ChE/MGMT 597

Financial Analysis and

Management of Projects

Net Present Value

March 30, 2020
Charlie Smith

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 Introduction

Mr. Charlie Smith

B.S. Chem Eng Purdue University, 1980

(317) 432-4285
Charlie4129@yahoo.com

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 Let’s Review GAAP vs. Cash

GAAP
Generally Accepted Accounting
Principles

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 GAAP vs Cash

GAAP dictates that businesses cannot use the

cash basis of accounting. Instead, businesses
must use the accrual basis of accounting that
recognizes revenues and expenses when they are
earned or occur. The cash basis is a much more
simplified accounting system then the accrual
basis.

People spend their entire career

thinking about accrual accounting.
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GAAP Structure

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 Cash Accounting

• Cash basis accounting is an accounting system

that recognizes and records income and
expenses as they are paid in cash.
• The cash basis is a much more simplified
accounting system then the accrual basis. Cash
basis accounting only recognizes income and
expenses when cash is actually collected or
disbursed. Net income under a cash basis system
would always equal the company’s cash receipts
minus the cash disbursements.
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 Cash Accounting

• Assume a company starts only one bank account and all the
cash receipts from the year are deposited in the account.
–All the revenue that the company collects is deposited in one
single account.
–All the expenses are paid out of this one account.
–At the end of the year, the balance of the bank account less
than the beginning balance would be the cash basis net
income for the company for the year.
• This is a simplified accounting system than the accrual
accounting system. The cash basis of accounting does not
recognize any accrued revenues or expenses because they
were not paid in cash during the period.
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 GAAP Accounting

• GAAP does not allow companies to use the

cash basis of accounting because it violates
the matching principle or time period
principle.
– From an accounting perspective, cash doesn’t
reflect the actual company performance or
financial status.
• Companies can use the cash basis for internal
purposes. Why would they do this?

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IFRS vs GAAP

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IFRS vs GAAP

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IFRS vs GAAP

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Cash versus Book Taxes

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 “Three Differences Between Tax and Book Accounting
that Legislators Need to Know” by David S. Logan
• Differences between book and tax accounting are confusing to many (i.e.
“Loopholes”), it is entirely reasonable that there be considerable
differences between the two practices.
– Corporate accounting standards are typically set by the independent Financial
Accounting Standards Board (FASB), driven by accrual methods and consistency.
– The Internal Revenue Code is a product of the political process between Congress
and the While House. Tax rules are driven by broader public policy concerns rather
than adherence to formal accounting practices.
• Generally Accepted Accounting Principles (GAAP) are intended to ensure
uniformity of companies’ financial statements and accounting methods,
similar activities may be treated very differently for tax purposes. Therefore,
it is possible for the financial reports of a company to differ from the tax
returns prepared for the IRS because of the different accounting methods.
The three most common differences between
book and tax accounting are as follows:
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 1) Cash-Based vs. Accrual-Based Accounting

• While certain activities of a corporation may be recorded

on a cash basis for tax accounting, most activities
accounted for in its financial statements are done so using
what is known as the accrual method.
• When a company receives payment for a service or
product, it is immediately taxable income in the view of
the IRS (unless it is deferred income).
• However, on a financial statement, the matching principle
must be used under U.S. GAAP rules. This principle, used
in book accounting, ensures that the income generated by
an output and the expense incurred for that output are
recognized in the same period.

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 1) Cash-Based vs. Accrual-Based Accounting, Example

• A magazine company is selling year-long subscriptions to its publication.

– The cost of printing each issue is $2 and the revenue generated by each issue sold
is $5.
– A consumer buys a year-long subscription on August 1st and the company
immediately receives $60.
• In the eyes of the IRS, this is immediately taxable income in the current
year. However, for book accounting purposes, the company (using US
GAAP) matches the revenue of each month’s issue with the cost
associated with that copy.
• In this manner, the company will only have made a $15 profit by the end
of the year. They must, however, pay income tax on the full $36 profit of
the initial transaction.
• In this case, a $21 difference exists between book and tax profit. This
difference results in a lower income tax liability on the company’s
financial statement than what is actually owed to the IRS.

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 2) Treatment of Depreciation

• Depreciation is “a method of allocating the

cost of a tangible asset over its useful life.
Businesses depreciate long-term assets for
both tax and accounting purposes.”
• Companies generally use two main types of
depreciation: straight line and accelerated.
(Resource companies also use Units of
Production.) There are many types of
accelerated depreciation.

