FIN3310 Chapter12

ANALYZING PROJECT CASH FLOWS
Chapter 12
Dr. Hyo Jin Yoon

Spring 9/13/23
09/13/2023 FIN3310 Business Finance • Spring 9/13/23 Dr. Hyo Jin Yoon Slide 1 of 29
OVERVIEW
Relevant Cash Flows
Evaluating Projects
Salvage Value
RELEVANT CASH FLOWS
• Relevant project cash flows for a capital investment:

o Cash flows associated with launching of Investment
o Operating period cash flows
o Terminal cash flows
• Should only consider incremental cash flow, which is the

additional cash flow a firm receives from taking on a new
project.
RELEVANT CASH FLOWS
• Proper identification of incremental cash flows
Relevant Not Relevant

o Synergistic effects o Sunk Costs
o Opportunity costs o Overhead Costs

o Working capital requirements o Interest payments and other
o Tax financing costs
Incremental Project ¿
Cash Flows ( Cash Flows
with the Project ) ( − Cash Flows
without the Project )
EXAMPLE 1
Last year, Company XYZ sold $300 Million of its ice cream
products and hopes to increase its sales in the coming year by
offering a new line of low-calorie ice cream. The new product
line is expected to generate $40 Million in sales next year.
However, the firm’s analysts estimate that about 60% of this
revenue will come from existing customers who switch their
purchases from one of the firm’s existing products to the new
healthier ones.
Q1. How much incremental revenue is attributable to the new
line of low-calorie ice cream?
60% - Existing customers
40% - New customers $40 M x 40% = $16M
EXAMPLE 1
Q2. Assume that 20% of Company XYZ’s existing customers

are actively looking for a healthier snack alternatives and will
move to alternative products offered by other companies if
XYZ does not introduce the new product line. How much
incremental sales would you attribute to this new line of low-
calorie ice cream in this case?
From our previous calculation, $16M came from new customers.
20% of existing customers may switch: $40 M x 20% = $8M
16 + 8 = 24 M
RELEVANT CASH FLOWS
Project Initial Investment Period Operating Period Terminal Period

Life Cycle
• Costs of purchasing plant • Incremental revenues • Proceeds from the

and equipment disposal of plant and
• Incremental expenses
equipment (net of
• Costs of installing
• Incremental taxes taxes)
equipment and training
employees • Increase in working- • Cleanup or
Relevant capital requirements decommissioning
Cash Flows • Investment in working-
• Incremental capital costs
capital requirements (Net
Operating Working expenditures for plant • Recapture of working-
Capital) and equipment capital investment
RELEVANT CASH FLOWS
1. Launching of Investment
• CAPEX (Capital Expenditure)
o Cash used to purchase, ship, & install fixed assets (e.g.
equipment, building, machine, etc.)
• Net Operating Working Capital

o When a firm invests in a new project, it often experiences an
increase in sales (A/R and Inventory Increases --- these are
financed by Cash and A/P)
Investment∈¿NetOperating
=( Increase∈¿AccountsReceivable )+ ( Increase∈¿Inventories ) − ( Increase∈¿ AccountsPayable )
WorkingCapital
RELEVANT CASH FLOWS
2. Operating Period
• Operating Cash Flows
o Compiled from pro forma financial statements (forecasts of
future financial statements)
Operating Cash Net Operating Depreciation

  Taxest 
Flow t Income (or Profit)t Expenset
            
NOPATt
o Recall from previous chapters that Net Operating Income =

Revenue – COGS – Operating Expenses
o Since Depreciation is a non-cash expense, need to add it back.
RELEVANT CASH FLOWS
Free Cash Flow

• Total amount of cash flow available for distribution to the
creditors who have loaned money to finance the project and to
the owners who have invested in the equity of the project.
• For each year, FCF can be calculated using the following:

Operating Cash Flow
                            Increase in Capital Increase in Net
Free Cash Net Operating Depreciation
=  Taxes   Expenditur es  Operating W orking
Flow Income (Profit) Expense
           (CAPEX ) Capital (NOWC )
Net Operating Profit after Taxes or NOPAT
EXAMPLE 2
Assume that a new project will annually generate revenues of

