Lecture no34 generalized cash flow approach

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Generalized Cash Flow Approach – Lease versus Buy

Lecture No 34

Chapter 10

Contemporary Engineering Economics

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Generalized Cash Flow Approach

results is less elaborate There are also analytical advantages in modeling project cash flows.

people.

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Setting Up Net Cash Flow Equations

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Presenting Cash Flows in Compact Tabular Forms

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Example 10.7: Using the Generalized Cash Flow Approach

o Investment = $125,000

o Investment in working capital = $23,333

o Project life = 5 years

o Salvage value = $50,000

o Annual revenues = $100,000

o Annual expenses other than depreciation = $40,000

o Debt interest payment

o Principal repayment

o Depreciation = 7-year MACRS

o Marginal tax rate = 40%

 Find: project cash flows based on the generalized cash flow approach.

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Solution

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Example: Lease-or-Buy Decision

• Lease option

o The proposed lease term: 60 months

o The proposed lease payment: $4,202

• Buy option

o Your income tax rate: 28%

o Your sales tax rate: 5%

o The cost of capital (discount rate): 8%

o The method of depreciation: 5-year MACRS

o The cost of equipment: $248,500

o You intend to use the equipment for: 60 months

o When you’re done with the equipment you believe you can sell it for: $49,700

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Lease Option

PW( 8%

12 )Lease = $4,202(1.05)(1 − 0.28) 1 + (P/ A, 8%

12 ,59)







÷

= $3,176.71(49.6472)

= $157,715

o Assumption: Lease payment at beginning of each month

o Total monthly lease payment = $4,202(1.05) = $4,412.10

o Net after-tax monthly lease expense = $4,412.10(1 − 0.28) =$3,176.71

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Buy Option

o Up-front cash payment:

$248,500(1.05) = $260,925

PW(8%)1 = $260,925

o Tax depreciation shield:

PW(8%)2 = $53,760

o Net proceeds from sale:

Net salvage = $49,700 − $5,500 = $44,200

PW(8%)3 = $30,082

o Total cost of buying option:

PW(8%) = $250,925 − $53,760 − $30,082 = $177,084

End of Year 5-Year MACRS Allowed Depreciation Tax Shield Present Worth

at 8%

1 20% $52,185 $14,612 $13,530

2 32% 83,496 23,379 20,044

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 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

 Gains tax = $19,642(0.28)= $5,500

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How Much Would You Save in Present Dollars?

o Lease option

oPW(8%/12) = $157,715

o Buy option

oPW(8%) = $177,084

o Net Savings over buy option

oSavings = $19,369

What should you do? Lease.

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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:

1 Operating activities

2 Investing activities

3 Financing activities

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o 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

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 Non-cash items

1 Depreciation expenses

2 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.

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