Process of Developing Project Cash Flows
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
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