As the name implies, operating cash flows are the incremental, after-tax cash flows that occur after a new investment is made. In this section, we use the income state- ment format to clarify what we mean by incremental, after-tax cash flows.
INTERPRETING ThE TERM AFTER-TAX
Benefits that result from capital expenditures must be measured on an after-tax basis because the firm will not have the use of any benefits until it has satisfied the government’s tax claims. These claims depend on the firm’s taxable income, so deducting taxes before making comparisons between proposed investments is nec- essary for consistency when evaluating capital expenditure alternatives.
INTERPRETING ThE TERM CASH FLOWS
All costs and benefits expected from a proposed project must be measured on a cash flow basis. Cash outflows represent costs incurred by the firm, and cash in- flows represent dollars that can be spent by the firm. Cash flows generally are not equal to accounting profits. One of the main reasons that accounting profits do not equal cash flows is because accounting does not allow firms to fully deduct or
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expense the cost of fixed assets at the time of purchase. Instead, firms expense a portion of the cost of fixed assets through depreciation deductions over the useful life of the fixed asset. As a result, when a firm pays cash for a fixed asset, the firm’s profits will not fully reflect the cost of the asset in the year of purchase. In subsequent years, firms reduce their profits by taking depreciation expenses, even though there are no cash outlays tied to those depreciation charges.
There is a simple technique for converting after-tax net profits into operating cash flows. The calculation requires adding depreciation and any other noncash charges (amortization and depletion) deducted as expenses on the firm’s income statement back to net profits after taxes. Recognize that depreciation expenses are not actually cash inflows themselves. Adding depreciation to profit simply recog- nizes that the profit calculation requires firms to deduct an expense that is not tied to a specific cash outlay. In a sense, adding depreciation to profit “corrects” this is- sue and provides a number that better matches the actual cash inflows and outflows.
Powell Corporation’s estimates of its revenue and expenses (excluding depreciation and interest), with and without the proposed new machine described in Example 11.5, are given in Table 11.4. Note that both the expected usable life of the proposed machine and the remaining usable life of the present machine are 5 years. The amount to be depreciated with the proposed machine is calculated by summing the purchase price of $380,000 and the installation costs of $20,000. The proposed machine is to be depreciated under MACRS using a 5-year recovery period.5 The resulting depre- ciation on this machine for each of the 6 years, as well as the remaining 3 years of depreciation (years 4, 5, and 6) on the present machine, are calculated in Table 11.5.6
The operating cash flows each year can be calculated by using the income statement format shown in Table 11.6. Note that we exclude interest because we are focusing purely on the “investment decision.” The interest is relevant to the
“financing decision,” which is separately considered. Because we exclude interest expense, “earnings before interest and taxes” (EBIT) is equivalent to “net profits before taxes,” and the calculation of “operating cash flow” (OCF) in Table 11.6 is Example 11.6 ▶
T A B L E 1 1 . 4 Powell Corporation’s Revenue and Expenses (Excluding Depreciation and Interest) for Proposed and Present Machines
With proposed machine With present machine
Year
Revenue (1)
Expenses (excl. depr. and int.)
(2) Year
Revenue (1)
Expenses (excl. depr. and int.)
(2)
1 $2,520,000 $2,300,000 1 $2,200,000 $1,990,000
2 2,520,000 2,300,000 2 2,300,000 2,110,000
3 2,520,000 2,300,000 3 2,400,000 2,230,000
4 2,520,000 2,300,000 4 2,400,000 2,250,000
5 2,520,000 2,300,000 5 2,250,000 2,120,000
5. As noted in Chapter 4, it takes n 1 1 years to depreciate an n-year class asset under current tax law. Therefore, MACRS percentages are given for each of 6 years for use in depreciating an asset with a 5-year recovery period.
