# Net (Operating) Cash Flows - Financial Management

Capital investment projects are expected to generate after -tax cash flow streams after the initial net investment has been made. The process of estimating incremental cash flows associated with a specific project is an important part of the capital budgeting process.

Capital budgeting is concerned primarily with the after -tax net (operating) cash flows (NCF) of a particular project, or change in cash inflows minus change in cash outflows. For any year during the life of a project, these may be defined as the change in operating earnings after taxes, _OEAT, plus the change in depreciation, _Dep, minus the change in the net working capital investment required by the firm to support the project, _NWC:

NCF = ΔOEAT +ΔDep –ΔNWC

The term change (Δ) refers to the difference in cash (and noncash) flows with and without adoption of the investment project.

Depreciation is the systematic allocation of the cost of an asset with an economic life in excess of one year. Although depreciation is not a cash flow, it does affect a firm’s after -tax cash flows by reducing reported earnings and there by reducing taxes paid by a firm. If a firm’s depreciation increases in a particular year as a result of adopting a project, after -tax net cash flow in that year will increase, all other things being equal.

After -tax net cash flow also considers changes in a firm’s investment in net working capital. If a firm increases its accounts receivable, for example, in a particular year without increasing its current liabilities as a result of adopting a specific project, after -tax net cash flow in that year will decrease, all other things being equal. On the other hand, a reduction in a firm’s investment in net working capital during a given year results in an increase in the firm’s NCF for that year.

From basic accounting definitions, the change in operating earnings after taxes (ΔOEAT) in Equation is equal to the change in operating earnings before taxes (ΔOEBT) times (1 – T) where T is the marginal corporate income tax rate. Furthermore, _OEBT is equal to the change in revenues (ΔR) minus the change in operating costs (ΔO) minus the change in depreciation (ΔDep). Substituting these terms in Equation yields the following definition of net cash flow:

NCF = (ΔR – ΔO – ΔDep)(1 – T) + ΔDep – ΔNWC

Equation can be further extended into an operational definition of NCF by defining ΔR as Rw – Rwo, ΔO as Ow – Owo, andΔDep as Depw – Depwo where

Rwo = Revenues of the firm without the project
Rw = Revenues of the firm with the project
Owo = Operating costs exclusive of depreciation for the firm without the project
Ow = Operating costs exclusive of depreciation for the firm with the project
Depwo = Depreciation charges for the firm without the project
Depw = Depreciation charges for the firm with the project

The definition given in Equation can be rewritten as follows:

NCF = [(Rw – Rwo) – (Ow – Owo) – (Depw – Depwo)] (1 – T) + (Depw – Depwo) – ΔNWC

These calculations and equations are summarized in Table In the final year of a project’s economic life, Equation must be modified to reflect recovery of the incremental after-tax salvage value of the asset(s).

The following two sections illustrate the calculation of net cash flows using these equations.

Recovery of After-Tax Salvage Value

Whenever an asset that has been depreciated is sold, there are potential tax consequences that may affect the after-tax net proceeds received from the asset sale. These tax consequences are important when estimating the after-tax salvage value to be received at the end of the economic life of any project. As discussed earlier, the tax consequences of asset sales are also important when calculating the net investment required in a replacement investment project. There are four cases that need to be considered.

Case 1: Sale of an Asset for Its Book Value If a company disposes of an asset for an amount exactly equal to the asset’s tax book value, there is neither a gain nor a loss on the sale and thus there are no tax consequences. For example, if Burlington Textile sells for $50,000 an asset with a book value for tax purposes of$50,000, no taxes are associated with this disposal.(In general, the tax book value of an asset equals the installed cost of the asset less accumulated tax depreciation.)

Case 2: Sale of an Asset for Less Than Its Book Value If Burlington Textile sells for $20,000 an asset having a tax book value of$50,000, Burlington Textile incurs a $30,000 pretax loss. Assuming that this asset is used in business or trade (an essential criterion for this tax treatment), this loss may be treated as an operating loss or an offset to operating income. This operating loss effectively reduces the company’s taxes by an amount equal to the loss times the company’s marginal tax rate. Summary of Net Cash Flow Calculations and Equations Assume that the company’s earnings before taxes is$100,000 (before consideration of the operating loss from the disposal of the asset). Taxes on these earnings are $100,000 times the company’s marginal (40 percent) tax rate, or$40,000. (We use a 40 percent marginal tax rate throughout the book for ease of calculation. Actual current corporate marginal tax rates are discussed in Appendix 2A.) Because of the operating loss incurred by selling the asset for $20,000, the company’s taxable income is reduced to$70,000 and the taxes decline to $28,000 (40 percent of$70,000). The $12,000 difference in taxes is equal to the tax loss on the sale of the old asset times the company’s marginal tax rate ($30,000 *40%).