$3 Million and cash expenses (including both fixed and
variable costs) of $900,000, while increasing depreciation by
$400,000 per year. If the firm’s tax rate is 34%, what is the
project’s estimated net operating profit after taxes? What are
the project’s annual operating cash flows?
SOLUTION
Revenue 3,000,000
- Cost of goods sold
= Gross profit
- Operating expenses (Cash) - 900,000
- Depreciation - 400,000
=Net Operating Income (EBIT) 1,700,000
-Interest Expense
-Tax - 578,000 ( = 1,700,000 x 34%)
=Net Operating Profit After Tax 1,122,000
Operating Cash Flow (OCF)

= Net Operating Income – Tax + Depreciation = 1,522,000
RELEVANT CASH FLOWS
• Calculating Depreciation Expense

= (Cost of equipment + Shipping & Installation Expense –
Expected salvage value) ÷ (Life of the equipment)
o Example: Consider a firm that purchased an equipment for

$500,000 and incurred an additional $50,000 for shipping and
installation. What will be the annual depreciation expense if
the equipment is expected to last 10 years and have a salvage
value of $25,000?
($500,000 + $50,000 − $25,000) ÷ (10)

= $52,500
EXAMPLE 3
Masulis scooters is considering a new investment project and

has an expected change in net operating income of $475,000
per year. This project will incur $200,000 of depreciation per
year and cause the following changes in Year 1. Assume a 30%
marginal tax rate.
Without Project With Project
Account receivable 105,000 130,000
Inventory 200,000 280,000
Account payable 90,000 130,000
What is the project’s Free Cash Flow (FCF) in Year 1?
SOLUTION
Revenue
- Cost of goods sold
= Gross profit
- Operating expenses (Cash)
- Depreciation
=Net Operating Income (EBIT) 475,000
-Interest Expense
-Tax - 142,500 ( = 475,000 x 30%)
=Net Operating Profit After Tax 332,500
Operating Cash Flow (OCF)

= Net Operating Income – Tax + Depreciation = 532,500
SOLUTION
Without Project With Project

Account receivable 105,000 130,000
Inventory 200,000 280,000
Account payable 90,000 130,000
Net Operating Working Capital (NOWC) = A/R + Inventory – A/P

Without Project: 105,000 + 200,000 – 90,000 = 215,000
With Project: 130,000 + 280,000 – 130,000 = 280,000
Incremental NOWC = 65,000 (Cash Outflow)

Project CF in Year 1 = - 65,000 + 532,500 = 467,500
RELEVANT CASH FLOWS
3. Terminal Period
• Salvage Value
o Value of fixed asset at the end of its useful life – Cash inflow
upon sale of it
• Recapture of Working-Capital Investments

o At the end of the project life, collect outstanding receivables,
sell down remaining inventory, and pay off outstanding
balance of accounts payable
• Other Clean-up Costs (If any)
RELEVANT CASH FLOWS
Launching Operating Terminal

Free Cash Flow Period Period Period
• Total amount of cash flow available for distribution to the

creditors & shareholders of the project.
• Can be used to fund new investments, or evaluated by the
lenders to determine whether to lend the firm more money.
Operating Cash Flow
                            Increase in Capital Increase in Net
Free Cash Net Operating Depreciation
=  Taxes   Expenditur es  Operating W orking
Flow Income (Profit) Expense
           (CAPEX ) Capital (NOWC )
Net Operating Profit after Taxes or NOPAT
t=0 1 2 3 ….. N
FCF0 FCF1 FCF FCF3 FCFN
2
EVALUATING PROJECTS
• Crockett Clothing Company is considering purchase of an automated

sewing machine that will cost $200,000 and is expected to operate for 5
years, after which time it is not expected to have any salvage value. The
investment is expected to generate $360,000 in additional revenues for
the firm during each of the 5 years of the project’s life. Due to the
expanded sales, Crockett expects to have to expand its investment in
accounts receivable by $60,000 and inventories by $36,000 in Year 0.
These investments in working capital will be partially offset by an
increase in the firm’s accounts payable of $18,000 in Year 0. The
project will also result in a COGS equal to 60% of revenues while
incurring other annual cash operating expenses of $5,000 per year. In
addition, the depreciation expense for the machine is $40,000 per year.
Profits from the investment will be taxed at 30% tax rate. Evaluate the
project based on its NPV, if investors require 20% return.
Years 0 1 2 3 4 5
Cash flow OCF1 OCF2 OCF3 OCF4 OCF5
CAPEX Salvage value

