Chapter 4 Building An Incremental Cash Flow Statement for An Investment Project

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Value-Oriented ManagementDefinition: the value-oriented management is defined as an emerging management philosophy

which focuses on maximizing a cash flow rather than on expanding a net income by maximizing a revenue or market share

Requirement: the added-value must be generated greater than the cost of capital in the production processes

Action Plan: to contrive a way to efficiently allocate the firm’s resources from a long-term

perspective so as to enhance the added-value in the production-marketing processes.

to figure out a way to obtain the capital necessary for business at the least cost of capital.

In order to implement the value-oriented management philosophy, the firm must estimate the cash flows and determine the cost of capital as done similarly to the DCF techniques. So, it may be called a cash flow-oriented management philosophy and its main purpose is to maximize the capital production

다.

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The Capital Production of Japanese Industries with respect to those of the U.S.A. Counterparties.

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1) cash flows from operating activities:net income + depreciation

2) cash flows from investing activities: investment, proceeds from the sale of the

fixed assets, gain taxes, working capital

3) cash flows from financing activities:money borrowed, repayment for the principal

A Cash Flow Statement for A Project

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Building A Cash Flow Statement

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opportunity costDef: (the real cost of something is what you give up to get it)

The concept of opportunity cost is crucial to understanding individual choice because,in the end, all costs are opportunity costs. That’s because every choice you make meansforgoing some other alternative.

Sometimes the money you have to pay for something is a good indication of its opportunitycost. But many times it is not. One very important example of how poorly monetary costcan indicate opportunity cost is the cost of attending college. Tuition and housing aremajor monetary expenses for most students; but even if these things were free, attendingcollege would still be an expensive proposition because most college students, if theywere not in college, they could have a job. That is, by going to college, students forgo theincome they could have made if they had worked instead. This means that theopportunity cost of attending college is what you pay for tuition and housing plus theforgone income you would have earned in a job.

It’s easy to see that opportunity cost of going to college is especially high for people whocould be earning a lot during what would otherwise have been their college years. That iswhy star athletes like LeBon James often skip college. Some, like Tiger Woods, leavebefore graduation

A firm has to use all kinds of its resources like computer, land, labor, and so on tomanufacture the products or services to provide for the customers and thereby it mustgive up using them for other alternatives. As a result, everything consumed by the firm isakin to the opportunity cost.

A Project Evaluation and Opportunity Cost

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ex) A firm plans to rent the idle space for 50 million won per year. But the firmwill use the space to manufacture the newly developed product instead. Discusswhat the opportunity cost is and why?

Sol] The 50 million won would be the opportunity cost because if the idle space hadbeen rented, the firm would have earned that much money. So when preparingthe cash flow statement for the investment analysis purpose, it must involve50million won as a cash outflow

연간 5,000만원임대 수익발생

연간 5,000만원임대 수익포기

유휴공간을임대할 경우

유휴공간을신제품개발에사용할 경우

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An Example for A Project Evaluation and Opportunity Cost

EX 4.1] An Economic Evaluation for An Investment ProjectGiven] A marketing survey and a feasibility study: 50 million won, a cost for a purchase of

a new equipment: 210 million won, A project life: 4 years, a salvage value for theequipment: 40million won, a price of a new product: 40,000won, an annual sale volume:10,000 units, MARR=12%, Other Financial Data in The Table Below.

itemsAmount of

moneyDirect labor cost(5*2hrs) 10

Direct material cost(4/ton*3kg) 12* Variable indirect cost 3

Total variable cost/unit 25Selling price 40

Contribution margin/unit 15Fixed indirect cost including depreciation 10**

Profit/unit 5

(unit: 000won)

To purchase a direct material for 4,000won/ton which will be used over thenext 2 years

->its current price is 6,000won/ton the fixed cost will be allocated to the product with the same pro rata as

currently done.-> to add up 15 M won of the production supervisor to the current fixed cost

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An Example for A Project Evaluation and Opportunity Cost

Revenue (10,000units*40) W400,000

Expenses:D.L. CD. M. CVCFC

(10,000units*10)(30,000kg*6)(10,000units*3)

W100,000W180,000W30,000W15,000

Total cost W325,000

Annual Net C. F. W75,000

(unit: 000 won)

∗∗∗∗

The cash flows w. r. t. the economic evaluation

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An Example for A Project Evaluation and Opportunity Cost

n C. F Discount Factor (MARR=12%)

