130 Part One Value
bre44380_ch05_105-131.indd 130 09/02/15 04:05 PM
Year
1 2 3 4 5- Revenue 180 180 180 180 180
- Operating costs 70 70 70 70 70
- Depreciationa^80 80 80 80 80
- Net income 30 30 30 30 30
- Start-of-year book valueb 400 320 240 160 80
- Book rate of return (4 ÷ 5) 7.5% 9.4% 12.5% 18.75% 37.5%
❱ TABLE 5.2 Income statement and book rates of return for high-temperature extraction of
hydrated zirconium ($ thousands).
a Straight-line depreciation over five years is 400/5 = 80, or $80,000 per year.
b Capital investment is $400,000 in year 0.down, because depreciation is higher. Income for year 7 goes up because the depreciation for
that year becomes zero. But there is no effect on year-to-year cash flows, because depreciation
is not a cash outlay. It is simply the accountant’s device for spreading out the “recovery” of the
up-front capital outlay over the life of the project.
CFO: So how do we get cash flows?
You: In these cases it’s easy. Depreciation is the only noncash entry in your spreadsheets (Tables
5.1 and 5.2), so we can just leave it out of the calculation. Cash flow equals revenue minus
operating costs. For the high-temperature process, annual cash flow is:
Cash flow = revenue − operating cost = 180 − 70 = 110, or $110,000
CFO: In effect you’re adding back depreciation, because depreciation is a noncash accounting
expense.
You: Right. You could also do it that way:
Cash flow = net income + depreciation = 30 + 80 = 110, or $110,000
CFO: Of course. I remember all this now, but book returns seem important when someone shoves
them in front of your nose.Year
1 2 3 4 5 6 7- Revenue 140 140 140 140 140 140 140
- Operating costs 55 55 55 55 55 55 55
- Depreciationa^57 57 57 57 57 57 57
- Net income 28 28 28 28 28 28 28
- Start-of-year book valueb 400 343 286 229 171 114 57
- Book rate of return (4 ÷ 5) 7% 8.2% 9.8% 12.2% 16.4% 24.6% 49.1%
❱ TABLE 5.1 Income statement and book rates of return for low-temperature extraction of
hydrated zirconium ($ thousands).
a Rounded. Straight-line depreciation over seven years is 400/7 = 57.14, or $57,140 per year.
b Capital investment is $400,000 in year 0.