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!