FEE ISM Ch10 3e OK

Fundamentals of Engineering Economics, 3rd ed.
2012
Chapter 10 Project Cash Flow Analysis

10.1)
a) Wages paid to temporary workers: Variable cost

b) Property taxes on factory building: Fixed cost
c) Property taxes on administrative building: Fixed cost
d) Sales commission: Variable cost
e) Electricity for machinery and equipment in a plant: Variable cost
f) Heat and air-conditioning for a plant: Fixed cost
g) Salaries paid to design engineers: Fixed cost
h) Regular maintenance on machinery and equipment: Fixed cost
i) Basic raw materials used in production: Variable cost
j) Factory fire insurance: Fixed cost
10.2)
a) Raw material costs: Product cost

b) Income taxes paid:Period cost
c) Interest expenses on borrowed funds:Period cost
d) Wages incurred in producing products:Product cost
e) Fire insurance premium paid on factory buildings:Period cost
f) Electricity bill for the warehouse operation:Period cost
g) Salary paid for engineers:Product cost
h) Material handling cost related to production:Product cost
i) Salary paid for plant manager:Product cost
j) Leasing expense for fork-lift trucks in warehouse operation:Period cost
k) Mortgage payments on factory buildings:Period cost
10.3)
a) Paint shop superintendents salary: Fixed cost

b) Labor costs in assembling a product: Variable cost
c) Rent on a factory building:Fixed cost
d) RFID units embedded in final product during shipping: Variable cost
e) Depreciation on machinery: Variable cost
f) Lubricants used for machines: Variable cost
g) CPU chips used in notebook production: Variable cost
h) Paint used in automobile production: Variable cost
i) Janitorial and custodian salaries:Fixed cost
j) Coffee beans used in packaging roasted coffee: Variable cost
k) Sugar used in ice cream production: Variable cost
l) Electricity for operation of machines: Variable cost
m) Electricity for heating and cooling the factory building:Fixed cost
n) Glue used in electronic board production: Variable cost
Page | 1
Fundamentals of Engineering Economics, 3rd ed. 2012
10.4)
a) 6
b) 11
c) 5(Note: It is tempting to select 1, but the graphs are drawn on
cumulative basis)
d) 4
e) 2
f) 10
g) 3
h) 7
i) 9
10.5)
(a) Contribution M arg in per unit = 250 - 80 = $170
170
Contribution M arg in percentage = 100 = 68% Ans.
250
50, 000
(b) B.E.P. = = 294.11 295units
250 - 80
10.6)
F 200, 000
(a) B.E.P. = $450, 000 =
P -V P -V
P P
P -V
= 0.444 44.4% Ans.
P
P - V P - 12
(b ) Contribution M arg in per unit = 0.444 = =
P P
P = 12 / 0.56 = $21.42 per unit Ans.
10.7) (a)
2
F 50, 000
(b) B.E.P. = = = $66666.66 Ans.
V 1 - 0.25
1-
P
(c ) New Variable cos t and selling price ratio = V / 0.94 P 0.25 / 0.94 = 0.2659
F 50, 000
B.E.P. = = = $68115.94 Ans.
V 1 - 0.2659
1-
P
10.8)
(a) Line A has the largest contribution margin
So, $255, 000 - $3(20, 000) = $195, 000 remains unchanged. For the line B,
$195, 000
= 97,500
$2 units should be produced. Therefore, 20,000 units of
line A and 97,500 units of line Bneed to be produced to breakeven.
(b) The total contribution margin:
$3(20,000) $2(100,000) $1(80,000) = $340,000.

The operating income:
$340, 000 - $255, 000 = $85, 000 .
(c) The operating income:
$3(20, 000) $2(80, 000) $1(100, 000) - $255, 000 = $65, 000 .
The new break-even point:
The fixed cost $255, 000 - 20,000($3) = $195, 000 remains
unchanged.
The demand of Line B is 80,000 units and the fixed cost
$195,000 - $2(80,000) = $35,000remains unchanged.
The break-even point for line C is $35,000 / $1 = 35,000units.
Therefore, the new break-even is 20,000 units of line A, 80,000
units of line B, and 35,000units of line C.
10.9)
a) Marginal tax rates:
Without project With project

