Econ 204-05

Chapter 5 Project Cash Flow Analysis
Cost Classifications Income Tax Rate to Use in Project Analysis Incremental Project Cash Flows Impacts of Inflation on Project Cash Flows Cost of Capital
Fundamentals of Engineering Economics 2004 by Chan S. Park 1
Engineering Economic Decisions

Evaluation of a Fixed Asset
Equipment Buildings
Valuation of Fixed Assets

Based on usable after-tax cash flows the asset produces
Fundamentals of Engineering Economics 2004 by Chan S. Park
General Cost Terms

Manufacturing Costs Direct materials Direct labor Mfg. Overhead Non-manufacturing Costs Overhead Marketing Administrative
Classifying Costs for Financial Statements

Matching Concept: The costs incurred to generate particular revenue should be recognized as expenses in the same period that the revenue is recognized. Period costs: Those costs that are matched against revenues on a time period basis Product costs:Those costs that are matched against revenues on a product basis.
Cost Classification for Predicting Cost Behavior

Volume index Cost Behaviors Fixed costs Variable costs Mixed costs Average unit costs
Volume Index
Def: The unit measure used to define volume Examples:
Automobile miles driven Generating plant kWh produced Stamping machine parts stamped
Fixed Costs
Def: The costs of providing a companys basic operating capacity Cost behavior: Remain constant over the relevant range
Variable Costs
Def: Costs that vary depending on the level of production or sales Cost behavior: Increase or decrease proportionally according to the level of volume
Average Unit Cost

Def: activity cost per unit basis Cost Behaviors:
Fixed cost per unit varies with changes in volume. Variable cost per unit of volume is a constant.
What Income Tax Rate Should be Used in Project Analysis?

Regular Project Business $200,000 $40,000 $130,000 $20,000 $70,000 $20,000 $12,500 ?
10
Revenues Expenses Taxable Income Income Taxes
Incremental Income Tax Rate

Before After Undertaking Undertaking Project Project $200,000 $240,000 The Effect of Project $40,000
Gross revenue
Expenses Taxable income Income taxes Average tax rate
130,000 $70,000 $12,500 17.86%
150,000 $90,000 $18,850 20.94%
20,000 $20,000 $6,350 31.75%
11
0.25($5,000/$20,000) + 0.34($15,000/$20,000) = 31.75%

Before Taxable income Income taxes Average tax rate Incremental tax rate $70,000 12,500 17.86% After $90,000 18,850 20.94% 31.75%
$20,000 incremental taxable income due to undertaking project
Incremental $20,000 6,350
Regular income from operation Marginal tax rate 15% $20,000 $40,000
$5,000 at 25% $15,000 at 34%
25% $60,000
34% $80,000 $100,000

12
$0
Elements of Investment Decision

Identification of Investment Opportunities Generation of Cash Flows Measures of Investment Worth Our focus in this Project Selection chapter is to develop the format Project Implementation of after-tax cash flow statements. Project-Control/Post-Audit
Types of Cash Flow Elements in Project Analysis
14
Cash Flows from Operating Activities

Approach 1 Income Statement Approach Operating revenues Cost of goods sold Depreciation Operating expenses Interest expenses Taxable income Income taxes Net income + Depreciation Approach 2 Direct Cash Flow Approach Operating revenues - Cost of goods sold
- Operating expenses - Interest expenses - Income taxes Cash flow from operation
15
A Typical Format used for Presenting Cash Flow Statement

