lecture no.33 chapter 10 contemporary engineering economics copyright © 2010 contemporary...

Lecture No.33Chapter 10

Contemporary Engineering EconomicsCopyright © 2010

Contemporary Engineering Economics, 5th edition, © 2010

Chapter Opening Story Intel to invest $7B on factory upgrades: Transition to new manufacturing 32-nanometers technology at factories in Oregon, Arizona and New Mexico. At Issue: How would you determine the cash flows from these factory upgrades?


Types of Cash Flow Elements in Project Analysis


Example 10.1 – When Projects Require Only Operating and Investing Activities

Project nature: An Expansion ProjectFinancial Data:

Investment: $125,000Project life: 5 yearsSalvage value: $50,000Annual labor savings: $100,000Annual manufacturing costs:

Labor: $20,000Materials:$12,000Overhead:$8,000

Depreciation method: 7-year MACRSIncome tax rate: 40%MARR: 15%

What’s Required: Determine the project cash flows



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

Payment -$125,000 $43,145 $48,245 $44,745 $42,245 $81,619

Project Balance

-$125,000 -$116,380 -$100,279 -$83,231 -$63,974 ≈0

The firm earns a 27.62% return on funds that remain internally investedin the project.

When Projects Require Working-Capital Investments

What is Working Capital?Working Capital Equations

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.


Example 10.2 Working Capital Requirements

Elements of Working Capital: Illustration of Working Capital Requirement


Price (revenue) per unit $10

Unit variable manufacturing costs:LaborMaterialOverhead

$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

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)


When Projects Results in Negative Taxable Income

Handling Project Loss


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.

Regular Business

Project Combined Operation

Taxable incomeIncome taxes (35%)

$100M

$35M

(10M)

?

$90M

$31.5M

Tax Savings = $35M - $31.5M = $3.5MOr (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

Financial Facts:Required investment: $536,000Service life: 16 yearsSalvage value: 0Reduction of WIP (working-capital release): $2,121,000 Depreciation Method: 7-year MACRSAnnual electricity cost: $86,000Income tax rate:40%MARR: 20%

Develop the project cash flow

PW(20%) = $991,008 i* = 4.24% and 291.56% A nonsimple and mixed investment RIC = 241.87% >20% Good investment!



When Projects are Financed with Borrowed FundsKey issue: Interest

payment is a tax-deductible 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.


End of Year

BeginningBalance

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

Amount financed: $62,500, or 50% of total capital expenditureFinancing rate: 10% per yearAnnual installment: $16,487 or, A = $62,500(A/P, 10%, 5)

$16,487

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%) = $44,439The 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%.


lecture no.33 chapter 10 contemporary engineering economics copyright © 2010 contemporary...

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