Net operating cash flow

Discounted cash flow analysis can be completed on the net operational cash flows for alternative competing investment projects for opportunity and prefeasibility studies. 

It is wise to begin with NPV and IRR analysis. The cost savings of 631,800 per year is the additional positive gross operating cash flow the company estimates it will realize. However, the NPV and IRR analysis requires net operating cash flow for a more precise and accurate analysis. Depreciation and tax expenses, salvage value, initial investment, and discount rate are needed for NPV and subsequent IRR analysis (Table 8.6). 

As mentioned earlier, net operating cash flows must be obtained from gross cash flows. Net operating cash flow (Table 8.7) is found from the following simplified formula ... 

Net operating cash flow = EBIT + Depreciation - Taxes... 

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... 

When to Scrap an Existing Process Let us suppose that a company invests 50,000 in a manufacturing process that has positive net annual flows (after tax) Acp of 10,000 in each year. During the third year of operation, an alternative process becomes available. The new process would require an investment of 40,000 but would have positive net annual cash flows (after tax) of 20,000 in each year. The cost of capital is 10 percent, and it is estimated that a market will exist for the product for at least 6 more years. Should the company continue with the existing process (project H), or should it scrap project H and adopt the new process (project 1) ... 

Without any changes to the production network, the operating cash flows and the NPV of the network would be reduced by approximately 10% in comparison to the baseline values. However, by re-allocating production volumes within existing capacities, it is possible to restore previously earned operating cash flows. To do so, production volumes are shifted to the major site A, which is located in the Euro zone. Contrarily, site C, which is located in the USA, would not be utilized at all by the product groups included in the example. It should be noted that this does not imply a closure of the US site since only a subset of the product portfolio was included in the analysis. The net present value of the network is nevertheless affected by the US appreciation because of the restructuring costs associated with the re-allocation of production volumes. 

The Investment outlay is represented by the net Investment required for the new equipment or change In operation, and the economic gain Is represented by estimated operating cash flows generated by the Investment. Different companies use different criteria for comparing outlays and gains. 

The algae pond system developed for the base case was applied to each of the 15 candidate PEF sites using local data. The major factors which influenced the relative value of the cash flow at the different sites were months of operation, the level of treatment, and the plant size. Higher levels of treatment result in lower net annual cash flows and increasing capital cost. The results of the site-specific performance runs indicate that, for the present, a carbon-limited, secondary treatment system will be most cost-effective. 

The BoE is involved in the repo market as part of its daily operations in the sterling money markets. From the first quarter of 2000 the DMO also used gilt repo as part of its cash management operations on behalf of the government, which are designed to smooth the net daily cash flows between central government and the private sector. ... 

This gives two choices ia interpreting calculated NRR values, ie, a direct comparison of NRR values for different options or a comparison of the NRR value of each option with a previously defined NRR cutoff level for acceptabiUty. The NPV, DTC, and NRR can be iaterpreted as discounted measures of the return, iavestment, and return rate, analogous to the parameters of the earher example. These three parameters characterize a venture over its entire life. Additional parameters can be developed to characterize the cash flow pattern duting the early venture years. Eor example, the net payout time (NPT) is the number of operating years for the cumulative discounted cash flow to sum to zero. This characterizes the early cash flow pattern it can be viewed as a discounted measure of the expected operating time that the investment is at risk. 

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 ... 

Now that you have determined the likely savings in terms of annual process and waste-treatment operating costs associated with each option, consider the necessary investment required to implement each option. Investment can be assessed by looking at the payback period for each option that is, the time taken for a project to recover its financial outlay. A more detailed investment analysis may involve an assessment of the internal rate of return (IRR) and net present value (NPV) of the investment based on discounted cash flows. An analysis of investment risk allows you to rank the options identified. 

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. 

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... 

Figure 27 shows the discounted cash flow diagram obtained from Table 8 using the data in Table 7. A net present value of 102,462.21 is obtained at end of 15 years of useful life operation, which shows a profitable investment. Approximate discounted payback period is about eight years. Discounted... 

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. 

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. 

To the remaining companies, we applied Merrill Lynch s Cash Realization Test. We eliminated companies that reported financial net income that materially exceeded cash flow from operations. Companies eliminated 7 — Companies remaining 62... 

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. 

In the chemical business, operating net profit and cash flow are received on a nearly continuous basis, therefore, there is justification for using the condensed continuous interest tables, such as Table 9-23, in discounted cash flow calculations. 

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... 

Net Present Worth Method The NPW method allows the conversion of all money flows to be discounted to the present time. Appropriate interest factors are applied depending on how and when the cash flow enters a venture. They may be instantaneous, as in the purchase of capital equipment, or uniform, as in operating expenses. The alternative with the more positive NPW is the one to be preferred. In some instances, the alternatives may have different lives so the cost analysis must be for the least common multiple number of years. For example, if alternative A has a 2-year life and alternative B has a 3-year hfe, then 6 years is the least common multiple. The rate of return, capitalized cost, cash flow, and uniform annual cost methods avoid this complication. 

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 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 ... 

Figure 6-1 shows the concept of cash flow for an overall industrial operation based on a support system serving as the source of capital or the sink for capital receipts. Input to the capital sink can be in the form of loans, stock issues, bond releases, and other funding sources including the net cash flow returned to the... 

Line 13 gives the annual cash flows for each of the operating years with the zero-year column giving only the total capital investment. In line 16, the present value of the annual cash flows to the project is obtained by summing the individual present values for each year of operation including the present value of the working-capital and salvage-value recovery at the end of the service life. Line 17 merely applies the definition of net present worth as used in this text as the difference between the total present value of the annual cash flows to the project and the initial required investment. 

Estimations of operating costs, income, and taxes indicate that the annual cash flow to the project (i.e., net profit plus depreciation per year) will be 310,000 flowing uniformly throughout the estimated life. This is an after-tax figure. 

The definition of net cash flow (NCF) for capital budgeting purposes is after tax cash flows from operations discounted at the present value of the cost of capital.26 In net present value analysis the cost of capital is a pre determined value based on the opportunity cost of capital. The cost of capital is defined as a weighted average cost of capital (WACC) and takes into account the firm s capital structure, the cost of equity and debt capital, and tax rates. The formula for the weighted average cost of capital (WACC) is... 

Since net cash flows are defined as the after tax cash flows from operations, taxes have to be included ... 

Putting all of this together, the operational expression for the calculation of the net present value (NPV) of net cash flows is... 

Cash flow (used by) operating activities Cash flow from investing activities Cash flow from financing activities Net increase or decrease in cash... 

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