Chapter 9 Project Cash Flow Analysis

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Chapter 9 Project Cash Flow Analysis
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General Cost Terms
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• Manufacturing Costs
• Direct materials
• Materials used in the final product.
• Direct labor
• Labor costs that goes to fabrication of a
  product.
• Manufacturing Overhead
• In particular, indirect materials, indirect
  labor, maintenance and repairs on production
  equipment, heat and light, property taxes,
  depreciation, insurance on manufacturing
  facilities, and overtime payment.
• Non-manufacturing Costs
• Overhead
• Heat and light, property taxes, depreciation,
  and similar items associated with selling and
  administrative functions.
• Marketing
• Advertising, shipping, sales travel, sales
  commissions, and sales salaries.
• Administrative

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COST FLOWS AND CLASSIFICATIONS IN MANUFACTURING
COMPANY
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• Matching Concept The costs incurred to generate
  particular revenue should be recognized as
  expenses in the same period that the revenue is
  recognized.
• Period costs Those costs that are charged to
  expenses in the period in which the expenses are
  incurred. Examples of periodic costs are all
  general and administrative expenses, selling
  expenses, insurance, and income tax expenses.
  Therefore, advertising costs, executive salaries,
  sales commissions, public relations costs, and
  other non-manufacturing costs would all be
  period cost. Such costs are not related to the
  production and flow of manufactured goods, but
  deducted from revenue in the income statement.
• Product costs Those costs involved in the
  purchase or manufacturing of goods. In the case
  of manufactured costs consist of direct
  materials, direct labor, and manufacturing
  overhead. Product costs are not viewed as
  expenses rather they are the cost of creating
  inventory. Thus, product costs are considered an
  asset until goods are sold.

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Cost Classification for Predicting Cost Behavior

• Volume index
• Operating cost respond in some way to changes in
  its operating volume.
• Cost Behaviors
• Fixed costs
• Variable costs
• Mixed costs
• In the car case, Depreciation, occur from
  passage of time (fixed portion) and also More
  miles are driven a year, loses its Market value
  (variable portion), cost of electrical power
  (lighting, number of machine hours worked).
• Average unit costs

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Volume Index

• Definition The unit measure used to define
  volume Based on production inputs (tons of coal
  processed, direct labor hours used, or machine
  hours worked).
• Examples
• Automobile miles driven
• Electricity Generating plant kWh produced
• Stamping machine parts stamped

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Fixed Costs

• Definition The costs of providing a companys
  basic operating capacity are known as its fixed
  costs or capacity costs. Must have a relatively
  wide span of output for which costs are expected
  remain constant.
• Fixed cost do not change within a given time
  period although volume may change. For car
  example, the annual insurance, property tax,
  license fee.
• Cost behavior Remain constant over the relevant
  range.

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Variable Costs

• Definition
• Costs that vary depending on the level of
  production
• or sales. In manufacturing, direct labor and
  material costs are major variable costs.
• Cost behavior
• Increase or decrease proportionally according
• to the level of volume

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Practice Problem

• You have 3000 units to produce.
• Total labor cost 20,000
• Total material cost 25,000
• Total overhead cost 15,000
• Total fixed cost 40,000
• What is the average cost per unit?
• Average cost (100,000)/3,000 33.33/unit

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Project Cash Flow Analysis
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Developing Project Cash Flow Statement

• 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
Income statement Revenues Expenses Cost
of goods sold Depreciation Debt
interest Operating expenses Taxable
income Income taxes Net income

Investing activities

Financing activities
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Example 9.1 When Projects Require only
Operating and Investing Activities

• Project Nature Installation of a new computer
  control system
• Financial Data
• Investment 125,000
• Project life 5 years
• Working capital investment 23,331
• Salvage value 50,000
• Annual Revenues 100,000
• Annual additional expenses
• Labor 20,000
• Material 12,000
• Overhead 8,000
• Depreciation Method 7-year MACRS
• Income tax rate 40
• MARR 15

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Questions

• (a) Develop the projects cash flows over its
  project life.
• (b) Is this project justifiable at a MARR of 15?
• (c) What is the internal rate of return of this
  project?

