using 20-year MACRS
• Land does not get depreciated