Transcript Generalized Cash Flow Approach – Lease versus Buy

Generalized Cash Flow
Approach – Lease versus Buy
Lecture No. 42
Chapter 10
Contemporary Engineering Economics
Copyright © 2006
Contemporary Engineering Economics, 4th
edition, © 2007
Generalized Cash Flow Approach
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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 the
results is less elaborate. There are also
analytical advantage in modeling project
cash flows.
Cons: The process is less intuitive and not
commonly understood by business people.
Contemporary Engineering Economics, 4th
edition, © 2007
Setting Up Net Cash Flow Equations
Contemporary Engineering Economics, 4th
edition, © 2007
Presenting Cash Flows in Compact
Tabular Forms
Mathematical Form
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Cash Flow Statement for Example 10.4 Using
the generalized Cash Flow Approach
Investing
activities
Operating
activities
Financing
activities
Contemporary Engineering Economics, 4th
edition, © 2007
Example 10.8 Lease-or-Buy Decision
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Lease Option:
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The proposed lease term: 60 months
The proposed lease payment: $4,202
Buy Option:
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Your income tax rate: 28%
Your sales tax rate: 5%
The cost of capital: 8%
The method of depreciation: 5year 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, 4th
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Lease Option
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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
PW (
8%
8%


)Lease  $4, 202(1.05)(1  0.28) 1  ( P / A,
,59) 
12
12


 $3,176.71(49.6472)
 $157, 715
Contemporary Engineering Economics, 4th
edition, © 2007
Buy Option
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Up-front cash payment:
$248,500(1.05) = $260,925
Tax
Shield
Present
Worth at
8%
$52,185
$14,612
$13,530
Tax depreciation shield:
2
32%
83,496
23,379
20,044
PW(8%)2 = $53,760
3
19.2%
50,098
14,027
11,135
4
11.52%
30,059
8,417
6,187
5
5.76%
15,029
4,208
2,864
PW(8%)1 = $260,925
Net proceeds from sale:
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Allowed
Depreciation
20%
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5-Year
MACRS
1
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End
of
Year
Net salvage = $49,700 - $5,500
= $44,200
PW(8%)3 = $30,082
Total cost of Buying Option:
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Total
Sum
PW(8%) = $250,925 - $53,760 - $30,082
= $177,084
$230,867
Book value at the end of year 5:
BV5 = $260,925 - $230,867
= $30,058
Taxable gains:
Gains = $49,700 - $30,058
= $19,642
Gains tax = $19,642(0.28)
= $5,500
Contemporary Engineering Economics, 4th
edition, © 2007
$53,760
How Much Would You Save in Present
Dollars?
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Lease Option:
PW(8%/12) = $157,715
Buy Option:
PW(8%) = $177,084
Net Savings over Buy Option:
Savings = $19,369
What should you do? Lease
Contemporary Engineering Economics, 4th
edition, © 2007
Summary
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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:
1. Operating activities.
2. Investing activities
3. Financing activities.
Contemporary Engineering Economics, 4th
edition, © 2007
•Cash Items
1. New investment and disposal of existing assets
2. Salvage value (or net selling price)
3. Working capital
4. Working capital release
5. Cash revenues/savings
6. Manufacturing, operating, and maintenance costs.
7. Interest and loan payments
8. Taxes and tax credits
Contemporary Engineering Economics, 4th
edition, © 2007

Non-cash items
1. Depreciation expenses
2. Amortization expenses
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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.
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The generalized cash flow approach to organizing cash flows
can be used when a project does not change a company’s
marginal tax rate. The cash flows can be generated more
quickly and the formatting of the results is less elaborate than
with the income statement approach. However, the
generalized approach is less intuitive and not commonly
understood by business people.
Contemporary Engineering Economics, 4th
edition, © 2007