Contemporary Engineering Economics, 4 th edition, © 2007 When Projects Require Working-Capital Investments Lecture No. 40 Chapter 10 Contemporary Engineering Economics Copyright © 2006

Contemporary Engineering Economics, 4 th edition, © 2007 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. What is Working Capital?

Contemporary Engineering Economics, 4 th edition, © 2007 Working Capital Equations 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, 4 th edition, © 2007 Price (revenue) per unit$10 Unit variable manufacturing costs: Labor Material Overhead $2 $1.20 $0.80 Monthly volume833 units Finished goods inventory to maintain2 – month supply Raw materials inventory to maintain1 – month supply Accounts payable30 days Accounts receivable60 days Example 10.2 Working Capital Requirements

Contemporary Engineering Economics, 4 th edition, © 2007 Required Working Capital Investments

Contemporary Engineering Economics, 4 th edition, © 2007 New entry related to working capital investment Cash Flow Statement with Working-Capital Requirement (Example 10.3)

Contemporary Engineering Economics, 4 th edition, © $23,331 Years $23,331 Working capital recovery cycles $43,145 $48,245 $44,745 $42,245 $81,619 Working capital recovery $23,331 $125,000 Investment in physical assets $23,331 Investment in working capital $23,331 Cash Flow Diagram including Working Capital

Contemporary Engineering Economics, 4 th edition, © 2007 Changes in Profitability NPW without the Working Capital Requirement  PW(15%) = $43,152 NPW with the Working Capital Requirement in the amount of $23,331  PW(15%) = $31,420 The $11,732 reduction in present worth is from the investment tied up in working capital that results in lost earnings.

Contemporary Engineering Economics, 4 th edition, © 2007 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 a tax savings. Handling Project Loss Regular Business ProjectCombined Operation Taxable income Income taxes (35%) $100M $35M (10M) ? $90M $31.5M Tax Savings = $35M - $31.5M = $3.5M Or (10M)(0.35) = -$3.5M Tax savings

Contemporary Engineering Economics, 4 th edition, © 2007 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% Develop the project cash flow

Contemporary Engineering Economics, 4 th edition, © 2007 Cash Flow Statement (Table 10.5)

Contemporary Engineering Economics, 4 th edition, © 2007 Measures of Investment Worth for the Cooling-Fan Project MARR = 20% PW(20%) = $991,008 i* = 4.24% and % A nonsimple and mixed investment RIC = % >20% Good investment!