EUP 222

ENGINEERS IN SOCIETY

PROJECT FINANCE

Dr. Sharifah Akmam Syed Zakaria

School of Civil Engineering
Email: akmam@usm.my
 Topic Outcomes:
1. Introduction to Project Finance
2. Capital Budgeting
3. Analyzing Project Cash Flow
4. Capital Investment Decisions
Principles Used for This Outcome We l e a d

Cash Flows Are the

Source of Value.
Identifying Incremental Cash Flows We l e a d

• Incremental cash flow refers to the

additional cash flow generated by a new
project.
 Guidelines for Forecasting We l e a d

Incremental Cash Flows

• Sunk Costs are Not Incremental Cash Flows

– Sunk costs are costs that have already been

incurred or are going to be incurred regardless of
whether or not the investment is undertaken.

– For example, the cost of market research or a pilot

program.
 Guidelines for Forecasting We l e a d

Incremental Cash Flows (cont.)

• Look for Synergistic Effects

– Oftentimes, the acceptance of a new project will

have a positive or negative effect on the cash
flows of the firm’s other projects or investments.

– For example, an introduction of new model of

smart phones can lead to loss of sales of existing
phones (a negative effect).
 Guidelines for Forecasting We l e a d

Incremental Cash Flows (cont.)

• Account for Opportunity Costs

– Opportunity cost refers to the cost of passing up

the next best choice when making a decision.

– For example, use of an existing vacant building for

a new project entails opportunity costs in the
form of potential lost rent.
 Guidelines for Forecasting We l e a d

Incremental Cash Flows (cont.)

• Work in Working Capital Requirements
– Additional working capital arises out of the fact
that cash inflows and outflows from the
operations of an investment are often
mismatched.
 Guidelines for Forecasting We l e a d

Incremental Cash Flows (cont.)

• Ignore Interest Payments and Other Financing
Costs

– Interest payments and other financing costs are

accounted for in the cost of capital (discount rate)
used to discount the project’s cash flows.

– Including it will lead to double counting.

Replacement Project Cash Flows We l e a d

• An expansion project increases the

scope of firm’s operations, but does not
replace any existing assets or operations.

• A replacement project replaces an older,

less productive asset.
Replacement Project Cash Flows We l e a d

• A distinctive feature of many

replacement investment is that
principal source of cash flows comes
from cost savings, not new revenues,
since the firm already operates an
existing asset to generate revenues.
Replacement Project Cash Flows We l e a d

(cont.)
• To facilitate the capital budgeting analysis
for replacement projects, we categorize
the investment cash flows into two:

– the initial cash flows (CF0), and

– subsequent cash flows (CF1-end).

Replacement Project Cash Flows We l e a d

(cont.)
Initial Outlay, CF0

Initial outlay typically includes:

 Cost of fixed assets.
 Shipping and installation expense.
 Investment in net working capital.
 Sale of old equipment.
 Tax implications from sale of old equipment.
Replacement Project Cash Flows We l e a d

(cont.)
• There are three possible scenarios when an
old asset is sold:
Selling Price of old
Tax Implications
asset

At depreciated value No taxes

Difference between the selling price and
Higher than depreciated depreciated book value is a taxable
value (or book value) gain and is taxed at the marginal
corporate tax rate.
Difference between the depreciated book
Lower than depreciated value and selling price is a taxable
value (or book value) loss and may be used to offset capital
gains.
Replacement Project Cash Flows We l e a d

(cont.)
• Annual Cash Flows

– Annual cash flows for a replacement decision

differ from a simple asset acquisition.
– We must now consider the differential operating
cash flow of the new versus the old (replaced)
asset.
Replacement Project Cash Flows We l e a d

(cont.)
• Change in Depreciation and Taxes:
– We need to compute the incremental change in
depreciation and taxes i.e. what the depreciation
and taxes would be if the assets were replaced
versus what they would be if the assets were not
replaced.
– For depreciation, the expenses will increase by the
amount of depreciation on the new asset but
decrease by the amount of the depreciation of the
replaced asset.
Replacement Project Cash Flows We l e a d

