Generalized Cash Flow Approach – Lease versus Buy Lecture No 34 Chapter 10 Contemporary Engineering Economics Copyright © 2016 th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Generalized Cash Flow Approach • • When to use: When a project does not change a company’s marginal tax rate Pros: The cash flows can be generated more quickly, and the formatting of results is less elaborate There are also analytical advantages in modeling project cash flows • Cons: The process is less intuitive and not commonly understood by business people th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Setting Up Net Cash Flow Equations th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Presenting Cash Flows in Compact Tabular Forms • Mathematical Form th Contemporary Engineering Economics, edition Park Tabular Presentation Copyright â 2016 by Pearson Education, Inc All Rights Reserved Example 10.7: Using the Generalized Cash Flow Approach Given: Reconsider Example 10.4 o o o o o o o o o o Investment = $125,000 Investment in working capital = $23,333 Project life = years Salvage value = $50,000 Annual revenues = $100,000 Annual expenses other than depreciation = $40,000 Debt interest payment Principal repayment Depreciation = 7-year MACRS Marginal tax rate = 40% Find: project cash flows based on the generalized cash flow approach 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: Lease-or-Buy Decision • Lease option • Buy option o o The proposed lease term: 60 months The proposed lease payment: $4,202 o o o o o o o Your income tax rate: 28% Your sales tax rate: 5% The cost of capital (discount rate): 8% The method of depreciation: 5-year MACRS The cost of equipment: $248,500 You intend to use the equipment for: 60 months When you’re done with the equipment you believe you can sell it for: $49,700 Contemporary Engineering Economics, 6th edition, © 2015 th Contemporary Engineering Economics, edition Park by Pearson Education, Inc Copyright © 2016 All Rights Reserved Lease Option o o o Assumption: Lease payment at beginning of each month Total monthly lease payment = $4,202(1.05) = $4,412.10 Net after-tax monthly lease expense = $4,412.10(1 − 0.28) =$3,176.71 8% 8% PW( )Lease = $4,202(1.05)(1− 0.28) 1+ (P / A, ,59)÷ 12 12 = $3,176.71(49.6472) = $157,715 th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Buy Option o Up-front cash payment: End of Year $248,500(1.05) = $260,925 o o Allowed Depreciation Tax Shield Present Worth at 8% PW(8%)1 = $260,925 20% $52,185 $14,612 $13,530 PW(8%)2 = $53,760 32% 83,496 23,379 20,044 Net proceeds from sale: 19.2% 50,098 14,027 11,135 11.52% 30,059 8,417 6,187 5.76% 15,029 4,208 2,864 Tax depreciation shield: Net salvage = $49,700 − $5,500 o 5-Year MACRS = $44,200 PW(8%)3 = $30,082 Total cost of buying option: PW(8%) = $250,925 − $53,760 − $30,082 = $177,084 Total Sum $230,867 $53,760 Book value at the end of year 5: BV5 = $260,925 − $230,867 = $30,058 Taxable gains: Gains = $49,700 − $30,058 = $19,642 th Contemporary Engineering Economics, edition Park Gains tax = $19,642(0.28)= $5,500 Copyright © 2016 by Pearson Education, Inc All Rights Reserved How Much Would You Save in Present Dollars? o Lease option o PW(8%/12) = $157,715 o Buy option o PW(8%) = $177,084 o Net Savings over buy option o Savings = $19,369 What should you do? Lease th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Summary o Identifying and estimating relevant project cash flows is perhaps the most challenging aspect of engineering economic analysis All cash flows can be organized into one of the following three categories: Operating activities Investing activities Financing activities th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved o Cash Items New investment and disposal of existing assets Salvage value (or net selling price) Working capital Working capital release Cash revenues/savings Manufacturing, operating, and maintenance costs Interest and loan payments Taxes and tax credits th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved Non-cash items Depreciation expenses Amortization expenses The income statement approach is typically used in organizing project cash flows This approach groups cash flows according to whether they are operating, investing, or financing functions The generalized cash flow approach to organizing cash flows can be used when a project does not change a company’s marginal tax rate th Contemporary Engineering Economics, edition Park Copyright © 2016 by Pearson Education, Inc All Rights Reserved ... Reserved Non -cash items Depreciation expenses Amortization expenses The income statement approach is typically used in organizing project cash flows This approach groups cash flows according... repayment Depreciation = 7-year MACRS Marginal tax rate = 40% Find: project cash flows based on the generalized cash flow approach th Contemporary Engineering Economics, edition Park Copyright ©.. .Generalized Cash Flow Approach • • When to use: When a project does not change a company’s marginal tax rate Pros: The cash flows can be generated more quickly,