Cash flow statement
+ Net income +Depreciation

Income statement Revenues Expenses Cost of goods sold Depreciation Debt interest Operating expenses Taxable income Income taxes Net income -Capital investment + Proceeds from sales of depreciable assets - Gains tax - Investments in working capital + Working capital recovery + Borrowed funds -Repayment of principal Net cash flow
Operating activities + Investing activities + Financing activities
16
Example 9.1 When Projects Require only Operating and Investing Activities
Project Nature: Installation of a new computer control system Financial Data: Investment: $125,000 Project life: 5 years Working capital investment: $23,331 Salvage value: $50,000 Annual labor savings: $100,000 Annual additional expenses: Labor: $20,000 Material: $12,000 Overhead: $8,000 Depreciation Method: 7-year MACRS Income tax rate: 40% MARR: 15%
17
Questions
(a) Develop the projects 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?
When Projects Require Working Capital Investments

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.
(a) Step 1: Depreciation Calculation Cost Base = $125,000 Recovery Period = 7-year MACRS
N 1 2 3 4 5 MACRS Rate 14.29% 24.49% 17.49% 12.49% 8.93% Depreciation Allowed Depreciation Amount Amount $17,863 $30,613 $21,863 $15,613 $11,150 $17,863 $30,613 $21,863 $15,613 $5,575
6 7 8
8.92% 8.93% 4.46%
$11,150 $11,150 $5,575

0 0 0
20
(a) Step 2: Gains (Losses) associated with Asset Disposal

Salvage value = $50,000 Book Value (year 5) = Cost Base 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
Example 9.1 - Income Statement

Income Statement
Revenues 0 1 2 3 4 5 $100,000 $100,000 $100,000 $100,000 $100,000 20,000 12,000 8,000 17,863 $42,137 16,855 $25,282 20,000 12,000 8,000 30,613 $29,387 11,755 $17,632 20,000 12,000 8,000 21,863 $38,137 15,255 $22,882 20,000 12,000 8,000 15,613 $44,387 17,755 $26,632 20,000 12,000 8,000 5,581 $54,419 21,768 $32,651
22
Expenses:
Labor Material Overhead Depreciation Taxable Income Income Taxes (40%) Net Income
Example 9.1- Cash Flow Statement

Cash Flow Statement
Operating Activities: Net Income Depreciation Investment Activities: Investment Working capital Salvage Gains Tax Net Cash Flow ($148,331) $43,145 $48,245 $44,745 $42,245
$25,282 $17,632 $22,882 $26,632 17,863 30,613 21,863 15,613
$32,651 5,581
(125,000) (23,331) 23,331 50,000 (6,613) $104,950

23
Example 9.1 - Net Cash Flow Table Generated by Traditional Method Using Approach 2
A
Year End 0 1 2 3 4 5 50,000* 23,331
B
Investment & Salvage Value -$125,000 -23,331
C
Revenue
D
Labor
E
Expenses Materials
F
Overhead
G
Depreciation
H
Taxable Income
I
Income Taxes
J
Net Cash Flow -$125,000
$100,000 100,000 100,000 100,000 100,000
20,000 20,000 20,000 20,000 20,000
12,000 12,000 12,000 12,000 12,000
8,000 8,000 8,000 8,000 8,000
$17,863 30,613 21,863 15,613 5,581
42,137 29,387 38,137 44,387 54,419 16,525
16,855 11,755 15,255 17,755 21,678 6,613
$43,145 $48,245 $44,745
$42,245 $38,232 $43,387 23,331
*Salvage value
Note that H = C-D-E-F-G I = 0.4 * H J= B+C-D-E-F-I
Information required to calculate the income taxes

24
Cash Flow Diagram including Working Capital

$23,331 $48,245 $44,745 Working capital recovery
$43,145
$81,619 $42,245
5 $23,331
$125,000 Investment in physical assets $23,331 Investment in working capital
$23,331
Years
Working capital recovery cycles
25
Question (b):
Is this investment justifiable at a MARR of 15%?
$48,245 $104,950
PW(15%) = -$148,331 + +$43,145(P/F, 15%, 1) + . . . . + $104,950 (P/F, 15%, 5) = $31,420 > 0 Yes, Accept the Project !
$43,145
$44,745 $42,245
0
1 2 3 4 5
Years $148,331
26
Question (C): IRR

