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CASH FLOW FROM OPERATIONS

The third component of project cash flow is cash flow from operations. There are several ways to work out this component.

Method 1. Take only the items from the income statement that represent cash flows. We start with cash revenues and subtract cash expenses and taxes paid. We do not, however, subtract a charge for depreciation because depreciation is just an accounting entry, not a cash expense. Thus

Cash flow from operations = revenues cash expenses taxes paid

Method 2. Alternatively, you can start with accounting profits and add back any deductions that were made for noncash expenses such as depreciation. (Remember from our earlier discussion that you want to discount cash flows, not profits.) By this reasoning, Cash flow from operations = net profit + depreciation

Method 3. Although the depreciation deduction is not a cash expense, it does affect net profits and therefore taxes paid, which is a cash item. For example, if the firm s tax bracket is 35 percent, each additional dollar of depreciation reduces taxable income by $1. Tax payments therefore fall by $.35, and cash flow increases by the same amount. The total depreciation tax shield equals the product of depreciation and the tax rate:

Depreciation tax shield = depreciation _ tax rate

This suggests a third way to calculate cash flow from operations. First calculate net profit assuming zero depreciation. This item would be (revenues cash expenses) Г— (1 tax rate). Now add back the tax shield created by depreciation. We then calculate operating cash flow as follows:

Cash flow from operations = (revenues cash expenses) Г— (1 tax rate) + (depreciation Г— tax rate)

The following example confirms that the three methods for estimating cash flow from operations all give the same answer.

Cash Flow from Operations

A project generates revenues of $1,000, cash expenses of $600, and depreciation charges of $200 in a particular year. The firm s tax bracket is 35 percent. Net income is calculated as follows:

Revenues 1,000 Cash expenses 600 Depreciation expense 200 = Profit before tax 200 Tax at 35% 70 = Net income 130

Methods 1, 2, and 3 all show that cash flow from operations is $330: Method 1: Cash flow from operations = revenues cash expenses taxes

= 1,000 600 70 = 330

Method 2: Cash flow from operations = net profit + depreciation = 130 + 200 = 330

Method 3: Cash flow from operations = (revenues cash expenses) Г— (1 tax rate) + (depreciation Г— tax rate) = (1,000 600) Г— (1 .35) + (200 Г— .35) = 330

In many cases, a project will seek to improve efficiency or cut costs. A new computer system may provide labor savings. A new heating system may be more energyefficient than the one it replaces. These projects also contribute to the operating cash flow of the firm not by increasing revenue, but by reducing costs. As the next example illustrates, we calculate the addition to operating cash flow on cost-cutting projects just as we would for projects that increase revenues.

Operating Cash Flow on Cost-Cutting Projects

Suppose the new heating system costs $100,000 but reduces heating expenditures by $30,000 a year. The system will be depreciated straight-line over a 5-year period, so the annual depreciation charge will be $20,000. The firm s tax rate is 35 percent. We calculate the incremental effects on revenues, expenses, and depreciation charges as follows.

Notice that the reduction in expenses increases revenues minus cash expenses. Increase in (revenues minus expenses) 30,000

Additional depreciation expense 20,000 = Incremental profit before tax = 10,000 Incremental tax at 35% 3,500 = Change in net income = 6,500

Therefore, the increment to operating cash flow can be calculated by method 1 as Increase in (revenues cash expenses) additional taxes =

$30,000 $3,500 = $26,500 or by method 2:

Increase in net profit + additional depreciation n = $6,500 + $20,000 = $26,500or by method 3: Increase in (revenues cash expenses) Г— (1 tax rate) + (additional depreciation Г— tax rate) = $30,000 Г— (1 .35) + ($20,000 Г— .35) = $26,500

DEPRECIATION TAX SHIELD Reduction in taxes attributable to the depreciation allowance.