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 2) Treatment of Depreciation, Cont’d
• Table 1 ( Next Page) gives examples of straight line and accelerated
depreciation of an asset originally valued at $100,000, with an expected
salvage value of $10,000 after 10 years.
• In the case of straight-line depreciation, an identical percentage of the
difference between initial and salvage value is depreciated every year (in
this case $9,000/year, 10 percent of ($100,000-$10,000=$90,000)),
resulting in a book value equal to salvage value at the end of the asset’s
useful period.
• On the right side of the table is an example using double-declining
depreciation (a specific type of accelerated depreciation). Using this
method, 20 percent of the asset’s book value is depreciated each year.
• As the table shows, this leads to higher depreciation (which is tax-
deductible) during the initial years of the asset’s life than in the final years.
Both methods, however, yield the same book and salvage value of $10,000
after 10 years.

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 Table 1 – Depreciation

Straight-Line (10% of beginning minus salvage value Double-Declining (20% of year’s beginning book value
 
every year) every year)

Accumulated Accumulated
Number of Years Depreciation Book Depreciation Book
Depreciation Depreciation

1 $9,000 $91,000 $9,000 $20,000 $80,000 $20,000

2 $9,000 $82,000 $18,000 $16,000 $64,000 $36,000

3 $9,000 $73,000 $27,000 $12,800 $51,200 $48,800

4 $9,000 $64,000 $36,000 $10,240 $40,960 $59,040

5 $9,000 $55,000 $45,000 $8,192 $32,768 $67,232

6 $9,000 $46,000 54,000 $6,554 $26,214 $73,786

7 $9,000 $37,000 $63,000 $5,243 $20,972 $79,028

8 $9,000 $28,000 $72,000 $4,194 $16,777 $83,223

9 $9,000 $19,000 $81,000 $3,355 $13,422 $86,578

10 $9,000 $10,000 $90,000 $3,422 $10,000 $90,000

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 2) Treatment of Depreciation, Cont’d
• The U.S. tax code and GAAP allow both methods.
– GAAP rules require that the rate of depreciation be consistent with the expected wear and
tear of the asset depending on its characteristics.
– This difference makes corporations depreciate these assets on their financial statements in
a way that truly reflects the use and growing obsolescence of some capital investments.
• Congress frequently enacts temporary depreciation allowances in hopes of
spurring economic growth via capital investment. Bonus (accelerated)
depreciation was allowed as part of the Economic Growth and Tax Relief
Reconciliation Act in 2001 and 2003, and the American Recovery and
Reinvestment Act in 2009 and 2010, to allow firms to greatly accelerate
depreciation on some expenses.
– This allows businesses to deduct a much larger percentage of an asset in the first year
than U.S. GAAP allows under the rules’ “period of usefulness” provision.
– Capital investment is incentivized because depreciation is tax-deductible, reducing their
tax liability.
• The investment immediately becomes more attractive.

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 3) Treatment of Inventory

• When you sell product from inventory, profit is the

difference between sales price and inventory value.
• You can value inventory as the cost of the initial
cost of building inventory (the “First-In”) or the
most recent cost (the “Last-In”).
• Consider companies with huge amounts of
inventories created many years ago.
– Does “First-In” or the “Last-In” maximize profit?
– Which is better for reporting profits?
– Which minimizes cash taxes to be paid?

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 3) Treatment of Inventory, Cont’d

• Different methods are used when accounting for

valuing inventory for book and tax purposes.
– LIFO (last-in, first-out) method. Using this method, the
cost of inputs purchased for production is matched with
the revenues generated by items sold in the same
period.
– This method is used regardless of whether the inputs
are physically used to produce anything during that
time. The IRS has stipulated that businesses using LIFO
to account for inventory on their tax returns must also
use LIFO when reporting taxable income on financial
statements.
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 3) Treatment of Inventory, Cont’d
• U.S. GAAP allow businesses to claim income using
either the LIFO or FIFO (first-in, first-out) system.
• Contrary to LIFO, FIFO matches the cost of the
oldest inputs with the revenue of goods sold in a
given period.
• The US Internal Revenue Code imposes the
condition that a taxpayer electing the LIFO method
for income tax reporting purposes must also use
the LIFO method for financial reporting to
shareholders, partner, other proprietors, or
beneficiaries, or for credit purposes.
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 First-In, First-Out (FIFO) vs. Last-In, First-Out (LIFO)

FIRST-IN, FIRST-OUT CALCULATIONS

FIFO Value of Sale of

LAST-IN, FIRST-OUT CALCULATIONS

LIFO Value of Sale of

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 3) Treatment of Inventory, Cont’d

• Companies that use LIFO typically use FIFO for

accounting systems, then create a LIFO
“reserve” which may be positive or negative.

