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