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Chapter 4 Building An Incremental Cash Flow Statement for An Investment Project

Chapter 4 Building An Incremental Cash Flow Statement for An Investment Project. 다. Value-Oriented Management.

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Chapter 4 Building An Incremental Cash Flow Statement for An Investment Project

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  1. Chapter 4 Building An Incremental Cash Flow Statement for An Investment Project

  2. 다. Value-Oriented Management • Definition: the value-oriented management is defined as an emerging management philosophy which focuses on maximizing a cash flow rather than on expanding a net income by maximizing a revenue or market share • Requirement: the added-value must be generated greater than the cost of capital in the production processes • Action Plan: • to contrive a way to efficiently allocate the firm’s resources from a long-term perspective so as to enhance the added-value in the production-marketing processes. • to figure out a way to obtain the capital necessary for business at the least cost of capital. • In order to implement the value-oriented management philosophy, the firm must estimate the cash flows and determine the cost of capital as done similarly to the DCF techniques. So, it may be called a cash flow-oriented management philosophy and its main purpose is to maximize the capital production

  3. The Capital Production of Japanese Industries with respect to those of the U.S.A. Counterparties.

  4. A Cash Flow Statement for A Project • cash flows from operating activities: net income + depreciation 2) cash flows from investing activities: investment, proceeds from the sale of the fixed assets, gain taxes, working capital 3) cash flows from financing activities: money borrowed, repayment for the principal

  5. Building A Cash Flow Statement

  6. A Project Evaluation and Opportunity Cost • opportunity cost Def: (the real cost of something is what you give up to get it) The concept of opportunity cost is crucial to understanding individual choice because, in the end, all costs are opportunity costs. That’s because every choice you make means forgoing some other alternative. Sometimes the money you have to pay for something is a good indication of its opportunity cost. But many times it is not. One very important example of how poorly monetary cost can indicate opportunity cost is the cost of attending college. Tuition and housing are major monetary expenses for most students; but even if these things were free, attending college would still be an expensive proposition because most college students, if they were not in college, they could have a job. That is, by going to college, students forgo the income they could have made if they had worked instead. This means that the opportunity cost of attending college is what you pay for tuition and housing plus the forgone income you would have earned in a job. It’s easy to see that opportunity cost of going to college is especially high for people who could be earning a lot during what would otherwise have been their college years. That is why star athletes like LeBon James often skip college. Some, like Tiger Woods, leave before graduation A firm has to use all kinds of its resources like computer, land, labor, and so on to manufacture the products or services to provide for the customers and thereby it must give up using them for other alternatives. As a result, everything consumed by the firm is akin to the opportunity cost.

  7. An Example for A Project Evaluation and Opportunity Cost ex) A firm plans to rent the idle space for 50 million won per year. But the firm will use the space to manufacture the newly developed product instead. Discuss what the opportunity cost is and why? Sol] The 50 million won would be the opportunity cost because if the idle space had been rented, the firm would have earned that much money. So when preparing the cash flow statement for the investment analysis purpose, it must involve 50million won as a cash outflow 연간 5,000만원 임대 수익발생 연간 5,000만원 임대 수익포기 유휴공간을 임대할 경우 유휴공간을 신제품개발에 사용할 경우

  8. An Example for A Project Evaluation and Opportunity Cost EX4.1] An Economic Evaluation for An Investment Project Given] A marketing survey and a feasibility study: 50 million won, a cost for a purchase of a new equipment: 210 million won, A project life: 4 years, a salvage value for the equipment: 40million won, a price of a new product: 40,000won, an annual sale volume: 10,000 units, MARR=12%, Other Financial Data in The Table Below. (unit: 000won) • To purchase a direct material for 4,000won/ton which will be used over the next 2 years • ->its current price is 6,000won/ton • the fixed cost will be allocated to the product with the same pro rata as currently done. • -> to add up 15 M won of the production supervisor to the current fixed cost

  9. An Example for A Project Evaluation and Opportunity Cost The cash flows w. r. t. the economic evaluation (unit: 000 won)

  10. An Example for A Project Evaluation and Opportunity Cost An Economic Analysis for the Investment Project to Produce A New Product (unit:000won)

  11. The numbers in the circle at the table below are used to calculate the present value

  12. Cash Flow and Net Income Net Income: it is a accounting tool to measure a firm’s profitability based on the accounting concept. The time at which a cash flow is incurred is completely ignored. Cash Flow:The cash flow of today is more valuable than of tomorrow given that there is the time value of money. Therefore, when economically evaluating the investment projects, it is required to perform it based on the cash flow

