Lecture of Economical Analysis of Projects by Peyman Sazandehchi

8/14/2019 Lecture of Economical Analysis of Projects by Peyman Sazandehchi

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Cash Flows and Financial Topics inCash Flows and Financial Topics in

Capital BudgetingCapital Budgeting

Prepared by:Prepared by:Peyman SazandehchiPeyman Sazandehchi


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:

.4

.6 ()

8.


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10

.

.


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)Book Value(

. .


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:

.

n

VVd s

=

adVVa

=

d=annual depreciation

V= original value

Vs=Salvage Value

n=Service life

Va=Book Valuea=the number of years in actual use.

( :) .

V=a=V)1-f(

Va=V)1-f(2=Vs

f=1-)Vs/V(1/n


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:1

() 22000 .()

10 2000 . ( ) 5

:

() () () 200(( )

)

adVVa

==22000-)5()2000(=12000

f=1-)Vs/V(1/n=1-)2000/22000(1/10=0.2131

) )

Va=V)1-f(2

=)22000()1-0.2131(5=6650$

) )

) )Va=V)1-f(2=)22000()1-0.1818(5=8060$


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((DepreciationDepreciation ))

s ..s

.. s

TTcc..


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11

Time value of money:

A dollar today is not the same as a dollartomorrow.

BASIC FINANCIAL TERMS: A REVIEWMoney can earn interest and its value may increase

with time.


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12

r =r = 1010%%

)FV()FV( ( =( =11 r ( +r ( + nn

0 1 2 3

100(1+10%)1 100(1+10%)2 10(1+10%)3= 110 = 121 = 133


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13

s Present Value (PV) = F/(1 + d)Present Value (PV) = F/(1 + d)nn = F.f= F.fdds Where:Where:s d : discount rated : discount rates fd : discount factor )1/)1+d(fd : discount factor )1/)1+d(nn((

100100( /( /11++1010%%))33== ==133133

)PV()PV( ==11( /( /11 r ( +r ( + nn

PVIF ) r, n ( =PVIF ) r, n ( = 0.75130.7513

0 1 2 3

133


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CCtt (Cash Flow)(Cash Flow)

s t.t.s t.t.s

t.t.s t.t.s t.t.


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15

)OCF()OCF(sTax-ShieldTax-Shield

OCFOCF == )S - C - D( + D - )S - C - D()S - C - D( + D - )S - C - D( TT

== )S - C()S - C( )1 - T( + )D)1 - T( + )D T(T(

== )S - C()S - C( )1 - T( +)1 - T( + TTsBottom-UpBottom-Up


== )S - C - D()S - C - D( )1 - T( + D)1 - T( + D

== ++sTop-DownTop-Down


== )S - C( - )S - C - D()S - C( - )S - C - D( TT

== ----


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Cash Flows & Other TopicsCash Flows & Other Topicsinin

Capital BudgetingCapital Budgeting

1999, Prentice Hall, Inc.


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Capital BudgetingCapital Budgeting:: the process of planning forthe process of planning for

purchases ofpurchases oflong-termlong-term assets.assets.

s exampleexample::

Our firm must decide whether to purchase aOur firm must decide whether to purchase a

new plastic molding machine fornew plastic molding machine for $127,000$127,000..

How do we decide?How do we decide?

s Will the machine be profitable?Will the machine be profitable?

s Will our firm earn a high rate of return onWill our firm earn a high rate of return on

the investment?the investment?

s The relevant project information follows:The relevant project information follows:


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s The cost of the new machine isThe cost of the new machine is $127,000$127,000..

s Installation will costInstallation will cost $20,000$20,000..

s

$4,000$4,000 in net working capital will be neededin net working capital will be neededat the time of installation.at the time of installation.

s The project will increase revenues byThe project will increase revenues by

$85,000$85,000 per year, but operating costs willper year, but operating costs willincrease byincrease by 35%35% of the revenue increase.of the revenue increase.

s Simplified straight line depreciation is used.Simplified straight line depreciation is used.

s

Class life isClass life is 55 years, and the firm is planningyears, and the firm is planningto keep the project forto keep the project for 55 years.years.

s Salvage value at year 5 will beSalvage value at year 5 will be $50,000$50,000..

s 14%14% cost of capital;cost of capital; 34%34% marginal tax rate.marginal tax rate.