NOWC NOWC
Year 1 - 5 Operating Period: OCF
Year 1-5
Project Revenues $360,000
− COGS (60% of revenues) −216,000
= Gross Profit $144,000
− Cash operating expense −$5,000
− Depreciation −$40,000
= Net operating income $99,000
− Taxes (30%) −$29,700
= Net Operating Profit after Taxes $69,300
(NOPAT)
+ Depreciation $40,000
= Operating Cash Flows (OCF) $109,300
Years 0 1 2 3 4 5
Cash flow OCF1 OCF2 OCF3 OCF4 OCF5
CAPEX Salvage value

NOWC NOWC
Year 0 Cash Flow: Year 5 Cash Flow:

CAPEX = 200,000 OCF
NOWC = A/R + Inventory – A/P Salvage Value = 0
= 78,000 Recapture NOWC
= 78,000
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
OCF 109,300 109,300 109,300 109,300 109,300
CAPEX (200,000
)
NOWC (78,000) 78,000
∑ (278,000 109,300 109,300 109,300 109,300 187,300
)
CF + 2nd + CLR WORK

N
CFt
NPV = ∑ ¿¿
¿ CF0 = -278,000
CF1 = 109,300
t = 0
F1 = 4 NPV =
80,200.36
Invest!
CF2 = 187,300
Required rate = 20% F2 = 1
NPV + (I=20) + CPT
ANOTHER EXAMPLE
Mark is considering a new project for his firm. Mark’s firm is in

the 34% marginal tax bracket and has a 15% required rate of
return for new investments. The new project is expected to last for
5 years. Evaluate the project based on NPV and IRR.
Cost of new equipment: $198,000,000

Shipping & installation costs: $2,000,000 Year Units Sold
Sales price: $800/unit (Yr 1-4), $600/unit (Yr 5) 1 1,000,000
Variable cost: $400/unit 2 1,800,000

Annual fixed costs: $10,000,000 3 1,800,000
Initial invested working capital: 2,000,000 4 1,200,000
For each year, total invested WC =10% of sales 5 700,000
No Salvage value of equipment
SOLUTION
Yr0 Yr1 Yr2 Yr3 Yr4 Yr5

Revenue 800 1440 1440 960 420
VC (400) (720) (720) (480) (280)
FC (10) (10) (10) (10) (10)
Depreciation (40) (40) (40) (40) (40)
NOI 350 670 670 430 90
Tax (119) (227.8) (227.8) (146.2) (30.6)
NOPAT 231 442.2 442.2 283.8 59.4
+ Depreciation 40 40 40 40 40
OCF 271 482.2 482.2 323.8 99.4
CAPEX (200) All recovered
by Yr 5
NOWC (2) (78) (64) 0 48 96
FCF (202) 193 418.2 482.2 371.8 195.4
SOLUTION
Yr0 Yr1 Yr2 Yr3 Yr4 Yr5

FCF (202) 193 418.2 482.2 371.8 195.4
CF + 2nd + CLR WORK CF + 2nd + CLR WORK

CF0 = -202 CF0 = -202
CF1 = 193; F1 = 1 CF1 = 193; F1 = 1
CF2 = 418.2; F2 = 1 CF2 = 418.2; F2 = 1
CF3 = 482.2; F3 = 1 CF3 = 482.2; F3 = 1
CF4 = 371.8; F4 = 1 CF4 = 371.8; F4 = 1
CF5 = 195.4; F5 = 1 CF5 = 195.4; F5 = 1
NPV + (I=15) + CPT IRR + CPT
NPV = 908.83 Invest! IRR = 139.73 Invest!
SALVAGE VALUE
• If the Salvage value is different from the book value of the

