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Chapter 12 Developing Project Cash Flows

Chapter 12 Developing Project Cash Flows. Estimating Cost/Benefit for Engineering Projects Incremental Cash Flows Developing Cash Flow Statements Generalized Cash Flow Approach. Engineering Economic Decisions. Evaluation of a Fixed Asset Equipment Buildings Valuation of Fixed Assets

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Chapter 12 Developing Project Cash Flows

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  1. Chapter 12Developing Project Cash Flows • Estimating Cost/Benefit for Engineering Projects • Incremental Cash Flows • Developing Cash Flow Statements • Generalized Cash Flow Approach (c) 2001 Contemporary Engineering Economics

  2. Engineering Economic Decisions • Evaluation of a Fixed Asset • Equipment • Buildings • Valuation of Fixed Assets • Based on usable after-tax cash flows the asset produces (c) 2001 Contemporary Engineering Economics

  3. Elements of Investment Decision • Identification of Investment Opportunities • Generation of Cash Flows • Measures of Investment Worth • Project Selection • Project Implementation • Project-Control/Post-Audit Our focus in this chapter is to develop the format of after-tax cash flow statements. (c) 2001 Contemporary Engineering Economics

  4. Classification of Investment Projects Expansion project Profit-adding project Product Improvement project Cost Improvement project Project Profit-maintaining project Replacement Project Necessity project (c) 2001 Contemporary Engineering Economics

  5. Types of Cash Flow Elements in Project Analysis (c) 2001 Contemporary Engineering Economics

  6. Cash Flows from Operating Activities (c) 2001 Contemporary Engineering Economics

  7. (c) 2001 Contemporary Engineering Economics

  8. A Typical Format used for Presenting Cash Flow Statement • Cash flow statement • + Net income • +Depreciation • Capital investment • + Proceeds from sales of • depreciable assets • Gains tax • Investments in working • capital • + Working capital recovery • + Borrowed funds • Repayment of principal • Net cash flow Operating activities Income statement Revenues Expenses Cost of goods sold Depreciation Debt interest Operating expenses Taxable income Income taxes Net income + Investing activities + Financing activities (c) 2001 Contemporary Engineering Economics

  9. Example 12.1 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 • 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% (c) 2001 Contemporary Engineering Economics

  10. Questions • (a) Develop the project’s cash flows over its project life. • (b) Is this project justifiable at a MARR of 15%? • (c) What is the internal rate of return of this project? (c) 2001 Contemporary Engineering Economics

  11. (a) Step 1: Depreciation Calculation • Cost Base = $125,000 • Recovery Period = 7-year MACRS With half-year convention (c) 2001 Contemporary Engineering Economics

  12. (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 (c) 2001 Contemporary Engineering Economics

  13. Example 12.1 - Income Statement (c) 2001 Contemporary Engineering Economics

  14. Example 12.1- Cash Flow Statement (c) 2001 Contemporary Engineering Economics

  15. Example 12.1 - Net Cash Flow Table Generated by Traditional Method Using Approach 2 Note that H = C-D-E-F-G I = 0.4 * H J= B+C-D-E-F-I Information required to calculate the income taxes *Salvage value (c) 2001 Contemporary Engineering Economics

  16. Question (b): • Is this investment justifiable at a MARR of 15%? • PW(15%) = -$125,000 + +$43,145(P/F, 15%, 1) + . . . . + $81,620 (P/F, 15%, 5) = $43,151 > 0 • Yes, Accept the Project ! $81,619 $48,245 $44,745 $42,245 $43,145 0 1 2 3 4 5 Years $125,000 (c) 2001 Contemporary Engineering Economics

  17. Question (C): • Determine the IRR for this investment project. • At i = 25% • PW(25%) = $7,351 • At i = 30% • PW (30%) = -$6,124 • IRR = 27.61% > 15%, accept the project. (c) 2001 Contemporary Engineering Economics

  18. Rate of Return Analysis (IRR = 27.61%) (c) 2001 Contemporary Engineering Economics

  19. When Projects Require Working Capital Investments • 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. (c) 2001 Contemporary Engineering Economics

  20. Working Capital Requirements (Example 12.2) (c) 2001 Contemporary Engineering Economics

  21. Required Working Capital Investments During year 1 This differential amount must be invested at the beginning of the year (c) 2001 Contemporary Engineering Economics

  22. Table 12.4 Item related to working capital investment (c) 2001 Contemporary Engineering Economics

  23. Cash Flow Diagram including Working Capital $23,331 Working capital recovery $44,745 $81,619 $48,245 $43,145 $42,245 1 2 3 4 5 0 $125,000 Investment in physical assets $23,331 Investment in working capital $23,331 5 1 2 3 4 0 Years $23,331 Working capital recovery cycles (c) 2001 Contemporary Engineering Economics

  24. Key issue: Interest payment is a tax-deductible expense. What Needs to Be Done: Once loan repayment schedule is known, separate interest payment from the annual installment. What about Principal Payment? As the amount of borrowing is NOT viewed as income to the borrower, the repayment of principal is NOT viewed as expenses either– NO tax effect. When Projects are Financed with Borrowed Funds (c) 2001 Contemporary Engineering Economics

  25. Loan Repayment Schedule (Example 12.4) 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) $16,487 (c) 2001 Contemporary Engineering Economics

  26. Table 12.5 Items related to financing activities (c) 2001 Contemporary Engineering Economics

  27. Negative taxable income (project loss) means you can reduce your taxable income from regular business operation by the amount of loss, which results in a tax savings. Handling Project Loss When Projects Results in Negative Taxable Income Tax savings Tax Savings = $35M - $31.5M = $3.5M Or (10M)(0.35) = -$3.5M (c) 2001 Contemporary Engineering Economics

  28. Generalized Cash Flow Approach • When to Use: When undertaking a project does not change a company’s marginal tax rate. • Pros: The cash flows can be generated more quickly. • Cons: The process is less intuitive and not commonly understood by business people. (c) 2001 Contemporary Engineering Economics

  29. Table 12.8 Investing activities Operating activities Financing activities (c) 2001 Contemporary Engineering Economics

  30. Summary • 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. (c) 2001 Contemporary Engineering Economics

  31. 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 (c) 2001 Contemporary Engineering Economics

  32. 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. The cash flows can be generated more quickly and the formatting of the results is less elaborate than with the income statement approach. However, the generalized approach is less intuitive and not commonly understood by business people. (c) 2001 Contemporary Engineering Economics

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