Chapter 4

Capital equipment

Payback period
1. Calculating Payback What is the
payback period for the following set
of cash flows.

 To calculate the payback period, we need to find

the time that the project has recovered its initial
investment. After two years, the project has
created:
$1,200 + 2,500 = $3,700 in cash flows.
The project still needs to create another:
$4,800 3,700 = $1,100 in cash flows.
During the third year, the cash flows from the
project will be $3,400. So, the payback period will
be 2 years, plus what we still need to make
divided by what we will make during the third
year.
The payback period is: Payback = 2 + ($1,100 /
$3,400) = 2.32 years

Return On Investment
The benefit (return) of an investment
is divided by the cost of the
investments; the result is expressed
as a percentage or a ratio. This is
referred to as simple ROI.
ROI= Gains from investment Cost of
investment
Cost of Investment
$700,000 - $500,000 = 40%
$500,000

Return On Investemnt
ROI is used to compare returns on
investment where the money gained
or lostor the money investedare
not easily compared using monetary
values. For example, a $1,000
investment that earns $50 in interest
obviously generates more cash than
a $100 investment that earns $20
interest, but the $100 investment
earns a higher return.

$50/$1,000
$1050 - $1000 = 50 = 5% ROI
$1000
$1000
$20/$100
$120-100 = 20 = 20% ROI
$100
$100

Cash flow method

Cash Defined -- refers to cash and cash
equivalents.
Cash equivalents are short-term,
highly liquid investments that are (1)
readily convertible to known amounts
of cash, and (2) near maturity
(typically within 3 months) with limited
risk of price changes due to interest
rate shifts.

Cash is the beginning and the end of a companys operating cycle.

Net cash flow is the end measure of
profitability.
Cash repays loans, replaces equipment, expands facilities, and
pays dividends.
Analyzing cash inflows and outflows
solvency, and financial flexibility.

helps

assess

liquidity,

Liquidity is the nearness to cash of assets and liabilities.

Solvency is the ability to pay liabilities when they mature.
Financial flexibility is the ability to react to opportunities and
adversities.

Developing Project Cash

Flows
Estimating Cost/Benefit for
Engineering Projects
Incremental Cash Flows
Developing Cash Flow Statements
Generalized Cash Flow Approach

Classification of Investment
Projects
Expansion project
Profit-adding
project

Projec
t
Profit-maintaining
project

Product
Improvement
project
Cost Improvement
project

Replacement Project

Necessity project
10

Cash Flow Diagram

Cash Flow Element

Operating activities:

Other Terms Used in Business

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

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

Working capital release

Working capital recovery

Gains taxes

Capital gains taxes, Ordinary gains taxes

Financing activities:
Borrowed funds

Borrowed amounts, Loan amount

Principal repayments

Loan repayment

A Typical Format used for Presenting

Cash Flow Statement
Cash flow statement
+ Net income
+Depreciation
Income statement
Revenues
Expenses
Cost of goods sold
Depreciation
Debt interest
Operating expenses
Taxable income
Income taxes
Net income

-Capital investment
+ Proceeds from sales of
depreciable assets
- Gains tax
- Investments in working
capital
+ Working capital recovery
+ Borrowed funds
-Repayment of principal

Operating
activities
+
Investing
activities
+
Financing
activities

Net cash flow

(c) 2001 Contemporary
Engineering Economics

13

When Projects Require only

Operating and Investing Activities
Project Nature: Installation of a new computer control
system
Financial Data:
Investment: $125,000
Project life: 5 years
Salvage value: $50,000
Annual labor savings: $100,000
Annual additional expenses:
Labor: $20,000
Material: $12,000
Overhead: $8,000
Depreciation Method: 7-year MACRS
Income tax rate: 40%

Example 12.1 - Net Cash Flow Table

Generated by Traditional Method Using
Approach 2
A

Year
End

Investment &
Salvage Value

Revenue

Labor

Expenses
Materials

Overhea
d

Depreciatio
n

Taxable
Income

Income
Taxes

Net Cash
Flow

-$125,000

$125,000

$100,000

20,00
0

12,000

8,000

$17,863

42,137

16,855

$43,145

100,000

20,00
0

12,000

8,000

30,613

29,387

11,755

$48,245

100,000

20,00
0

12,000

8,000

21,863

38,137

15,255

$44,745

100,000

20,00
Note that 0
20,00
H 100,000
= C-D-E-F-G
I = 0.4 * H 0

12,000

8,000

15,613

44,387

17,755

$42,245

12,000

8,000

*Salvage value
50,000*

J= B+C-D-E-F-I

5,581
54,419
21,678 to$38,232
Information
required
calculate the income taxes
16,525

(c) 2001 Contemporary

Engineering Economics

6,613

$43,387

15

Time value money

The Interest Rate
Which would you prefer -$10,000 today or $10,000 in 5
years?
Obviously, $10,000 today.
You already recognize that there is
TIME VALUE TO MONEY!!

Why time
TIME allows you the opportunity to
postpone consumption and earn
INTEREST.
Types of Interest
Simple Interest
Interest paid (earned) on only the original amount,
or principal, borrowed (lent).

Compound Interest
Interest paid (earned) on any previous interest
earned, as well as on the principal borrowed (lent).

Simple Interest Formula

Formula

SI = P0(i)(n)

SI:Simple Interest
P0: Deposit today (t=0)
i: Interest Rate per Period
n: Number of Time Periods

Example
Assume that you deposit $1,000 in
an account earning 7% simple
interest for 2 years. What is the
accumulated interest at the end of
the 2nd year?
= P0(i)(n)
SI
$1,000(.07)(2)

=
= $140

Simple Interest (FV)

What is the Future Value (FV) of the
deposit?
FV = P0 + SI
=
$1,000 + $140
= $1,140
Future Value is the value at some
future time of a present amount of
money, or a series of payments,
evaluated at a given interest rate.

