Last time.

Basics of financial analysis

Estimating revenues and expenses is
crucial
Time value of money concept
The significance of present value
comparisons
Conversion of cash flows to present values
Profit Revisited
Profit = Revenues - Expenses

Expenses should include loss of value of
equipment with time due to
Wear and Tear
Obsolescence

Loss of value (expiration of assets) is the
basis of DEPRECIATION

Depreciation and Taxes
Suppose a company has $10 million in profits on
December 31, i.e.
Profits = Revenues - Expenses = $10,000,000
Corporate taxes are, in simplest terms, based on a
a percentage of profits
Suppose that as a way of beating taxes the
company purchases $10 million worth of new
equipment on December 31
Is the profit = 0?
No! Profit is not zero
The company has merely converted one
asset (cash) to another (equipment). This is
why Uncle Sam controls how equipment is
expensed-- i.e. you cannot declare items of
capital equipment as expenses when
purchased. Instead, they are depreciated.
Depreciation Calculations-
Information Needed
We need:
Price originally paid for the equipment or
asset
Estimate of lifetime (IRS)
Salvage Value at the end of lifetime
Calculations to be shown neglect special
circumstances, e.g. investment tax credits,
additional first year allowances
Depreciation
A new machine is not as
good as an old machine
Depreciation is a way to
account for the expiration
of the machine, or any asset
Many methods: straight line
versus accelerated
Has important tax
consequences,
which need to be considered in
present value calculations
Mmmm. Math
C
i
= Initial cost of an asset
C
s
= Final salvage value of an
asset
C
d
=Depreciable cost =(C
i
- C
s
)
m = lifetime for tax purposes
(often differs from actual
lifetime)
d
k
= fractional depreciation
in year k
D
k
= Dollar amount of depreciation, year k
D
k
= d
k
C
d
, Book Value = C
i
- C
d
E d
k

Book Value is often not true asset value.
Depreciation Methods
Straight Line
D
k
= C
d
/m (same over lifetime)

Link to Summary of Depreciation Methods
Sum of the Years Digits
D
k
= C
d
(Useful years left = m-k +1)/E
E = m + (m-1) + (m-2) + ... + 2 + 1
k = current year
m = lifetime
Accelerated Depreciation
Double Declining Balance
D
1
= C
i
(2/m) B
1
= C
i
- D
1
D
2
= B
1
(2/m) = [ C
i
(1-2/m)](2/m)],etc.
After-Tax Interest Rate
If we have an investment of $P yielding i interest per year,
at the end of one year we have:
P(1 + i)
We have to pay taxes on earnings
Earnings = P(1 + i) - P = P i
Tax rate is T
Taxes = P i T
Real Earnings = Pi - P i T
= Pi (1 - T)
Define after tax interest rate
i
T
= i(1 - T)
So, real after tax earnings = Pi
T
We will use i
T
in after-tax comparisons
Consider the Effect of Depreciation
and Taxes on Present Value (P)
If no depreciation & taxes, the decision to
invest $C
i
in a piece of equipment at time
zero is worth
P = -C
i

Reflects that C
i
of cash of unavailable for
other investments
Now, we need to consider the fact that
depreciation gives us a tax savings each year
Cash Flow Time Line for Investments

0 4 1
N
2 3
D
1
T D
N
T D
2
T D
3
T D
4
T
C
S

C
i

Cash outflow is shown below the line
Savings and/or revenues above the line
C
s
is salvage value
Cash Flow Time Line for Investments
N N N
d d m T
m m
T
m 1 m 1 T T
C C D T 1 1 (1 i )
T T
N N i
(1 i ) (1 i )

= =
(
+
= =
(
+ +
(


N
T
s d
N
T
T
1 T 1 (1 i )
P C 1 C 1
N i
(1 i )

( (
+

= +
( ( `
+
( (


)

