Process of Developing Project Cash Flows Lecture No.33 Chapter 10 Contemporary Engineering Economics Copyright © 2016

Example: When Projects Require Only Operating and Investing Activities Given: 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% Find: Determine the project cash flows

Profitability NPW of the investment if MARR is 15%: PW(15%) = $43,152

When Projects Require Working-Capital Investments What is working capital? Definition: The amount carried in cash, accounts receivable, and inventory that is available to meet day-to-day operating needs. Working capital is used for non-depreciable assets (like raw material inventory, labor salaries, safety stock inventory…). So, no depreciation is allowed on working capital expenditures. You need to invest in these assets before you receive your first revenue stream. When the project ends, working capital will be fully recovered!

Example: When Projects Require Operating, Investing Activities and Working Capital Suppose now that $23,331 is required as working capital for the previous example. You are NOT expected to know how $23,331 is obtained. However you are responsible for how you would use this amount in the project cash flow (next slide)

Profitability 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)

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.

Now suppose that half of the investment is financed. Amount financed: $62,500 Financing rate: 10% per year Annual installment: $16,487 or, A = $62,500(A/P, 10%, 5) End of Year Beginning Balance Interest Payment Principal Payment Ending 1 $62,500 $6,250 $10,237 $52,263 2 52,263 5,226 11,261 41,002 3 4,100 12,387 28,615 4 2,861 13,626 14,989 5 1,499 14,988 $16,487

Effects of debt financing on profitability NPW with debt financing PW(15%) = $44,439