Rec2 Project Cashflows

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15.414 - Recitation IIJiro E. KondoSummer 2003


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Topics inTodaysRecitation:I.FromAccountingDatatoPVAnalysis: Guide-lines and Reasoning.II. Turbo Widgets: An Example.III. Practice Problem Requests.

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I.Continued... Obtaining Cashflows: Methodology (withsome details left out)... Start with accounting data, namely the in-come statement and thebalance sheet.STEPONE: From the income statement,getameasureofearningsbeforetaxesandde-preciation (EBTD),alsocalledoperatingprof-its.EBTD: SimplificationofEBITDA(Iveleftout some details)... We choose not to include depreciation inthis figure (i.e. use EBTD instead of EBT)onlyoutofconvenience,thoughonecouldalsoargue that it is intuitive because depreciationisnt a cashflow. In any case, we could per-form this step by computing EBT here whileusing depreciation (instead of the depreciationtax shield) in step two (same answer obtains).

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I.Continued... STEPTWO: Compute the depreciationtax shield (DTS).DTS: Amountofdepreciationbookeddur-ing the year times the tax rate.

DTS=Depreciation(1tax). (1)Why? Thoughnotacashflow, depreciationrepresents the accounting treatment of capi-tal expenditures on profits. As a result, sinceaccountingprofitsareusedtocomputetax lia-bility,depreciationreducesthistaxburden(i.e.increases cashflows).

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I.Continued... STEPTHREE: Find the capital expen-diture, maintenance, and asset sales (CAPX)figures from investment data (e.g. can backthis out from the balance sheet). We include this because CAPX is a cash-flow, but it wasnt accounted for in steps oneand two. STEPFOUR: Calculate net working cap-ital (NWC) and keep track of changes in thismeasure. More on this starting next slide... STEPFIVE: Now we put it all together.You can think of steps two to four as be-ing adjustments that change accounting prof-its (roughly computed in step one) into actualcashflows via the formula:CF =EBTD(1tax)+DTS+CAPXNWC.

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I.Continued...Letsdescribethediscrepancies(betweenac-counting profits and cashflows) addressed bythe use of the NWC in steps 4 and 5.Discrepancy#1: SalesandCOGSarerec-ognized

even

if

revenue

from

the

sale

hasnt

been received yet or some costs of productionhavent been paid.Recognizingthesecashflowsearly(asinthecase of unreceived revenues) or late (unpaidbills) is misleading given that there is a timevalue of money. All else equal, we all preferpaying late and receiving early, right? Discrepancy#2: Expenses incurred to-wards gathering inventory are not recognizeduntil the items are actually sold. Again, the expense inevitably occurs beforethesale. Notrecognizingthiscostattherighttime overstates profits because it neglects thetime-value of money.

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I.Continued...ExtremeExample: FuturesalesandCOGSmay be booked by a supplier once long-termcontracts between it and another downstreamfirm are signed even if much of the ensuingproduction hasnt begun. Discrepancies #1 and #2 are addressed viatheNetWorkingCapitaladjustment...NetWorkingCapital: Defined as...

NWC = CACL (3)= AR+INVAP (4)

where INV is entered at cost (not at value). Why do we enter inventory at cost? Whydoesthisadjustmentaddressdiscrepancies#1and #2? Reducing operating income by thechange in NWC yields cashflows that correctlyaccount for timing of payments.

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I.Continued...Other Issues:...1. Sunk costs: Not relevant. Dont mistakesunkcostswithfixedcosts, theyreverydiffer-ent.2. Opportunitycosts: Takeintoaccountnotonly cash costs, but also value creation that isforgone when undertaking the project.3. Inflation: Treat consistently.4. Average vs. Marginal cost: ...5. Project interactionandRealoptions: ...

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II.TurboWidgets. See Lewellen handout.SomeComments: Regardingthetreatmentof warehouse space for inventory in cashflowcalculations. Different assumptions could bemade...

1. You rent the space: This is a cost andas a result it reduces your a cashflow (throughEBTD).2. You own the space, but could rent ittosomeoneelse: This isanopportunity costand it should be considered in your PV analy-sis.3. You own the space, but cannot rentit to someone else: There is direct cost oropportunity cost. This shouldnt affect yourcashflows. This is the assumption made in Lewellenslecture notes.

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III.PracticeProblemRequests. Chapter6,Question8: An example of amake or buy decision...

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III.Continued...Chapter6,Question11: Manufacturehigh-protein hog feed?

Summarize on blackboard.

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