  13. Why do we use a cash flow when performing the economic analysis for the investment projects: based on the mathematical concept • An economic profit(cash flow)  the project generates the rate of return on investment greater than the cost of capital.  the amount of the cash flow is equal to that of dividends distributed to the stockholders Given] the capital structure:100% of equity the source of fund: Revenue (Rev) and the amount of money collected by issuing m stocks whose initial offering price is S the use of fund: wage, salaries, materials, services, and so on=> denoted by “W&S” • the fund balance equation at time= “t” • if there is no new stocks issued, mtSt=0 . Then, the amount of dividend at time= “t” is given by • the stock price is given by based on the dividend model. Where, I=investment capital, Div= dividend *the firm’s value based on the dividend concept

  14. Continued……… • Accounting Profit(net income)  it does not consider the investment cost(I) unlike the cash flow  it considers the book value which is derived by subtracting a depreciation cost (dept) from the initial depreciation basis annually. • the net income (NIt) at time=t • the change in the book value of the fixed asset at time = “t”(net investment capital) • it is already known that the accounting definition of profit, NIt, is different from the economic profit, DIVt. However, it can be adjusted by subtracting net investment, , as follows: • The conspicuous difference between the accounting and economic profit the time at which a cash flow is incurred is not considered in the accounting profit concept, whereas it is clearly considered in the economic profit concept where,dept: depreciation

  15. Continued………Example This example shows the difference between the accounting and economic profits in terms of the business valuation

  16. Why do we use a cash flow when performing the economic analysis for the investment projects: based on the accounting concept • Depreciation: it is a non-cash flow item recorded in an income statement • The reason why the depreciation cost is recorded in the income 1) to deal with the depreciation cost an the expense item to identify change in the value of the fixed assets annually based on the matching principle 2) by doing so, the firms can reduces a certain amount of taxes Ex4.2] A Difference Between A Net Income and A Cash Flow Given] investment cost (I)= 80 million, depreciable life(N)= 8years, salvage value(S)=0 depreciation method(D)=straight-line depreciation method: SL, the relevant data (unit: 000 won)

  17. Continued………. Find] Net Income and Cash Flow Sol]  A depreciation cost with the SL method  the difference between the net income and the cash flow (unit: 000won)

  18. Net income: it an accounting instrument to measure a firm’s profitability based on the matching principle which tells us the fact that each time revenue is incurred, cost is also incurred accordingly. But it ignores the amount and time of cash flow being incurred. Cash Flow:cash of today is more valuable than that of tomorrow when considering the time value of money because the former generates more money than the latter. In the line with the statement, it is desirable to use cash flow when economically evaluating the investment project. Why do we use a cash flow when performing the economic analysis for the investment projects: based on the matching princeple

  19. Continued……… Ex] Company A and B have the same amount of the sum of the net income and cash flow. But Company A obtains 1 billion won of cash flow at the end of year 1 and 2, whereas Company B obtains 2 billion won at the end of year 2. The advantage of Company A over B is that the former may generates more profit by investing 1 billion won at the end of year 1. This point is very critical to the company which wants to increase its wealth in the end. (unit: 000 won)

  20. A Comparison of the Accounting and Economic Profits • cost: costs are the monetary value of expenditures(resources consumed) services or products. It is the sum of the direct material costs, the direct labor costs, and the indirect manufacturing costs. • expense: It is an outflow of cash or other valuable assets from a person or company to another person or company. This outflow of cash is generally one side of a trade for products or services that have equal or better current or future value to the buyer than to the seller. Technically, an expense is an event in which an asset is used up or a liability is incurred. It is the monetary value of the firm’s resources used for the purpose of managing the firm.

  21. An Example for A Comparison of the Accounting and Economic Profits Problem Description] Woonho works as a secretary at the big company and receives 45million won of an annual salary. And he possesses a small building and receives 9 million won of an annual renting fee and 345,000 won of an annual interest on the amount of 3.45million won for holding a CD. But he will sell the CD. He is now contemplating quitting the current work position and wants to run a pizza store at his own building which he rents.. Given] Give up the current renting fee to open the pizza store there, the disposal of theCD: 3.45 million won, Borrowing: 30 million won at the interest rate of 10%= wages, the purchase and renting charge of the equipment, and materials for the 1st year, Revenue: 127.5 million won.  accounting profit= revenue – total cost(consider the costs clearly identified) = 127,500 - 67,500 = 60 million won Total cost: 67.5 million won=wage, the purchase and rent charge of the equipments, and materials(64.5million won)+ interest payment( 3 million won)  economic profit= revenue- total cost(consider the costs clearly identified and opportunity costs) = 127,500 – (67,500 + 57,450) = 2.44 million won • opportunity cost: building renting fee(9 million won), the annual salaries foregone: 45million won, interest from holding the CD: 3.45 million won

