Contemporary Engineering Economics, 4 th edition, © 2007 Generalized Cash Flow Approach – Lease versus Buy Lecture No. 42 Chapter 10 Contemporary Engineering Economics Copyright © 2006

Contemporary Engineering Economics, 4 th edition, © 2007 Generalized Cash Flow Approach When to Use: When a project does not change a company’s marginal tax rate. Pros: The cash flows can be generated more quickly, and the formatting of the results is less elaborate. There are also analytical advantage in modeling project cash flows. Cons: The process is less intuitive and not commonly understood by business people.

Contemporary Engineering Economics, 4 th edition, © 2007 Setting Up Net Cash Flow Equations

Contemporary Engineering Economics, 4 th edition, © 2007 Presenting Cash Flows in Compact Tabular Forms Mathematical Form

Contemporary Engineering Economics, 4 th edition, © 2007 Investing activities Operating activities Financing activities Cash Flow Statement for Example 10.4 Using the generalized Cash Flow Approach

Contemporary Engineering Economics, 4 th edition, © 2007 Example 10.8 Lease-or-Buy Decision Lease Option:  The proposed lease term: 60 months  The proposed lease payment: $4,202 Buy Option:  Your income tax rate: 28%  Your sales tax rate: 5%  The cost of capital: 8%  The method of depreciation: 5year MACRS  The cost of equipment: $248,500  You intend to use the equipment for: 60 months  When you’re done with the equipment you believe you can sell it for: $49,700

Contemporary Engineering Economics, 4 th edition, © 2007 Lease Option Assumption: Lease payment at beginning of each month Total monthly lease payment = $4,202(1.05) = $4, Net after-tax monthly lease expense = $4,412.10(1 – 0.28) =$3,176.71

Contemporary Engineering Economics, 4 th edition, © 2007 Buy Option Up-front cash payment: $248,500(1.05) = $260,925  PW(8%) 1 = $260,925 Tax depreciation shield:  PW(8%) 2 = $53,760 Net proceeds from sale:  Net salvage = $49,700 - $5,500 = $44,200  PW(8%) 3 = $30,082 Total cost of Buying Option:  PW(8%) = $250,925 - $53,760 - $30,082 = $177,084 End of Year 5-Year MACRS Allowed Depreciation Tax Shield Present Worth at 8% 1 20%$52,185$14,612$13, %83,49623,37920, %50,09814,02711, %30,0598,4176, %15,0294,2082,864 Total Sum $230,867$53,760 Book value at the end of year 5: BV 5 = $260,925 - $230,867 = $30,058 Taxable gains: Gains = $49,700 - $30,058 = $19,642 Gains tax = $19,642(0.28) = $5,500

Contemporary Engineering Economics, 4 th edition, © 2007 How Much Would You Save in Present Dollars? Lease Option: PW(8%/12) = $157,715 Buy Option: PW(8%) = $177,084 Net Savings over Buy Option: Savings = $19,369  What should you do? Lease

Contemporary Engineering Economics, 4 th edition, © 2007 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. Summary

Contemporary Engineering Economics, 4 th edition, © 2007 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

Contemporary Engineering Economics, 4 th edition, © 2007 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.