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 3) Switching from LIFO to FIFO

• Converting to FIFO would require tax recognition of

this reserve as an addition or subtraction to income.
• Nearly all foreign accounting standards disallow
LIFO inventory accounting. To help unify U.S. and
international standards and thus lower the cost of
compliance, many accounting professionals
advocate for the disallowance of LIFO treatment
under U.S. GAAP standards.
– Converting the U.S. to IFRS would trigger recognition of
this reserve for U.S. companies using LIFO.

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 Summary Comments

• Accounting principles use accrual methods to match

costs to revenues are the revenues are recognized.
• Rules are in place (GAAP, IFRS) to standardize this
across companies for consistency.
• Cash accounting tracks money in and out of a venture
according to when the cash event actually occurs.
• There are differences between cash (IRS) taxes and
book (GAAP, IFRS) taxes because tax laws vary from
accounting accrual rules.
When you evaluate investments, you care
about when cash is spent and received!
ChE 597 Lecture 2 26
Net Present Value Analyses

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 Goal

• I believe graduating engineers / scientists arrive

in industry deficient at being able to articulate
the value of their ideas.
• They tend to look at the world in technical terms.
– “More efficient”
– “Bigger”
– “Faster”
• To compete in the marketplace, they must be
able to present their ideas in business terms, not
technical or scientific terms.
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 Charlie’s Principle of Engineering Success

“You don’t have a good idea until you

can:
1.articulate its expected net
present value,
2.defend its merits, and
3.prove it through
implementation.”
Charlie Smith

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Capital Investment Decision Making

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 Capital Project

• A capital project is a long-term investment used

to build, add or improve on a project.
• It is any task that requires the use of
significant capital, both financial and labor.
• Every company defines a capital project
differently in terms of duration, $, scope, etc.
– Typically defined by accounting standards.
– Grey areas defined by company accountants.
– Some companies allocate indirect costs that is
imputed or opportunity costs.
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 Capital Costs

Material Labor

Indirect Opportunity

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 Capital Investment Decision
• Decide whether to invest in new long-lived assets that will be
the source of cash flows in the future.
• From a financial management perspective, a good project/
investment decision is a decision that increases the value of
an organization, thus creating value for the firm’s owners.
– Privately held Companies
– Publicly traded Companies

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 Capital Investment Process

Identification

Evaluation

Selection

Implementation/follow-up
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Capital Investment Process

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 Capital Investment Process

Engagement

Execution
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 Capital Investment Process

Sunk Costs

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 Classification of Capital Projects

• Project classification
– Required investments – do it or get out of business
– Safety investments – Important, may be discretionary
– Replacement investments – worn out equipment
– Upgrade assets – improve efficiency or yields
– Expansion investments – Increased scale
– Diversification investments – most risk

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 Evaluation of Capital Projects

• Financial evaluation
– Estimation of costs
– Estimation of useful life
– Estimation of cash flows the project is expected to
generate over the useful life
– The appropriate discount rate

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 Why Is Financial Analysis Important to
Engineers?
• Quantitative decision making
• Justify or kill ideas
• Compare mutually exclusive projects
• Decide on the best course of action for
creating value

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 Charlie’s Principle of Engineering Success

“You don’t have a good idea until you can:

1.articulate its expected net present
value,
2.defend its merits, and
3.prove it through implementation.”
Charlie Smith
 Discounted Cash Flow Models

• Decision models that consider both the time

value of money of an investment’s cash flows
are called discounted cash flow (DCF) models.
• Project risk must be baked into the model
assumptions!
– Discount rate is cost of capital, not risk of
failure.
• Net Present Value (NPV) is one DCF model.

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 Fundamental Finance Principle

A business proposal – such as a new investment, the acquisition of

another company, or a restructuring plan – will create value only if the
present value of the future stream of net cash benefits the proposal is
expected to generate exceeds the initial cash outlay required to carry
out the proposal.

NPV = - Initial Cash Outlay + PV of the future cash flows

If NPV > 0, then value is created

If NPV < 0, then value is destroyed

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In Simple Terms – Getting Someone to Give You
Money to Pursue Your Ideas

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 Example

Your plant is considering a new production line to make a

new product. The cost to purchase and install it is $50k.
The production line will increase the plant’s thru-put for
the next 5 years and bring in an additional $15k in cash
flow each year.
The company cost of capital is 5%.

Should you do the project?

