Cash Flow and Depreciation

6 Cash Flow and Depreciation 597 Select one of the two pumps in Example 17.24 on the basis of capitalized costs. 

To use capitalized costs when annual operating costs are also required (in this case for maintenance), it is appropriate to discount the operating cost payments to present worth, using the annuity equation [Eq. (17.32)], and to add this to the equipment installed cost. For pump A, the initial adjusted installed cost is 

Indeed, pump B has the lower capitalized cost, a result consistent with the comparison in Example 17.24 of the two present worths. In fact, P/ /Pg in Example 17.24 equals in Example 17.25.  

As was discussed in Chapter 16, cash flow for a company has become an important financial factor. Cash flow is defined as the net passage of money into or out of a company due to an investment. It may be positive (into) or negative (out of). For investment evaluation, investments are considered a negative cash flow, while after-tax profits plus depreciation are 

To estimate the cash flow for a particular year of plant operation, the pretax earnings are computed from Eq. (17.4) and the after-tax earnings from Eq. (17.5). However, in the calculation of the production cost, a more elaborate depreciation schedule, discussed in the next section, replaces the straight-line depreciation used in Section 17.2. The cash flow from plant operations is the after-tax earnings plus the depreciation  

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Be able to compute cash flows and depreciation, and use them to project the net present value and investor s rate of return (IRR) (also known as the discounted cash-flow rate of return, DCFRR), two measures that account for projections of revenues and costs over the life of the proposed process, and the time value of money. 

The term f x D is only the result of an algebraic manipulation, and no interpretation should be assumed. This term f x D is the contribution to cash flow from depreciation, and (1 — t) x i and (1 — f) X C are the contributions to cash flow from revenues and cash operating expenses, respectively. Example 7 is a sample calculation of the after-tax cash flow and the tabulated results. 

Certain terminology has been developed to identify the equipment under consideration. The item in place is called the defender, and the candidate for replacement is called the challenger. This terminology and methodology was reported by E. L. Grant and W. G. Ireson in Engineering Economy, Wiley, New York, 1950. To apply this method, there are certain rules. The value of the defender asset is a sunk cost and is irrelevant except insofar as it affects cash flow from depreciation for the rest of its life and a tax credit for the book loss if it is... 

Corrosion economics and corrosion management forms the theme of the fifth chapter. Discounted cash flow calculations, depreciation, the declining balance method, double declining method, modified accelerated cost recovery system and present worth calculation procedures are given, together with examples. In the second part, corrosion management, including the people factor in corrosion failure is briefly presented. Some of the expert systems presently available in the literature are briefly discussed. 

Example 6 Application of annuities in determining amount of depreciation with continuous cash flow and interest compounding. Repeat Example 5 with continuous cash flow and nominal annual interest of 6 percent compounded continuously. 

Internal uses by company managers at all levels include inventory control, depreciation valuation, cash flow, and availability. Additional internal reasons for the proper use of accmmting records parallel a major external concern, i.e., liquidity and profitability, which are also serious internal concerns for pharmaceutical managers. 

The economic analysis of investment alternatives generally entails the estimation of cash flows and the application of some measure of worth, such as net present value or the internal rate of return, in order to make a decision. The estimation of these cash flows requires the estimation of prices, whether they be the price of goods sold to forecast revenues or the estimation of wages to forecast labor costs. Over time these prices change. An increase in price is known as inflation, while a decrease in price is termed deflation. These concepts and their measurement are explained in this chapter. Cash flow analysis methods are revisited under the assumption of price changes, as their effects can be significant (Fleischer 1994). This is especially true when one considers after-tax cash flow analysis, as the effects of depreciation and taxes represent one of the most important aspects of investment analysis (Park and Sharp-Bette 1990). 

The shop floor measures of throughput, inventory, and operating expenses can be translated into profit, return on investment, and cash flow and vice versa. Consider an example where Throughput (T) equals 1,000 and Operating Expenses (OE), Cost of Materials, and Inventory are equal to 500, 1,000, and 2,000, respectively. Since T = Sales Revenue - Raw Materials Cost, the Sales Revenue for the period being considered is 2,000 (i.e., Sales Revenue = T + Raw Materials Cost). The profit is T - OE, so the profit is 1,000 - 500 = 500. The Return on Investment (ROI) is 500/ 2,000 which equals 25%. (Remember, the inventory measure is the value of all non-depreciated assets including material). 

Icible 9.4 Evaluation of Cash Flows and Profits in Terms of Revenue (R), Cost of Manufactmii (COM), Depreciation (d), and Tax Rate (t)... 

The sum of the profits and cash flows over the 10-year period are 217 million and 357 million, respectively. These totals are the same for each of the depreciation schedules used. The difference between the cash flows and the profits is seen to be the depreciation ( 357 - 217 = 140 million). 

