ECLT5930B/SEEM5740B — Engineering Economics

Assignment: Number 4 Due Date: 23:59PM 16/Apr./2023

Term: 2022-2023 Second Term Instructor: Dr. Daniel Zhuoyu LONG
Note: If you have any questions, please feel free to contact Yue Lin (ylin@se.cuhk.edu.hk)

Problem 1 (10pts)
A special-purpose machine is to be depreciated as a linear function of use (units-of-
production method). It costs $40,000 and is expected to produce 150,000 units and then
be sold for $10,000. Up to the end of the third year, it had produced 60,000units, and
during the fourth year it produced 18,000 units. What is the depreciation deduction for
the fourth year and the BV at the end of the fourth year?
Depreciation per unit of production= $40,000−$10,000
150,000
= $0.2 per unit.
The depreciation deduction for the fourth year is 18, 000 × 0.2 = $3, 600.
BV=40, 000 − 0.2 × (60, 000 + 18, 000) = $24, 400.

Problem 2 (10pts)
Liberty Airways is considering an investment of $800,000 in ticket purchasing kiosks at
selected airports. The kiosks (hardware and software) have an expected life of four years.
Extra ticket sales are expected to be 60,000 per year at a discount price of $40 per
ticket. Fixed costs, excluding depreciation of the equipment, are $400,000 per year, and
variable costs are $24 per ticket. The kiosks will be depreciated over four years, using
the SL method with a zero salvage value. The onetime commitment of working capital
is expected to be 1/12 of annual sales dollars. The after-tax MARR is 15% per year,
and the company pays income tax at the rate of 34%. What’s the after-tax PW of this
proposed investment? Should the investment be made?
The investment on working capital is expected to be 60, 000 × 40/12 = 200, 000.
The initial capital investment should be 800, 000 + 200, 000 = 1, 000, 000.
The annual income is 60, 000 × (40 − 24) − 400, 000 = 560, 000.
Using SL method, the annual depreciation is 800, 000/4 = 200, 000.
The working capital will be recovered at the end of year 4, which incurs an ATCF of
200,000$. Then the general format is as below.

EOY BTCF Depreciation Deduction Taxable Income Income taxes ATCF

0 -1,000,000 -1,000,000
1 560,000 200,000 360,000 -122,400 437,600
2 560,000 200,000 360,000 -122,400 437,600
3 560,000 200,000 360,000 -122,400 437,600
4 560,000 200,000 360,000 -122,400 437,600
4 200,000

PW(15%) of ATCF is $363689>0. The investment should be made.

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Problem 3 (10pts)
Your company has purchased equipment (for $50,000) that will reduce materials and
labor costs by $14,000 each year for N years. After N years, there will be no further need
for the machine, and because the machine is specially designed, it will have no MV at any
time. The government’s tax department, however, has ruled that you must depreciate
the equipment on a SL basis with a tax life of five years. If the effective income tax rate
is 40%, what is the minimum number of years your firm must operate the equipment to
earn 10% per year after taxes on its investment?
The annual income is exactly the reduce of materials and labor costs. In the first five
years, the annual depreciation deduction is 50,000/5=10,000.
EOY BTCF Depreciation Deduction Taxable Income Income taxes ATCF
0 -50,000 -50,000
1 14,000 10,000 4,000 -1,600 12,400
2 14,000 10,000 4,000 -1,600 12,400
3 14,000 10,000 4,000 -1,600 12,400
4 14,000 10,000 4,000 -1,600 12,400
5 14,000 10,000 4,000 -1,600 12,400
6 14,000 0 14,000 -5,600 8,400
7 14,000 0 14,000 -5,600 8,400
8 14,000 0 14,000 -5,600 8,400
...
It can be calculated that the minimum N such that PW(10%)>0 is 6.
Hence, the minimum number of years to operate the equipment is 6.

Problem 4 (15pts)
In a chlorine fluxing installation in a large aluminum company, engineers are considering
the replacement of existing plastic pipe fittings with more expensive, but longer lived,
copper fittings. The following table gives a comparison of the capital investments, lives,
salvage values, etc., of the two mutually exclusive alternatives under consideration:
(A) Plastic (B) Copper
Capital Investment $5,000 $10,000
Useful Life 5 years 10 years
Salvage Value for Depreciation $ 1,000(SV5 ) $5,000(SV10 )
Annual Expenses $300 $100
Market Value at End of Useful Life $0 $0
Depreciation amounts are calculated with the SL method. Assume an income-tax rate
of 40% and a minimum attractive rate of return after-taxes of 12% per year. Under the
repeatability assumption, which pipe fitting would you select and why?

Using the repeatability assumption, we compare the two pipes based on a 10-year study
period. Note that at the end of useful life, the market value is less than the salvage value,
we need to consider the tax credit resulting from this loss on disposal.
The general format for pipe A is:

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 EOY BTCF Depreciation Deduction Taxable Income Income taxes ATCF
0 -5,000 -5,000
1 -300 800 -1,100 440 140
2 -300 800 -1,100 440 140
3 -300 800 -1,100 440 140
4 -300 800 -1,100 440 140
5 -300 800 -1,100 440 140
5 -1,000 400 400
5 -5,000 -5,000
6 -300 800 -1,100 440 140
7 -300 800 -1,100 440 140
8 -300 800 -1,100 440 140
9 -300 800 -1,100 440 140
10 -300 800 -1,100 440 140
10 -1,000 400 400
The general format for pipe B is:
EOY BTCF Depreciation Deduction Taxable Income Income taxes ATCF
0 -10,000 -10,000
1 -100 500 -600 240 140
2 -100 500 -600 240 140
3 -100 500 -600 240 140
4 -100 500 -600 240 140
5 -100 500 -600 240 140
6 -100 500 -600 240 140
7 -100 500 -600 240 140
8 -100 500 -600 240 140
9 -100 500 -600 240 140
10 -100 500 -600 240 140
10 -5,000 2,000 2,000
It can calculated that PW(12%) of A=-6690 and PW(12%) of B=-8565<-6690.
Therefore, we should choose pipe A.

Problem 5 (10pts)
An automobile manufacturing company in Country X is considering the construction and
operation of a large plant on the eastern seaboard of the United States. Their MARR =
20% per year on a before-tax basis. (This is a market rate relative to their currency in
Country X.) The study period used by the company for this type of investment is 10 yr.
Additional information is provided as follows:
• The currency in Country X is the Z-Kron.
• It is estimated that the U.S. dollar will become weaker relative to the Z-Kron during
the next 10 yr. Specifically, the dollar is estimated to be devalued at an average
rate of 2.2% per year.

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 • The present exchange rate is 92 Z-Krons per U.S. dollar.

• The estimated before-tax net cash flow (in U.S. dollars) is as follows:
EOY Net Cash Flow(U.S.Dollars)
0 -168,000,000
1 -32,000,000
2 69,000,000
... ...
10 69,000,000

Based on a before-tax analysis, will this projected meet the company’s economic decision
criterion?

Using the equation ix = ius + fe + fe (ius ), as the US dollar is being devalued relative to
the currency in Country X, we have fe = −0.022 and then ius = 0.2+0.022
1−0.022
= 22.7%.
PW(22.7%)=14,351,321>0.
Yes, this project will meet the company’s economic decision criterion.

Problem 6(20pts)
You have been assigned the task of analyzing whether to purchase or lease some trans-
portation equipment for your company. The analysis period is six years, and the base
year is year zero (b = 0). Other pertinent information is given in the following table:

Best Estimate of
Cash Flow Item Estimate in Year-0 Dollars
Price Change(per year)
Purchase Lease
Capital Investment 600,000 - -
MV at end of six years 90,000 - 2%
Annual expenditures 26,000 26,000 6%
Annual maintenance expenses 32,000 32,000 9%

Also,

• The contract terms for the lease specify a cost of $300,000 in the first yar and
$200,000 annually in years two through six (the contract, i.e., these rates, does not
cover the annual expense items).