Case 3: Sale of an Asset for More Than Its Book Value but Less Than Its Original Cost

If Burlington Textile sells the asset for $60,000—$10,000 more than the current tax book value —$50,000 of this amount constitutes a tax -free cash inflow, and the remaining$10,000 is taxed as operating income. As a result, the firm’s taxes increase by $4,000, or the amount of the gain times the firm’s marginal tax rate ($10,000 _40%). (The IRS treats this gain as a recapture of depreciation.)

Case 4: Sale of an Asset for More Than Its Original Cost If Burlington Textile sells the asset for $120,000 (assuming an original asset cost of$110,000), part of the gain from the sale is treated as ordinary income and part is treated as a long-term capital gain. The gain receiving ordinary income treatment is equal to the difference between the original asset cost and the current tax book value, or $60,000 ($110,000*$50,000). The capital gain portion is the amount in excess of the original asset cost, or$10,000. Under the Revenue Reconciliation Act of 1993, both ordinary income and capital gains are taxed at the same corporate rate (35 percent).

Recovery of Net Working Capital

In the last year of a project that, over its economic life, has required incremental net working capital investments, this net working capital is assumed to be liquidated and returned to the firm as cash. At the end of a project’s life, all net working capital additions required over the project’s life are recovered —not just the initial net working capital outlay occurring at time 0. Hence, the total accumulated net working capital is normally recovered in the last year of the project. This decrease in net working capital in the last year of the project increases the net cash flow for that year, all other things being equal. Of course, no tax consequences are associated with the recovery of NWC.

Interest Charges and Net Cash Flows

Often the purchase of a particular asset is tied closely to the creation of some debt obligation, such as the sale of mortgage bonds or a bank loan. Nevertheless, it is generally considered incorrect to deduct the interest charges associated with a particular project from the estimated cash flows. This is true for two reasons.

First, the decision about how a firm should be financed can —and should—be made independently of the decision to accept or reject one or more projects. Instead, the firm should seek some combination of debt, equity (common stock), and preferred stock capital that is consistent with management’s wishes concerning the trade-off between financial risk and the cost of capital. In many cases, this will result in a capital structure with the cost of capital at or near its minimum. Because investment and financing decisions should normally be made independently of one another, each new project can be viewed as being financed with the same proportions of the various sources of capital funds used to finance the firm as a whole.

Second, when a discounting framework is used for project evaluation, the discount rate, or cost of capital, already incorporates the cost of funds used to finance a project. Thus, including interest charges in cash flow calculations essentially would result in a double counting of costs.

Depreciation was defined earlier as the systematic allocation of the cost of an asset over more than one year. It allows a firm to spread the costs of fixed assets over a period of years to better match costs and revenues in each accounting period. The annual depreciation expense recorded for a particular asset is simply an allocation of historic costs and does not necessarily indicate a declining market value. For example, a company that is depreciating an office building may find the building’s market value appreciating each year.

There are a number of alternative methods of recording the depreciation of an asset for financial reporting purposes. These include straight-line depreciation and various accelerated depreciation methods. Under the straight-line depreciation method, the annual amount of an asset’s depreciation is calculated as follows:

Depreciation =Annual Installed Cost / Amount Number of years over which the asset is depreciated

The installed cost includes the purchase price of the asset plus shipping and installation charges, that is, Step 1 of the NINV calculation described earlier.

For tax purposes, the depreciation rate a firm uses has a significant impact on the cash flows of the firm. This is so because depreciation represents a noncash expense that is deductible for tax purposes.Hence, the greater the amount of depreciation charged in a period, the lower the firm’s taxable income will be.With a lower reported taxable income, the firm’s tax obligation (a cash outflow) is reduced and the cash inflows for the firm are increased. For example, suppose that the Badger Company in a given year has revenues of $1,000,000, operating expenses exclusive of depreciation of$500,000, straight-line depreciation of $100,000, and a marginal tax rate of 40 percent. Its operating cash flow is calculated in part (a) of Table to be$340,000. Now suppose Badger opts to use an accelerated depreciation method for tax purposes, rather than the straight-line method. As a result, its depreciation expense is recorded as $150,000 instead of$100,000. Its operating cash flow is now $360,000, as shown in part (b) of Table Comparison of Straight-Line and Accelerated Depreciation Methods: A comparison of the two cash flow statements shows that the use of accelerated depreciation reduces operating earnings after taxes from$240,000 to $210,000 and reduces taxes from$160,000 to $140,000 but increases operating cash flow from$340,000 to \$360,000. Hence, the use of accelerated depreciation for tax purposes is desirable for the firm because it reduces tax outlays and thereby increases cash flow. In general, a profitable firm will depreciate its assets as quickly as the tax law allows, and it should use whatever allowable method permits the highest percentage depreciation in the early years of an asset’s life.

The tax method currently used in the United States is the Modified Accelerated Cost Recovery System (MACRS) method.

The cash flow examples discussed in this chapter use straight -line depreciation to keep the calculations simple. In actual practice, companies today should use the MACRS method when computing the NCFs from a project. The relevant depreciation number that should be used when computing the after -tax net cash flows expected from a capital expenditure project is the tax depreciation amount.

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