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When Projects Require Working Capital Investments

• Working capital represents the amount carried in
  cash, accounts receivable, and inventory that are
  needed for the operation of the project
• Working Capital includes the stocks of finished
  and semi-finished goods that will be economically
  consumed in the near future or will be made into
  a finished consumer good in the near future.
• How to treat working capital investments just
  like a capital expenditure except that no
  depreciation is allowed.

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• (a) Step 1 Depreciation Calculation
• Cost Base 125,000
• Recovery Period 7-year MACRS

N MACRS Rate Depreciation Amount Allowed Depreciation Amount
1 14.29 17,863 17,863
2 24.49 30,613 30,613
3 17.49 21,863 21,863
4 12.49 15,613 15,613
5 8.93 11,150 5,581
6 8.92 11,150 0
7 8.93 11,150 0
8 4.46 5,575 0
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(a) Step 2 Gains (Losses) associated with Asset
Disposal

• Salvage value 50,000
• Book Value (year 5) Cost Base Total
  Depreciation
• 125,000 - 91,533
• 33,467
• Taxable gains Salvage Value Book Value
• 50,000 - 33,467
• 16,533
• Gains taxes (Taxable Gains) (Tax Rate)
• 16,533 x (0.40)
• 6,613

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Step 3 Create an Income Statement
Income Statement 0 1 2 3 4 5
Revenues 100,000 100,000 100,000 100,000 100,000
Expenses
Labor 20,000 20,000 20,000 20,000 20,000
Material 12,000 12,000 12,000 12,000 12,000
Overhead 8,000 8,000 8,000 8,000 8,000
Depreciation 17,863 30,613 21,863 15,613 5,581
Taxable Income 42,137 29,387 38,137 44,387 54,419
Income Taxes (40) 16,855 11,755 15,255 17,755 21,768
Net Income 25,282 17,632 22,882 26,632 32,651
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Step 4 Develop a Cash Flow Statement
Cash Flow Statement 0 1 2 3 4 5
Operating Activities
Net Income 25,282 17,632 22,882 26,632 32,651
Depreciation 17,863 30,613 21,863 15,613 5,581
Investment Activities
Investment (125,000)
Working capital (23,331) 23,331
Salvage 50,000
Gains Tax (6,613)
Net Cash Flow (148,331) 43,145 48,245 44,745 42,245 104,950
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Cash Flow Diagram including Working Capital
Working capital recovery
23,331
44,745
81,619
48,245
43,145
42,245
1
2
3
4
5
0
125,000 Investment in physical
assets
23,331
23,331
Investment in working capital
23,331
5
1
2
3
4
0
Years
23,331
23,331
Working capital recovery cycles
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Question (b)

• Is this investment justifiable at a MARR of 15?
• PW(15) -148,331 43,145(P/F, 15, 1) . .
  . . 104,950 (P/F, 15, 5)
• 31,423 gt 0
• Yes, Accept the Project !

104,950
48,245
44,745
42,245
43,145
0
1
2
3
4
5
Years
148,331
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Question (C) IRR
A B
1 Period Cash Flow
2 0 (148,331)
3 1 43,145
4 2 48,245
5 3 44,745
6 4 42,245
7 5 104,950
IRR(B2B7,0.10)
IRR 22.55
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Rate of Return Analysis (IRR 22.55)
n 0 n 1 n 2 n 3 n 4 n 5
Beginning Balance -148,331 -138,635 -121,652 -104,339 -85,622
Return on Investment (interest) -33,449 -31,262 -27,432 -23,528 -19,328
Payment -148,331 43,145 48,245 44,745 42,245 104,950
Project Balance -148,331 -138,635 -121,652 -104,339 -85,622 0