Net cash flow

The net cash flow into the project each year is made up of two items the PAT and the depreciation allowance for that year. The depreciation is added to the PAT because, unlike all the other costs, it does not actually leave the balance sheet. 

In order to carry out a proper financial appraisal, the net cash flow figures must be calculated as inputs to the project s funds for each year of its operating life. Although these sums actually arise throughout the year, they are conventionally taken as arising on the last day of the year. 

The display below shows the higher initial capital outlay for the supercritical equipment followed by lower cash flow requirements versus the deionized water system. 

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Cash surplus is also commonly known as net cash flow. 

The project cashflow s constructed by performing the calculation for every year of the project life. Atypical project cashflow is shown in Figure 13.9, along with a cumulative cashflow showing how cumulative revenue is typically split between the capex, opex, the host government (through tax and royalty) and the investor (say the oil company). The cumulative amount of money accruing to the company at the endof the project is the cumulative cash surplus or field life net cash flow. 

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. 

Let us consider projects A and B, having net annual cash flows as listed in Table 9-2. Both projects have initial fixed-capital expenditures of 100,000. On the basis of payback period, project A is the more desirable since the fixed-capital expenditure is recovered in 3 years, compared with 5 years for projec t B. However, project B runs for 7 years with a cumulative net cash flow of 110,000. This is obviously more profitable than project A, which runs for only 4 years with a cumulative net cash flow of only 10,000. 

Comparisons on the Basis of Capitalized Cost A machine in a process generates a positive net cash flow of 1000. Two alternatives are available machine L, costing 2000, requires replacement every 4 years, and machine M, costing 3000, requires replacement every 6 years. Neither machine has any scrap value. The cost of capital is 10 percent. Which machine is the more profitable to operate ... 

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)... 

C-D The cash-flow curve turns up at C, as the process comes on stream and income is generated from sales. The net cash flow is now positive but the cumulative amount remains negative until the investment is paid off, at point D. 

The point F gives the final cumulative net cash flow at the end of the project life. 

Net cash flow is a relatively simple and easily understood concept, and forms the basis for the calculation of other, more complex, measures of profitability. 

In Figure 6.8 the net cash flow is shown at its value in the year in which it occurred. So the figures on the ordinate show the future worth of the project the cumulative net future worth (NFW). 

The money earned in any year can be put to work (reinvested) as soon as it is available and start to earn a return. So money earned in the early years of the project is more valuable than that earned in later years. This time value of money can be allowed for by using a variation of the familiar compound interest formula. The net cash flow in each year of the project is brought to its present worth at the start of the project by discounting it at some chosen compound interest rate. 

Net present worth (NPW) Estimated net cash flow in year n (NFW)... 

The rate of return is often calculated for the anticipated best year of the project the year in which the net cash flow is greatest. It can also be based on the book value of the investment, the investment after allowing for depreciation. Simple rate of return calculations take no account of the time value of money. 

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. 

End of year Forecast sales 10 1 2 3 4 5t Forecast selling Price /t Raw material costs /t product Sale income less operating costs 106 Net cash flow 106 Cumulative cash flow 106 (Project NFW) Discounted cash flow at 15 per cent 106 Cumulative DCF (Project NPW) 106 Project NPW at 25 per cent discount rate Project NPW at 35 per cent discount rate Project NPW at 37 per cent discount rate... 

Net cash flow = sales income - costs - investment... 

The other indices to be described, net present value and discounted cash flow return, are more comprehensive because they take account of the changing pattern of project net cash flow with time. They also take account of the time value of money. 

Internal rate of return (IRR) the interest or discount rate for which the future net cash flows equal the initial cash outlay. 

The principle of the NPV method is to forecast over time all cash flows associated with an investment. Each period s net cash flows are then discounted to the present.29 As discount rate usually the company s cost of capital is used because in this case a positive NPV indicates that the investment increases the company s value (cf. Rappaport 1998, p. 37 see Appendix 1 for a detailed discussion of how to derive the appropriate discount rate). The calculation of the NPV is based on the following formula ... 

A simple graph of net cash flow out of, or in to, the project s account illustrates the way in which the cumulative net cash flow moves over the lifetime of the project, and enables the payback time to be easily seen, as in Figure 3. The payback time may be expressed as less than 3 years , or more precisely, such as 2.4 years or 2 years 5 months. 

Because the calculation of the NPVs takes into account the ways in which the relevant sums of money have been invested or recovered, as well as their size, the IRR is characteristic of the project and its cash flows the IRR is the rate of return achieved by investing the total capital employed in the project in the same pattern as in building the project, to produce income in the pattern of the net cash flows of the project. 

The annual net cash flow is the annual revenue for the project that is to be balanced against the investments. It is calculated as the net profit (PAT) in each year plus the depreciation allowance for that year ... 

These net cash flow figures are now used as the bases for the... 

The investments for the construction period and the net cash flows for the 10-year operating lifetime can now be discounted to determine the net present values at various discount factors. The undiscounted payments and revenues can be seen in the left hand column ... 

From this table a number of key discoveries can be made. Firstly, the total net cash flow of 156 millions is close to twice the total investment, so there is a reasonable overall profit. However, the undiscounted payback time is about 5 years and 8 months (the total revenues for years 1-5 are still 10 millions short of covering the total costs). This is a long time before payback - 2 to 3 years would be preferable - so this project is beginning to look a little unexciting. 

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