Lecture No.33 Chapter 10 Contemporary Engineering Economics Copyright © 2010 Contemporary Engineering Economics, 5th edition, © 2010

Chapter Opening Story  Intel to invest $7B on factory upgrades: Transition to new manufacturing 32- nanometers technology at factories in Oregon, Arizona and New Mexico.  At Issue: How would you determine the cash flows from these factory upgrades? Contemporary Engineering Economics, 5th edition, © 2010

Key Elements of Investment Decision Contemporary Engineering Economics, 5th edition, © 2010 Step 1 Identify investment opportunities Step 2 Estimate project cash flows Step 3 Measure the investment worth Step 4 Select the best project Step 5 Implement the project Step 6 Post-audit the project Contemporary Engineering Economics, 5th edition, © 2010

Types of Cash Flow Elements in Project Analysis Contemporary Engineering Economics, 5th edition, © 2010

Example 10.1 – When Projects Require Only Operating and Investing Activities  Project nature: An Expansion Project  Financial Data:  Investment: $125,000  Project life: 5 years  Salvage value: $50,000  Annual labor savings: $100,000  Annual manufacturing costs: Labor: $20,000 Materials:$12,000 Overhead:$8,000  Depreciation method: 7-year MACRS  Income tax rate: 40%  MARR: 15%  What’s Required: Determine the project cash flows Contemporary Engineering Economics, 5th edition, © 2010

Return on Invested Capital Contemporary Engineering Economics, 5th edition, © 2010 n = 0n =1n = 2n = 3n = 4n = 5 Beginning Balance -$125,000-$116,380-$100,279-$83,231-$63,974 Return on Investment (27.62%) -$34,525-$32,144-$27,697-$22,988-$17,670 Payment-$125,000$43,145$48,245$44,745$42,245$81,619 Project Balance -$125,000-$116,380-$100,279-$83,231-$63,974≈0 The firm earns a 27.62% return on funds that remain internally invested in the project.

When Projects Require Working-Capital Investments What is Working Capital? Working Capital Equations 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. 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, 5th edition, © 2010

Example 10.2 Working Capital Requirements  Elements of Working Capital: Illustration of Working Capital Requirement Contemporary Engineering Economics, 5th edition, © 2010

Example 10.3 – Cash Flow Statement with Working Capital  Changes in Profitability  NPW without the Working Capital Requirement PW(15%) = $43,152  NPW with the Working Capital Requirement PW(15%) = $31,420  Difference: $11,732 (lost earnings due to funds tied up in working capital) Contemporary Engineering Economics, 5th edition, © 2010

When Projects Results in Negative Taxable Income Handling Project Loss Contemporary Engineering Economics, 5th edition, © 2010  Negative taxable income (project loss) means you can reduce your taxable income from regular business operation by the amount of loss, which results in tax savings. 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

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 PW(20%) = $991,008 i* = 4.24% and % A nonsimple and mixed investment RIC = % >20% Good investment! Contemporary Engineering Economics, 5th edition, © 2010

Cash Flow Statement (Table 10.7) Contemporary Engineering Economics, 5th edition, © 2010

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, 5 th edition, © 2010 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)

Example Cash Flow Statement with Debt Financing  Effects 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%. Contemporary Engineering Economics, 5 th edition, © 2010