(cont.)
• Changes in Working Capital:

– Increase in working capital is necessitated by the

increase in accounts receivable and increased
investment in inventories.
Replacement Project Cash Flows We l e a d

(cont.)
• Changes in capital spending:

– The replacement asset may require an outlay at

the time of acquisition and additional capital over
its life.
– However, we must net out any additional capital
spending requirements of the older, replaced
asset.
Dealing with Depreciation Expense, We l e a d

Taxes and Cash Flow

• Depreciation expenses is subtracted while
calculating the firm’s taxable income.
However, depreciation is a non-cash expense.

• Thus depreciation must be added back to the

net operating income to determine the cash
flows.
 Calculating Free Cash Flows for a
Replacement Investment We l e a d

• Titan Engineering Company (TEC) is

considering the replacement of one its old
equipment with the new ones using the latest
technology.
• The appeal of the new equipment is that it is
more automated (requires two fewer
employees to operate the equipment).
• The older machine requires four employees
with salaries totalling RM 200,000 and fringe
benefits costing RM 20,000.
 We l e a d

• The new equipment cuts this total in half.

• In addition, the new equipment is able to
reduce defects, which reduces the annual cost
of defects which are RM 20,000 with the new
equipment compared to RM70,000 for the
older model.
• However, the added automation feature
comes at the cost of higher annual
maintenance fees of RM 60,000 compared to
only RM 20,000 for the older equipment.
 We l e a d

• TEC faces a 30% marginal tax rate and uses a

15% discount rate to evaluate equipment
purchases for its business.

Should TEC replace the older

equipment with the newer one?
The following information summarizes
the new versus old equipment costs: We l e a d

Purchase New Old

Price
Equipment Equipment
Net operating income RM 580,000 RM 580,000
Annual cost of defect RM 20,000 RM 70,000
Book value of equipment RM 350,000 RM100,000
Salvage value (today)/sale price N/A RM150,000
Salvage value (Year 5) RM 50,000 -
Shipping cost RM 20,000 N/A
Installation cost RM 30,000 N/A
Project life (years) 5 5
Net operating working capital RM 60,000 RM 60,000
Salaries RM 100,000 RM 200,000
Fringe Benefits RM 10,000 RM 20,000
Maintenance RM 60,000 RM 20,000
 Step 1: Picture the Problem We l e a d

• The new equipment will require an initial

outlay, which will be partially offset by the
after-tax cash flows from the old equipment.

• The new equipment will help improve

efficiency and reduce repairs, but it will also
increase the annual maintenance expense.
Step 1: Picture the Problem (cont.) We l e a d

Years
0 1 2 3 4 5

Cash flows(New) CF(N)0 CF(N)1 CF(N)2 CF(N)3 CF(N)4 CF(N)5

MINUS
Cash Flows (Old) CF(O)0 CF(O)1 CF(O)2 CF(O)3 CF(O)4 CF(O)5

EQUALS
Difference (New – Old) ∆CF0 ∆ CF1 ∆ CF2 ∆ CF3 ∆CF4 ∆ CF5
Step 1: Picture the Problem (cont.) We l e a d

• The decision to replace will be based on the

replacement cash flows.
 Step 2: Decide on a Solution We l e a d

Strategy
• The cash flows will be calculated using this
equation:
 Step 2: Decide on a Solution We l e a d

Strategy (cont.)
• However, for replacement projects, the
emphasis is on the difference in costs and
benefits of the new equipment versus the old.

• Accordingly, we compute the initial cash

outflow and the annual cash flows
(from Year 1 through Year 5).
 Step 3: Solve We l e a d

• Initial cash outflow (CF0)

= Cost of new equipment.

