Accounting Break Even and Cash Flow

(S - VC - FC - D) + D - 0 85 X ($40,000 - 20,000) - 500,000 $1,200,000 per year

Ross et al.: Fundamentals I IV. Capital Budgeting I 11. Project Analysis and I I © The McGraw-Hill of Corporate Finance, Sixth Evaluation Companies, 2002

Edition, Alternate Edition

364 PART FOUR Capital Budgeting per year to break even on an accounting basis. This is 25 boats less than projected sales; so, assuming that Wettway is confident its projection is accurate to within, say, 15 boats, it appears unlikely that the new investment will fail to at least break even on an accounting basis.

To calculate Wettway's cash flow in this case, we note that if 60 boats are sold, net income will be exactly zero. Recalling from the previous chapter that operating cash flow for a project can be written as net income plus depreciation (the bottom-up definition), we can see that the operating cash flow is equal to the depreciation, or $700,000 in this case. The internal rate of return is exactly zero (why?).

Payback and Break-Even As our example illustrates, whenever a project breaks even on an accounting basis, the cash flow for that period will be equal to the depreciation. This result makes perfect accounting sense. For example, suppose we invest $100,000 in a five-year project. The depreciation is straight-line to a zero salvage, or $20,000 per year. If the project exactly breaks even every period, then the cash flow will be $20,000 per period.

The sum of the cash flows for the life of this project is 5 X $20,000 = $100,000, the original investment. What this shows is that a project's payback period is exactly equal to its life if the project breaks even every period. Similarly, a project that does better than break even has a payback that is shorter than the life of the project and has a positive rate of return.

The bad news is that a project that just breaks even on an accounting basis has a negative NPV and a zero return. For our sailboat project, the fact that Wettway will almost surely break even on an accounting basis is partially comforting because it means that the firm's "downside" risk (its potential loss) is limited, but we still don't know if the project is truly profitable. More work is needed.

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