0 4 1
N
2 3
D
1
T D
N
T D
2
T D
3
T D
4
T
C
S

C
i

N
s m
d s
m N
m 1 T T
C D T
P (C C )
(1 i ) (1 i )
=
= +
+ +

C
i

After-Tax Cost
Comparison Formulae
Link to After-Tax Cost
Comparison Formulae
Effect of Revenues in
After Tax Comparisons
For every $R of revenue, a profit making firm pays $RT
in tax where
T = fractional tax rate
Thus, the firm actually keeps
($R - $RT) = $R(1 - T)
An after-tax cash flow time line would therefore have
amounts as shown
R(1 - T)
0 4 1 2 3
R(1 - T) R(1 - T) R(1 - T) R(1 - T)
...
Expenses in After-Tax Comparisons
An expense of X in a particular tax year has two effects
on cash flow
-the actual out-of-pocket payment of X
-the reduction of taxes as a result of the expense
(XT)
Profit Before Expense (t) - Expense (X)
= Profit After Expense (t
x
)
Tax = t
x
T = tT - XT
Profit after Taxes = t
x
- t
x
T
= t
x
(1 - T)
Therefore, Effect of Expense = -X(1 - T)
After-Tax Cash Flow Time Line Showing
Revenues, Expenses and Depreciation
C
S

R(1 - T) R(1 - T) R(1 - T) R(1 - T)
0 4 1 2 3
DT DT DT DT
C
i
X(1 - T) X(1 - T) X(1 - T) X(1 - T)
Note! Depreciation is not a real cash flow into
company. It has the effect of reducing taxes.
Note! No taxes associated with C
i
or C
s
terms.
Profitability vs. Cash Flow
Assume Companies A & B make the same product, in same
quantities and have the same revenues
R = $100,000/yr
Raw materials & labor $50,000/yr for both
A produces products on a machine worth $200,000 and
consumes 20% of its useful life/yr
Bs machine also costs $200,000, but they consume 15%/yr
of its useful life
Assume actual maintenance costs are the same for A & B
Cash flow, before taxes
For A = $100,000 - $50,000 = $50,000/yr
For B = $100,000 - $50,000 = $50,000/yr
NO DIFFERENCE!
Yet, we know that B is more profitable because it consumes
less of its capital assets.
Profits (Including Depreciation) before Taxes
For A = $100,000 - $50,000 - (0.20)(200,000) = $10,000/yr
For B = $100,000 - $50,000 - (0.15)(200,000) = $20,000/yr
B shows itself to be better!

Taxes @ (50%) A = 0.50($10,000) = $5000
B = 0.50($20,000) = $10,000
After-Tax Income
(Before Tax Profit) - (Taxes)
A = 10,000 - 5000 = $5000
B = 20,000 - 10,000 = $10,000
But after tax cash flow
[R - X - Taxes]
A = $100,000 - $50,000 - $5000 = $45,000
B = $100,000 - $50,000 - $10,000 = $40,000
Which company is better?
Which company is better?
B is the better company!
A has turned more of its assets into cash,
but is using its assets less efficiently than B,
as profit illustrates
Therefore, profitability = cash flow
Depreciation - a Source of Cash??
Sales
Uncle Sams perspective
Profitability Measures
Payout time / Payback period

- Many definitions of this
- Generally

Payback Period (N, in years) =

Initial investment is C
i
total investment for some people, only
C
d
(depreciable investment) for others

Income/yr for some is average profit/yr, excluding depreciation
and taxes, but some include depreciation and taxes

Basic question addressed
How soon do I recoup my original investment?

Initial Investment
Income/yr
ROI (Return on Original Investment)

ROI =

Neither payback period nor ROI explicitly
considers the time value of money!
Income / yr
Initial investment
Preferred Methods
Net Present Value (NPV)
Also known as Venture Worth (VW)



Discounted Cash Flow Rate of Return
(DCFRR)
Same as NPV = 0, solve for i
T

I
w
= working capital (similar to initial investment
in treatment)

t
N
N
s k k w
i w
k k N N
k 1 k 1 T T T T
C D T (R X) (1 T) I
P C I
(1 i ) (1 i ) (1 i ) (1 i )
= =

= + + + +
+ + + +

Which Method is Better?
Net Present Value
Requires setting a value of i
T
before you start
Any NPV > 0 means a worthwhile project
In choosing between alternatives with unequal
lifetimes, need to choose on an annualized
income basis (i.e. convert P X at end)

DCFRR
No need to have same time basis or to choose i
T
a
priori
Go down list from highest i
T
to lowest (down to a
minimum acceptable i
T)



