1. Contemporary Engineering Economics, 4 th edition, © 2007 When Projects Require Only Operating and Investing Activities Lecture No. 39 Chapter 10 Contemporary Engineering Economics Copyright © 2006

2. Contemporary Engineering Economics, 4 th edition, © 2007 Example 10.1 Cash Flow Statement: Operating and Investing Activities for an Expansion Project 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 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

3. Contemporary Engineering Economics, 4 th edition, © 2007  (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? Questions

4. Contemporary Engineering Economics, 4 th edition, © 2007 N MACRS Rate Depreciation Amount Allowed Depreciation Amount 114.29%$17,863 224.49%$30,613 317.49%$21,863 412.49%$15,613 58.93%$11,150$5,575 68.92%$11,1500 78.93%$11,1500 84.46%$5,5750 (a) Step 1: Determine the allowed depreciation amounts Cost basis: $125,000 Depreciation Method: 7-year MACRS

5. Contemporary Engineering Economics, 4 th edition, © 2007  Salvage value = $50,000  Book Value (year 5) = Cost Basis – 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 (a) Step 2: Gains (Losses) associated with Asset Disposal

6. Contemporary Engineering Economics, 4 th edition, © 2007 Income Statement012345 Revenues$100,000 Expenses: Labor20,000 Material12,000 Overhead8,000 Depreciation17,86330,61321,86315,6135,581 Taxable Income$42,137$29,387$38,137$44,387$54,419 Income Taxes (40%)16,85511,75515,25517,75521,768 Net Income$25,282$17,632$22,882$26,632$32,651 (a) Step 3 – Create the Income Statement

7. Contemporary Engineering Economics, 4 th edition, © 2007 Cash Flow Statement012345 Operating Activities: Net Income$25,282$17,632$22,882$26,632$32,651 Depreciation17,86330,61321,86315,6135,581 Investment Activities: Investment(125,000) Salvage50,000 Gains Tax(6,613) Net Cash Flow($125,000)$43,145$48,245$44,745$42,245$81,619 (a) Step 4 – Develop a Cash Flow Statement

8. Contemporary Engineering Economics, 4 th edition, © 2007 Creating the Cash Flow Statement using Excel

9. Contemporary Engineering Economics, 4 th edition, © 2007 Question (b): Is This Investment Justifiable at a MARR of 15%? PW(15%) = -$125,000 + $43,145(P/F,15%,1) +... + $81,619 (P/F,15%,5) = $43,152 > 0  Yes, Accept the project !

10. Contemporary Engineering Economics, 4 th edition, © 2007 AB 1PeriodCash Flow 20($125,000) 3143,145 4248,245 5344,745 6442,245 7581,619 =IRR(B2:B7,0.10) IRR = 27.62%> 15% Question (c): What is the IRR of this project? Simple investment

11. Contemporary Engineering Economics, 4 th edition, © 2007 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 Project Balance Concept – Return on Invested Capital The firm earns a 27.62% rate of return on funds that remain internally invested in the project.