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Lecture No. 27
Professor C. S. Park
Fundamentals of Engineering Economics
Copyright © 2005
1
Elements of Investment Decision
• Identification of Investment Opportunities
• Generation of Cash Flows
• Measures of Investment Worth
• Project Selection Our focus in this
chapter is to
• Project Implementation develop the format
of after-tax cash
• Project-Control/Post-Audit flow statements.
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Types of Cash Flow Elements in Project
Analysis
Differential or incremental cash flow: cash flow due asset
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Cash Flows from Operating Activities
Approach 1 Approach 2
Income Statement Approach Direct Cash Flow Approach
Operating revenues Operating revenues
Cost of goods sold - Cost of goods sold
Depreciation
Operating expenses - Operating expenses
Interest expenses - Interest expenses
Taxable income
Income taxes - Income taxes
Net income Cash flow from operation
+ Depreciation
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A Typical Format used for Presenting Cash Flow
Statement
Cash flow statement
Operating
+ Net income
activities
+Depreciation
Income statement
Revenues -Capital investment +
Expenses + Proceeds from sales of
Cost of goods sold depreciable assets
Depreciation - Gains tax Investing
Debt interest - Investments in working activities
Operating expenses capital
Taxable income + Working capital recovery +
Income taxes
Net income + Borrowed funds Financing
-Repayment of principal activities
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Example 9.1 When Projects Require only Operating
and Investing Activities
• Project Nature: Installation of a new computer control system
• Financial Data:
– Investment: $125,000
– Project life: 5 years
– Working capital investment: $23,331
– Salvage value: $50,000
– Annual labor savings: $100,000
– Annual additional expenses:
• Labor: $20,000
• Material: $12,000
• Overhead: $8,000
– Depreciation Method: 7-year MACRS
– Income tax rate: 40%
– MARR: 15%
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Questions
• (a) Develop the project’s cash flows over its
project life.
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• (a) Step 1: Depreciation Calculation
– Cost Base = $125,000
– Recovery Period = 7-year MACRS
MACRS Depreciation Allowed
N Rate Amount Depreciation Amount
1 14.29% $17,863 $17,863
2 24.49% $30,613 $30,613
3 17.49% $21,863 $21,863
4 12.49% $15,613 $15,613
5 8.93% $11,150 $5,575
6 8.92% $11,150 0
7 8.93% $11,150 0
8 4.46% $5,575 0
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(a) Step 2: Gains (Losses) associated with
Asset Disposal
• Salvage value = $50,000
• Book Value (year 5) = Cost Base – Total Depreciation
= $125,000 - $ 91,525
= $ 33,475
• Taxable gains = Salvage Value – Book Value
= $50,000 - $ 33,475
= $16,525
• Gains taxes = (Taxable Gains)(Tax Rate)
= $16,525 (0.40)
= $6,610
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Step 3 – Create an Income Statement
Income 0 1 2 3 4 5
Statement
Revenues $100,00 $100,00 $100,00 $100,00 $100,00
0 0 0 0 0
Expenses:
Labor 20,000 20,000 20,000 20,000 20,000
Material 12,000 12,000 12,000 12,000 12,000
Overhead 8,000 8,000 8,000 8,000 8,000
Depreciation 17,863 30,613 21,863 15,613 5,581
Taxable Income $42,137 $29,387 $38,137 $44,387 $54,419
Income Taxes (40%) 16,855 11,755 15,255 17,755 21,768
Net Income $25,282 $17,632 $22,882 $26,632 $32,651
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Step 4 – Develop a Cash Flow Statement
Cash Flow Statement 0 1 2 3 4 5
Operating Activities:
Investment Activities:
Investment (125,000)
Salvage 50,000
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An Excel Worksheet
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Example 9.1 - Net Cash Flow Table Generated by
Traditional Method Using Approach 2
A B C D E F G H I J
Year Investment & Revenue Labor Expenses Overhead Depreciation Taxable Income Net Cash
End Salvage Value Materials Income Taxes Flow
0 -$125,000 -$125,000
-23,331
1 $100,000 20,000 12,000 8,000 $17,863 42,137 16,855 $43,145
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Cash Flow Diagram including Working Capital
$23,331 Working capital
recovery
$48,245 $44,745 $81,619
$43,145 $42,245
1 2 3 4 5
0
$125,000 Investment in
physical assets $23,331 $23,331
$23,331 Investment in
working capital
0 1 2 3 4 5
$23,331 Years
$23,331
Working capital recovery cycles
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Question (b):
Is this investment justifiable
at a MARR of 15%?