Example - Two Competing
Investment Opportunities
Opportunity 1 Opportunity 2
Revenues ($/yr)
Costs ($/yr)
Salvage Value at End ($)
Project Life (yrs)
60,000 75,000
10,000 15,000
130,000
150,000
10,000
30,000
Required Investment ($)
Depreciation Lifetime (yrs)
4
3
3
5
After tax interest rate = 0.10/yr = i
T

Combined Fed/State tax rate = 0.48 = T
Depreciation method = Straight line
Cash Flow Time Lines
(Amounts in 1000s)
Opportunity 1
60(1 - T)
0 4 1 2 3
130
10(1- T)
- T)
0
5
1 2 3
40T
40T 40T
60(1 - T) - T) 60(1 - T) - T) 60(1 - T) - T) 60(1 - T) - T)
10(1- T)
10(1- T) 10(1- T) 10(1- T)
10
Note:
d i s
D D
C C C 130 10
D 40
N N 3

= = = =
ND = depreciation lifetime = N = Project Lifetime
Cash Flow Time Lines
(Amounts in 1000s)
Opportunity 2
75(1 - T)
0 4 1 2 3
150
15(1- T)
- T)
0 1 2 3
40T
40T 40T
75(1 - T) - T) 75(1 - T) - T) 75(1 - T) - T)
15(1- T)
15(1- T) 15(1- T)
30
Note: D =
150 30
40
3

=
Present Value Calculations
5 3
T T
1
5
T T
T
5 3
5
Cs 1 (1 i ) 1 (1 i )
P Ci (R X)(1 T) DT
i i
(1 i )
10 1 (1 0.1) 1 (1 0.1)
130 (60 10)(1 0.48) 40(0.48)
0.1 0.1
(1 0.1)
22.52 (thousands of dollars)


( (
+ +
= + + +
( (
+
( (

( (
+ +
= + + +
( (
+
( (

=
4 3
2
4
30 1 (1 0.1) 1 (1 0.1)
P 150 (75 15)(1 0.48) 40(0.48)
0.1 0.1
(1 0.1)
17.14 (thousands of dollars)

( (
+ +
= + + +
( (
+
( (

=
Present Value Calculations cont
Since P
1
> 0 and P
2
> 0, do both projects, if possible
If can only choose one or the other




Choose Opportunity 1 over Opportunity 2 (X
1
> X
2
)

Note, if P
1
had been just a bit less, could have had
P
1
> P
2
but X
1
< X
2
. In this case, would choose
Opportunity 2 instead.
3
1
5
3
2
4
0.1 22.52
X 22.52 $5.94x10 / yr
3.79
1 (1 0.1)
0.1 17.14
X 17.14 $5.42x10 / yr
3.16
1 (1 0.1)

(
= = =
(
+

(
= = =
(
+

DCFRR
Let P
1
= 0 and solve for i
T

Need a root finding technique
Know i
T
> 0.1 / yr
In this case

(i
T
)
1
from



(i
T
)
2
from


Choose projects based on i
T
, highest to lowest until you
run out of money to invest (Here, choose 1 over 2)
Use a graphical or numerical approach to solve for i
T

5 3
T T
5
T T
T
T
10 1 (1 i ) 1 (1 i )
0 130 (50)(.52) 40(0.48)
i i
(1 i )
I 17%

( (
+ +
= + + +
( (
+
( (

=
4 3
T T
4
T T
T
T
30 1 (1 i ) 1 (1 i )
0 150 (60)(.52) 40(0.48)
i i
(1 i )
I 15%

( (
+ +
= + + +
( (
+
( (

=
Continuous Interest and
Discounting
Treats compounding in a continuous manner,
as if in every infinitesimal time period, interest
accrues (instead of only at year end):
1+ i
annual
= (1 + i
cont
/k)
k

where there are k compounding periods per
year.
Now let k , (1 + i
cont
/k)
k
e
icont
Continuous Discounting
Thus
i
annual
= e
icont
-1

and
S = P (1 + i
annual
)
n
= P (1 + e
icont
-1)
n

= P e
i n

where it is now understood that in these types
of calculations, i = i
cont

Link to Continuous Interest Formulae