PresentValue

0 -210,000 (1+0.12)0=1.000 -210,000

1 75,000 (1+0.12)-1=0.893 66,964

2 75,000 (1+0.12)-2=0.797 59,790

3 75,000 (1+0.12)-3=0.712 53,384

4 115,000 (1+0.12)-4=0.636 73,085

NPV= 43,222

IRR= 20.808%

(unit:000won)

An Economic Analysis for the Investment Project to Produce A New Product

(12%) 210,000( / ,12%,0) 75,000( / ,12%,1) 75,000( / ,12%,2)NPV P F P F P F= − + +75,000( / ,12%,3) 115,000( / ,12%,4) 43 222,000P F P F million won+ + =

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An Example for A Project Evaluation and Opportunity Cost

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The numbers in the circle at the table below are used to calculate the present value

12

Cash Flow and Net Income

Net Income: it is a accounting tool to measure a firm’sprofitability based on the accounting concept.The time at which a cash flow is incurred iscompletely ignored.

Cash Flow: The cash flow of today is more valuable than oftomorrow given that there is the time value ofmoney. Therefore, when economically evaluatingthe investment projects, it is required to performit based on the cash flow

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Why do we use a cash flow when performing the economic analysis for the investment

projects: based on the mathematical concept An economic profit(cash flow) the project generates the rate of return on investment greater than the cost of capital. the amount of the cash flow is equal to that of dividends distributed to the stockholders

Given] the capital structure: 100% of equitythe source of fund: Revenue (Rev) and the amount of money collected by issuing m stocks whose

initial offering price is Sthe use of fund: wage, salaries, materials, services, and so on => denoted by “W&S”

the fund balance equation at time= “t”

if there is no new stocks issued, mtSt=0 . Then, the amount of dividend at time= “t” is given by

the stock price is given by based on the dividend model.

tttttt ISWDiVSmv ++=+ )&(Re Where, I=investment capital, Div= dividend

tttt ISWvDiV −−= )&(Re

∑∞

= +−−

=0

0 )1()&(Re

tt

s

ttt

kISWvS

∑∞

= +=

00 )1(t

ts

t

kDivS*the firm’s value based on the

dividend concept

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Accounting Profit(net income) it does not consider the investment cost(I) unlike the cash flow it considers the book value which is derived by subtracting a depreciation cost

(dept) from the initial depreciation basis annually. the net income (NIt) at time=t

the change in the book value of the fixed asset at time = “t”(net investment capital)

it is already known that the accounting definition of profit, NIt, is different from the economic profit, DIVt. However, it can be adjusted by subtracting net investment, , as follows:

The conspicuous difference between the accounting and economic profit

the time at which a cash flow is incurred is not considered in the accounting profit concept, whereas it is clearly considered in the economic profit concept

∑∑∞

=

∞

= +∆−

=+

−−−−=

000 )1()1(

)()&(Ret

ts

tt

tt

s

ttttt

kANI

kdepIdepSWvS

Re ( & )t t t tNI v W S dep= − −

where, dept: depreciation

tA∆

ttt depIA −=∆

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Continued………

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Continued………ExampleThis example shows the difference between the accounting and economic profits in terms of the business valuation

LIFO FIFO Material Inventory Costing SystemRevenue 100 100 1st Inventory: 25 ←FIFOCOGS 90 25 2nd Inventory: 40Gross Profit 10 75 3rd Inventory: 60Tax(40%) 4 30 4th Inventory: 90 ←LIFONet Income 6 45EPS(100shares) 0.06 0.45

6( P ) 0.06 for LIFO# tan 100

=0.45 for FIFO

NetIncomeEPS Earnings erShareofCommonStockOuts ding

= = =

100 4( ) 0.96 for LIFO# tan 100

=0.70 for FIFO

CashFlowCFPS CashFlowPerShareofCommonStockOuts ding

−= = =

Depreciation: it is a non-cash flow item recorded in an income statement The reason why the depreciation cost is recorded in the income

1) to deal with the depreciation cost an the expense item to identify change in the value of the fixed assets annually based on the matching principle

2) by doing so, the firms can reduces a certain amount of taxesEx 4.2] A Difference Between A Net Income and A Cash Flow

Given] investment cost (I)= 80 million, depreciable life(N)= 8 years, salvage value(S)=0depreciation method(D)=straight-line depreciation method: SL, the relevant data

Item AmountRevenue 140,000CGOS 60,000

Depreciation 10,000Operating 12,000

(unit: 000 won)

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Why do we use a cash flow when performing the economic analysis for the investment projects: based on the accounting concept

Continued……….