Taxable income $350,000 $530,000
Income taxes $119,000 $180,200
marginal tax rate without the project = 34%

marginal tax rate with the project = 34%
b) Average tax rates:
3
without the project = $119,000/$350,000

= 34%
with the project = $180,200/$530,000
= 34%
10.10)
a) Marginal tax rates with the project:
b) Average tax rates
10.11)
Incremental tax rate calculation:
Year 1 Year 2
Revenue $200,000 $200,000
Operating Costs $100,000 $100,000
Depreciation $10,000 $16,000
Taxable income $90,000 $84,000
4
Comments: Note that the marginal tax rates over the project life remain
unchanged because the additional income from the new project is not large
enough to push the company into a higher tax bracket.
10.12) Taxable income from the project during year 1:
D1 = 0.20($100, 000) = $20, 000

Taxableincome = $80, 000 - $20, 000 = $60, 000
a)& b)Increment in income tax due to the project during year 1:
Year 1
Taxable income without project $195,000
Income taxes $59,300
Taxable income with project $255,000

Incremental taxable income $60,000

Incremental income taxes $23,400
Incremental tax rate 39%
10.13) Incremental tax calculations:
a) Additional taxable income due to project:
Year 1 Year 2 Year 3

Annual revenue $90,000 $90,000 $90,000
Operating cost $25,000 $25,000 $25,000
Depreciation $16,667 $22,222 $3,704
Taxable income $48,333 $42,778 $61,296
b) Additional income tax calculation:
5
10.14)
(a) Taxable gain:
Ordinary gains = proceeds from old equipment - book value

= $23, 000 - $20, 000
= $3, 000
(b) Taxable income:
Note: Income taxes = $113,900 + 0.34($1,125,300- $335,000)

= $382,602
Note: Ordinary gains are not included in this calculation, even though
these gains will be treated as ordinary income. Of course, these figures can
be included to find the total tax liabilities.
(c) Marginal and average tax rates:
Marginal tax rate = 34%

Average (effective) tax rate = $382, 602 / $1,125,300
= 34%
(d) Net cash flow:
6
10.15)
(a) Income tax liability:
Note 1: book loss = $60,000 - $75,000 = ($15,000)

Note 2: Income taxes = $113,900 + 0.34($575,000- $335,000)
= $195,500
(b) Operating income:
Taxable operating income $590,000

Net operating income $389,400
Note 1: The loss from disposal of the asset is not a part of operating
activities, so it is not included in the operating income calculation.
Note 2: Income taxes = $113,900 + 0.34($590,000- $335,000)
= $200,600
(c) Net cash flow:
7
10.16)
(a), (b), and (c)
10.17) Investment in industrial robot:

10.18)
X = $60, 000( P / A,15%,10)
= $301,128
10.21) Investment in energy management system: N = 9 years

10.22) Investment decision based on after-tax IRR:

10.23)
The required lease payment should be $16,651 per year, payable at the end of each year.
If the ACLC schedules each lease payment to be made at the beginning of each year, the
required lease payment should be much lower, or precisely $15,137 per year.
10.24)
Investment decision based on after-tax IRR:
10.25)
Investment in a new trench excavator:
10.26)
Tucson Solar Company:
(a)
(b)
AE(12%) = ( $62, 469 ) ( A / P /12%, 6)
= $15,194
10.27)
Investment in 3-D computerized car-styling system
10.28)
Investment in Mazda automatic screw machine:
Since PW(15%) > 0, accept the investment.

10.29)
a) Equal repayment of the principal:
Loan Repayment Loan

n Interest Principal Balance
0 $300,000
1 $36,000 $50,000 $250,000
2 $30,000 $50,000 $200,000
3 $24,000 $50,000 $150,000
4 $18,000 $50,000 $100,000
5 $12,000 $50,000 $50,000
6 $6,000 $50,000 0
b) Equal repayment of the interest:
Loan Repayment Loan

0 $300,000
1 $36,000 $300,000
2 $36,000 $300,000
3 $36,000 $300,000
4 $36,000 $300,000
5 $36,000 $300,000
6 $36,000 $300,000 0
c) Equal annual installment:
A = $300, 000( A / P,12%, 6) = $72,968
Loan Repayment Loan