$104,950
$148,331
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Question (C): IRR
A B
1 Period Cash Flow
2 0 ($148,331)
=IRR(B2:B7,0.10)
3 1 43,145
4 2 48,245
5 3 44,745 IRR = 22.55%
6 4 42,245
7 5 104,950
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Rate of Return Analysis (IRR = 22.55%)
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When Projects are Financed with Borrowed
Funds
Key issue: Interest What about Principal
payment is a tax- Payments? As the
deductible expense. amount of borrowing is
What Needs to Be NOT viewed as income
Done: Once a loan to the borrower, the
repayment schedule is repayments of principal
known, separate the
interest payments from are NOT viewed as
the annual installments. expenses either– NO
tax effect.
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Loan Repayment Schedule (Example 9.2)
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)
$16,487
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Table 9.4
Additional
entries related
to debt financing
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When Projects Results in Negative Taxable
Income
Negative taxable Handling Project Loss
income (project loss)
means you can
reduce your taxable Regular Project Combined
income from regular Business Operation
business operation Taxable $100M (10M) $90M
by the amount of income
loss, which results in Income $35M ? $31.5M
a tax savings. taxes
(35%) Tax savings
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Effects of Inflation on Project Cash Flows
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Item Effects of Inflation
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Item Effects of Inflation
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Item Effects of Inflation
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Item Effects of Inflation
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A B C D E F G H
1 Example 9.3 Cash Flow Statement for the Automated Machining Center Project
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8 Income Statement
9 Inflation Rate 0 1 2 3 4 5
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12 Revenues 5% $ 105,000 $ 110,250 $ 115,763 $ 121,551 $ 127,628
13 Expenses:
14 Labor 5% 21,000 22,050 23,153 24,310 25,526
15 Material 5% 12,600 13,230 13,892 14,586 15,315
16 Overhead 5% 8,400 8,820 9,261 9,724 10,210
17 Depreciation 17,863 30,613 21,863 15,613 5,581
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19 Taxable Income $ 45,137 $ 35,537 $ 47,595 $ 57,317 $ 70,996
20 Income Taxes (40%) 18,055 14,215 19,038 22,927 28,398
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22 Net Income $ 27,082 $ 21,322 $ 28,557 $ 34,390 $ 42,598
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24 Cash Flow Statement
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26 Operating Activities:
27 Net Income 27,082 21,322 28,557 34,390 42,598
28 Depreciation 17,863 30,613 21,863 15,613 5,581
29 Investment Activities:
30 Investment (125,000)
31 Salvage 5% 63,814
32 Gains Tax (12,139)
33 Working Capital 5% (23,331) (1,167) (1,225) (1,287) (1,351) 28,361
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35 Net Cash Flow $ (148,331) $ 43,778 $ 50,710 $ 49,133 $ 48,652 $ 128,215
36 (in actual dollars)
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Example 9.4 Applying Specific Inflation Rates
Example 9.4 Cash Flow Statement for AMC Project under Inflation (Multiple Price Indices)
Income Statement
Inflation Rate 0 1 2 3 4 5
Operating Activities:
Net Income 27,754 22,739 30,796 37,537 46,744
Depreciation 17,863 30,613 21,863 15,613 5,581
Investment Activities:
Investment (125,000)
Salvage 3% 57,964
Gains Tax (9,799)
Working Capital 5% (23,331) (1,167) (1,225) (1,287) (1,351) 28,361
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Rate of Return Analysis under Inflation
_
f 10%
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Decision Criterion
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Input Output
Tax Rate(%) = 40 PW(i) = $37,761
MARR(%) = 15 IRR(%) = 33.74%
0 1 2 3 4 5 6
Income Statement
Net Cash Flow ($68,701) $27,195 $29,998 $28,074 $26,700 $25,722 $31,499
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