1
2 3 4 5 6 7 A Period 0 1 2 3 4 5 B Cash Flow ($148,331) 43,145 48,245 44,745 42,245 104,950
=IRR(B2:B7,0.10)
IRR = 22.55%
Rate of Return Analysis (IRR = 22.55%)

n=0 Beginning Balance Return on Investment (interest) Payment Project Balance -$148,331 n =1 n=2 n=3 n=4 n=5
-$148,331 -$138,635 -$121,652 -$104,339 -$85,622 -$33,449 -$31,262 -$27,432 -$23,528 -$19,328
$43,145
$48,245
$44,745
$42,245 $104,950 -$85,622 0
-$148,331 -$138,635 -$121,652 -$104,339
28
When Projects are Financed with Borrowed Funds

Key issue: Interest payment is a taxdeductible expense. What Needs to Be Done: Once loan repayment schedule is known, separate interest payment from the annual installment. What about Principal Payment? As the amount of borrowing is NOT viewed as income to the borrower, the repayment of principal is NOT viewed as expenses either NO tax effect.
29
Loan Repayment Schedule (Example 9.2)

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) End of Year 1 2 3 Beginning Balance $62,500 52,263 41,002 Interest Payment $6,250 5,226 4,100 Principal Payment $10,237 11,261 12,387 Ending Balance $52,263 41,002 28,615
4
5
28,615
14,989
2,861
1,499
13,626
14,988
14,989
0
$16,487
Table 9.4
Additional entries related to debt financing
31
When Projects Results in Negative Taxable Income

Negative taxable income (project loss) means you can reduce your taxable income from regular business operation by the amount of loss, which results in a tax savings.
Handling Project Loss

Regular Business Project Combined Operation
Taxable income Income taxes (35%)
$100M
$35M
(10M)
?
Tax savings
$90M
$31.5M
Tax Savings = $35M - $31.5M = $3.5M Or (10M)(0.35) = -$3.5M

32
Effects of Inflation on Project Cash Flows

Item
Depreciation expense
Effects of Inflation
Depreciation expense is charged to taxable income in dollars of declining values; taxable income is overstated, resulting in higher taxes
Note: Depreciation expenses are based on historical costs and always expressed in actual dollars
33
Item
Salvage value
Inflated salvage value combined with book values based on historical costs results in higher taxable gains.
34
Item
Loan repayments Borrowers repay historical loan amounts with dollars of decreased purchasing power, reducing the debt-financing cost.
35
Item
Working capital requirement
Known as working capital drain, the cost of working capital increases in an inflationary environment.
36
Item
Rate of Return and NPW
Unless revenues are sufficiently increased to keep pace with inflation, tax effects and/or a working capital drain result in lower rate of return or lower NPW.
37
Example 9.3 Cash Flow Statement for the Automated Machining Center Project
Income Statement Inflation Rate Revenues Expenses: Labor Material Overhead Depreciation Taxable Income Income Taxes (40%) Net Income Cash Flow Statement Operating Activities: Net Income Depreciation Investment Activities: Investment Salvage Gains Tax Working Capital Net Cash Flow 5% 5% 5% 5% 0 1 2 3 4 5
$100,000 $100,000 $100,000 $100,000 $ 100,000 20,000 12,000 8,000 17,863 20,000 12,000 8,000 30,613 20,000 12,000 8,000 21,863 20,000 12,000 8,000 15,613 20,000 12,000 8,000 5,581
$ 42,137 $ 29,387 $ 38,137 $ 44,387 $ 54,419 16,855 11,755 15,255 17,755 21,768 $ 25,282 $ 17,632 $ 22,882 $ 26,632 $ 32,651
25,282 17,863 (125,000) 5% 5% (23,331) (1,167)
17,632 30,613
22,882 21,863
26,632 15,613
32,651 5,581
(1,225)
(1,287)
(1,351)
50,000 (6,613) 28,361
$ (148,331) $ 41,978 $ 47,020 $ 43,458 $ 40,894 $ 109,980
38
Example 9.4 Applying Specific Inflation Rates

