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Chapter 9 – Incremental Cash Flow. Learning Objectives Understand the importance of cash flow Calculate the operating cash flow Produce a Sources and Uses of Cash Understand the relationship of the three financial statements Calculate depreciation and cost recovery

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chapter 9 incremental cash flow
Chapter 9 – Incremental Cash Flow
  • Learning Objectives
    • Understand the importance of cash flow
    • Calculate the operating cash flow
    • Produce a Sources and Uses of Cash
    • Understand the relationship of the three financial statements
    • Calculate depreciation and cost recovery
    • Estimate cash flow for capital budgeting decisions
three financial statements
Three Financial Statements
  • Income Statement – Measure of performance over a specific time
  • Statement of Financial Position or Balance Sheet – Listing of all assets, liabilities, and ownership claims
  • Sources and Uses of Cash or Statement of Cash Flow – Where dollars came from and where dollars were spent
income statement
Income Statement
  • Income Statement bottom line is net income
  • Net income is not cash flow
    • Accrual Accounting – timing of cash and recording of economic transaction different
    • Noncash items – depreciation for example
  • Want operating cash flow (OCF)
    • Use modified income statement
    • Interest expense is not part of OCF
    • OCF = EBIT + Depreciation - Taxes
balance sheet
Balance Sheet
  • The Balance Sheet Categories
    • Cash Account
      • Key element is change in cash over the period
      • Cash includes money, checking accounts, etc.
    • Working Capital Accounts
      • Current Assets and Current Liabilities
      • Assets and Liabilities typically converted to cash or paid over the business cycle
    • Long-Term Debt
    • Owner’s Accounts
  • Snapshot of company at a specific point in time
sources and uses of cash
Sources and Uses of Cash
  • Statement of Cash Flow or Sources and Uses of Cash
    • Cash flow from business operations
    • Cash flow from financing
      • From Owners (residual claims)
      • From Lenders (fixed claims)
    • Cash flow for capital spending
      • Purchase of capital equipment
      • Recapture cash from sale of assets
  • Ties to the change in Cash Account over the period
accounting relationship
Accounting Relationship
  • Accounting Identity in two forms
    • Assets ≡ Liabilities + Owner’s Equity
    • Cash Flow from Assets ≡ Cash Flow to Creditors + Cash Flow to Owners
  • Work through components, pages 266-267
  • Building the Cash Flow Identity
    • Cash Flow from Assets = Operating Cash Flow – Increases in Net Working Capital – Increases in Capital Spending
accounting relationship1
Accounting Relationship
  • Continued Building the Cash Flow Identity
    • Cash Flow to/from Creditors
      • Interest paid on debt – shows up in this section not in operating cash flow
      • Any repayment of principal on debt claims
      • New borrowed funds are from (negative to lenders)
    • Cash Flow to Owners
      • Dividend Payments
      • Any retirement of common stock
      • New shares issued are funds from (negative to owners)
cash flow identity to sources and uses of cash
Cash Flow Identity to Sources and Uses of Cash
  • Once the components of the cash flow identity are calculated…
    • Convert the information into the Statement of Cash Flow or Sources and Uses of Cash
    • The change in the cash account is the “bottom line” of this statement
  • Three Categories
    • Operating Activities
    • Investing Activities
    • Financing Activities
estimating incremental cash flow
Estimating Incremental Cash Flow
  • Objective – Estimate future cash flow of a project (for decision making)
  • Only Incremental Cash Flow used in decision
    • Sunk Costs – Do not use
    • Erosion Costs – Must account for lost sales of old products when new product introduced
    • Synergy Gains – 2 + 2 = 5
    • Working Capital – new projects require working capital, must include in cash flow
    • Capital Expenditures – Usually large up front cash flow out
    • Depreciation and cost recovery on divesting assets
capital spending and depreciation
Capital Spending and Depreciation
  • Capital Spending for a project is usually an up front cash outflow
  • It is expensed on the income statement over time via depreciation
    • Depreciation is not a cash flow
    • Deprecation impacts cash flow through reduction in taxes, a real cash flow
  • Different Types
    • Straight line depreciation
    • Modified Accelerated Cost Recovery System (MACRS)
capital spending and depreciation1
Capital Spending and Depreciation
  • Depreciation example for Cogswell Cola
    • Bottling Machine – Initial cost is $1,500,00
      • Include installation costs, another $150,000
      • Property class for MACRS is 7 years
    • Annual depreciation expense
      • Year 1 = $1,650,000 x 0.1429 = $235,785
      • Year 2 = $1.650,000 x 0.2449 = $404,085
      • Year 8 = $1,650,000 x 0.0445 = $73,425
  • Table 9.5 page 275 for all eight years
disposal of capital equipment
Disposal of Capital Equipment
  • When a capital asset is disposed of by a company it can result in cash flow
    • Fully depreciated assets: cash flow is sale price minus taxes
    • When asset is not fully depreciated
      • Determine current “book value” of asset
      • Difference between sales price and book value is the gain or loss on disposal
      • Tax a gain and tax credit on a loss
      • Cash flow is sales price – tax on gain (or + credit on loss)
  • Example 9.3 College Doughnuts Disposal
projected cash flow for project
Projected Cash Flow for Project
  • Putting all the elements together on incremental cash flow for decision making on a project
    • Initial Investment (typically capital spending and increases in working capital)
    • Annual operating cash flow
    • Disposal of equipment
    • Decrease in working capital at conclusion of project
  • Use Incremental Cash Flow with
    • NPV Model
    • IRR Model
  • Example Pulsar Cola Project – Table 9.8
homework
Homework
  • Problems 5 through 10 – Accounting Relationship
  • Problem 12 – Erosion Costs
  • Problem 16 – Depreciation
  • Problem 18 – Cost Recovery
  • Problem 20 – Incremental Cash Flow