Find] Net Income and Cash FlowSol]

A depreciation cost with the SL method

the difference between the net income and the cash flow

80,000 0 108

I SD millionN− −= = =

item amount

Income statementCash flow statement

Revenue 140,000 140,000Expenses:

CGOS 60,000 -60,000Depreciation 10,000Operatomg 12,000 12,000

Taxable income 58,000Tax(25%) 14,500 -14,500Net Income 43,500Net Cash Flow 53,500

(unit: 000won)

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Net income: it an accounting instrument to measure a firm’sprofitability based on the matching principle which tells us the factthat each time revenue is incurred, cost is also incurred accordingly.But it ignores the amount and time of cash flow being incurred.

Cash Flow: cash of today is more valuable than that of tomorrowwhen considering the time value of money because the formergenerates more money than the latter. In the line with thestatement, it is desirable to use cash flow when economicallyevaluating the investment project.

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Why do we use a cash flow when performing the economic analysis for the investment projects: based on the matching princeple

Continued………Ex] Company A and B have the same amount of the sum of the net income and cash flow.

But Company A obtains 1 billion won of cash flow at the end of year 1 and 2, whereasCompany B obtains 2 billion won at the end of year 2.The advantage of Company A over B is that the former may generates more profit byinvesting 1 billion won at the end of year 1. This point is very critical to the companywhich wants to increase its wealth in the end.

Year A B

1Net incomeCash flow

1,000,0001,000,000

1,000,0000

2Net incomeCash flow

1,000,0001,000,000

1,000,0002,000,000

(unit: 000 won)

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A Comparison of the Accounting and Economic Profits

cost: costs are the monetary value of expenditures(resources consumed) services orproducts. It is the sum of the direct material costs, the direct labor costs, and theindirect manufacturing costs.

expense: It is an outflow of cash or other valuable assets from a person or company toanother person or company. This outflow of cash is generally one side of a trade forproducts or services that have equal or better current or future value to the buyerthan to the seller. Technically, an expense is an event in which an asset is used up or aliability is incurred. It is the monetary value of the firm’s resources used for thepurpose of managing the firm.

2015-12-17 20

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Problem Description] Woonho works as a secretary at the big company and receives 45million won of an annual salary. And he possesses a small building and receives 9 million won of an annual renting fee and 345,000 won of an annual interest on the amount of 3.45million won for holding a CD. But he will sell the CD. He is now contemplating quitting the current work position and wants to run a pizza store at his own building which he rents..

Given] Give up the current renting fee to open the pizza store there, the disposal of the CD: 3.45 million won, Borrowing: 30 million won at the interest rate of 10%= wages, the purchase and renting charge of the equipment, and materials for the 1st year, Revenue: 127.5 million won.

accounting profit = revenue – total cost(consider the costs clearly identified)= 127,500 - 67,500 = 60 million won

Total cost: 67.5 million won=wage, the purchase and rent charge of the equipments, andmaterials(64.5million won)+ interest payment( 3 million won)

economic profit = revenue- total cost(consider the costs clearly identified and opportunity costs)= 127,500 – (67,500 + 57,450) = 2.44 million won

opportunity cost: building renting fee(9 million won), the annual salaries foregone: 45million won, interest from holding the CD: 3.45 million won

An Example for A Comparison of the Accounting and Economic Profits

Building A Cash Flows Statement-Consider No Inflation Effect

Ex 4.3] The investment project for the automatic machining centerGiven]

- Investment cost: 125 M won- Project life: 5 years- Annual revenue: 100 M won- Annual Expenses: Labor: 20 M won Material: 12 M won Indirect Manufacturing : 8 M won

- Annual working capital: 23 M won- Loan: 62562.5 M won- Loan condition: interest rate 10%, an equal payment over 5 years- Depreciation method: Straight-Line over 8 years- No salvage value , but 50 M won at the end of the 5th year- tax rate: 25%- MARR: 15%

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Find

(a) Find the after-tax cash flow

(b) What is the after-tax net present value at the MARR of 15%?

(c) Determine the annual equivalent worth and internal rate of return?

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The Calculations for Building A Cash Flow Statement

1. depreciationGiven] I: 125 M won, S: 0, Depreciation Method: SL with D.L. of 8 years

2. Gain Taxes

(125,000 0) 15.625 won8

I SD MN− −= = =

( )1

5 (15,625 / )78.125

nAnnualDepreciation tt

yearMwon

= ∑=

= ×=

Accumulated Depreciation Cost

-Accumulated Depreciation Costs125,000 78,125 46.875I

Mwon== − =

Book Value

50,000 46,875 3.125SalvageValue BookValue

Mwon= −= − =

Gain/Loss

arg(0.25) (3,125) 781,300M inalTaxRate Gain

won= ×= × =

Gain Taxes

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Calculations to Build A Cash Flows Statement

3. Principal and Interest Repayment1) Pay interest only during the middle of the payment schedule and pay the full amount of principal at the last time period of the payment schedule.

