Chapter 10

Incremental Cash Flow

Three Financial Statements
Fundamental Accounting Relationship
Cash Flow Identity to Sources and Uses
Estimating Incremental Cash Flow
Capital Spending and Depreciation
Disposal of Capital Equipment
Projected Cash Flow for Project

Three Financial Statements

Income Statement Measure of
performance over a specific time
Statement of Financial Position or Balance
Sheet Listing of all assets, liabilities, and
ownership claims
Sources and Uses of Cash or Statement
of Cash Flow Where dollars came from
and where dollars were spent

Three Financial Statements

Income Statement bottom line is net
income
Net income is not cash flow

Accrual Accounting timing of cash and

recording of economic transaction different
Noncash items depreciation for example

Want operating cash flow (OCF)

Use modified income statement
Interest expense is not part of OCF

Three Financial Statements

The Balance Sheet Categories
Cash Account
Key element is change in cash over the period
Cash includes money, checking accounts, etc.
Working Capital Accounts
Current Assets and Current Liabilities
Assets and Liabilities typically converted to cash or paid over
the business cycle

Long-Term Debt
Owners Accounts

Snapshot of company at a specific point in time

Three Financial Statements

Statement of Cash Flow or Sources and Uses of
Cash

Cash flow from business operations

Cash flow from financing
From Owners (residual claims)
From Lenders (fixed claims)
Cash flow for capital spending
Purchase of capital equipment
Recapture cash from sale of assets

Ties to the change in Cash Account over the

period

Fundamental Accounting
Relationship
Accounting Identity in two forms
Assets Liabilities + Owners Equity
Cash Flow from Assets Cash Flow to
Creditors + Cash Flow to Owners

Building the Cash Flow Identity

Cash Flow from Assets = Operating Cash
Flow Increases in Net Working Capital
Increases in Capital Spending
Work through components, pages 269-271

Fundamental Accounting
Relationship
Continued Building the Cash Flow Identity
Cash Flow to Creditors
Interest paid on debt shows up in this section not
in operating cash flow
Any repayment of principal on debt claims

Cash Flow to Owners

Dividend Payments
Any retirement of common stock

Increases in debt or common stock are

cash flow from owners or creditors

Cash Flow Identity to

Sources and Uses of Cash
Once the components of the cash flow identity
are calculated
Convert the information into the Statement of Cash
Flow or Sources and Uses of Cash
The change in the cash account is the bottom line of
this statement

Three Categories

Operating Activities
Investing Activities
Financing Activities

Estimating Incremental Cash Flow

Objective Estimate future cash flow of a

project (for decision making)

Only Incremental Cash Flow used in decision
Sunk Costs Do not use
Erosion Costs Must account for lost sales of old
products when new product introduced
Working Capital new projects require working
capital, must include in cash flow
Capital Expenditures Usually large up front cash
flow out
Depreciation and cost recovery on divesting assets

Capital Spending and Depreciation

Capital Spending for a project is usually an up

front cash outflow

It is expensed on the income statement over time
via depreciation
Depreciation is not a cash flow
Deprecation impacts cash flow through reduction in
taxes, a real cash flow

Different Types
Straight line depreciation
Modified Accelerated Cost Recovery System
(MACRS)

Capital Spending and Depreciation

Depreciation example for Cogswell Cola
Bottling Machine Initial cost is $1,500,00
Include installation costs, another $150,000
Property class for MACRS is 7 years
Annual depreciation expense
Year 1 = $1,650,000 x 0.1429 = $235,785
Year 2 = $1.650,000 x 0.2449 = $404,085

Year 8 = $1,650,000 x 0.0445 = $73,425

Table 10.7 for all eight years

Disposal of Capital Equipment

When a capital asset is disposed of by a
company it can result in cash flow
Fully depreciated assets, sale price minus taxes paid
on gain on sale
When asset is not fully depreciated
Determine current book value of asset
Difference between sales price and book value is the gain or
loss on disposal
Tax a gain and tax credit on a loss
Cash flow is sales price tax or sales price + credit

Example 10.3 College Doughnuts Disposal

Projected Cash Flow for Project

Putting all the elements together on incremental
cash flow for decision making on a project

Initial Investment (typically capital spending and

increases in working capital)
Annual operating cash flow
Disposal of equipment
Decrease in working capital at conclusion of project

Use Incremental Cash Flow with

NPV Model
IRR Model

Example Bottle Water Project Table 10.12

Problems

Problem 1 Balance Sheet Accounts

Problem 3 Operating Cash Flow
Problem 5 Income Statement
Problem 6 Cash Flow from Assets
Problem 7 Cash Flow to Creditors
Problem 8 Cash Flow to Owners
Problem 9 Cash Flow Identity
Problem 11 Erosion Costs
Problem 15 Depreciation Costs