Process of Developing Project Cash Flows
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Transcript Process of Developing Project Cash Flows
Lecture No.33
Chapter 10
Contemporary Engineering Economics
Copyright © 2010
Contemporary Engineering Economics, 5th edition, © 2010
Chapter
Opening Story
Intel to invest $7B on
factory upgrades:
Transition to new
manufacturing 32nanometers technology
at factories in Oregon,
Arizona and New
Mexico.
At Issue: How would
you determine the cash
flows from these factory
upgrades?
Contemporary Engineering Economics, 5th edition, © 2010
Key Elements of Investment
Decision
Step 1
• Identify investment opportunities
Step 2
• Estimate project cash flows
Step 3
• Measure the investment worth
Step 4
• Select the best project
Step 5
• Implement the project
Contemporary Engineering Economics, 5th edition, © 2010
Step 6
• Post-audit the project
Contemporary Engineering Economics, 5th edition, © 2010
Types of Cash Flow Elements in Project
Analysis
Contemporary Engineering Economics, 5th edition, © 2010
Example 10.1 – When Projects Require Only Operating and
Investing Activities
Project nature: An Expansion
Project
Financial Data:
Investment: $125,000
Project life: 5 years
Salvage value: $50,000
Annual labor savings:
$100,000
Annual manufacturing
costs:
Labor: $20,000
Materials:$12,000
Overhead:$8,000
Depreciation method:
7-year MACRS
Income tax rate: 40%
MARR: 15%
What’s Required: Determine
the project cash flows
Contemporary Engineering Economics, 5th edition, © 2010
Return on Invested Capital
The firm earns a 27.62% return on funds that remain internally invested
in the project.
n=0
n =1
n=2
n=3
n=4
n=5
Beginning
Balance
-$125,000
-$116,380
-$100,279
-$83,231
-$63,974
Return on
Investment
(27.62%)
-$34,525
-$32,144
-$27,697
-$22,988
-$17,670
$81,619
Payment
-$125,000
$43,145
$48,245
$44,745
$42,245
Project
Balance
-$125,000
-$116,380
-$100,279
-$83,231
-$63,974
Contemporary Engineering Economics, 5th edition, © 2010
≈0
When Projects Require Working-Capital
Investments
Working Capital Equations
What is Working Capital?
Working capital means 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.
Accounting definition:
WC = Current Asset – Current Liabilities
WC = CA - CL
where WC = changes in working
capital
CA = changes in current assets
CL = changes in current liabilities
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.
Contemporary Engineering Economics, 5th edition, © 2010
Example 10.2 Working Capital Requirements
Elements of Working Capital:
Illustration of Working Capital
Requirement
Price (revenue) per unit
$10
Unit variable manufacturing costs:
Labor
Material
Overhead
$2
$1.20
$0.80
Monthly volume
833 units
Finished goods inventory to maintain
2 – month supply
Raw materials inventory to maintain
1 – month supply
Accounts payable
30 days
Accounts receivable
60 days
Contemporary Engineering Economics, 5th edition, © 2010
Example 10.3 – Cash Flow Statement with Working Capital
Changes in Profitability
NPW without the Working
Capital Requirement
PW(15%) = $43,152
NPW with the Working Capital
Requirement
PW(15%) = $31,420
Difference: $11,732 (lost earnings due
to funds tied up in working capital)
$23,331
$43,145
0
1
$48,245 $44,745
2
3
$125,000 Investment in
physical assets
$23,331 Investment in
working capital
Working capital
recovery
$81,619
$42,245
4
5
$23,331
$23,331
0
$23,331
1
$23,331
2
3
4
5
Years
Working capital recovery cycles
Contemporary Engineering Economics, 5th edition, © 2010
When Projects Results in Negative Taxable Income
Negative taxable
income (project
loss) means you
can reduce your
taxable income
from regular
business operation
by the amount of
loss, which results
in tax savings.
Handling Project Loss
Taxable
income
Income
taxes
(35%)
Regular
Business
Project
Combined
Operation
$100M
(10M)
$90M
$35M
?
$31.5M
Tax savings
Tax Savings = $35M - $31.5M
= $3.5M
Or (10M)(0.35) = -$3.5M
Contemporary Engineering Economics, 5th edition, © 2010
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
Financial Facts:
Required investment:
$536,000
Service life: 16 years
Salvage value: 0
Reduction of WIP
(working-capital release):
$2,121,000
Depreciation Method:
7-year MACRS
Annual electricity cost:
$86,000
Income tax rate:40%
MARR: 20%
PW(20%) = $991,008
i* = 4.24% and 291.56%
A nonsimple and mixed investment
RIC = 241.87% >20%
Good investment!
Develop the project cash flow
Contemporary Engineering Economics, 5th edition, © 2010
Cash Flow Statement (Table 10.7)
Contemporary Engineering Economics, 5th edition, © 2010
When Projects are Financed with Borrowed
Funds
Key issue: Interest
payment is a taxdeductible expense.
What Needs to Be Done:
Once a loan repayment
schedule is known,
separate the interest
payments from the
annual installments.
What about Principal
Payments? As the
amount of borrowing is
NOT viewed as income to
the borrower, the
repayments of principal
are NOT viewed as
expenses either – NO tax
effect.
Contemporary Engineering Economics, 5th edition, © 2010
Loan Repayment Schedule (Example 10.4)
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
Year
Beginning
Balance
Interest
Payment
Principal
Payment
Ending
Balance
1
$62,500
$6,250
$10,237
$52,263
2
52,263
5,226
11,261
41,002
3
41,002
4,100
12,387
28,615
4
28,615
2,861
13,626
14,989
5
14,989
1,499
14,988
0
$16,487
Contemporary Engineering Economics, 5th edition, © 2010
Example 10.4 -Cash Flow Statement with Debt
Financing
Effects of Debt Financing
on Profitability
MARR = 15%, debt interest rate =
10%
NPW without debt financing
(100% equity)
PW(15%) = $31,420
NPW with debt financing (50%
debt)
PW(15%) = $44,439
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%.
Contemporary Engineering Economics, 5th edition, © 2010