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Capital Budgeting Steps:Capital Budgeting Steps:

1)1) Evaluate Cash FlowsEvaluate Cash Flowss Look at all incremental cash flowsLook at all incremental cash flows

occurring as a result of the project.occurring as a result of the project.

Initial outlayInitial outlay..

Differential Cash FlowsDifferential Cash Flows over the life ofover the life of

the project (also referred to as annual cashthe project (also referred to as annual cashflows).flows).

Terminal Cash FlowsTerminal Cash Flows..


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Capital Budgeting Steps:Capital Budgeting Steps:

1)1) Evaluate Cash FlowsEvaluate Cash Flows

0 1 2 3 4 5 n6 . . .

TerminalTerminal

Cash flowCash flow

Annual Cash FlowsAnnual Cash Flows

InitialInitial

outlayoutlay


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Step 1: Evaluate Cash FlowsStep 1: Evaluate Cash Flows

s

a)a) Initial OutlayInitial Outlay:: What is the cash flow atWhat is the cash flow attime 0?time 0?

(Purchase Price of the Asset)(Purchase Price of the Asset)

+ (+ (shipping and installation costs)shipping and installation costs)

(Depreciable Asset)(Depreciable Asset)+ (Investment in working capital)+ (Investment in working capital)

++ After-tax proceeds from sale of old assetAfter-tax proceeds from sale of old asset

Net Initial OutlaNet Initial Outla


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s


(127,000)(127,000)

+ (+ (shipping and installation costs)shipping and installation costs)





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s


(127,000)(127,000)

++ (( 20,00020,000))





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s


(127,000)(127,000)

+ (+ ( 20,00020,000))

(147,000)(147,000)+ (Investment in working capital)+ (Investment in working capital)




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s


(127,000)(127,000)

+ (+ ( 20,00020,000))

(147,000)(147,000)++ ( 4,000)( 4,000)




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s


(127,000)(127,000)

+ (+ ( 20,00020,000))

(147,000)(147,000)+ ( 4,000)+ ( 4,000)

++ 00



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s


(127,000)(127,000)

+ (+ ( 20,00020,000))

(147,000)(147,000)+ ( 4,000)+ ( 4,000)

++ 00

$151 000$151,000


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s

b)b) Annual Cash FlowsAnnual Cash Flows:: What incrementalWhat incrementalcash flows occur over the life of thecash flows occur over the life of the

project?project?


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Incremental RevenueIncremental Revenue

- Incremental Costs- Incremental Costs

-- Depreciation on projectDepreciation on project

Incremental Earnings before TaxesIncremental Earnings before Taxes

-- Tax on Incremental EBTTax on Incremental EBT

Incremental Earnings after TaxesIncremental Earnings after Taxes

++ Depreciation ReversalDepreciation Reversal

Annual Cash FlowAnnual Cash Flow

For Each Year, Calculate:For Each Year, Calculate:


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Incremental RevenueIncremental Revenue








For Years 1 - 5:For Years 1 - 5:


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85,00085,000









1


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85,00085,000

(29,750)(29,750)








F Y 1 5


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85,00085,000

(29,750)(29,750)

(29,400)(29,400)







F Y 1 5


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85,00085,000

(29,750)(29,750)

(29,400)(29,400)

25,85025,850






1F Y 1 5


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85,00085,000

(29,750)(29,750)

(29,400)(29,400)

25,85025,850

(8,789)(8,789)





F Y 1 5F Y 1 5


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85,00085,000

(29,750)(29,750)

(29,400)(29,400)

25,85025,850

(8,789)(8,789)

17,06117,061




F Y 1 5F Y 1 5


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85,00085,000

(29,750)(29,750)

(29,400)(29,400)

25,85025,850

(8,789)(8,789)

17,06117,061

29,40029,400



F Y 1 5F Y 1 5


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85,00085,000 RevenueRevenue

(29,750)(29,750) CostsCosts

(29,400)(29,400) DepreciationDepreciation

25,85025,850 EBTEBT(8,789)(8,789) TaxesTaxes

17,06117,061 EATEAT

29,40029,400 Depreciation reversalDepreciation reversal

46,461 =46,461 = Annual Cash FlowAnnual Cash Flow


S 1 l C h lS 1 E l C h Fl


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s

c)c) Terminal Cash FlowTerminal Cash Flow: What is the cash: What is the cashflow at the end of the projects life?flow at the end of the projects life?

