ED72.

13 Development and Evaluation

of Energy Projects 3(2-3)

III. Cost Concepts and Financial Calculations (contd.)

(Please refer to book contemporary engineering economics 4 th edition)

Dr. Shobhakar Dhakal

Associate Professor, School of Environment, Resources and
Development, Asian Institute of Technology
 Developing project cash-flows
Identifying and estimating project cash
flows is very challenging- and most
important step
All cash flows of a project is often
organized into few categories, namely
Operating activities
Investing activities, and
Financing activities

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 Cash flow vs. net income
Net income
Measures a firm’s profitability. Costs become
expenses and evaluated against revenue
The actual timing of cash inflows and outflows
are ignored
Cash flow
Time value of money is considered and it is
better to receive cash now than later

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 Typical income statement
• The ‘income statement’ is a major financial statements used by accountants and
businesses
• Income statement shows profitability of a company during the specified time
interval
Revenues Project description
Expenses – Purchased an equipment costing
$28,000
Cost of goods sold
– Gross income: $50,000/yr
Depreciation – Cost of goods sold: $20,000/yr
Debt interest – Operating expenses: $6,000/yr
Operating expenses • Depreciation method – 7-year
MACRS
Taxable income • Income tax rate: 40%
Income taxes • Determine the net income
Net income during the first year of operation

4 Modified Accelerated Cost Recovery System

(MACRS)
 MACRS
Depreciation
Schedules for
Personal
Properties with
Half-Year
Convention,
Declining-
Balance Method

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 Capital expenditure vs. depreciation
expenses

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 Net income and Net cash flow statements

Item Income Cash

Gross income (revenue) flow
$50,000
Expenses: 50,000
Cost of goods sold 20,000
Depreciation 4,000 - 20,000
Operating expenses 6,000
- 6,000
Taxable income 20,000
Taxes (40%) 8,000
-8,000
Net income $12,000
Net cash flow Net income (12,000) and depreciation (4,000) =
$16,000
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Net cash flow (deprec. is generally not a cash flow,
it not ‘paid’, and accounted separately)
 Preparing “cash flow statement”
 “Net income” and “depreciation” is taken from “Income
Statement”- these are called “operating activities”

Examples of operating activities and business terminologies

Gross income Gross revenue, sales revenue, gross profit,
operating revenue
Cost savings Cost reduction
Manufacturing expenses Cost of goods sold, cost of revenue
O & M cost Operating expenses
Operating income Operating profit, gross margin
Interest expenses Interest payments, debt cost
Income taxes Income taxes owed
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 Preparing “cash flow statement” to determine
“net cash flow”
 However, there are cash flow components other than
operating activities that needs to be accounted, these are
Investing activities, and
Financing activities

Gains tax: Tax levied on the profits that

an investor/company makes when
selling the capital asset (stock, bond or
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real estate etc.) for a price that is higher
than the purchase price Contemporary Engg Economics, pp 499
 Cash flow elements and their equivalent terms
as practiced in business
Investing activities:
Capital investment Purchase of new equipment,
capital expenditure
Salvage value Net selling price, disposal value,
resale value
Investment in working capital Working-capital requirement
Release of working capital Working-capital recovery
Gains taxes Capital gains taxes, ordinary gains taxes
Financing activities:
Borrowed funds Borrowed amounts, loan amount
Repayment of principal Loan repayment

(Some of them could be tax deductible such as payment of interest (they

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are in operating activities)
 Cash outflows (-) and inflows (+) examples
Cash outflows
Purchase of New Equipment
Investments in Working Capital
Manufacturing, Operating, and Maintenance Costs
Leasing Expenses
Interest and Repayment of Borrowed Funds
Income Taxes and Tax Credits
Cash inflows
Borrowed Funds
Operating Revenues
Cost Savings (or Cost Reduction)
Salvage Value
Working-Capital Release
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 Typical cash flow elements

