Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Generalized Cash Flow Approach – Lease versus Buy Lecture No. 34 Chapter 10 Contemporary Engineering Economics Copyright © 2016

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved 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 results is less elaborate. There are also analytical advantages in modeling project cash flows. Cons: The process is less intuitive and not commonly understood by business people.

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Setting Up Net Cash Flow Equations

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Presenting Cash Flows in Compact Tabular Forms Mathematical Form Tabular Presentation

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Example 10.7: Using the Generalized Cash Flow Approach  Given : Reconsider Example o Investment = $125,000 o Investment in working capital = $23,333 o Project life = 5 years o Salvage value = $50,000 o Annual revenues = $100,000 o Annual expenses other than depreciation = $40,000 o Debt interest payment o Principal repayment o Depreciation = 7-year MACRS o Marginal tax rate = 40%  Find : project cash flows based on the generalized cash flow approach.

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Solution

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Example: Lease-or-Buy Decision Lease option o The proposed lease term: 60 months o The proposed lease payment: $4,202 Buy option o Your income tax rate: 28% o Your sales tax rate: 5% o The cost of capital (discount rate): 8% o The method of depreciation: 5-year MACRS o The cost of equipment: $248,500 o You intend to use the equipment for: 60 months o When you’re done with the equipment you believe you can sell it for: $49,700 Contemporary Engineering Economics, 6th edition, ©

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Lease Option o Assumption: Lease payment at beginning of each month o Total monthly lease payment = $4,202(1.05) = $4, o Net after-tax monthly lease expense = $4,412.10(1 − 0.28) =$3,176.71

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Buy Option o Up-front cash payment: $248,500(1.05) = $260,925 PW(8%) 1 = $260,925 o Tax depreciation shield: PW(8%) 2 = $53,760 o Net proceeds from sale: Net salvage = $49,700 − $5,500 = $44,200 PW(8%) 3 = $30,082 o 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, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved How Much Would You Save in Present Dollars? o Lease option o PW(8%/12) = $157,715 o Buy option o PW(8%) = $177,084 o Net Savings over buy option o Savings = $19,369 What should you do? Lease.

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved Summary o 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

Contemporary Engineering Economics, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved o 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, 6 th edition Park Copyright © 2016 by Pearson Education, Inc. All Rights Reserved 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.