Simple Interest (PV)

What is the Present Value (PV) of the
previous problem?
The Present Value is simply the
$1,000 you originally deposited.
That is the value today!
Present Value is the current value of a
future amount of money, or a series of
payments, evaluated at a given
interest rate.

Future Value (U.S. Dollars)

Why Compound
Interest?

Future Value
Single Deposit
(Graphic)

Assume that you deposit $1,000

at a compound interest rate of
7% for 2 years.
0
2

7%

$1,000
FV2

Future Value
Single Deposit
(Formula)
FV1 = P0 (1+i)1 = $1,000 (1.07)
= $1,070
Compound Interest
You earned $70 interest on your
$1,000 deposit over the first year.
This is the same amount of interest
you would earn under simple interest.

Future Value
Single Deposit (Formula)
FV1

= P0 (1+i)1

= $1,000 (1.07)
= $1,070

FV2

= FV1 (1+i)1
= P0 (1+i)(1+i)
(1.07)
= P0 (1+i)2
$1,000(1.07)2
= $1,144.90

= $1,000(1.07)
=

You earned an EXTRA $4.90 in Year 2 with

General Future
Value Formula
FV1 = P0(1+i)1
FV2 = P0(1+i)2
etc.

General Future Value Formula:

FVn = P0 (1+i)n
or FVn = P0 (FVIFi,n) -- See Table I

Valuation Using
Table I
FVIFi,n is found on Table I
at the end of the book.

Period
1
2
3
4
5

6%
1.060
1.124
1.191
1.262
1.338

7%
1.070
1.145
1.225
1.311
1.403

8%
1.080
1.166
1.260
1.360
1.469

Using Future Value

Tables

FV2 = $1,000 (FVIF7%,2)

$1,000 (1.145)
$1,145 [Due to Rounding]
Period
6%
7%
1
1.060
1.070
2
1.124
1.145
3
1.191
1.225
4
1.262
1.311
5
1.338
1.403

8%
1.080
1.166
1.260
1.360
1.469

Story Problem
Example
Julie Miller wants to know how large her
deposit of $10,000 today will become at a
compound annual interest rate of 10% for 5
years.
0

10%
$10,000
FV5

Story Problem
Solution

Calculation based on general

formula:
FVn = P0 (1+i)n

FV5 = $10,000 (1+ 0.10)

= $16,105.10
Calculation
based on Table I:
FV5 = $10,000 (FVIF10%, 5)
$10,000 (1.611)
=
$16,110 [Due to Rounding]

31

Types of Annuities

An Annuity represents a series of equal

payments (or receipts) occurring over a
specified number of equidistant periods.

Ordinary Annuity: Payments or receipts

occur at the end of each period.
Annuity Due: Payments or receipts
occur at the beginning of each period.

32

Examples of Annuities

Student Loan Payments

Car Loan Payments
Insurance Premiums
Mortgage Payments
Retirement Savings

33

Parts of an Annuity
(Ordinary Annuity)
End of
Period 1

Today

End of
Period 2

End of
Period 3

$100

$100

$100

Equal Cash Flows

Each 1 Period Apart

34

Parts of an Annuity
(Annuity Due)
Beginning of
Period 1

Beginning of
Period 2

$100

$100

$100

Today

Beginning of
Period 3

Equal Cash Flows

Each 1 Period Apart

35

Overview of an
Ordinary Annuity -- FVA
Cash flows occur at the end of the period

. . .

i%
R

R = Periodic
Cash Flow

FVAn = R(1+i) + R(1+i) +

... + R(1+i)1 + R(1+i)0
n-1

n-2

FVAn

n+1

36

Example of an
Ordinary Annuity -- FVA
Cash flows occur at the end of the period

$1,000

$1,000

$1,000

7%

$1,070
$1,145
FVA3 = $1,000(1.07)2 +
$1,000(1.07)1 + $1,000(1.07)0
= $1,145 + $1,070 + $1,000
= $3,215

$3,215 = FVA3

37

Hint on Annuity Valuation

The future value of an ordinary
annuity can be viewed as
occurring at the end of the last
cash flow period, whereas the
future value of an annuity due
can be viewed as occurring at
the beginning of the last cash
flow period.

38

Valuation Using Table III

FVAn = R (FVIFAi%,n)
= $1,000 (FVIFA7%,3)
$1,000 (3.215) = $3,215
Period
6%
7%
1
1.000
1.000
2
2.060
2.070
3
3.184
3.215
4
4.375
4.440
5
5.637
5.751

FVA3
=

8%
1.000
2.080
3.246
4.506
5.867

39

Overview View of an
Annuity Due -- FVAD
Cash flows occur at the beginning of the period

i%
R

. . .

FVADn = R(1+i)n + R(1+i)n-1 +

... + R(1+i)2 + R(1+i)1
= FVAn (1+i)

n-1

FVADn

40

Example of an
Annuity Due -- FVAD
Cash flows occur at the beginning of the period

$1,000

$1,000

$1,070

7%
$1,000

$1,145
$1,225
FVAD3 = $1,000(1.07)3 +
$1,000(1.07)2 + $1,000(1.07)1
= $1,225 + $1,145 + $1,070
= $3,440

$3,440 = FVAD3

41

Valuation Using Table III

FVADn = R (FVIFAi%,n)(1+i)
FVAD3 = $1,000 (FVIFA7%,3)(1.07)
$1,000 (3.215)(1.07) = $3,440
Period
6%
7%
8%
1
1.000
1.000
1.000
2
2.060
2.070
2.080
3
3.184
3.215
3.246
4
4.375
4.440
4.506
5
5.637
5.751
5.867

42