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Contemporary Engg Economics, pp 496
 Working-capital
Working capital = Current assets – current liabilities
Companies with big working capital are better
positions to expand business
Working capital is a common measure of company’s
financial health
Companies need enough short term assets to cover its
short term debt- otherwise trouble paying back to
creditors in the short term- worst-case scenario is
bankruptcy
Investment in non-depreciable assets: Called
investment in working capital
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 Cases of developing project cash flow
statements
Case I: When projects require only operating and
investing activities (no financing activities)-
example 10.1
Case II: When projects require working-capital
investments- example 10.2 and 10.3
Case III: When projects are financed with
borrowed fund
Case IV: When projects result in negative taxable
income
Case V: When projects require multiple assets
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 Example 10.1
A computerized machining center has been proposed
for a small tool manufacturing company. If the new
system, which costs $125,000, is installed, it will
generate annual revenues of $100,000 and will require
$20,000 in annual labor, $12,000 in annual material
expenses, and another $8,000 in annual overhead
(power and utility) expenses. The automation facility
would be classified as a seven-year MACRS property.
The company expects to phase out the facility at the end
of five years, at which time it will be sold for $50,000.
(a) Find the year-by-year after-tax net cash flow for the
project at a 40% marginal tax rate based on the net
income (b) is project justifiable at MARR of 15%? if so,
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determine the after-tax net present worth of the project
 Strategies
Develop ‘income statement’
Calculate operating activities
‘net income’ and ‘depreciation’ (cash flow
statement)
Calculate investment activities- investment,
salvage value and gains tax
Calculate “net cash flow”
Carry out investment analysis (justified?)
and present worth and IRR
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17 NPW (15%) = $43,152
 Case II- With working capital
Investment in working capital are necessary when, say,
replacing new machine will deliver increased capacity so
that more energy, more materials, inventory holding etc.
will increase and these new cash flow changes are to be
financed.
Consideration to working capital “investment” OR
“release” change the present worth
If to be invested- PW will decline
If to be released – PW will increase
Working capital investment is to be treated same as
investment in depreciable assets except no tax effect (no
depreciable allowance for tax benefits possible)
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Problem
10.3:
Assuming
working
capital
investment
as 23,331$
in problem
10.1

NPW (15%) = $31,420

19 NPW decreased !!!
 Project financed through borrowed capital
We see how to add “Financing activities” in cash
flow
How companies finance equipment and physical
plants
Partly debt, partly own earnings (equity)
The “total debt/total investment” OR “Debt
Ratio” shows % of initial investment that is
borrowed
Interest is tax deductibles expense so companies
may prefer debt financing
In last problem (10.3), say, out of $125,000 the debt
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ratio is 0.5. The borrowed money is repaid in equal
 Example 10.4
Borrowed capital: 50% of 125,000 = $62,500
Remaining 50% from equity (retained earnings)
How to show this in ‘income statement’ and ‘cash flow’?
remember interest payment are tax deductibles- we want to
get tax benefits as much as possible
Strategies: Split annual repayment into two parts (a)
interest repayment (b) principal repayment
Equal annual repayment of loan=?
= 62500 (A/P, 10%,5) = $16,487
No we split it into interest repayment and principal
repayment
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 Repayment schedule for annual payment of
$16,487(say, this as L)
Year Beginning Interest Principal Ending balance
balance (A) payment (B) payment (L-B) [A- (L-B)]
10% of A
1 62,500 6,250 = 16,487 – 6,250 = 52,263
10,237
2 52,263 5,226 = 16,487 – 5,226 = 41,002
11,261
3 41,002 4,100 = 16,487 – 4,100 = 28,615
12,387
4 28,615 2,861 = 16,487 – 2,861 = 14,989
13,626
5 14,989 1,499 = 16,487 – 1,499 = 0
14,988

Cash flow statements

22 Income statement- used for tax deductions
NPW (15%) =
$44,439

Why increased
?