Example 9.4 Cash Flow Statement for AMC Project under Inflation (Multiple Price Indices)
Income Statement Inflation Rate Revenues Expenses: Labor Material Overhead Depreciation Taxable Income Income Taxes (40%) Net Income Cash Flow Statement Operating Activities: Net Income Depreciation Investment Activities: Investment Salvage Gains Tax Working Capital Net Cash Flow (in actual dollars) 6% 5% 4% 5% 0 1 2 3 4 5
$106,000 $112,360 $119,102 $ 126,248 $ 133,823 21,000 12,480 8,400 17,863 22,050 12,979 8,820 30,613 23,153 13,498 9,261 21,863 24,310 14,038 9,724 15,613 25,526 14,600 10,210 5,581
$ 46,257 $ 37,898 $ 51,327 $ 62,562 $ 77,906 18,503 15,159 20,531 25,025 31,162 $ 27,754 $ 22,739 $ 30,796 $ 37,537 $ 46,744
27,754 17,863 (125,000) 3% 5% (23,331) (1,167)
22,739 30,613
30,796 21,863
37,537 15,613
46,744 5,581
(1,225)
(1,287)
(1,351)
57,964 (9,799) 28,361
$ (148,331) $ 44,450 $ 52,127 $ 51,372 $ 51,799 $ 128,851
39
Rate of Return Analysis under Inflation

_
f 10%
Principle:True (real) rate of return should be based on constant dollars. If the rate of return is computed based on actual dollars, the real rate of return can be calculated as:
i' 1 i
_
n 0 1 2 3 4
IRR
Net cash flows in actual dollars -$30,000 13,570 15,860 13,358 13,626
31.34%
Net cash flows in constant dollars -$30,000 12,336 13,108 10,036 9,307
19.40%
1 f 1 0.3134 1 1 0.10 19.40%
Not correct IRR

40
Cost of Capital
1. Calculating the after-tax cost of debt 2. Calculating the cost of equity 3. Calculating the weighted after-tax cost of capital
41
Methods of Financing
Equity Financing Capital is coming from either retained earnings or funds raised from an issuance of stock Debt Financing Money raised through loans or by an issuance of bonds Capital Structure Well managed firms establish a target capital structure and strive to maintain the debt ratio
Capital Structure
Debt Equity
42
Equity Financing
Flotation (discount) Costs: the expenses associated with issuing stock Types of Equity Financing:
Retained earnings Common stock
Retained earnings + Preferred stock + Common stock
43
Bond Financing:
Debt Financing
Incur floatation cost No partial payment of principal

Only interest is paid each year (or semi-annually) The principal (face value) is paid in a lump sum when the bond matures Bond Financing
+
Term Loans
Term Loan:
Involve an equal repayment arrangement. May incur origination fee Terms negotiated directly between the borrowing company and a financial institution
44
Cost of Capital
Cost of Equity (ie) Opportunity cost associated with using shareholders capital Cost of Debt (id) Cost associated with borrowing capital from creditors Cost of Capital (k) Weighted average of ie and id
Cost of Debt
Cost of Equity
45
1. Calculating the after-tax Cost of Debt

id (cs / cd )ks (1 tm ) (cb / cd )kb (1 tm )
where Cs the amount of the term loan, Cb the amount of bond financing, ks the before - tax interest rate on the term loan, kb the before - tax interest rate on the bond, tm the firm' s marginal tax rate, and Cd Cs Cb
Practice Problem
Source Amount $1.33M Fraction 0.333
Alpha Corporation has decided to finance the remaining $4 million by securing a term loan and issuing 20-year $1,000 par bonds for the following condition.
Interest rate 12%
Term Loan Bond
$2.67M
0.667
10.74%
Alphas marginal tax rate 0.333 0.12 1 0.667 0.1074 1 is 38%, and it is expected i = a fa fa 0.38f+ a fa fa 0.38f = 6.92%. to remain constant in the future. What is the aftertax cost of debt? Fundamentals of Engineering 47
d
Economics 2004 by Chan S. Park
2. Calculating the Cost of Equity