0 $300,000
1 $36,000 $36,968 $263,032
2 $31,564 $41,404 $221,628
3 $26,595
$26,000 $46,373 $175,255
4 $21,031 $51,937 $123,318
5 $14,798 $58,170 $65,148
6 $7,818 $65,148 0
10.30)
10.31)
(a), (b), and (c)
10.32) Income statement approach: (a), (b), and (c)

10.33) (a)
(b) This is a service project. The equivalent annual cost is
AEC(18%) = $1,318, 770( A / P,18%,5)

= $421, 713.40
10.34)(a) and (b)

10.35) (a) with no borrowed funds:
(b) With borrowed funds:

(c) Which alternative to choose? The debt financing option is more attractive.
10.36) Net cash flow
10.37)
PW(18%) = -$3,500 $6,343( P / F ,18%,1) L $9, 454( P / F ,18%,15)

= $22,134 > 0
Accept the investment.

10.38)
Option 1: Lease (a lease paid at the start of each period)
PW(12%)lease = -$144, 000(1 - 0.40) ( 1 ( P / A,12%, 29) )

= -$779, 484
Option 2: Purchase
- Note 1: It is assumed that the property is placed in service during

January.
D1 & D30 = (11.5 /12)(1/ 39)($650, 000) = $15,972

D2 to D29 = (12 /12)(1/ 39)($650, 000) = $16, 667
- Note 2: Property tax calculation:
($800,000)(0.05) = $40,000
PW(12%)purchase = -$931,551
Option 3: Remodel
- Note 1: Depreciation base: Remodeling cost = $300,000

D1 & D30 = (11.5 /12)(1/ 39)($300, 000) = $7,372
D2 to D29 = (12 /12)(1/ 39)($300, 000) = $7, 692
- Note 2: Cost basis for property tax calculation:
Land + building + remodeling cost = $660,000
PW(12%)remodel = -$494, 425
Option 3 is the least costly alternative.
10.39) Comparison by annual equivalent cost (all units in thousand dollars):

Plant A Plant B Plant C

Book Value (n = 20) $380.61 $423.80 $470.56
Salvage Value $853.00 $949.80 $1,054.60
Taxable gains $472.39 $526 $584.04
Gains tax (39%) $184.23 $205.14 $227.78
Net Proceeds from sale $668.77 $744.66 $826.82
Plant A
Capital recovery cost with return:
A1 = ($8,530 - $668.77)( A / P,12%,20) $668.77(0.12) = $1,132.70
After-tax O&M cost:
A2 = (1 - 0.39)($1,964) = $1,198.04
Depreciation tax shield:
A3 = 0.39($8,530) 0.0375( P / F ,12%,1) L ( A / P,12%, 20)

= $172.22
Total equivalent annual cost:
A = $1,132.70 $1,198.04 - $172.22 = $2,158.52
Unit cost:
$2,158,520
= $0.04317 / kWh
50,000,000kWh
Plant B
A1 = ($9, 498 - $744.66)( A / P,12%, 20) $744.66(0.12) = $1, 261.25
After-tax O&M cost:
A2 = (1- 0.39)($1,744) = $1,063.84

A3 = 0.39($9, 498) 0.0375( P / F ,12%,1) L ( A / P,12%, 20)

= $191.76
A = $1, 261.25 $1, 063.84 - $191.76 = $2,133.33
Unit cost:
$2,133,330
= $0.04267 / kWh
50, 000, 000kWh
Plant C
A1 = ($10,546 - $826.82)( A / P,12%, 20) $826.82(0.12) = $1, 400.41
After-tax O&M cost:
A2 = (1 - 0.39)($1, 632) = $995.52
A3 = 0.39($10,546) 0.0375( P / F ,12%,1) L ( A / P,12%, 20)

= $212.92
A = $1, 400.41 $1,995.52 - $212.92 = $3,183.01
Unit cost:
$3,183, 010
= $0.06366 / kWh
50, 000, 000kWh
Plant B is the most economical.
10.40)
(a) H&Hs cost of leasing in present worth:
after-tax lease expense = (1 - 0.40)($11,000)

= $6,600
PW(15%) lease = -$6, 600 - $6, 600( P / A,15%,3)
= -$21, 670
(b) H&Hs cost of owning in present worth:
PW of after-tax maintenance expenses:
P1 = -$1, 200(1 - 0.40)( P / A,15%, 4)