10% interests
rate at which
money can be
borrowed is
less than
MARR
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 When project results in negative taxable
income
In a typical year, revenue might decline and
cost increase. With annually ‘allowed
depreciation’ of asset (by fixed %), this
might result in negative taxable income in
some year !!
Does not mean, no tax is needed to pay, but
this –ve figure can be used to reduce taxable
income generated in other business
operations- causing tax saving
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 When project requires multiple assets
Often many assets are needed to purchase in the
project that belong to different property classes.
Example: A power plant may need a new generator
as well as building to house the generator
Moreover, different assets may have to be put in
different time
How we handle such complex project?
See Problem 10.6

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 Langley Manufacturing Company (LMC), a manufacturer of fabricated metal
products, is considering purchasing a new computer-controlled milling machine to
produce a custom-ordered metal product. The following summarizes the financial
data related to the project:
• The machine costs $90,000. The costs for its installation, site preparation, and
wiring are expected to be $10,000. The machine also needs special jigs and dies,
which will cost $12,000. The milling machine is expected to last 10 years, the jigs
and dies 5 years. The machine will have a $10,000 salvage value at the end of its life.
The special jigs and dies are worth only $1,000 as scrap metal at any time in their
lives. The milling machine is classified as a 7-year MACRS property and the jigs and
dies as a 3-year MACRS property.
• LMC needs to either purchase or build an warehouse in which to store the product
before it is shipped to the customer. LMC has decided to purchase a building near the
plant at a cost of $160,000. For depreciation purposes, the warehouse cost of
$160,000 is divided into $120,000 for the building (39-year real property) and
$40,000 for land. At the end of 10 years, the building will have salvage value of
$80,000, but land will have appreciated to $110,000.
• The revenue from increased production is expected to be $150,000 per year. The
additional annual production costs are estimated as follows: materials, $22,000;
labor, $32,000; energy $3,500; and other miscellaneous costs, $2,500.
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• For the analysis, a 10-year life will be used. LMC has a marginal tax rate of 40%
 Problem 10.6
Three type of assets
The milling machine: 90,000 + 10,000; 10 years; salvage value
10,000 at end of 10 years; 7-year MACRS property
Jigs and dies: 12,000; 5 years; salvage value 1,000; 3 year
MACRS property
Warehouse (building): 120,000; salvage value 80,000 at the end
of 10 years; 39 year real property
Warehouse (land): 40,000; salvage value 110,000 at the end of
10 years (appreciate value); no depreciation for land
Assumptions
Replacement cost of Jigs and dies is same as initial purchase
cost
Warehouse property is put in service in January

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Problem 10.6
Tools machine Building

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 Example 10.6

PW (18%) = $32,343

PW(i) > 0; project is acceptable
IRR = 21%
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 Organizing project cash flows
The income statement approach
Generally used in organizing project cash flows
Groups cash flows according to whether they are
operating, investing, or financing functions
 The generalized cash flow approach
Used when a project does not change a company’s
marginal tax rate
Can be generated more quickly and the formatting of
the results is less elaborate than with the income
statement approach
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 Generalized cash flow approach
When to Use
When a project does not change a company’s marginal
tax rate (company operating in top tax bracket)
Applying max tax rate to each taxable item and
obtaining after-tax cash flows
Advantages
The cash flows can be generated more quickly
Formatting of the results is less elaborate
Analytical advantage in modeling project cash flows
Disadvantages
The process is less intuitive and not commonly
31 understood by business people
 Setting up net cash flow equations
An = Net after-tax cash flow at the end of period n
Depreciation is not a
cash flow, excluded, but
must be used in tax
calculation

Net salvage value

after adjusting gain
tax

Tax shield or tax saving

Total income tax, Tn = taxable income * tax rate

= (Rn – En – IPn – Dn)tm
= (Rn – En)tm– (IPn + Dn)tm
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An = Rn-En-Ipn - (Rn – En)tm– (IPn + Dn)tm - In – (Sn-Gn) – Wn +Bn -PPn
 Cash flow in compact
tabular form
Grouped and presented by
time of activities
Problem 10.4 can be shown
as below (net cash flow
Example
same)

Example 10.7: Self practice

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