Cost of Retained Earnings (kr) Cost of issuing New Common Stock(ke) Cost of Preferred Stock (kp) Cost of equity: weighted average of kr ke, and kp
Cost of Retianed Earnings Cost of Issuing New Stock Cost of Issuing Preferred Stock
48
Calculating Cost of Equity based on Financing Sources
ie (cr / ce ) kr (cc / ce ) ke (cp / ce ) k p

Where Cr = amount of equity financed from retained earnings, Cc = amount of equity financed from issuing new stock, Cp = amount of equity financed from issuing preferred stock, and Ce = Cr + Cc + Cp
Determining the Cost of Equity

Source Retained earnings New common stock Preferred stock Amount Interest Fraction of Total Rate Equity $1 M 20.50% $4 M 22.27% 0.167 0.666
$1 M 10.08%
0.167
ie (0167)(0.205) (0.666)(0.2227) (0167)(01008) . . . 19.96% Fundamentals of Engineering

Economics 2004 by Chan S. Park
50
The cost of equity is the risk-free cost of debt (20 year U.S. Treasury Bills around 7%) plus a premium for taking a risk as to whether a return will be received. The premium is the average return on the market (12.5%) less the risk-free cost of debt. This premium is multiplied by Beta, a measure of stock price volatility. Beta quantifies risk and is an approximate measure of stock price volatility. It measures one firms stock price compared (relative) to the market stock prices as a whole. A number greater than one means that the stock is more volatile than the market on average; a number less than one means that the stock is less volatile than the market on average. The following formula quantifies the cost of equity (ie).
ie rf [ rM rf ] where rf = risk free interest rate (commonly referenced to U.S. Treasury bond yield) rM = market rate of return (commonly referenced to average return on S&P 500 stock index funds)
Calculating Cost of Equity based on CAPM
Practice Problem Cost of Equity

Alpha Corporation needs to raise $10 million for plant modernization. Alphas target capital structure calls for a debt ratio of 0.4, indicating that $6 million has to be financed from equity. Alpha is planning to raise $6 million from the financial market Alphas Beta is known to be 1.8, which is greater than 1, indicating the firm is perceived more risky than market average. The risk free interest rate is 6%, and the average market return is 13%. Determine the cost of equity to finance the plant modernization.
3. Calculating the Weighted after-tax Cost of Capital

id Cd ieCe k V V
Cd= Total debt capital(such as bonds) in dollars, Ce=Total equity capital in dollars, V = Cd+ Ce, ie= Average equity interest rate per period considering all equity sources, id = After-tax average borrowing interest rate per period considering all debt sources, and k = Tax-adjusted weighted-average cost of capital.
Marginal Cost of Capital

Given: Cd = $4 million, Ce = $6 million, V= $10 millions, id= 6.92%, ie=19.96% Find: k
0.0692(4) 01996(6) . k 10 10 14.74%
Comments: This 14.74% would be the marginal cost of capital that a company with this financial structure would expect to pay to raise $10 million.
Cost of Capital
Cost of Debt
Cost of debt = debt interest rate (1 - tax rate)
Cost of Equity
Cost of Equity = Risk free return + Risk Premium =R f [ RM R f ] where R f risk free return (U.S. Treasury Bills) RM Average rate of return on market
= stock price volatility
Cost of Capital = (cost of debt) x (% of capital from debt) + (cost of equity) x (% of capital from equity)
Summary
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.
56
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
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.
58
Methods of financing: 1. Equity financing uses retained earnings or funds raised from an issuance of stock to finance a capital. 2. Debt financing uses money raised through loans or by an issuance of bonds to finance a capital investment. Companies do not simply borrow funds to finance projects. Well-managed firms usually establish a target capital structure and strive to maintain the debt ratio when individual projects are financed.
The selection of an appropriate MARR depends generally upon the cost of capitalthe rate the firm must pay to various sources for the use of capital. The cost of the capital formula is a composite index reflecting the cost of funds raised from different sources. The formula is
id Cd ieCe k , V V
where V Cd Ce
60
The marginal cost of capital is defined as the cost of obtaining another dollar of new capital. The marginal cost rises as more and more capital is raised during a given period.
61