Salvage ValueSalvage Value

+/- Tax effects of capital gain/loss+/- Tax effects of capital gain/loss

++

Recapture of Net Working CapitalRecapture of Net Working Capital

Terminal Cash FlowTerminal Cash Flow

S 1 E l C h FlS 1 E l C h Fl


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s


50,00050,000 Salvage ValueSalvage Value

+/- Tax effects of capital gain/loss+/- Tax effects of capital gain/loss

++

Recapture of Net Working CapitalRecapture of Net Working Capital


T Eff t f S l f A tT Eff t f S l f A t


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Tax Effects of Sale of Asset:Tax Effects of Sale of Asset:

s Salvage value = $50,000Salvage value = $50,000

s Book Value = depreciable asset - totalBook Value = depreciable asset - total

amount depreciated.amount depreciated.

s Book Value = $147,000 - $147,000Book Value = $147,000 - $147,000= $0.= $0.

s Capital Gain = SV - BVCapital Gain = SV - BV

= 50,000 - 0 = $50,000= 50,000 - 0 = $50,000

s Tax payment = 50,000 x .34 = ($17,000)Tax payment = 50,000 x .34 = ($17,000)

s Which of these are Cash Flows?Which of these are Cash Flows?

T Eff t f S l f A tT Eff t f S l f A t


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Tax Effects of Sale of Asset:Tax Effects of Sale of Asset:

s Salvage value = $50,000Salvage value = $50,000

s Book Value = depreciable asset - totalBook Value = depreciable asset - total

amount depreciated.amount depreciated.

s Book Value = $147,000 - $147,000Book Value = $147,000 - $147,000= $0.= $0.

s Capital Gain = SV - BVCapital Gain = SV - BV

= 50,000 - 0 = $50,000= 50,000 - 0 = $50,000

s Tax payment = 50,000 x .34 = ($17,000)Tax payment = 50,000 x .34 = ($17,000)

S 1 E l C h FlSt 1 E l t C h Fl


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s


50,000 Salvage Value50,000 Salvage Value

(17,000)(17,000) Tax on Capital GainTax on Capital Gain

++

Recapture of NWCRecapture of NWC



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St 1 E l t C h FlSt 1 E l t C h Fl


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s

c)c)


: What is the cash: What is the cash

flow at the end of the projects life?flow at the end of the projects life?

50,000 Salvage Value50,000 Salvage Value

(17,000) Tax on Capital Gain(17,000) Tax on Capital Gain

4,0004,000

Recapture of NWCRecapture of NWC

37,000 Terminal Cash Flow37,000 Terminal Cash Flow


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Project NPV:Project NPV:

s CF)0( = -151,000CF)0( = -151,000

s CF)1 - 4( = 46,461CF)1 - 4( = 46,461

s CF)5( = 46,461 + 37,000 = 83,461CF)5( = 46,461 + 37,000 = 83,461

s Discount rate = 14%Discount rate = 14%

sNPV = 27,721NPV = 27,721s We wouldWe would acceptaccept the project.the project.


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Payback Period

1. Annual cash flow is equal

3. Annual cash flow is different


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C l l i b kC l l i b k


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Calculating paybackCalculating payback

PaybackL = 2 + / = 2.375 years

CFt -100 10 60 100

Cumulative -100 -90 0 50

0 1 2 3

=

2.4

30 80

80

-30

Project L

PaybackS = 1 + / = 1.6 years

CFt -100 70 100 20Cumulative -100 0 20 40

0 1 2 3

=

1.6

30 50

50-30

Project S

Discounted Payback IllustratedDiscounted Payback Illustrated


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Discounted Payback IllustratedDiscounted Payback Illustrated

$-$-10001000 R =R = 10%10%

11 $$ 200200 $$ 18218222 400400 331331

44 700700 52652655 300300 205205

11 $$ 182182

22 513513

33 10391039

44 12441244

%10%1033 ..