= -$2, 055
PW of after-tax loan repayment
P2 = -$13,169( P / A,15%, 4)
= -$37,597
PW of tax credit (shield) on depreciation and interest:
n Dn In Combined Tax Savings

1 $8, 000 $4,800 $12,800(0.40) = $5,120
2 $12,800 $3, 796 $16,596(0.40) = $6, 638
3 $7, 680 $2, 671 $10,351(0.40) = $4,140
4 $2,304 $1, 411 $3, 715(0.40) = $1, 486
P3 = $5,120( P / F ,15%,1) $6, 638( P / F ,15%, 2)

$4,140( P / F ,15%,3) $1, 486( P / F ,15%, 4)
= $13, 043
PW of net proceeds from sale:

total depreciation amount = $30,784

book value = $9,216
taxable gain = $10,000 - $9,216
= $784
gains tax = (0.40)($784) = $314
net proceeds from sale = $10,000 - $314
= $9,686
P4 = $9,686(P / F ,15%, 4)
= $5,538
PW (15%) buy = P1 P2 P3 P4 = -$21, 071
(c) Should the truck be leased or purchased? The borrowbuy option is a better
choice.
10.41)
Note: Since the operating revenues will be the same for both options, we will only
consider the cost of ownership.
(a) PW (incremental) cost of owning the equipment:
PW of after-tax O&M
P1 = -$50, 000(1 - 0.40)( P / A,15%, 4)

= -$85, 649
PW of after-tax loan repayment:
P2 = -$37,857( P / A,15%, 4)
= -$108, 080


1 $24,000 $12,000 $36,000(0.40) = $14,400
2 $38,400 $9,414 $47,817(0.40) = $19,126
3 $23,040 $6,570 $29,610(0.40) = $11,844
4 $6,912 $3,441 $10,353(0.40) = $4,141
P3 = $14, 400( P / F ,15%,1) $19,126( P / F ,15%, 2)

$11,844( P / F ,15%,3) $4,141( P / F ,15%, 4)
= $37,139

book value = $27,648
taxable gain = $20,000 - $27,648 = ($7,648)
loss credit = (0.40)($7,648) = $3,059
net proceeds from sale = $20,000 + $3,059
= $23,059
P4 = $23,059(P / F ,15%, 4)
= $13,184
PW (15%)buy = P1 P2 P3 P4 = -$143, 406
Input Output
PW(15%)
Tax Rate(%) = 40 = ($143,405)
MARR(%) = 15
0 1 2 3 4
Income Statement
Revenues (savings) $0 $0 $0 $0
Expenses:
O&M $50,000 $50,000 $50,000 $50,000
Depreciation 24,000 38,400 23,040 6,912
Debt interest (10%) 12,000 9,414 6,570 3,441
Taxable Income (86,000) (97,814) (79,610) (60,353)

Income Taxes (40%) (34,400) (39,126) (31,844) (24,141)
Net Income ($51,600) ($58,688) ($47,766) ($36,212)

Cash Flow Statement

Operating Activities:
Net Income (51,600) (58,688) (47,766) (36,212)
Depreciation 24,000 38,400 23,040 6,912
Investment Activities:
Investment (120,000)
Salvage 20,000
Gains Tax 3,059
Financing Activities:
Borrowed funds 120,000
Principal repayment (25,857) (28,442) (31,286) (34,415)
Net Cash Flow $0 ($53,457) ($48,730) ($56,012) ($40,656)
(b) PW (incremental) cost of leasing the equipment:
PW of after-tax operating cost:
P1 = $40,000(1 - 0.40)( P / A,15%, 4)

= $68,519
PW of after-tax leasing
P2 = $44, 000(1 - 0.40) $44, 000(1 - 0.40)( P / A,15%,3)

= $86, 677
P = P1 P2
= $155,196
(c) Should ICI buy or lease the equipment? The buying option is a better choice.
10.42)
(a) OMC PW cost of leasing (payments at start of year):
PW(15%)leasing = $22, 000(0.60)( P / A,15%,3)*(1.15)

=$34,658.98
(b) OMC PW cost of owning:
PW of after-tax maintenance expenses:

P1 = $6, 000(1 - 0.40)( P / A,15%,3)

= $8, 219.52
PW cost of after-tax loan repayment:
P2 = $40,386( P / A,15%,3)
= $92, 209.32

1 $13,861 $11,640 $25,501(0.40) = $10,200
2 $23,755 $8,191 $31,946(0.40) = $12,778
3 $8,483 $4,327 $12,810(0.40) = $5,124
P3 = $10,200(P / F,15%,1) $12,778(P / F,15%,2)

$5,124(P / F,15%,3)
= $21,901

book value = $50,901
taxable loss = $45,000 - $50,901 = -$5,901
tax credit = (0.40)($5,901) = $2,360
net proceeds from sale = $45,000 + $2,360
= $47,360
P4 = $47,360(P / F,15%,3)
= $31,140
PW(15%) buy = P1 P2 - P3 - P4 = $47,387.84

10.43) (a) and (b)
Sample calculation:
O & M Expense in year 1: $53,800(1 + 0.05) = $56,490

Salvage value in year 2: $27,000(1 + 0.05)2=$29,768
Note that both depreciation and interest expenses are not responsive to
inflation.
10.44) (a) and (b)

(c) Present value gain (or loss) due to inflation:
0.18 - 0.05
=
i = 12.38%
1 0.05
PW(12.38%) no inflation = $92, 781
PW(18%) with inflation = $98, 771
present value gain = $98, 771 - $92, 781
=$5,990
(d) Present value gain due to borrowing:
Net Financing cost NET

n Principal Interest(A/T) Loan flow
0 $130,000 $130,000
1 -$7,020 -$7,020
2 -$130,000 -$7,020 -$137,020
Note: Interest payment (before tax) = $130,000(0.09) = $11,700

Interest payment (after-tax) = $11,700(1 0.40) = $7,020
PW(18%) Loan = $130, 000 - $7, 020( P / F ,18%,1)

-$137, 020( P / F ,18%, 2)
= $25, 642.79
10.45)
(a), (b)
(c). The project is acceptable

10.46)
10.47)
10.48) (a) Real after-tax yield on bond investment:

Nontaxable municipal bond:
0.09 - 0.03

imunicipal = = 5.825%
1 0.03
Taxable corporate bond:
0.12(1 - 0.3) - 0.03

imunicipal = = 5.245%
1 0.03
(b) Given i = 6%, and f = 3%

isavings = 2.91%
i > 2.91% i > 2.91%

Since municipal and corporate , both bond investments are better
than the savings account. Now to compare two mutually exclusive bond
investment alternatives, we need to perform an incremental analysis.
After- tax Cash F low

n Municipal Corporate Incremental
0 -$10,000 -$10,000 $0
1 $900 $840 -$60
2 $900 $840 -$60
3 $900 $840 -$60
4 $900 $840 -$60
5 $900 $840 -$60
We cannot find the rate of return on incremental investment, as returns from

municipal bond dominate those from corporate bond in every year. Municipal
bond is a clear choice for any value of MARR.
10.49) (a), (b), and (c)
Select B.
10.50) (a) & (b) Actual and constant dollar analysis:
(c) Given f = 8%, i = 15%
0.15 - 0.08
i= = 6.48%
1 0.08 (Inflation-free MARR)
Since IRR> 6.48%, the project is a profitable one.

10.51)
(a) & (b) Project cash flows in actual and constant dollars:
(c) The effects of project financing under inflation:

(d) The present value loss due to inflation:
Present value loss = $136,553 - $140,656 = ($4,103)
(e) Required additional before-tax annual revenue in actual dollars (equal amount) to make-up the inflation loss.
$4,103( A / P,18%, 6)
= $1,955
1 - 0.40
10.52)(a), (b), and (c)

(Unit:$000)
Note 1: In a strict sense, capital gains are only realized for the sale of land.
Note 2: It is assumed that the building will be disposed of at the end of December of the 12th year.
10.53)
(a) The net after-tax cash flows for each financing option:
Option 1: Equity Financing (Retained earnings)

Option 2: Debt Financing at 12%

Option 3: Lease Financing

(b) Vermonts PW cost of owning the equipment by borrowing:
PW of total after-tax revenue:
P1 = $174,000(1 - 0.39)( P / A,18%, 6)

