Lecture no34 generalized cash flow approach

Generalized Cash Flow Approach – Lease versus Buy

Lecture No. 34
Chapter 10
Contemporary Engineering Economics
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Generalized Cash Flow Approach

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When to use: When a project does not change a company’s marginal tax rate
Pros: The cash flows can be generated more quickly, and the formatting of
results is less elaborate. There are also analytical advantages in modeling
project cash flows.

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Cons: The process is less intuitive and not commonly understood by business
people.

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Setting Up Net Cash Flow Equations

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Presenting Cash Flows in Compact Tabular Forms

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Mathematical Form

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Tabular Presentation

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Example 10.7: Using the Generalized Cash Flow Approach

 Given: Reconsider Example 10.4.
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Investment = $125,000
Investment in working capital = $23,333
Project life = 5 years
Salvage value = $50,000
Annual revenues = $100,000
Annual expenses other than depreciation = $40,000
Debt interest payment
Principal repayment
Depreciation = 7-year MACRS
Marginal tax rate = 40%

Find: project cash flows based on the generalized cash flow approach.

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Solution

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Example: Lease-or-Buy Decision

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Lease option

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Buy option

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The proposed lease term: 60 months
The proposed lease payment: $4,202

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Your income tax rate: 28%
Your sales tax rate: 5%
The cost of capital (discount rate): 8%
The method of depreciation: 5-year MACRS
The cost of equipment: $248,500
You intend to use the equipment for: 60 months
When you’re done with the equipment you believe you can sell it for: $49,700

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Lease Option
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Assumption: Lease payment at beginning of each month
Total monthly lease payment = $4,202(1.05) = $4,412.10
Net after-tax monthly lease expense = $4,412.10(1 − 0.28) =$3,176.71



8%
8%
PW( )Lease = $4,202(1.05)(1− 0.28) 1+ (P / A, ,59)÷
12
12


= $3,176.71(49.6472)
= $157,715
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Buy Option
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Up-front cash payment:
End of Year

$248,500(1.05) = $260,925

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Allowed Depreciation

Tax Shield

Present Worth
at 8%

PW(8%)1 = $260,925
1

20%

$52,185

$14,612

$13,530

PW(8%)2 = $53,760

2

32%

83,496

23,379

20,044

Net proceeds from sale:

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19.2%

50,098

14,027

11,135

4

11.52%

30,059

8,417

6,187

5

5.76%

15,029

4,208

2,864

Tax depreciation shield:

Net salvage = $49,700 − $5,500

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5-Year MACRS

= $44,200

PW(8%)3 = $30,082

Total cost of buying option:
PW(8%) = $250,925 − $53,760 − $30,082 = $177,084

Total Sum

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$230,867

$53,760

Book value at the end of year 5:
BV5 = $260,925 − $230,867 = $30,058

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Taxable gains:
Gains = $49,700 − $30,058 = $19,642


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Gains tax = $19,642(0.28)= $5,500

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How Much Would You Save in Present Dollars?

o Lease option

o PW(8%/12) = $157,715

o Buy option

o PW(8%) = $177,084

o Net Savings over buy option
o Savings = $19,369

What should you do? Lease.

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Summary
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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

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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

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 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.

 The generalized cash flow approach to organizing cash flows can be used when a project does not
change a company’s marginal tax rate.

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