6. It is important to recognize that although both machines will provide 5 years of use, the proposed new machine will be depreciated over the 6-year period, whereas the present machine, as noted in the preceding example, has been depreciated over 3 years and therefore has remaining only its final 3 years (years 4, 5, and 6) of depreciation (12%, 12%, and 5%, respectively, under MACRS).
identical to the definition that we provided in Chapter 4 (defined in Equation 4.3, on page 171). Simply stated, the income statement format calculates the OCF.
Substituting the data from Tables 11.4 and 11.5 into this format and assum- ing a 40% tax rate, we get Table 11.7, which demonstrates the calculation of op- erating cash flows for each year for both the proposed and the present machine.
Because the proposed machine is depreciated over 6 years, the analysis must be T A B L E 1 1 . 5 Depreciation Expense for Proposed and Present Machines
for Powell Corporation
Year
Cost (1)
Applicable MACRS depreciation percentages (from Table 4.2)
(2)
Depreciation [(1) 3 (2)]
(3) With proposed machine
1 $400,000 20% $ 80,000
2 400,000 32 128,000
3 400,000 19 76,000
4 400,000 12 48,000
5 400,000 12 48,000
6 400,000 5 20,000
Totals 100% $400,000
With present machine
1 $240,000 12% (year-4 depreciation) $28,800
2 240,000 12 (year-5 depreciation) 28,800
3 240,000 5 (year-6 depreciation) 12,000
4 Because the present machine is at the end of the third year of its cost recovery at the time the analysis is performed, it has only the final 3 years of depreciation (as noted above) still applicable.
0
5 0
6 0
Total $69,600a
aThe total $69,600 represents the book value of the present machine at the end of the third year, as calcu- lated in Example 11.5.
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T A B L E 1 1 . 6 Calculation of Operating Cash Flows Using the Income Statement Format Revenue
2 Expenses (excluding depreciation and interest)
Earnings before depreciation, interest, and taxes (EBDIT) 2 Depreciation
Earnings before interest and taxes (EBIT) 2 Taxes (rate 5 T)
Net operating profit after taxes [NOPAT 5 EBIT 3(1 2 T)]
1 Depreciation
Operating cash flows (OCF) (same as OCF in Equation 4.3)
7. Although here we have calculated the year-6 operating cash flow for the proposed machine, this cash flow will later be eliminated as a result of the assumed sale of the machine at the end of year 5.
Calculation of Operating Cash Flows for Powell Corporation’s Proposed and Present Machines
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
With proposed machine
Revenuea $2,520,000 $2,520,000 $2,520,000 $2,520,000 $2,520,000 $ 0
2 Expenses (excluding depreciation
and interest)b 2,300,000 2,300,000 2,300,000 2,300,000 2,300,000 0
Earnings before depreciation,
interest, and taxes $ 220,000 $ 220,000 $ 220,000 $ 220,000 $ 220,000 $ 0 2 Depreciationc 80,000 128,000 76,000 48,000 48,000 20,000 Earnings before interest and taxes $ 140,000 $ 92,000 $ 144,000 $ 172,000 $ 172,000 2$20,000 2 Taxes (rate, T 5 40%) 56,000 36,800 57,600 68,800 68,800 2 8,000 Net operating profit after taxes $ 84,000 $ 55,200 $ 86,400 $ 103,200 $ 103,200 2$12,000 1 Depreciationc 80,000 128,000 76,000 48,000 48,000 20,000 Operating cash flows $ 164,000 $ 183,200 $ 162,400 $ 151,200 $ 151,200 $ 8,000 With present machine
Revenuea $2,200,000 $2,300,000 $2,400,000 $2,400,000 $2,250,000 $ 0
2 Expenses (excluding depreciation
and interest)b 1,990,000 2,110,000 2,230,000 2,250,000 2,120,000 0
Earnings before depreciation,
interest, and taxes $ 210,000 $ 190,000 $ 170,000 $ 150,000 $ 130,000 $ 0 2 Depreciationc 28,800 28,800 12,000 0 0 0
Earnings before interest and taxes $ 181,200 $ 161,200 $ 158,000 $ 150,000 $ 130,000 $ 0 2 Taxes (rate, T 5 40%) 72,480 64,480 63,200 60,000 52,000 0
Net operating profit after taxes $ 108,720 $ 96,720 $ 94,800 $ 90,000 $ 78,000 $ 0 1 Depreciationc 28,800 28,800 12,000 0 0 0
Operating cash flows $ 137,520 $ 125,520 $ 106,800 $ 90,000 $ 78,000 $ 0
aFrom column 1 of Table 11.4.
bFrom column 2 of Table 11.4.
cFrom column 3 of Table 11.5.