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Chapter 5 Project Cash Flow Analysis

Engineering Economic Decisions

Valuation of Fixed Assets

Fundamentals of Engineering Economics 2004 by Chan S. Park

General Cost Terms

Fundamentals of Engineering Economics 2004 by Chan S. Park

Classifying Costs for Financial Statements

Cost Classification for Predicting Cost Behavior

Fundamentals of Engineering Economics 2004 by Chan S. Park

Fundamentals of Engineering Economics 2004 by Chan S. Park

Average Unit Cost

What Income Tax Rate Should be Used in Project Analysis?

Revenues Expenses Taxable Income Income Taxes

Fundamentals of Engineering Economics 2004 by Chan S. Park

Incremental Income Tax Rate

Expenses Taxable income Income taxes Average tax rate

130,000 $70,000 $12,500 17.86%

150,000 $90,000 $18,850 20.94%

20,000 $20,000 $6,350 31.75%

Fundamentals of Engineering Economics 2004 by Chan S. Park

0.25($5,000/$20,000) + 0.34($15,000/$20,000) = 31.75%

Incremental $20,000 6,350

34% $80,000 $100,000

Fundamentals of Engineering Economics 2004 by Chan S. Park

Elements of Investment Decision

Types of Cash Flow Elements in Project Analysis

Fundamentals of Engineering Economics 2004 by Chan S. Park

Cash Flows from Operating Activities

Fundamentals of Engineering Economics 2004 by Chan S. Park

A Typical Format used for Presenting Cash Flow Statement

+ Net income +Depreciation

Operating activities + Investing activities + Financing activities

When Projects Require Working Capital Investments

8.92% 8.93% 4.46%

$11,150 $11,150 $5,575

(a) Step 2: Gains (Losses) associated with Asset Disposal

Example 9.1 - Income Statement

Fundamentals of Engineering Economics 2004 by Chan S. Park

Example 9.1- Cash Flow Statement

$25,282 $17,632 $22,882 $26,632 17,863 30,613 21,863 15,613

(125,000) (23,331) 23,331 50,000 (6,613) $104,950

$100,000 100,000 100,000 100,000 100,000

20,000 20,000 20,000 20,000 20,000

12,000 12,000 12,000 12,000 12,000

8,000 8,000 8,000 8,000 8,000

$17,863 30,613 21,863 15,613 5,581

42,137 29,387 38,137 44,387 54,419 16,525

16,855 11,755 15,255 17,755 21,678 6,613

$43,145 $48,245 $44,745

$42,245 $38,232 $43,387 23,331

Note that H = C-D-E-F-G I = 0.4 * H J= B+C-D-E-F-I

Information required to calculate the income taxes

Fundamentals of Engineering Economics 2004 by Chan S. Park

Cash Flow Diagram including Working Capital

$125,000 Investment in physical assets $23,331 Investment in working capital

Fundamentals of Engineering Economics 2004 by Chan S. Park

Fundamentals of Engineering Economics 2004 by Chan S. Park

Question (C): IRR

Rate of Return Analysis (IRR = 22.55%)

$42,245 $104,950 -$85,622 0

-$148,331 -$138,635 -$121,652 -$104,339

Fundamentals of Engineering Economics 2004 by Chan S. Park