Process of Developing Project Cash Flows Lecture No.33 Chapter 10 Contemporary Engineering Economics Copyright © 2016 th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Chapter Opening Story Eclipse has spent $1.4 billion to develop its six-seat 550 twin engine jet o Base price: $2,895,000 o Fuel efficiency: 59 gallons per hour o Flying range: 430 miles o Operating cost: $648 per hour o Demand: unknown At Issue: How would you determine the cash flows from this jet investment? th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Key Elements of Investment Decision th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Types of Cash Flow Elements in Project Analysis th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Example 10.1: When Projects Require Only Operating and Investing Activities Given: Financial Data o Investment: $125,000 o Project life: years o Salvage value: $50,000 o Annual labor savings: $100,000 o Annual manufacturing costs o Labor: $20,000 o Materials:$12,000 o Overhead:$8,000 o Depreciation method: 7-year MACRS o Income tax rate: 40% o MARR: 15% Find: Determine the project cash flows th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Solution th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Return on Invested Capital The firm earns a 27.62% return on funds that remain internally invested in the project n=0 Beginning n =1 n=2 n=3 n=4 n=5 −$125,000 −$116,380 −$100,279 −$83,231 −$63,974 −$34,525 −$32,144 −$27,697 −$22,988 −$17,670 $81,619 Balance Return on Investment (27.62%) Payment −$125,000 $43,145 $48,245 $44,745 $42,245 Project −$125,000 −$116,380 −$100,279 −$83,231 −$63,974 Balance th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved ≈0 When Projects Require Working-Capital Investments What is Working Capital? Working Capital Equations Accounting definition: The amount carried in cash, accounts receivable, and inventory that is available to meet day-to-day operating needs WC = Current Asset – Current Liabilities ∆WC = ∆CA - ∆CL where ∆WC = changes in working capital How to treat working capital investments: ∆CA = changes in current assets just like a capital expenditure except that ∆CL = changes in current liabilities no depreciation is allowed If ∆WC > 0, working capital requirement With the net change being positive, the firm has a net requirement of working capital that has to be financed during the year Therefore, the WC requirement appears as uses of cash in the cash flow statement If ∆WC < 0, working capital release If this amount were negative, there would have been a cash inflow from working capital release, which could add to the sources of cash th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved When Projects Require Working-Capital Investments What is working capital? Definition: The amount carried in cash, accounts receivable, and inventory that is available to meet day-to-day operating needs How to treat working capital investments Just like a capital expenditure except that no depreciation is allowed Working Capital Equations oAccounting definition WC = Current Asset − Current Liabilities ΔWC = ΔCA − ΔCL where ΔWC = changes in working capital ΔCA = changes in current assets ΔCL = changes in current liabilities oIf ΔWC > 0, working capital requirement oIf ΔWC < 0, working capital release th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Example 10.2: Working Capital Requirements Given: Elements of Working Capital Find: Working capital requirement th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Solution th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Example 10.3: Cash Flow Statement with Working Capital th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Changes in Profitability Changes in Profitability o NPW without the Working Capital Requirement PW(15%) = $43,152 o NPW with the Working Capital Requirement PW(15%) = $31,420 Difference: $11,732 (lost earnings due to funds tied up in working capital) th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved When Projects Results in Negative Taxable Income Negative taxable income (project Regular loss) means you can reduce your Project Business Combined Operation taxable income from regular business operation by the amount of loss, which results in a tax savings Taxable $100M (10M) $90M $35M ? $31.5M income Income taxes (35%) Tax savings Tax Savings = $35M − $31.5M = $3.5M Or (10M)(0.35) = −$3.5M th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Example 10.5: Project Cash Flows for a Cost-Only Project Project Nature: Installing a cooling-fan at Alcoa Aluminum’s McCook plant to reduce the work-in-process inventory buildup Given: Financial facts o Required investment: $536,000 o Service life: 16 years o Salvage value: o Reduction of WIP (working-capital release): $2,121,000 o Depreciation Method: 7-year MACRS o Annual electricity cost: $86,000 o Income tax rate:40% o MARR: 20% Find: Develop the project cash flow th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Cash Flow Statement th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Analysis o o o PW(20%) = $991,008 o o RIC = 241.87% >20% i* = 4.24% and 291.56% A nonsimple and mixed investment Good investment th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved When Projects Are Financed with Borrowed Funds • Key issue: Interest payment is a tax-deductible • What about principal payments? • As the amount of borrowing is NOT viewed as expense • What needs to be done • Once a loan repayment schedule is known, separate the interest payments from the income to the borrower, the repayments of principal are NOT viewed as expenses either— NO tax effect annual installments th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Example 10.4: Loan Repayment Schedule o o o Amount financed: $62,500, or 50% of total capital expenditure Financing rate: 10% per year Annual installment: $16,487 or, A = $62,500(A/P, 10%, 5) End of Beginning Year Balance Interest Payment Principal Payment Ending Balance $62,500 $6,250 $10,237 $52,263 52,263 5,226 11,261 41,002 41,002 4,100 12,387 28,615 28,615 2,861 13,626 14,989 14,989 1,499 14,988 $16,487 th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Solution Effects of debt financing on profitability o o MARR = 15%, debt interest rate = 10% NPW without debt financing (100% equity) PW(15%) = $31,420 o NPW with debt financing (50% debt) PW(15%) = $44,439 o The debt financing increases the present worth by $13,019 This result is largely caused by the firm’s being able to borrow the funds at a cheaper rate (10%) than its MARR of 15% th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved ... Rights Reserved Example 10.5: Project Cash Flows for a Cost-Only Project Project Nature: Installing a cooling-fan at Alcoa Aluminum’s McCook plant to reduce the work-in -process inventory buildup... positive, the firm has a net requirement of working capital that has to be financed during the year Therefore, the WC requirement appears as uses of cash in the cash flow statement If ∆WC < 0, working... Reserved Types of Cash Flow Elements in Project Analysis th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Example 10.1: When Projects