T A B L E 1 1 . 7
performed over the 6-year period to capture fully the tax effect of its year-6 depre- ciation. The resulting operating cash flows appear in the final row of Table 11.7 for each machine. The $8,000 year-6 operating cash inflow for the proposed ma- chine results solely from the tax benefit of its year-6 depreciation deduction.7
INTERPRETING ThE TERM INCREMENTAL
The final step in estimating the operating cash flows for a proposed replacement project is to calculate the incremental (relevant) cash flows. Incremental operat- ing cash flows are needed because our concern is only with the change in operating cash flows that result from the proposed project. Clearly, if it were an expansion project, the project’s cash flows would be the incremental cash flows.
Table 11.8 demonstrates the calculation of Powell Corporation’s incremental (relevant) operating cash flows for each year. The estimates of operating cash flows developed in Table 11.7 appear in columns 1 and 2. Column 2 values rep- resent the amount of operating cash flows that Powell Corporation will receive if it does not replace the present machine. If the proposed machine replaces the present machine, the firm’s operating cash flows for each year will be those shown in column 1. Subtracting the present machine’s operating cash flows from the proposed machine’s operating cash flows, we get the incremental operating cash flows for each year, shown in column 3. These cash flows represent the amounts by which each respective year’s cash flows will increase as a result of the replacement. For example, in year 1, Powell Corporation’s cash flows would in- crease by $26,480 if the proposed project were undertaken. Clearly, these are the relevant inflows to be considered when evaluating the benefits of making a capi- tal expenditure for the proposed machine.8
Example 11.7 ▶
8. The following equation can be used to calculate more directly the incremental cash flow in year t, ICIt: ICIt=[∆EBDITt*(1-T)]+(∆Dt*T)
where
∆EBDITt= change in earnings before depreciation, interest, and taxes [revenues – expenses (excl. depr. and int.)] in year t
T=firm’s marginal tax rate
∆Dt=change in depreciation expense in year t
Applying this formula to the Powell Corporation data given in Tables 11.4 and 11.5 for year 3, we get the following values of variables:
∆EBDIT3=($2,520,000-$2,300,000)-($2,400,000-$2,230,000)
=$220,000-$170,000=$50,000
∆D3=$76,000-$12,000=$64,000 T=0.40
Substituting into the equation yields
ICI3=[$50,000*(1-0.40)]+($64,000 *0.40)
=$30,000+$25,600=$55,600
The $55,600 of incremental cash inflow for year 3 is the same value as that calculated for year 3 in column 3 of Table 11.8.
T A B L E 1 1 . 8 Incremental (Relevant) Operating Cash Flows for Powell Corporation
Operating cash flows
Year
Proposed machinea (1)
Present machinea (2)
Incremental (relevant) [(1) 2 (2)]
(3)
1 $164,000 $137,520 $26,480
2 183,200 125,520 57,680
3 162,400 106,800 55,600
4 151,200 90,000 61,200
5 151,200 78,000 73,200
6 8,000 0 8,000
aFrom final row for respective machine in Table 11.7.
➔REVIEW QuESTIONS
11–9 How does depreciation enter into the calculation of operating cash flows? How does the income statement format in Table 11.6 relate to Equation 4.3 (on page 171) for finding operating cash flow (OCF)?
11–10 How are the incremental (relevant) operating cash flows that are associ- ated with a replacement decision calculated?