  22. Building A Cash Flows Statement-Consider No Inflation Effect Ex 4.3] The investment project for the automatic machining center Given] - Investment cost: 125 M won - Project life: 5 years - Annual revenue: 100 M won - Annual Expenses:  Labor: 20 M won  Material: 12 M won  Indirect Manufacturing : 8 M won - Annual working capital: 23 M won - Loan: 62562.5 M won - Loan condition: interest rate10%, an equal payment over 5 years - Depreciation method: Straight-Line over 8 years - No salvage value , but 50 M won at the end of the 5th year - tax rate: 25% - MARR: 15%

  23. Find • Find the after-tax cash flow • What is the after-tax net present value at the MARR of 15%? (c) Determine the annual equivalent worth and internal rate of return?

  24. The Calculations for Building A Cash Flow Statement 1. depreciation Given] I: 125 M won, S: 0, Depreciation Method: SL with D.L. of 8 years 2. Gain Taxes

  25. Calculations to Build A Cash Flows Statement 3. Principal and Interest Repayment 1) Pay interest only during the middle of the payment schedule and pay the full amount of principal at the last time period of the payment schedule. Ex 1] A firm borrowed 100 million won form Tongil Bank and had a contract to pay interest at 10% only during the middle of the payment schedule and pay the full amount of principal at the end of the last period of time. (unit: ooo won)

  26. Continued…………. 2) Pay the same amount of principal and interest over the period of a schedule time Ex 2] A firm borrowed 125 million won from Tongil Back and pay the same amount of principal and interest at an annual rate of 10% over 5 years. (unit:000 won)

  27. Continued………. 3) Pay the same amount of money which involves the repayment and interest over the period of the schedule time Ex 3] A firm borrowed 62.5 million won from Tongil Banl and was asked to pay the same installment at an annual interest rate of 10% over 5 years. (unit: 000 won)

  28. Continued……. 4. Working Capital - I t is assumed that a working capital is invested at the beginning of each year and fully recovered at the end of the year (unit: 000 won)

  29. Income Statement (unit: 000 won)

  30. A Cash Flow Statement (unit: 000 won)

  31. 33,982 105,013 33,726 33,205 33,135 n 1 2 0 3 4 5 85,500 A Cash Flow Diagram for The Automatic Machining Center

  32. Net Cash Flow r The IRR for the Investment Project Break_Even Interest Rate=IRR

  33. A Trial-Error Technique Step 4: obtain an approximate i* with extrapolation. Step 1: Guess an interest rate. i*=18% Step 2: Calculate NPV(i*) Step 3: if NPV(i*) > 0, increase i*, if NPV(i*) < 0 이면, decrease i*. Recalculate the NPV(i*) 50,722 0 -3,768 i 40% 18%

  34. Building an incremental cash flow statement with inflation Ex.4.4] Automatic Machining Center Project Financial Data] - Investment: 125 M won - Project Life: 5years - Annual Revenue: 100 M won - Annual Expense:  Labor: 20 M won  Material: 12 M won  Indirect Manufacturing: 8 M won - Annual Working Capital: 23 M won - Financing: 625 M won - Loan Condition: The same annual installment at the interest rate of 10% over 5 years - Depreciation Methods : the SL with the depreciable life of 8 years - No salvage value , but 50 M won at the end of the 5th year - Tax rate: 25% - MARR: 15% - General inflation rate (f): 5%

  35. The Calculations to Build A Cash Flow Statement 1. Revenue 1st year= 100,000(1+0.05)=105 M won 2nd year= 105,000(1+0.05)=100,000(1+0.05)2=110.250 M won ………………………………………………………………………………. 5th year= 121,551(1+0.05)= 100,000(1+0.05)5=127.628 M won 2. Gain tax for the sale of the fixed asset -the salvage value at the end of the 5th year accounted for the general inflation rate=50,000(1+0.05)5 =50,000(F/P,5%,5)=63.814 M won - Gain/Loss=63,814-46,875=16.939 M won - Gain tax(0.25)(16,939)=4.235 M won

  36. Continued……….. 3. Working capital - a working capital is invested at the beginning of each year and fully recovered at the end of the year - inflation rate: 5% 4. Market interest rate (unit: ooo won)

  37. A Cash Flow Statement Build with Consideration of An Inflation Effect (unit:000 won)

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