asset, then there is a tax effect upon sale of the asset.
 Book value = initial cost – accumulated depreciation
 Salvage value = the market price of the asset at time of sale
• 3 Tax Scenarios:
Asset is sold for a price Asset if sold for Asset is sold for less
above book value book value than book value
Firm incurs additional
tax due to the gain
No tax effect Results in tax savings
(equal to its marginal
tax rate)
EXAMPLE
You purchase equipment for $350,000, which will have

depreciated book value of $100,000, 5 years from now. You
believe that you can sell the equipment for $150,000 when you
are done with it in 5 years. The company’s marginal tax rate is
30%. What is the depreciation expense each year and taxes due
from the gain in sale of the asset?
Depreciation expense = (350K – 100K) / 5 = 50K
Yr5 Book value ($100,000) Market value ($150,000)

You have been depreciating more, and so paying less tax over time
Tax Due from the gain = (150K – 100K) x 30% = 15K outflow
ANOTHER EXAMPLE
Depreciated book value of an asset is $100,000. It is sold for

$70,000. Assuming the firm’s marginal corporate tax rate is
30%, what is the tax effect from the sale of the asset?
You have been depreciating less, and so paying more tax over time
Tax savings = (100K – 70K) x 30% = 9K Cash inflow

FIN3310 Chapter12

Uploaded by

Copyright:

Available Formats

You might also like

FIN3310 Chapter12

Uploaded by

Document Information

Original Description:

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

FIN3310 Chapter12

Uploaded by

Copyright:

Available Formats

ANALYZING PROJECT CASH FLOWS

Dr. Hyo Jin Yoon

Relevant Cash Flows

• Relevant project cash flows for a capital investment:

• Should only consider incremental cash flow, which is the

• Proper identification of incremental cash flows

Relevant Not Relevant

o Opportunity costs o Overhead Costs

Q2. Assume that 20% of Company XYZ’s existing customers

From our previous calculation, $16M came from new customers.

20% of existing customers may switch: $40 M x 20% = $8M

Project Initial Investment Period Operating Period Terminal Period

• Costs of purchasing plant • Incremental revenues • Proceeds from the

• Net Operating Working Capital

Operating Cash Net Operating Depreciation

o Recall from previous chapters that Net Operating Income =

Free Cash Flow

• For each year, FCF can be calculated using the following:

Assume that a new project will annually generate revenues of

Operating Cash Flow (OCF)

• Calculating Depreciation Expense

o Example: Consider a firm that purchased an equipment for

($500,000 + $50,000 − $25,000) ÷ (10)

Masulis scooters is considering a new investment project and

What is the project’s Free Cash Flow (FCF) in Year 1?

Operating Cash Flow (OCF)

Without Project With Project

Net Operating Working Capital (NOWC) = A/R + Inventory – A/P

Incremental NOWC = 65,000 (Cash Outflow)

• Recapture of Working-Capital Investments

• Other Clean-up Costs (If any)

Launching Operating Terminal

• Total amount of cash flow available for distribution to the

• Crockett Clothing Company is considering purchase of an automated

CAPEX Salvage value

CAPEX Salvage value

Year 0 Cash Flow: Year 5 Cash Flow:

CF + 2nd + CLR WORK

Mark is considering a new project for his firm. Mark’s firm is in

Cost of new equipment: $198,000,000

Sales price: $800/unit (Yr 1-4), $600/unit (Yr 5) 1 1,000,000

Variable cost: $400/unit 2 1,800,000

Yr0 Yr1 Yr2 Yr3 Yr4 Yr5

FCF (202) 193 418.2 482.2 371.8 195.4

Yr0 Yr1 Yr2 Yr3 Yr4 Yr5

CF + 2nd + CLR WORK CF + 2nd + CLR WORK

• If the Salvage value is different from the book value of the

You purchase equipment for $350,000, which will have

Depreciation expense = (350K – 100K) / 5 = 50K

Yr5 Book value ($100,000) Market value ($150,000)

Depreciated book value of an asset is $100,000. It is sold for

Tax savings = (100K – 70K) x 30% = 9K Cash inflow

You might also like