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)NPV()NPV(

.1.1

++--

PVPV2.2.

NPV = -CNPV = -C00++ )PV)PV )).3.3

.. 00> NPV> NPV 4.4. NPV > 0NPV > 0 ..

..

N P V lN t P t V l


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Net Present ValueNet Present Value

CFR

CF

n

i

iiNPV 0

1 (1)= +=

n

n

n

n

r

C

r

C

r

CC

r

R

r

R

r

RRNPV

(1)

...

(1)(1)

(1)...

(1)(1)

2

2

1

10

2

2

1

10

+

++

+

+

+

+

+

++

+

+

+

+=

== +

+

=

n

yy

y

n

yy

y

rC

rRNPV

00 (1)(1)


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The Net Present Value Method: SummaryThe Net Present Value Method: Summary

NPVNPV


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NPVNPVN D

$ $-400 -400 0

-100 -100 5

+1200 8

+200 15

+2500 +6600 30

758400(06.1)

100

(06.1)

200

(06.1)

660051530

=+=DNPV

: = %6R

713400(06.1)

100

(06.1)

1200

(06.1)

2500

5830

=+=N

NPV


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NPVNPVs XX

::

--$$11001100

==%10%10

11 $$10001000 $$50050022 20002000 10001000

s NPVNPV


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NPVNPV0 1 2

)$1100(

$1000 500

$500

$2000 1000

$1000 $1100

+454/54

+826/45

+$181

1$500

1/1

1$1000

1/12

NPV


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)Internal Rate of Return()Internal Rate of Return(

IRRIRR ..

IRRIRR =0=0NPVNPV ..

IRRIRR MARMAR

..

0(1)(1) 00=

+

+==

n

yy

yn

yy

y

IRR

C

IRR

R

(0)0 1 (1) CFRCFn

ii

i

NPV==

+=


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The Internal Rate of Return Method: SummaryThe Internal Rate of Return Method: Summary


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:

0 1 2 3 4

-1000 500 400 300 100IRR :

IRR = 5/14%

( ) ( ) ( )NPV IRR IRR IRR IRR= + + + + + + + + =1000

500

1

400

1

300

1

100

102 3 4


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0 $275

1 100

2 100

3 100

4 100

Discount rate

2% 6% 10% 14% 18%

120

100

80

60

40

20

NPV

0

20

40

22%

IRR

NPVNPV


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::NPVNPVs

DeereTownDeereTown ::

00

11

22

1/61/6 1010 --1010

s IRRIRR

):: )NPV IRR IRR= + + + =1 610

1

10

10

2

.

. % 40025 IRR


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(PI (Profit Index(PI (Profit Index

s ..

0Cf

PVPI =

x 1PI .

x PINPV

.

//


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)Benefit-Cost Ratio()Benefit-Cost Ratio(

sB/CB/C MARMAR sB/CB/C ..

s B/CB/C 11..

=

=

+

+=

n

y

y

y

n

yy

y

r

C

r

R

ratioCB

0

0

(1)

(1)/

NPVNPV


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NPVN VN D

$ $

-400 -400 0

-100 -100 5

+1200 8

+200 15

+2500 +6600 30

758400(06.1)

100

(06.1)

200

(06.1)

660051530

=+=DNPV

: = %6R

713400(06.1)

100

(06.1)

1200

(06.1)

2500

5830

=+=N

NPV


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//

6.2400

06.1

10006.1

200

06.1

6600

/5

1530

=+

+

=CB

Break-Even Point AnalysisBreak-Even Point Analysis


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y

Variable Costs: vary directly with the volume of production

Fixed Costs : independent of the volume of production

Total cost = fixed cost plus )variable cost times volume(

TC= F + cQ

What types of costs do we consider?

Break-even point: the volume at which total sales

equal total costs.

Break-Even Point AnalysisBreak-Even Point Analysis


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yy

Cost

Volume

Total revenueTotal cost

Fixed cost

BEP

Compare costs of different processes.

Make decisions about process and capacity. Break-Even Point: costs equal revenues.