Ex 1] A firm borrowed 100 million won form Tongil Bank and had a contract to pay interest at 10% only during the middle of the payment schedule and pay the full amount of principal at the end of the last period of time.

nBeginning

PrincipalInterest

Principa

l Repay.

Total

repayment

Ending

Principal

0 100,000

1 100,000 10,000 0 10,000 100,000

2 100,000 10,000 0 10,000 100,000

3 100,000 10,000 0 10,000 100,000

4 100,000 10,000 0 10,000 100,000

5 100,000 10,000 100,000 110,000 0

(unit: ooo won)

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Continued………….

2) Pay the same amount of principal and interest over the period of a schedule time

Ex 2] A firm borrowed 125 million won from Tongil Back and pay the same amount of principal and interest at an annual rate of 10% over 5 years.

(unit:000 won)

nBeginning principal

Principal Repay.

InterestTotal

PaymentEnding

Principal0 125,0001 125,000 25,000.00 12,500 37,500 100,000

2 100,000 25,000.00 10,000 35,000 75,0003 75,000 25,000.00 7,500 32,500 50,0004 50,000 25,000.00 5,000 30,000 25,000

5 25,000 25,000.00 2,500 27,500 0

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Continued……….

3) Pay the same amount of money which involves the repayment and interest over the period of the schedule time

Ex 3] A firm borrowed 62.5 million won from Tongil Banl and was asked to pay the same installment at an annual interest rate of 10% over 5 years.

(unit: 000 won)

(10%) 62,500( / ,10%,5)16,487(000 )

AE A Pwon

==

n Beginning

principal

interest Principal

repay.

Total

payment

Ending

principal

0 62,500.00

1 62,500.00 6,250.00 10,237.34 16,487.34 52,262.66

2 52,262,66 5,226.27 11,261.08 16,487.34 41,001.58

3 41,001.58 4,100.16 12,387.18 16,487.34 28,614.40

4 28,614.40 2,861.44 13,625.90 16,487.34 14,988.49

5 14,988.49 1,498.85 14,988.49 16,487.34 0.00

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Continued…….

4. Working Capital- I t is assumed that a working capital is invested at the beginning of each year and fully recovered at the end of the year

(unit: 000 won)

N 0 1 2 3 4 5

Recovery 23,000 23,000 23,000 23,000 23,000

Investing -23,000 -23,000 -23,000 -23,000 -23,000Net Working

Capital-23,000 0 0 0 0

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Income Statement

input MARR 15%

세율 25% Debt Interest rate: 10%

Income Statem 0 1 2 3 4 5

Rev. 100,000 100,000 100,000 100,000 100,000

Exp.:

Labor 20,000 20,000 20,000 20,000 20,000

Material 12,000 12,000 12,000 12,000 12,000

Indirect Mfg 8,000 8,000 8,000 8,000 8,000

Depreciation 15,625 15,625 15,625 15,625 15,625

Interest 6,250 5,226 4,100 2,861 1,499

Taxable Income 38,125 39,149 40,275 41,514 42,876

Tax Rate(25%) 9,531 9,787 10,069 10,379 10,719

Net Income 28,594 29,362 30,206 31,136 32,157

Depreciation: SL with Depreiable Life of 8 years

(unit: 000 won)

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A Cash Flow Statement(unit: 000 won)

Cash Flow Stat. 0 1 2 3 4 5

Operating Activ ities:

Net Income 28,594 29,362 30,206 31,136 32,157

Depreciation 15,625 15,625 15,625 15,625 15,625

Investing Activ ities:

Investment (125,000)

Salvage Value 50,000

Gain Taxes (781)

Working Capital (23,000) 23,000

Financing Activ itieis:

Borrow 62,500

Prin. Rep. (10,237) (11,261) (12,626) (13,626) (14,988)

NCF (85,500) 33,982 33,726 33,205 33,135 105,013

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A Cash Flow Diagram for The Automatic Machining Center

0 1 2 3 4 5

85,500

33,982

33,72633,205

33,135

105,013

n

(15%) 85,500( / ,15%,0) 33,982( / ,15%,1)33,726( / ,15%,2) 33,205( / ,15%,3)33,135( / ,15%,4) 105,013( / ,15%,5)62,538.5(000 )