= $371, 236
PW cost of working capital drain:
P2 = $25,000 - $25, 000( P / F ,18%, 6)

= $15,739
PW cost of operating expense:
P3 = $22, 000(1 - 0.39)( P / A,18%,6)
= $46,938
PW cost of owning by borrowing:
Net cost = -$214, 469 P1 - P2 - P3

= $94, 090
(c) Vermonts PW cost of leasing the equipment:
PW cost of after-tax leasing
P = $55, 000(1 - 0.39) $55, 000(1 - 0.39)( P / A,18%,5)

= $138, 467
(d) Buy the tipping machine.

10.54) (a),(b),(c) & (d): Assumption: The building will be placed in service in January.
Note: If the firm decides not to invest in the project, the firm could write off the R&D expenditure. The amount of write-off will
be (0.38)($8,000,000) = $3,040,000. If the firm decides to undertake this project, then an opportunity cost of $3,040,000 will be
incurred.
(e)
(f)
10.55) (a) The net cash flow from the cogeneration project with bond financing:
(b). The maximum annual lease amount that ACC is willing to pay is $907,673.
10.56)
(a) & (b) The project cash flows and IRR with no inflation:
(c) & (d)

(e). The economic gain in present worth due to inflation = $108,411- $90,992 = $17,419.

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Fundamentals of Engineering Economics, 3rd ed.

Chapter 10 Project Cash Flow Analysis

a) Wages paid to temporary workers: Variable cost

a) Raw material costs: Product cost

a) Paint shop superintendents salary: Fixed cost

(b) The total contribution margin:

$3(20,000) $2(100,000) $1(80,000) = $340,000.

(c) The operating income:

Without project With project

marginal tax rate without the project = 34%

without the project = $119,000/$350,000

b) Average tax rates

10.12) Taxable income from the project during year 1:

D1 = 0.20($100, 000) = $20, 000

Taxable income with project $255,000

Incremental taxable income $60,000

10.13) Incremental tax calculations:

a) Additional taxable income due to project:

Year 1 Year 2 Year 3

b) Additional income tax calculation:

Ordinary gains = proceeds from old equipment - book value

Note: Income taxes = $113,900 + 0.34($1,125,300- $335,000)

(c) Marginal and average tax rates:

Marginal tax rate = 34%

(d) Net cash flow:

(a) Income tax liability:

Note 1: book loss = $60,000 - $75,000 = ($15,000)

(b) Operating income:

Taxable operating income $590,000

(c) Net cash flow:

10.17) Investment in industrial robot:

10.21) Investment in energy management system: N = 9 years

10.22) Investment decision based on after-tax IRR:

Since PW(15%) > 0, accept the investment.

a) Equal repayment of the principal:

Loan Repayment Loan

b) Equal repayment of the interest:

Loan Repayment Loan

c) Equal annual installment:

A = $300, 000( A / P,12%, 6) = $72,968

Loan Repayment Loan

10.32) Income statement approach: (a), (b), and (c)

(b) This is a service project. The equivalent annual cost is

AEC(18%) = $1,318, 770( A / P,18%,5)

10.34)(a) and (b)

10.35) (a) with no borrowed funds:

(b) With borrowed funds:

10.36) Net cash flow

PW(18%) = -$3,500 $6,343( P / F ,18%,1) L $9, 454( P / F ,18%,15)

Accept the investment.

PW(12%)lease = -$144, 000(1 - 0.40) ( 1 ( P / A,12%, 29) )

- Note 1: It is assumed that the property is placed in service during

D1 & D30 = (11.5 /12)(1/ 39)($650, 000) = $15,972

- Note 2: Property tax calculation:

- Note 1: Depreciation base: Remodeling cost = $300,000

- Note 2: Cost basis for property tax calculation:

Land + building + remodeling cost = $660,000

PW(12%)remodel = -$494, 425

Option 3 is the least costly alternative.

10.39) Comparison by annual equivalent cost (all units in thousand dollars):

Plant A Plant B Plant C

A1 = ($8,530 - $668.77)( A / P,12%,20) $668.77(0.12) = $1,132.70

After-tax O&M cost: