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Tutorial: Cash Flow Classifications and B/C Relations

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Tutorial: Cash Flow Classifications and B/C Relations

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sara
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Tutorial

Cash Flow Classifications and B/C Relations


9-2
Must identify each cash flow as either benefit, disbenefit, or
cost
Benefit (B) -- Advantages to the
public
Disbenefit (D) -- Disadvantages to the
public
Cost (C) -- Expenditures by the government
Note: Savings to government are subtracted from costs

Conventional B/C ratio = (B–D) / C


Modified B/C ratio = [(B–D) – C] / Initial
Investment
Profitability Index = NCF / Initial Investment
Note 1: All terms must be expressed in same units, i.e., PW, AW, or
FW
Note 2: Do not use minus sign ahead of costs
© 2012 by McGraw-Hill All Rights Reserved
Alternative Selection Using B/C Analysis
– Independents Alternatives

For independent alternatives:

Compare each alternative VS. Do-Nothing alternative

If B/C > 1.0 Accept the alternative

Otherwise Reject the alternative


Alternative Selection Using Incremental
B/C Analysis – Two or More ME 9-4

Alternatives
Procedure similar to ROR analysis for multiple
alternatives

© 2012 by McGraw-Hill All Rights Reserved


Select the better of two proposals to improve street safety and lighting in a colonia in south
central New Mexico. Use a B/C analysis and an interest rate of 8% per year.

Proposal 1 Proposal 2
Initial cost, $ 900,000 1,700,000
Annual M&O cost, $/year 120,000 60,000
Annual benefi ts, $/year 530,000 650,000
Annual disbenefi ts, $/year 300,000 195,000
Life, years 10 ∞
Breakeven Point
Value of a parameter that makes two elements
equal
The parameter (or variable) can be an amount of
revenue, cost, supply, demand, etc. for one
project or between two alternatives

● One project - Breakeven point is identified as QBE.


Determined using linear or non-linear math relations for
revenue and cost

● Between two alternatives - Determine one of the parameters


P, A, F, i, or n with others constant

13-3 © 2012 by McGraw-Hill All Rights Reserved


Cost-Revenue Model ― One Project
Quantity, Q — An amount of the
variable in question, e.g., units/year,
hours/month
Breakeven value is QBE
Fixed cost, FC — Costs not directly dependent on the variable,

Variable cost, VC — Costs that change with parameters.


Variable cost per unit is v

Total cost, TC — Sum of fixed and variable costs, TC = FC + VC

Revenue, R — Amount is Profit, P — Amount of


dependent on quantity sold revenue remaining after
Revenue per unit is r costs
13-4
P = R – TC = r Q – (FC+VC)
© 2012 by McGraw-Hill All Rights Reserved
Problem 6 (Problem 13.21 – Blank – 7th edition):
Samsung Electronics is trying to reduce supply chain risk by making more
responsible make-buy decisions through improved cost estimation. A high-
use component (expected usage is 5000 units per year) can be purchased for
$25 per unit with delivery promised within a week. Alternatively, Samsung
can make the component in-house and have it readily available at a cost of $5
per unit, if equipment costing $150,000 is purchased. Labor and other
operating costs are estimated to be $35,000 per year over the study period of
5 years. Salvage is estimated at 10% of first cost and i =12% per year.
Neglect the element of availability
(a) to determine the breakeven quantity and
(b) to recommend making or buying at the expected usage level.
The water can be cooled using one of two systems: a single-pass heat exchanger
or a closed-loop heat exchange system.

The single-pass system, good for 3 years, requires a small chiller costing $920
plus stainless steel tubing, connectors, valves, etc. costing $360. The cost of
water, treatment charges, electricity, etc. will be $3.10 per hour.

The closed-loop system will cost $3850 to buy, will have a useful life of 5 years,
and will cost $1.28 per hour to operate.

What is the minimum number of hours per year that the cooling system must be
used in order to justify purchase of the closed-loop system? The MARR is 10%
per year, and the salvage values are negligible.
Understanding Inflation
14-11
Inflation: Increase in amount of money needed to purchase same
amount of goods or services.
Inflation results in a decrease in purchasing power, i.e., one unit of
money buys less goods or services

Two ways to work problems when considering


(1)inflation:
Convert to constant value (CV) dollars, then use real rate i.
If f = inflation rate (% per year), the equation is:
Constant-value dollars = future dollars = then-current dollars © 2012
by
(1+ f)n (1+ f)n McGraw-
Hill
All

(1) Leave money amounts as is and use interest rate adjusted Rights
Reserved

for inflation, if
if = i + f + (i)(f)
Three Different Rates
14-12
► Real or inflation rate i – Rate at which interest is earned when
effects of inflation are removed; i represents the real increase in
purchasing power

► Market or inflation-adjusted rate if – Rate that takes inflation


into account. Commonly stated rate everyday

► Inflation rate f – Rate of change in value of currency

Market rate is: if = i + f + (i)(f)

© 2012 by McGraw-Hill All Rights Reserved


Q1- Calculate the real interest rate per month if the nominal inflation-adjusted interest rate per
year, compounded monthly, is 18% and the inflation rate per month is 0.5%.

Q2- The inflation rate in a Central American country is 6% per year. What real rate of return
will an investor make on a $100,000 investment in a copper mine stock that yields an overall
internal rate of return of 28% per year?

Q3- How much can the manufacturer of superconducting magnetic energy storage systems
afford to spend now on new equipment of spending $75,000 four years from now? The
company’s real MARR is 12% per year, and the inflation rate is 3% per year.

Q4- Construction equipment has a cost today of $80,000. If its cost has increased only by the
inflation rate of 6% per year, when the market interest rate was 10% per year, its cost 10 years
ago was
Q5- An alternative has the following cash flows: Benefits of $100,000 per year Disbenefits of
$54,000 per year Initial cost of $500,000 M&O costs of $20,000 per year If the alternative has
an infinite life and the interest rate is 10% per year, the B/C ratio is

Q6- If you expect to receive a gift of $100,000 six years from now, the present worth of the
gift at a real interest rate of 5% per year and an inflation rate of 4% per year is

Q7- If the market interest rate is 18% per year when the inflation rate is 8% per year, the real
interest rate is

Q8- A manufacturing process has fixed costs of $40,000 per year with variable costs of $30
per unit. If the company sells each unit for $40, the number of units that must be sold each
year in order to breakeven is
Thank you

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