Contemporary Engineering Economics, 4 th edition, © 2007 When Projects Require Working-Capital...
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Transcript of Contemporary Engineering Economics, 4 th edition, © 2007 When Projects Require Working-Capital...
Contemporary Engineering
Economics, 4th edition, © 2007
When Projects Require Working-Capital Investments
Lecture No. 40Chapter 10Contemporary Engineering EconomicsCopyright © 2006
Contemporary Engineering
Economics, 4th edition, © 2007
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.
What is Working Capital?
Contemporary Engineering
Economics, 4th edition, © 2007
Working Capital Equations Accounting definition:
WC = Current Asset – Current Liabilities WC = CA - CL
where WC = changes in working capital CA = changes in current assets CL = changes in current liabilities
If WC > 0, working capital requirement. With the net change being positive, the firm has a net requirement of working capital that has to be financed during the year. Therefore, the WC requirement appears as uses of cash in the cash flow statement.
If WC < 0, working capital release. If this amount were negative, there would have been a cash inflow from working capital release, which could add to the sources of cash.
Contemporary Engineering
Economics, 4th edition, © 2007
Price (revenue) per unit $10
Unit variable manufacturing costs:
Labor
Material
Overhead
$2
$1.20
$0.80
Monthly volume 833 units
Finished goods inventory to maintain 2 – month supply
Raw materials inventory to maintain 1 – month supply
Accounts payable 30 days
Accounts receivable 60 days
Example 10.2 Working Capital Requirements
Contemporary Engineering
Economics, 4th edition, © 2007
Required Working Capital Investments
Contemporary Engineering
Economics, 4th edition, © 2007
New entry related toworkingcapitalinvestment
Cash Flow Statement with Working-Capital Requirement (Example 10.3)
Contemporary Engineering
Economics, 4th edition, © 2007
0 1 2 3 4 5
$23,331Years
$23,331
Working capital recovery cycles
0 1 2 3 4 5
$43,145$48,245 $44,745
$42,245$81,619
Working capitalrecovery
$23,331
$125,000 Investment in physical assets
$23,331 Investment inworking capital
$23,331
$23,331
Cash Flow Diagram including Working Capital
Contemporary Engineering
Economics, 4th edition, © 2007
Changes in Profitability
NPW without the Working Capital Requirement PW(15%) = $43,152
NPW with the Working Capital Requirement in the amount of $23,331 PW(15%) = $31,420
The $11,732 reduction in present worth is from the investment tied up in working capital that results in lost earnings.
Contemporary Engineering
Economics, 4th edition, © 2007
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)
?
$90M
$31.5M
Tax Savings = $35M - $31.5M = $3.5MOr (10M)(0.35) = -$3.5M
Tax savings
Contemporary Engineering
Economics, 4th edition, © 2007
Example 10.5 Project Cash Flows for a Cost-Only Project Project Nature: Installing a cooling-fan at Alcoa
Aluminum’s McCook plant to reduce the work-in-process inventory buildup
Financial Facts: Required investment: $536,000 Service life: 16 years Salvage value: 0 Reduction of WIP (working-capital release): $2,121,000 Depreciation Method: 7-year MACRS Annual electricity cost: $86,000 Income tax rate:40% MARR: 20%
Develop the project cash flow
Contemporary Engineering
Economics, 4th edition, © 2007
Cash Flow Statement (Table 10.5)
Contemporary Engineering
Economics, 4th edition, © 2007
Measures of Investment Worth for the Cooling-Fan Project MARR = 20% PW(20%) =
$991,008 i* = 4.24% and
291.56% A nonsimple and
mixed investment RIC = 241.87%
>20% Good investment!