Assumptions:

All costs are linear.

All units produced

are sold.

Price does not change.

Calculation of Break-Even PointCalculation of Break-Even Point


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TC = F + cQTC = F + cQ

TC = total costTC = total cost

F = fixed costF = fixed costc = variable costc = variable cost

Q = quantity produced and soldQ = quantity produced and sold

TR = pQTR = pQ

TR = total revenueTR = total revenue

p = price per unitp = price per unit

To find BEPTo find BEP in unitsin units , find Q where TC=TR:, find Q where TC=TR:

pQ =F + cQpQ =F + cQ cpF

Q

=


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End of ChapterEnd of Chapter


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Fixed capital investment costDirect costs


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1- Purchased equipment )15-40%(

All equipment listed on a complete flow sheet

Spare parts

Freight charge

Taxes, insurance, duty

2- Installation )6-14%(

Installation All equipment listed on a complete flow sheet

Structural support, insulation, paint

3- Instrumentation and controls )2-8%(

Purchase, installation, calibration

4-Piping )3-20%(

Pipe hangers, fittings, valves

Insulation-piping

Fixed capital investment costDirect costs5 Electrical equipment and materials )2 10%(


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5- Electrical equipment and materials )2-10%(

-Electrical equipment switches, motors, conduit, wire, fitting, feeders, grounding,

instrument and control wiring, lighting, panels, labor

6- Building )including services()3-18%(

-Process building- platforms, supports, stairways, access ways, cranes, monorails,

elevators

-Auxiliary building, administration and office, medical or dispensary, cafeteria, garage,

product warehouse, parts warehouse, guard and safety, fire station, change house,personnel building, research and control laboratory

-Maintenance shops- electric, piping, sheet metal, machine, welding, carpentry,

instrument

- Building services-plumbing, heating, ventilation, dust collection, air conditioning,building lighting, elevators, escalators, telephones, intercommunication systems,

painting, fire alarm

7- Site preparation )2-5%(

- Site development- site clearing, grading, roads, walkways, railroads, fences, parkingarea recreational facilities landsca in


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Fixed capital investment costIndirect costs1 Engineering and supervision )4-21%(


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1. Engineering and supervision )4-21%(

- Engineering costs- administrative, process, design and general engineering, drafting,

cost engineering, procuring, expediting, reproduction, communications, scale mode,

consultant fees, travel- Engineering supervision and inspection

2. Construction expenses )4-16%(

- Construction, operation and maintenance of temporary facilities ,office, road,

parking lots, railroads, electrical, piping, communications, fencing- Construction tools and equipment

- Construction supervision, accounting, timekeeping, purchasing, expediting

- Warehouse personnel and expense, guards

- Safety, medical, fringe benefits

- Permits, field tests, special licenses

- Taxes, insurance interest

3. Fee contractor )2-6%(

4. Contin enc 5-15%

Direction Production Costs


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Total Production Cost

)Capital investment(

Manufacturing Costs

General Expenses


Fixed Charge

Plant overhead Costs

Administrative Expenses

Distribution & Marketing Expens



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Raw materials

Operating labor

Operating supervision

Steam

Electricity

Fuel

Refrigeration

Water

Maintenance and repairs

Operating supplies

Laboratory charges

Royalties (if not lump-sum)

Catalysts and solvent

Power and Utilities

Fixed Charges


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Fixed Charges

Depreciation

Taxes

Insurance

Rent

Plant Overhead Costs


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Medical

Safety and protection

General plant

Payroll overhead

Packaging

Restaurant

Recreation

Salvage

Control laboratories

Plant superintendence

Storage facilities


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Administrative Expenses

Executive salaries

Clerical wages

Engineering and legal costs

office maintenance

communications

Distribution & Marketing Expenses


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Distribution & Marketing Expenses

Sales offices

Salesmen expenses

Shipping

Advertising

Technical sales service


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%

40-15

14-6

8-2

20-3

10-218-3

5-2

20-8

2-1

21-4

16-4

6-2

15-5

( )

h kTh k Y


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Thank YouThank You

Lecture of Economical Analysis of Projects by Peyman Sazandehchi

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