+ Shipping cost.
+ Installation cost.
– Sale of old equipment.
± Tax effects from sale of old equipment.
SOLUTIONS:
In order to decide whether to purchase the
new machine or not, the analysis has to go
through these steps:
1. Determine the net cash flow with the
replacement of old equipment.
2. Estimate the annual cash flow for years 1
through 5.
3. Determine the Net Present Value (NPV) for
this replacement project based on discount
rate of 15%.
1) Determine the net cash flow with the
replacement of old equipment: We l e a d

• The initial cash outlay for Year 0 reflects

the difference in the cost of acquiring the
new equipment (including shipping and
installation costs) and their after-tax
proceeds TEC realizes from the sale of
old equipment.
• Refer to Table 1:
 Table 1: We l e a d
Year 0
NEW EQUIPMENT:
Purchase Price A(next table) (RM 350,000)
Shipping cost B (RM 20,000)
Installation cost C (RM 30,000)
(RM 400,000)
OLD EQUIPMENT:
Sale price D RM150,000
Less: Tax on gain = (*RM 150 000 D – RM
100,000 E) X 30%
* (Sale Price - Book Value) (RM 15,000)
After Tax Proceeds from the Sale of the Old
RM 135,000
Equipment
Change in Net Operating Working Capital F 0
Replacement Net Cash Flow (RM 265,000)
The following information summarizes
the new versus old equipment costs: We l e a d

Purchase Price New Old

A Equipment Equipment
Net operating income RM 580,000 RM 580,000
Annual cost of defect RM 20,000 RM 70,000
Book value of equipment E RM 350,000 RM100,000
Salvage value (today)/sale price D N/A RM150,000
Salvage value (Year 5) RM 50,000 -
Shipping cost B RM 20,000 N/A
Installation cost C RM 30,000 N/A
Project life (years) 5 5
Net operating working capital F RM 60,000 RM 60,000
Salaries RM 100,000 RM 200,000
Fringe Benefits RM 10,000 RM 20,000
Maintenance RM 60,000 RM 20,000
 Explanation to Table 1: We l e a d

• The new equipment costs RM 400,000 to purchase

and install.
• This cost is partially offset by the after-tax proceeds
from the sale of the older equipment, which equal
RM 135,000.
• Net operating working capital (NOWC) = 0, as no
difference between New Equipment and Old
Equipment. If NOWC of New Equipment is greater
than Old Equipment, the difference of NOWC must
be deducted from After Tax Proceeds.
• Thus, the initial cash outlay is RM 265,000 =
RM 400,000 – RM 135,000.
SOLUTIONS:
In order to decide whether to purchase the
new machine or not, the analysis has to go
through these steps:
1. Determine the net cash flow with the
replacement of old equipment.
2. Estimate the annual cash flow for years 1
through 5.
3. Determine the Net Present Value (NPV) for
this replacement project based on discount
rate of 15%.
2) Estimate the annual cash flow for
years 1 through 5 We l e a d

• Next, we estimate the annual cash flow for

years 1 through 5 assuming that the new
equipment is purchased and the older one is
sold.
• Meaning that we intend to determine the
FREE CASH FLOW of this replacement.
 Table 2: We l e a d
Year 1-4 Year 5
Analysis of the Annual Cash Flows (RM) (RM)
CASH INFLOWS:
*Increase in operating income ∆ A 0
*Reduced defects ∆ B 50,000
*Reduced salaries ∆ C 100,000
*Reduced fringe benefits ∆ D 10,000 160,000 160,000
*Compare new and old equipment from question.
CASH OUTFLOWS:
*Increased maintenance ∆ E (40,000)
**Increased depreciation F-G
(**difference between book value and salvage value) (50,000) (90,000) (90,000)
Net Operating Income (Cash Inflows – Cash Outflows) 70,000 70,000
Less: Taxes (30% X RM 70,000) (21,000) (21,000)
Plus: Depreciation 50,000 50,000
Operating Cash Flow 99,000 99,000
Plus: Increase in net operating working capital 0 0
Plus: Salvage value (Year 5) 0 50,000

FREE CASH FLOW RM 99,000 RM 149,000

The following information summarizes
the new versus old equipment costs: We l e a d

