What's going to happen in the operating phase? Now this is where we're actually operating whatever the project is. Perhaps we're setting a product. Perhaps it was just a machine that we're now operating that was going to save costs, but now the machine is actually operating, it's up and running. So, what are the kinds of things that go on during the operating phase? Well, what we want to measure here, again, is how the relevant cash flows of the organization change on an after tax basis because of the project. So in order to do that, what we're going to calculate is, what are the changes in the cash receipts associated with the project? What are the changes in the cash expenditures associated with the project? And what is the change in the tax bill associated with the project. So, suppose for example that the project increases the company's sales by $14,000. And let's suppose that the company collects all of that money during this period. So we sold $1,400 worth of products to customers and they paid us the $1,400 in this period. What would the change in the cash receipts be because of the project? Well, it would simply be the $1,400. Now let's suppose that the cost of those products that we sold was $500. And let's also assume that we only made exactly the number of products that we sold. So in that case, what are the cash expenditures associated with the production of this project? They're $500, right? So the cash receipts are going to be $1,400, the cash expenditures are going to be $500. So what that means is that, so far, the cash flows associated with the project would be $900, which is the $1,400- $500. But we haven't figured out the tax bill yet. We haven't figured out how the taxes are going to change. So, we have to take that into consideration as well. But to do that, we also need to consider whether or not there is going to be any depreciation because of this project. So, let's assume that we had purchased a machine that helped produce these products. And let's suppose that in this year that there was going to be $300 of depreciation expense associated with the machine that we bought during the initial investment phase that helped us produce these products. And let's suppose that the company faces a tax rate of 40%. Well, the taxable income of the company will be equal to the revenues minus cost of goods sold minus the depreciation. So the taxable income would be the $1400 of revenue minus the $500 of the cost of goods sold, or production cost, minus the $300 of depreciation, which would give us taxable income of $600. The taxes on that would be 40% of $600, or $240. And let's assume we pay the taxes at the end of the year. So the cash flow for the year would be the cash receipts minus the cash expenditures minus the taxes associated with the project. Which would be the $1,400 in receipts, the $500 in expenditures, and the $240 in taxes that we just estimated. And so that would give us cash flows during this operating phase for the first year of $660. Now, you have to include as part of this calculation, any additional working capital investment that is required. Such as receivables and inventory, net of any increases in accounts payable. And these ongoing working capital investments would typically affect the cash receipts and cash expenditures. So, let's make a slight change to our prior example to see how that would work. As we said before, what we want to measure is the change in the cash flows, which are the cash receipts minus the change in the cash expenditures minus the change in the taxes. But, let's add some working capital. So, before we had that the project increased the company's sales by $1,400, but let's assume that accounts receivable went up by $200 during this year, associated with the project. What that means is that while we sold products for $1,400, we didn't collect all of the $1,400 because customers still owe us $200 of that $1,400. That increase in accounts receivable is a cash outflow. So our cash receipts now are our revenues less the increase in accounts receivable, or $1400- $200. So the cash receipts now are only $1,200 because we didn't collect all of the money from customers. Let's suppose in addition to the cost of the products that we produced that we sold, let's suppose that the company also felt that it needed to increase the inventory level that it had this period in order to accommodate future sales. So, the company's anticipating more sales next period and it wants to raise its inventory levels. So, let's assume that it wants to raise its inventory level by $200. So what does that mean? We spend $500 on the products that we sold, but now we've also spent an additional $200 to increase our inventory level. So that means that our cash expenditures are $700. The $500 for the cost of the products sold plus the $200 increase in the inventory. So what does that imply? What that implies is that the cash flows associated with the project before taxes are $500 now, which is the $1,200 in cash receipts minus $700 in cash expenditures. Well, we haven't figured out the taxes yet. Well, the taxes are going to be the same as they were before. And we're going to assume the same $300 in depreciation because the tax bill is not based on cash receipts and cash expenditures. It's based on what your taxable income is, which is based upon your revenues, your cost of goods sold, and your depreciation. So our taxable income remains $600, just as it did in the prior example. And our tax bill is still going to be $240, or 40% of that $600. So it's exactly the same tax bill as it was before. And so now what are our cash flows now? Take the cash receipts, subtract cash expenditures minus taxes. So we have $1,200 in cash receipts, $700 in cash expenditures, $204 in taxes. And so now our cash flows are $260. So, a quick note, side note on depreciation. Depreciation's not a cash flow in the years it's taken. You get to depreciate an asset now that you bought previously. So, in the initial investments phase, you spend some money on a piece of equipment. And now that the project is operating, you're going to get to depreciate that equipment over time. So, while it's an expense, it's not really a cash flow this period because when did the cash flow occur? It occurred back when you bought the piece of equipment originally. But depreciation affects the company's cash flows indirectly, because it reduces the amount of taxes that the company has to pay. Because it goes into the calculation of what the company's taxable income is. In many countries, corporations can use a different form of depreciation for tax purposes than they use for their financial records that then might show shareholders. And so a lot of countries will allow an accelerated form of depreciation, which gives the company a faster write-off of the asset. Which, of course, reduces the amount of taxes that they have to pay in the early years. What depreciation method should you use for purposes of this analysis? Well, the relevant depreciation to use is whatever method they're using for tax purposes. So, it doesn't matter what depreciation method they might be using for financial reporting purposes and generating their financial statements to their shareholders. What matters is, what are they showing the tax authorities? And so, if they're using am accelerated form of depreciation for tax purposes you're going to want to use that same accelerated form of depreciation when you calculate, what are the annual operating cash flows? Now the simplest form of depreciation is straight-line. And that just calculates annual depreciation by taking whatever the original cost of the equipment was. We usually subtract from that whatever the estimated salvage value is at the time that the equipment is no longer going to be used. And we divide by the life of the asset. So if you had a machine that cost $1,000 and it had an estimated salvage value of $250 at the end of its 5 year life. You would take the $1,000, you would subtract $250, which is the salvage value, you would divide by 5. And that would give you $150 of depreciation every year. As I said before, there are accelerated forms of depreciation. And those are going to write the asset off over the same time frame. But the depreciation will be higher in the earlier and lower in the later years compared to straight line. So again, with an accelerated form, you're going to get more depreciation than straight-line depreciation in the early years and less in the later years. If corporations have an accelerated form of depreciation that they can use, given their country's tax code, they will typically use it to reduce the present value of the taxes that they've paid. Assuming that they're paying taxes. Obviously, if the corporation isn't profitable and isn't paying taxes, then there would be no benefit associated with using the accelerated form of depreciation. When you're going through this operating phase, make sure that you also include any additional investment required in property, plant and equipment for example. So, you might have a situation where you're going to produce a product that you've never produced before. And as part of your initial investment, you're going to create a production line for the production of that product. And you're anticipating, for example, that that production line will be sufficient to produce the products that you anticipate that you'll be able to sell during the first three years. But let's suppose that in the fourth year you're anticipating that the sales are going to be so high of this product that you're going to need a second production line. So, what would that mean? That would mean that in the third year, you're probably going to have to make another investment in property plant and equipment to produce that second production line. So that it's ready to be able to produce product at the beginning the fourth year. So in that third year, you would reduce your cash flows by that capital investment that you had to make in that year.
