Lecture no33 process of developing project cash flows

Types of Cash Flow Elements in Project Analysis... Return on Invested CapitalBeginning Balance Return on Investment 27.62% Project Balance The firm earns a 27.62% return on funds that

Process of Developing Project Cash Flows

Lecture No.33

Chapter 10

Contemporary Engineering Economics

Copyright © 2016

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?

Key Elements of Investment Decision

Types of Cash Flow Elements in Project Analysis

Example 10.1: When Projects Require Only Operating and Investing

Activities

 Given: Financial Data

o Investment: $125,000

o Project life: 5 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

Solution

Return on Invested Capital

Beginning

Balance

Return on

Investment

(27.62%)

Project

Balance

The firm earns a 27.62% return on funds that remain internally invested

in the project

When Projects Require Working-Capital Investments

What is Working Capital?

 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

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.

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

o Accounting definition

WC = Current Asset − Current Liabilities

ΔWC = ΔCA − ΔCL

working capital

ΔCA = changes in current

assets

ΔCL = changes in current

liabilities

o If ΔWC > 0, working capital

requirement

o If ΔWC < 0, working capital

release

Example 10.2: Working Capital Requirements

 Given : Elements of Working Capital

 Find : Working capital requirement

Solution

Example 10.3: Cash Flow Statement with Working Capital

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)

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 a tax savings.

Regular Business

Project Combined

Operation

Taxable income Income taxes (35%)

$100M

$35M

(10M)

?

$90M

$31.5M

Tax Savings = $35M − $31.5M = $3.5M

Or (10M)(0.35) = −$3.5M

Tax savings

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: 0

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%

 Find: Develop the project cash flow

Cash Flow Statement

o PW(20%) = $991,008

o i* = 4.24% and 291.56%

o A nonsimple and mixed

investment

o RIC = 241.87% >20%

o Good investment

When Projects Are Financed with Borrowed Funds

expense

• Once a loan repayment schedule is known,

separate the interest payments from the

annual installments.

• 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.

Example 10.4: Loan Repayment Schedule

End of

Year

Beginning Balance

Interest Payment Principal Payment Ending

Balance

o Amount financed: $62,500, or 50% of total capital expenditure

o Financing rate: 10% per year

o Annual installment: $16,487 or, A = $62,500(A/P, 10%, 5)

$16,487

 Effects of debt financing on

profitability

o MARR = 15%, debt interest rate = 10%

o 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%.