Purchase
New Old
Price Equipment Equipment
Net operating income ∆ A RM 580,000 RM 580,000
Annual cost of defect ∆ B RM 20,000 RM 70,000
Book value of equipment RM 350,000 RM100,000 F
Salvage value (today)/sale price N/A RM150,000 G
Salvage value (Year 5) RM 50,000 -
Shipping cost RM 20,000 N/A
Installation cost RM 30,000 N/A
Project life (years) 5 5
Net operating working capital RM 60,000 RM 60,000
Salaries ∆ C RM 100,000 RM 200,000
Fringe Benefits ∆ D RM 10,000 RM 20,000
Maintenance ∆ E RM 60,000 RM 20,000
 Explanation to Table 2: We l e a d

• Depreciation = RM 50,000
Depreciation expenses is subtracted while calculating the firm’s
taxable income. However, depreciation is a non-cash expense.
Thus depreciation must be added back to the net operating
income to determine the cash flows.

• Salvage value (year 5) = RM 50,000

Capital expenditures (CAPEX) are generally outflows, hence
subtracted out. However, in this case, when a project has a
salvage value at the end of its useful life, the capital expenditure
(CAPEX) takes on a positive value and is added to the free cash
flows in the project’s final year.
 Explanation to Table 2 (cont’d): We l e a d

• In this case, we observe that although the net

operating income of new and old equipment
are the same (no increase or decrease).
• However, the new equipment has generated
cost savings.
• The new equipment will reduce cost (totaling
RM 160,000 per year), compared to the older
equipment.
 Explanation to Table 2 (cont’d) We l e a d

• However, the new equipment requires an

additional RM 40,000 in maintenance
expenses and has more RM 50,000
depreciation expense.
• For years 1 through 4, this results in increased
after tax operating cash flow of RM 99,000 per
year.
• In Year 5, the new equipment is salvaged for
an estimated RM 50,000 (recall that this is
also the book value of the machine).
SOLUTIONS:
In order to decide whether to purchase the
new machine or not, the analysis has to go
through these steps:
1. Determine the net cash flow with the
replacement of old equipment.
2. Estimate the annual cash flow for years 1
through 5.
3. Determine the Net Present Value (NPV) for
this replacement project based on discount
rate of 15%.
3. Determine the Net Present Value
(NPV), discount rate = 15% We l e a d

• Based on the estimates of initial cash outflow

and subsequent annual free cash flows for
years 1-5, we can compute the NPV.
• Note that this replacement project has NPV
with Unequal Periodic Net Cash Inflows:
• Refer to Table 1 and Table 2.
 Table 3: We l e a d

Present Present Value

Present
value of Factor/Discount
Years Net Cash Inflow Value
each year’s Factor
FROM TABLE 2 (RM)
inflow: (i = 15% )
1 (n=1) RM 99,000 0.8696 86,090
2 (n=2) RM 99,000 0.7561 74,854
3 (n=3) RM 99,000 0.6575 65,093
4 (n=4) RM 99,000 0.5718 56,608
5 (n=5) RM 149,000 0.4972 74,083
Total PV of Cash Flow RM 356,728
0 Initial Investment FROM TABLE 1 (RM 265,000)
Net Present Value (NPV) of the Replacement
Project
RM 91,728
 We l e a d

Table A: Future Value Interest Factors for One Dollar Compounded at k Percent for n Periods
Decision Rule: NPV We l e a d
 Explanation to Table 3: We l e a d

• Net Present Value (NPV) of the Replacement

Project is RM 91,728.
• The decision rule for net present value is that
a positive net present value means that the
project earns more than the required rate of
return, and the company should invest in the
project.
• Based on financial factors alone, only projects
with a zero or positive NPV are acceptable.
Net Present Value (NPV) Method We l e a d

• The NPV method calculates the expected

monetary gain or loss from a project by
discounting all expected future cash inflows
and outflows back to the present point in
time, using the required rate of return (RRR).
• A negative net present value means that the
project earns less than the required rate of
return, and the company should not invest in
the project.
END OF TOPIC OUTCOME 3 We l e a d

Topic Outcomes:
1. Introduction to Project Finance
2. Capital Budgeting
3. Analyzing Project Cash Flow
4. Capital Investment Decisions