Solutions to Mid-Term Exam

ENGR 301 Section G: Engineering Management Principles and Economics

4:15-5:30pm, October 23, 2007

1. Multiple-Choice Questions (totally 40 points, 5 points each)

Q1.1. (d)
Q1.2: (a), (b), (c)
Q1.3: (b) (d)
Q1.4. (c)
Q1.5. (b)
Q1.6. (a)
Q1.7. (c) (d)
Q1.8. (b)

Question #2 (20 points)

A piece of equipment was bought 3 years ago for $20,000. At the time of purchase, it was estimated
that the equipment would have a useful life of 6 years with a salvage value of $4,000. If we want to
continue using the equipment in the following years, a major repair of $2,000 is required now. The
equipment has a current market value of $7,500. If the equipment is retained, its updated market
values and operating costs for the next three years will be as follows:

Year End Market Value Operating Costs

0 7,500
1 4,500 3,200
2 2,100 4,400
3 500 5,200

In replacement analysis, what is the Equivalent Uniform Annual Cost of retaining the equipment for
the next two years? (MARR = 10%)

Answer:

PEC = (2000+7500) + 3200/(1+10%) + (4400-2100)/ (1+10%)2

= 9500 + 2909.09 + 1900.83 = 14,309.92

EUAC = PEC (A/P, 10%, 2) = 8,245.24

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Question #3 (40 points)
A machinery firm is considering investing in a new production line. The required equipments would
cost $600,000. The building would cost $1,200,000, and the land would cost $200,000. The project
life is 4 years. The new production line is expected to result in additional revenues of $900,000 per
year, and additional operating costs of $250,000 per year. At the end of the project, the equipments
can be sold for $200,000, the building for $600,000, and the land for $300,000.
The equipments are classified as class 43 property with CCA rate 30%. The CCA rate for the
building is 4%. The firm’s income tax rate is 40%. The capital gain tax rate is 20%. The firm’s
minimum attractive rate of return is 17%. 40% of the required initial investment is financed with a
term loan with 12% interest rate.
(a) Calculate the principal and interest payments of the term loan over the project life.
(b) Calculate the net cash flow in the first year.
(c) Calculate the net cash flow in the final year (year 4).
(d) Evaluate the project using the income statement approach.

Answer:

(a)
The amount of the term loan: P = 40% (600,000+1,200,000+200,000) = $800,000
Annual debt payment: A = P*(A/P, 12%, 4) = 263,388
Using the tabular method for calculating the principal and interest payments:

B0 = 800,000
I1 = B0*12% = 96,000; PP1 = A – I1 = 167,388; B1 = B0 – PP1 = 632,612
I2 = B1*12% = 75,913; PP2 = A – I2 = 187,474; B2 = B1 – PP2 = 445,138
I3 = B2*12% = 53,417; PP3 = A – I3 = 209,971; B3 = B2 – PP3 = 235,167
I4 = B3*12% = 28,220; PP4 = A – I4 = 235,167; B4 = B3 – PP4 = 0

(b) Net cash flow in the first year:

CCA1E = 600 K * 30% / 2 = 90 K

CCA1B = 1200 K * 4% / 2 = 24 K
Taxable income:
= OR − OC − CCA1E − CCA1B − I 1
= 900 K − 250 K − 90 K − 24 K − 96 K
= 440 K
Income tax = 440K * 40% = 176K
Net income = 264K

Net cash flow in the first year:

NCF1 = 264K + (96 K + 24K ) − 167.4 K = 210.6 K

(c) Net cash flow in the final year:

CCA4E = 600 K * 30%(1 − 15%)(1 − 30%) 2 = 74.97 K

CCA4B = 1200 K * 40%(1 − 2%)(1 − 4%) 2 = 43.35K

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U 4E = 600 K * (1 − 15%)(1 − 30%) 3 = 174.9 K
U 4B = 1200 K * (1 − 2%)(1 − 4%) 3 = 1,040 K

Net salvage values:

NS E = 200 K + t (U 4E − S E ) = 200 K + 0.4(174.9 K − 200 K )
= 200 K − 10.04 K = 189.96 K
NS B = 600 K + t (U 4B − S B ) = 600 K + 0.4(1040 K − 600 K )
= 600 K + 176 K = 776 K
NS L = 300 K + t CG ( PL − S L ) = 300 K + 0.2(200 K − 300 K )
= 300 K − 20 K = 280 K

Taxable income:
= OR − OC − CCA4E − CCA4B − I 4
= 900 K − 250 K − 74.97 K − 43.35 K − 28.2 K
= 503.48 K

Net income = 302.1K

Net cash flow in the final year:

NCF4 = 302.1K + (74.97 K + 43.35K ) + 189.96K + 776K + 280K − 235.1K = 1,431.28K

(d) Project evaluation:

Net cash flow in the 2nd year:

Net income = (1-t) * (900K-250K-47.04K-153K-75.9K) = 224.5K

NCF2 = 224.5K + 47.04K+153K-187.5K = 236.96K

Net cash flow in the 3rd year:

Net income = (1-t) * (900K-250K-152.26K-53.4K) = 266.6K

NCF3 = 266.6K + 152.26K-210.0K = 208.86K

The present worth:

MARR = 17%
210.6 K 236.96 K 208.06 K 1431.28 K
PW = −1200 K + + + +
1.17 1.17 2 1.17 3 1.17 4
= −1200 K + 180 K + 173.1K + 129.87 K + 763.65 K
= $47,415
>0
Thus, the project should be accepted.

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