• The after-tax MARR (not including inflation) is 13.208% per year (ir ).

• The general inflation rate (f ) is 6%.

• The effective income tax rate (t) is 34%.

• Assume the equipment is in the following depreciation scheme:

Year 1 2 3 4 5 6
Depreciation rate 0.2 0.32 0.192 0.1152 0.1152 0.0576

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Which alternative is preferred? Use an after-tax, actual dollar analysis.

im = ir + f + ir (f ) = 20%.
The general format of purchasing the equipment is:

EOY BTCF (A$) Depreciation (A$) Taxable Income Income Taxes ATCF(A$)
0 -600,000 -600,000
1 -62440 120000 -182440 62030 -410
2 -67233 192000 -259233 88139 20906
3 -72407 115200 -187607 63786 -8621
4 -77995 69120 -147115 50019 -27976
5 -84030 69120 -153150 52071 -31959
6 -90549 34560 -125109 42537 -48012
6 101355 101355 -34461 66894

It can be computed that PW(20%)=-610824.

The general format of leasing the equipment is:
EOY BTCF (A$) Income Taxes ATCF(A$)
1 -362440 123230 -239210
2 -267233 90859 -176374
3 -272407 92618 -179789
4 -277995 94518 -183477
5 -284030 96570 -187460
6 -290549 98787 -191762

It can be computed that PW(20%)=-653906<-610824.

Comparing the PW, I prefer purchasing the equipment.

Problem 7(25pts)
A nationwide motel chain is considering locating a new motel in Bigtown, USA. The
cost of building a 150-room motel (excluding furnishings) is $5 million. The firm uses a
15-year planning horizon to evaluate investments of this type. The furnishings for this
motel must be replaced every five years at an estimated cost of $1,875,000 (at k = 0,
5, 10). The old furnishings have no market value. Annual operating and maintenance
expenses for the facility are estimated to be $125,000. The market value of the motel
after 15 years is estimated to be 20% of the original building cost.

Rooms at the motel are projected to be rented at an average rate of $45per night. On
the average, the motel will rent 60% of its rooms each night. Assume the motel will be
open 365 days per year. MARR is 10% per year.

(a) Using an annual-worth measure of merit, is the project economically attractive?

(b) Investigate sensitivity to decision reversal for the following three factors: (1) capital
investment, (2) MARR, and (3) occupancy rate (average percent of rooms rented per

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night). To which of these factors is the decision most sensitive?
(c) Graphically investigate the sensitivity of the AW to changes in the above three fac-
tors. Investigate changes over the interval 40%. On your graph, use percent change as
the x-axis and AW as the y-axis.

(a) The annual cash inflow is R = 150 × 0.6 × 45 × 365 = 1478250.

The furnishings cost is annually equivalent to 1875000(A/P, 10%, 5) = 494620.
The annual equivalent expenditure is E = 494620 + 125000 = 619620.
CR(10%)=5000000(A/P, 10%, 15) − 0.2 ∗ 5000000(A/F, 10%, 15) = 625895.
Hence, AW(10%)=R-E-CR(10%)=1478250 − 619620 − 625895 = 232735 > 0.
The project is economically attractive.

(b) When the capital investment(I) varies by p%,

AW(10%)= 1478250 − 619620 − (1 + p%) ∗ 625895 = 232735 − 625895 ∗ p% = 0.
=⇒ p = 37.18
When MARR varies by p%,
AW((1+p%)∗10%) = 1478250−1875000(A/P, (1+p%)∗10%, 5)−125000−5000000(A/P, (1+
p%) ∗ 10%, 15) − 0.2 ∗ 5000000(A/F, (1 + p%) ∗ 10%, 15) = 0.
=⇒ p = 42.89.
When the occupancy rate varies by p%,
AW(10%)= 1478250 ∗ (1 + p%) − 619620 − 625895 = 232735 + 1478250 ∗ p% = 0.
=⇒ p = −15.74.
The decision is most sensitive to changes in the occupancy rate.