The use of cash flow diagrams to visualize the timing of cash flows and to manage cash flows during a project was illustrated. A shorthand notation for the many discount factors involved in economic calculations (factors that account for the time value of money) were introduced to simplify cash flow calculations. Other items necessary for a corrprehensive economic evaluation of a chemical plant were covered and included depreciation, taxation, and the evaluation of profit and cash flow. 

C.2 Cash Flows and Capital Budgeting Techniques C.3 Generalized Equation for Straight-Line Depreciation C.4 Examples C.S Summary References... 

Many investors are particularly interested in a company s cash flow and find that the price-to-cash-flow ratio is more useful and reliable than the price-to-earnings ratio. Investors realize that net earnings take into account many noncash charges such as depreciation and amortization that reduce net earnings. Since stock prices fluctuate based on future cash flow projections, this ratio measures stock investment attractiveness. Since investors value companies based on future cash flows, the discussion in later chapters will concentrate on firm value and cash flow. 

Mfg cost (less depr and int) Capitalized fixed capital Capitalized total capital Operating income Interest on debt Depreciation (Tax basis) Net taxable income Federal income tax Investment tax credit Net income Cash flow... 

The relationships among the various annual costs given by Eqs. (9-1) through (9-9) are illustrated diagrammaticaUy in Fig. 9-1. The top half of the diagram shows the tools of the accountant the bottom half, those of the engineer. The net annual cash flow Acp, which excludes any provision for balance-sheet depreciation Abd, is used in two of the more modern methods of profitability assessment the net-present-value (NPV) method and the discounted-cash-flow-rate-of-return (DCFRR) method. In both methods, depreciation is inherently taken care of by calculations which include capital recoveiy. 

FIG. 9-1 Relationship between annual costs, annual profits, and cash flows for a project. A d — annual depreciation allowance Acf — annual net cash flow after tax Ac/ = annual cash income Age = annual general expense Aqp = annual gross profit A/r = annual tax A e = annual manufacturing cost Avc/ = annual net cash income Avvp = annual net profit after taxes A/ p = annual net profit As = annual sales Apc = annual total cost (DCFRR) = discoiinted-cash-flow rate of return (NPV) = net present value. 

TABLE 9-5 Annual Cash Flows, Straight-Line Depreciation, and 10 Percent Discount Factor... 

Example 3 Sensitivity Analysis The following data describe a project. Revenue from annual sales and total annual expense over a 10-year period are given in the first three columns of Table 9-5. The fixed-capital investment Cfc is 1 million. Plant items have a zero salvage value. Working capital C c is 90,000, and the cost of land Ci is 10,000. There are no tax allowances other than depreciation i.e., is zero. The fractional tax rate t is 0.50. For this project, the net present value for a 10 percent discount factor and straight-line depreciation was shown to be 276,210 and the discoiinted-cash-flow rate of return to be 16.4 percent per year. 

We shall use these data and the accompanying information of Table 9-5 as the base case and calculate for straight-line depreciation the net present value (NPV) with a 10 percent discount factor and the discoiinted-cash-flow rate of return (DCFRR) for the project with the following situations. 

As can be seen in Table 2 all revenues less expenses associated with selling are summed in Row 17. All expenses including noncash expenses such as depreciation, amortization, and depletion are summed in Row 30. The net profit before tax, Row 32, is obtained by subtracting Row 30 from Row 17 and making any inventory adjustment required. Row 34 is the cash taxes that are to be paid unless offset by investment or energy tax credits in Row 36. The deferred income tax is shown in Row 35. The deferred tax decreases the net profit after tax in the early years and increases the net profit after tax in later years. The impact on cash flow is just the other way around as discussed later. Row 37, profit after tax, is obtained as foliow s ... 

Finally, let s consider cash flow. Although cash flow does not have a direct effect on a company s revenues or expenses, the concept must be considered. If the project involves procurement costs, they often must be paid upon delivery of the equipment - yet cash recovery could take many months or even years. Three things about any project can affect a firm s available cash. First, cash is used at the time of purchase. Second, it takes time to realize financial returns from the project, through either enhanced revenues or decreased expenses. Depreciation expense is calculated at a much slower rate than the cash was spent. As a result of the investment, a company could find itself cash-poor. Even though cash flow does not directly affect revenues and expenses, it may be necessary to consider. 

The net profit is the total income minus operating costs minus depreciation minus tax. The ROI is often calculated for the anticipated best year of the project the year in which the profit is greatest. This criterion is also used for small investments. In general, acceptable ROT are about 20 %, but typical values are difficult to give. Both POT and ROI provide a one-moment-in-time view and do not take into account future cash flows, which may not be constant in the lifetime of the venture. 

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