Contemporary Engineering Economics, 4 th edition, © 2007 When Projects Require Financing Activities Lecture No. 41 Chapter 10 Contemporary Engineering Economics Copyright © 2006

Contemporary Engineering Economics, 4 th edition, © 2007 When Projects are Financed with Borrowed Funds Key issue: Interest payment is a tax- deductible 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, 4 th edition, © 2007 End of Year Beginning Balance Interest Payment Principal Payment Ending Balance 1$62,500$6,250$10,237$52, ,2635,22611,26141, ,10012,38728, ,86113,62614, ,49914,9880 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 Loan Repayment Schedule (Example 10.4)

Contemporary Engineering Economics, 4 th edition, © 2007 Additional entries related to debt financing Cash Flow Statement with Debt Financing

Contemporary Engineering Economics, 4 th edition, © 2007 Effect 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%.