NPV P F P FP F P FP F P F

won

= − ++ ++ +=

(15%) 62,538.5( / ,15%,5)18,656(000 )

AE A Pwon

==

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The IRR for the Investment Project

r

NetCash

Flow

0.2 0.4 0.6 0.8 1.0

50000

50000

100000

150000

Break_Even Interest Rate=IRR

0)1(

013,105)1(

135,33)1(

205,33)1(

726,33)1(

982,33500,85

)1()(

5*4*3*2*1*

0*

*

=+

++

++

++

++

+−=

+=∑

=

iiiii

iCFiNPV

N

tt

t

2015-12-17 32

A Trial-Error Technique

Step 1: Guess an interest rate.i*=18%

Step 2: Calculate NPV(i*)

Step 3: if NPV(i*) > 0, increase i*,if NPV(i*) < 0 이면, decrease i*.

Recalculate the NPV(i*)

(18%) 50,722(000 )NPV won=

(40%) 3,768(000 )NPV won= −

Step 4: obtain an approximate i* with extrapolation.

50,722

0-3,768

18% i 40%

+

+=3768722,50

722,50%22%18*i

%48.38=

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Building an incremental cash flow statement with inflation

Ex.4.4] Automatic Machining Center Project

Financial Data] - Investment: 125 M won- Project Life: 5years- Annual Revenue: 100 M won- Annual Expense: Labor: 20 M won Material: 12 M won Indirect Manufacturing: 8 M won

- Annual Working Capital: 23 M won- Financing: 625 M won

- Loan Condition: The same annual installment at the interest rate of 10% over 5 years

- Depreciation Methods : the SL with the depreciable life of 8 years- No salvage value , but 50 M won at the end of the 5th year- Tax rate: 25%- MARR: 15%- General inflation rate (f): 5%

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The Calculations to Build A Cash Flow Statement

1. Revenue1st year= 100,000(1+0.05)=105 M won2nd year= 105,000(1+0.05)=100,000(1+0.05)2=110.250 M won……………………………………………………………………………….5th year= 121,551(1+0.05)= 100,000(1+0.05)5=127.628 M won

2. Gain tax for the sale of the fixed asset-the salvage value at the end of the 5th year accounted for the general inflation

rate=50,000(1+0.05)5

=50,000(F/P,5%,5)=63.814 M won

- Gain/Loss=63,814-46,875=16.939 M won

- Gain tax(0.25)(16,939)=4.235 M won

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Continued………..

3. Working capital- a working capital is invested at the beginning of each year and fully recovered at the end of the year- inflation rate: 5%

4. Market interest rate

(unit: ooo won)

n 0 1 2 3 4 5

W.C. Recovery 23,000 24,150 25,358 26,626 27,957

W.C. Invested -23,000 -24,150 -25,358 -26,626 -27,957Net W.C. invested

-23,000 -1,150 -1,208 -1,268 -1,331

2075.0)05.0()15.0(05.015.0

''

=∗++=

∗++= fifii

2015-12-17 36

A Cash Flow Statement Build with Consideration of An Inflation Effect

(unit:000 won)

입력자료 MARR 15% 감가상각방법:내용연수 8년 정률법 상환기간: 5년

인플레이션율=5% 세율 25% 부채이자율: 10%상환방법:원리균등상환

손익계산서 0 1 2 3 4 5

매출액 5% 105,000 110,250 115,763 121,551 127,628

비용:

임금 5% 21,000 22,050 23,153 24,310 25,526

원자재 5% 12,600 13,230 13,892 14,586 15,315

제조간접비 5% 8,400 8,820 9,261 9,724 10,210

감가상각비 15,625 15,625 15,625 15,625 15,625

부채이자 6,250 5,226 4,100 2,861 1,499

과세표준 41,125 45,299 49,733 54,444 59,453

법인세(25%) 10,281 11,325 12,433 13,611 14,863

당기순이익 30,844 33,974 37,299 40,833 44,590

현금흐름표

영업활동:

당기순이익 30,844 33,974 37,299 40,833 44,590

감가상각비 15,625 15,625 15,625 15,625 15,625

투자활동:

투자 (125,000)

잔존가치 5% 63,814

자산처분세 (4,235)

운전자본 (23,000) (1,150) (1,208) (1,268) (1,331) 27,957

재무활동:

융자액 62,500

원금상환 (10,237) (11,261) (12,626) (13,626) (14,988)

순현금흐름 (85,500) 35,082 37,130 39,030 41,501 132,763

NPV(20.75%)= 62,426.89

AW(15%)= 18,623

IRR= 44.5531%

2015-12-17 37