Page 192 - DMGT521_PROJECT_MANAGEMENT

Unit 11: Project Cash Flow

so that changes in taxable income result in tax changes at 34% whether positive or negative. Notes
Assume any gain on the sale of the old machine is also taxed at 34% since corporations
don’t receive favorable tax treatment on capital gains.
3. Example A: There are two kinds of cash flows in this problem—those that can be estimated
fairly objectively and those that require some degree of subjective guesswork. Objective
Cash Flows: The initial outlay is relatively straightforward: Example $110.1 Initial outlay
39.9 Less proceeds from sale of old machine $150.0 Cost of new machine The old machine
has a current market value of $45,000 and a book value of $30,000 (initial cost of $80,000
less depreciation of $50,000). Thus, a gain on the sale of the old machine of $15,000 results
in additional taxes of $5.1. The net cash proceeds on the sale of the old machine are $39.9
(or $45.0 – $5.1).

4. Example A: Depreciation and labor savings are straightforward as well: Example $25.0
$25.0 $25.0 $25.0 $25.0 Labor savings $10.2 $10.2 $6.8 $6.8 $6.8 Cash tax savings @ 34% $30.0
$30.0 $20.0 $20.0 $20.0 Net increase in depreciation 10.0 10.0 10.0 Old depreciation $30.0
$30.0 $30.0 $30.0 $30.0 New depreciation 5 4 3 2 1 Year Represent the cost savings from
needing only two employees rather than three.
5. Example A: The subjective benefits (which are based on opinions) are hard to quantify and
lead to biases when estimated by people who want project approval. The financial analyst
should ensure that only reasonable estimates of unprovable benefits are used. Example
$30.0 $30.0 $30.0 $30.0 $45.0 Savings 15.0 15.0 15.0 15.0 In warranty New machine
maintenance $45.0 $45.0 $45.0 $45.0 $45.0 Old machine maintenance 5 4 3 2 1 Year The
question is: Should we assume maintenance on the old machine would have remained at
$45.0 or increase as the machine gets older? Also, will maintenance on the new machine
rise as the new machine ages?

6. Example A: Another subjective estimate is that of downtime. The old machine has been
having about 130 hours of downtime while the new one promises 30 hours—a savings of
100 hours. But, argument could be made for using different assumptions for downtime
hours. Another question is: How much is each hour of downtime savings worth?
Arguments range from no savings (as we are unable to say exactly how much it’s worth)
to $500 an hour. Most people favor a middle-of-the-road approach—we’ll use $200 an
hour, which yields an estimated cash flow savings of $20,000 per year. Example $49.5 $49.5
$49.5 $49.5 $59.4 Net after tax $75.0 $75.0 $75.0 $75.0 $90.0 Total $20.0 $20.0 $20.0 $20.0 $20.0
Downtime savings $30.0 $30.0 $30.0 $30.0 $45.0 Maintenance savings $25.0 $25.0 $25.0 $25.0
$25.0 Labor savings $59.7 $59.7 $56.3 $56.3 $66.2 Cash flow 10.2 10.2 6.8 6.8 L Tax savings on
depreciation 25.5 25.5 25.5 25.5 30.6 Tax 5 4 3 2 1 Year.

Task Discuss about Cost of Capital.

11.4 Cost of Capital

Capital is a term used in the field of financial investment to refer to the cost of a company’s funds
(both debt and equity), or, from an investor’s point of view “the shareholder’s required return
on a portfolio company’s existing securities”. It is used to evaluate new projects of a company as
it is the minimum return that investors expect for providing capital to the company, thus setting
a benchmark that a new project has to meet.

For an investment to be worthwhile, the expected return on capital must be greater than the cost
of capital. The cost of capital is the rate of return that capital could be expected to earn in an

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