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 Example
$15k $15k $15k $15k $15k
•  

1 2 3 4 5

$50k

5
NPV = -$50,000 + ∑ $15,000 /(1 +0.05)j
j=1
NPV = -$50,000 + + + …
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 Problem 1

Discount Rate, % 5.0%

Year 0 1 2 3 4 5
Cash Flow, $MM $ (50.0) $ 15.0 $ 15.0 $ 15.0 $ 15.0 $ 15.0
End of Year Discount Factor 1.000 0.952 0.907 0.864 0.823 0.784
Discounted Values, $MM $ (50.0) $ 14.3 $ 13.6 $ 13.0 $ 12.3 $ 11.8
Total Net Present Value, $MM $ 14.94

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 NPV Decision Criteria

NPV > 0 Value is created, do the project. The

actual rate of return/interest rate is greater than the
interest rate used for the NPV calculation.

NPV < 0 Value is destroyed, do NOT do the project.

The actual interest rate is lower than what you can obtain
elsewhere.

NPV = 0 The project has a return that is the same

as the interest rate. You should be indifferent.
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 Why Is the NPV a Good Investment Rule?

• It is a direct measure of value creation

• It considers the timing of the projected cash

flow returns

• It is additive

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 Comments on the NPV

• NPV is a core concept.

• Can be used to evaluate projects in a simple
and timely manner.
• There are other methods for evaluating
projects, but the NPV is the most broadly
used.
• Reveals the best options for creating
maximum value.

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 Comparing Alternatives
Investments with Different Useful Lives

Option A Option B
• Cheaper machine • Cost $120,000
• Cost $80,000 • Useful life 4 years
• Useful life 2 years • Annual maintenance costs
• Annual maintenance costs $3,000
$4,000 • No value at the end of the
• No value at the end of the fourth year
second year
• Replace with a second
Discount Rate = 10%
The two machines will generate identical future cash flows.
Which option should you buy?
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 Comparing Projects with
Unequal Time Spans

Option A: Two Machines in Option 2: One

Sequence Machine
Cash Flow Cash Flow
End of year Total PV at 10% Cash Flows PV at 10%
Machine 1 Machine 2

Now -$80,000  -$80,000 -$80,000 -$120,000 -$120,000

1 -$4,000  -$4,000 -$3,636 -$3,000 -$2,727
2 -$4,000 -$80,000 -$84,000 -$69,422 -$3,000 -$2,479
3   -$4,000 -$4,000 -$3,005 -$3,000 -$2,255
4   -$4,000 -$4,000 -$2,732 -$3,000 -$2,049

Present
value of
    costs   -$158,795   -$129,510

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 Risking Outcomes

• What about risky activities such as oil

exploration?

• Consider a $10MM well cost.

– Success results in 9 years of production
– Failure results in plugging the well.

• How would you do this analysis?

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 Cash Flows
Well Drilling
Year 1 2 3 4 5 6 7 8 9 10
Drill Costs, $MM -10.0

Discount Rate 10%

Discount Factors 1.000 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467 0.424

Success - Find Oil

Plugging Cost, $MM -1.0
Net Production Value, $MM 5.0 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.0
Cash Flows -8.9 5.9 4.8 4.3 3.7 3.1 2.6 2.0 1.5 -0.6
Discounted Cash Flows, $MM -8.9 5.4 4.0 3.2 2.5 1.9 1.4 1.0 0.7 -0.2
Present Value of Success, $MM 11.0

Failure - Dry Hole

Plugging Cost, $MM -1
Cash Flows, $MM -11.0
Present Value of Failure, $MM -11.0

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 What is the Expected Value?

• Present Value of Success is +$11 million

• Present Value of Failure is -$11 million

• How would you calculate the expected value

of the project?

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 Organizational Bias in Financial Analysis

Organizations typically underestimate execution risk.

Big / Complex Fast Track

Revamps / Retrofits New / Different

Company Makers Delays

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 Alternative – Investment Efficiency

• Compares Net Present Value to Money Spent

• Typically considered when capital is restricted
• Useful when stacking multiple projects over broad
organizations
Project 1 Project 2
NPV, $MM $100.00 $ 80.00
Cost, $MM $ 50.00 $ 10.00
Ratio 2.0 8.0

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 Monday – Cost of Capital

• HBR Reading
– “Refresher on Cost of Capital” by Amy Gallo
– “Does the Capital Asset Pricing Model Work?” by
David W. Mullins
– What’s Your Real Cost of Capital” by James J.
McNulty et al.

ChE 597 Lecture 2 58

Questions / Discussion

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