Cash flow depreciation

Profit before taxes = continuous cash flow - depreciation before taxes... 

DecoveTj of Capital. In Figure 1, the annual book depreciation is used to retire the fixed capital investment. Whereas this accounting model does not correspond to the typical money flow, it is one possible model for recovery of capital. This model assumes that the investment is reduced each year by the amount of the annual depreciation. Another model (22) assumes that a uniform yearly book depreciation payment is made to an interest-bear sinking fund that accumulates to the depreciable fixed capital amount at the end of the venture. Using this second model, the investment is outstanding throughout the lifetime of the project. This also does not correspond to the actual money flow in most cases. ProfitabiUty analysis utilizes a third model based on discounted cash flows. 

Possible numerators include the gross income net pretax income net after-tax income gross profit, ie, gross income minus book depreciation cash flow or net income. An average return value is selected by defining a typical or mature proof year as the basis of calculation. The denominator can be the original total investment, depreciated book-value investment, lifetime averaged investment, or fixed capital investment. 

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. 

In addition, we shall calculate the discounted-cash-flow rate of return (DCFRR) with straight-line depreciation. 

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. 

Year, n Net capital expendihire, Atc Revenue from sales, Total expenses. Ate Cash income, Aci Depreciation charge. Ad Taxable income, Aci - Ad) Amount of tax at t = 0.5, A,t Net cash flow, Acf Discount factor at i = 10%, f. Discounted net cash flow, Adcf Net present value (NPV)... 

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. 

Inflation depreciates money in a manner similar to, but different from, the idea of discounting to allow for the time value of money. The effect of inflation on the net cash flow in future years can be allowed for in a similar manner to the net present worth calculation given by equation 6.9, using an inflation rate in place of, or added to, the discount rate r. However, the difficulty is to decide what the inflation rate is likely to be in future years. Also, inflation may well affect the sales price, operating costs and raw material prices differently. One approach is to argue that a decision between alternative projects made without formally considering the effect of inflation on future earnings will still be correct, as inflation is likely to affect the predictions made for both projects in a similar way. 

Chapter 3 treats the most common type of objective function, the cost or revenue function. Historically, the majority of optimization applications have involved trade-offs between capital costs and operating costs. The nature of the trade-off depends on a number of assumptions such as the desired rate of return on investment, service life, depreciation method, and so on. While an objective function based on net present value is preferred for the purposes of optimization, discounted cash flow based on spreadsheet analysis can be employed as well. 

The longer it takes to build a facility, the lower its rate of return. Formulate the ratio of total investment I divided by annual cash flow C (profit after taxes plus depreciation) in terms of 1-, 2-, and 3-year construction periods if i = interest rate, and n — life of facility (no salvage value). 

In Chapter 3 we discussed the formulation of objective functions without going into much detail about how the terms in an objective function are obtained in practice. The purpose of this appendix is to provide some brief information that can be used to obtain the coefficients in objective functions in economic optimization problems. Various methods and sources of information are outlined that help establish values for the revenues and costs involved in practical problems in design and operations. After we describe ways of estimating capital costs, operating costs, and revenues, we look at the matter of project evaluation and discuss the many contributions that make up the net income from a project, including interest, depreciation, and taxes. Cash flow is distinguished from income. Finally, some examples illustrate the application of the basic principles. 

The reconciliation between the cash flow statement and the income and expense statement is as follows. Start with the 40,000 from the last line in the cash flow statement, subtract 20,000 for the depreciation expense, and add back the 30,000 mortgage loan principal payment (not an allowed expense). The result is the net after-tax earnings. Figure B.ll is a set of statements from a small oil company. The statement of operations lists revenue and expenses, whereas the balance sheet lists various assets, liabilities, and stockholders equity ( net worth ). So-called capital items such as buildings, equipment, oil and gas property, and various intangibles are assets. Operating costs are deductions from revenues for operations not including expenditures for capital items. 

Depreciation The Internal Revenue Service allows a deduction for the exhaustion, wear and tear and normal obsolescence of equipment used in the trade or business. (This topic is treated more fufly later in this section.) Briefly, for manufacturing expense estimates, straight-line depreciation is used, and accelerated methods are employed for cash flow analysis and profitability calculations. 

Depreciation is entered as an indirect expense on the manufacturing expense sheet based upon the straight-line method. However, when one is determining the after-tax cash flow, straight-line depreciation is removed from the manufacturing expense and the MACRS depreciation is entered. This is illustrated under the section on cash flow. 

Cash flow is the amount of funds available to a company to meet current operating expenses. Cash flow may be expressed on a before- or after-tax basis. After-tax cashflow is defined as the net profit (income) after taxes plus depreciation. It is an integral part of the net present worth (NPW) and discounted cash flow profitability calculations. 

The cash flow diagram, also referred to as a cash flow model (Fig. 9-9), shows the relationship between revenue, cash operating expenses, depreciation, and profit. This diagram is similar in many respects to a process flow diagram, but it is in dollars. Revenue is generated from the... 

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. 

Example 7 After-Tax Cash Flow The revenue from the manufacture of a product in the first year of operation is 9.0 million, and the cash operating expenses are 4.5 million. Depreciation on the invested capital is 1.7 million. If the federal income tax rate is 35 percent, calculate the after-tax cash flow. 

Land for the project is available at 300,000. The fixed capital investment was estimated to be 12,000,000. A working capital of 1,800,000 is needed initially for the venture. Start-up expenses based upon past experience are estimated to be 750,000. The project qualifies under IRS guidelines as a 5-year class life investment. The company uses MACRS depreciation with the half-year convention. At the conclusion of the prmect, the land and working capital are returned to management. Develop a cash flow analysis for this project, using a cumulative cash position table (Table 9-25). 

Payout Period Plus Interest Payout period (POP) is the time that will be required to recover the depreciable fixed capital investment from the accrued after-tax cash flow of a project with no interest considerations. In equation format... 

This model does not take into account the time value of money, and no consideration is given to cash flows that occur in a project s later years after the depreciable investment has been recovered. A variation on this method includes interest, called payout period plus interest (POP + I) and the net effect is to increase the payout period. This variation accounts for the time value of money. 

Cash operating expenses Depreciation Total operating expenses Operating income Net income before taxes Federal income taxes Net income after taxes Cash flow Capital recovery Cumulative cash flow... 

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