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Part two:

Evaluation of business and


engineering assets

Accept/reject an investment
Comparison of alternative investments

3 common measures based on cash flow equivalences:


1) Equivalent present worth (PW)
2) Equivalent future worth (FW)
3) Equivalent annual worth (AE)

Chapter 5
Chapter 6

Chapter 5
5.1) Describing project cash flows
5.2) Initial project screening method
5.3) Discounted cash flow analysis
5.4) Variations of present worth analysis
5.5) Comparing mutually exclusive alternatives

5.1) Describing project cash flows


All engineering economic decision problems have in
common that:
1. There is an investment, usually made in a lump sum at a
specific point in time that is called today or time 0
2. There is a stream of cash benefits that are expected to
result from the investment over some years in the future

Figure 5.1 A bank loan versus an investment project.

5.2) Initial project screening method

5.2) Initial project screening method


Payback method: how long it takes for net receipts to equal
investment outlays.
1.Conventional payback method
2.Discounted payback method

Example 5.2
Consider the cash flows given in Example 5.1. Determine
the payback period for this computer-process control
system project.

Example 5.3

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Figure 5.3 Illustration of conventional payback period (Example 5.3).

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Cash Flow

0
1
2
3
4
5
6

-$105,000+$20,000
$15,000
$25,000
$35,000
$45,000
$45,000
$35,000

Cum. Cash Flow


-$85,000
-$70,000
-$45,000
-$10,000
$35,000
$80,000
$115,000

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Figure 5.3 Illustration of conventional payback period (Example 5.3).

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Conventional payback period


Benefits: simplicity
Drawbacks:
It fails to measure profitability (no profit is made during the PP)
It ignores differences in the timing of cash flows
It ignores all proceeds after the PP

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Payback
period = 3,6
years

Payback period = 3 years


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5.3) Discounted cash flow analysis


The present worth of all cash inflows is compared against
the present worth of all cash outflows associated with an
investment project.
The difference between the present worth of the these
cash flows is referred to as the net present worth (NPW).

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Net-present-worth criterion
1.Determine the interest rate that the firm wishes to earn on its
investment: the required rate of return or minimum attactive
rate of return (MARR).
2.Estimate the service life of the project.
3.Estimate the cash inflow for each period over the service life.
4.Estimate the cash outflow for each period over the service life.
5.Determine the net cash flows.
6.Find the present worth of each net cash flow at the MARR.
Add up all the present worth figures; their sum is defined as
the projects NPW.

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Decision rule
Single project evaluation

Comparing multiple alternatives

If we compare cost AND revenues


If we ONLY compare costs (they all have the same revenues)

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Example 5.4

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Example 5.5

$35,560

$37,360

$31,850

$34,400

inflow

0
1

outflow

$76,000

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>0

<0

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Figure 5.5 Present-worth profile described in Example 5.5 the machine tool project is acceptable as long as the
firms MARR is less than 30%.

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5.3.2) Meaning of net present worth

In present-worth analysis, we assume that all the funds in a


firms treasury can be placed in investments that yield a return
equal to the MARR. We may view these funds as an
investment pool.
If NO fund is available for investment, we assume that the firm
can borrow them at the MARR (or cost of capital) from the
capital market.

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5.3.2) Meaning of net present worth Investment pool concept


$35,560 $37,360 $31,850

$34,400

inflow

0
1

outflow

$76,000

MARR = 12%

Option 1: do not invest in the project


Option 2: invest in the project
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5.3.2) Meaning of net present worth Borrowed-funds concept


Suppose the firm borrows all of its capital from a bank at an interest rate
of 12%, invest in the project, and uses the proceeds from the investment
to pay off the principal and the interest on the bank loan.
$35,560 $37,360 $31,850

$34,400

inflow

0
1

outflow

$76,000

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Year
0
1
2
3
4

Interest

Debt

Receipt

Project
Balance
-76,000

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Year
0
1
2
3
4

Interest

Debt

Receipt

9,120

85,120

35,560

Project
Balance
-76,000
-49,560

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Year
0
1
2
3
4

Interest

Debt

Receipt

9,120
5,947

85,120
55,507

35,560
37,360

Project
Balance
-76,000
-49,560
-18,147

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Year

Interest

Debt

Receipt

0
1
2
3
4

9,120
5,947
2,178
-1,383

85,120
55,507
20,325
-12,908

35,560
37,360
31,850
34,400

Project
Balance
-76,000
-49,560
-18,147
11,525
47,308

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5.3.3) Basis for selecting the MARR: elements to be considered


1. Cost of capital, the required return necessary to make an
investment project worthwhile.
It includes:
cost of debt (the interest rate associated with borrowing)
cost of equity (the return that stockholders require for a company)
This is normally considered as the rate of return that a firm would
receive if it invested its money someplace else with a similar risk.
2. Any additional risk associated with the project: If the project has
associated a high risk the additional risk premium may be
added onto the cost of capital.

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5.4) Variations of the present-worth


analysis

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1.

Future worth analysis

2.

Capitalized equivalent-worth analysis

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5.4.1 Future-worth analysis


Net present worth measures the surplus in an investment project at
time 0.
Net future worth (NFW) measures this surplus at a time other than
0.

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35

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After completion:

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Figure 5.9 Cash flow diagram for the Helpmate project (Example 5.6).

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Capitalized equivalent method


It is useful when the proposed project is perpetual or the
planning horizon is extremely long.
1. Perpetual service life

2. Projects life is extremely long

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1. Perpetual service life


Figure 5.10 Equivalent present worth of an infinite cash flow series.

The process of computing the PW cost for this infinite series is


referred to as the capitalization of the project cost
P = capitalized cost: the amount of money that must be invested
today to yield a certain amount A at the end of each and every
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period forever, asssuming an interest rate of i.

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2. Projects life is extremely long


Example 5.8

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Figure 5.11 Net cash flow diagram for Mr. Bracewells hydroelectric project (Example 5.8).

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5.5) Comparing mutually exclusive


alternatives

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Service projects Revenue projects


Total-investment approach Incremental-investment approach
Scale of investment

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Service projects versus revenue projects


Service projects: their revenues do not depend on the choice
of project. All the projects must produce the same amount of
output (and therefore revenue).
Revenue projects: their revenues depend on the choice of
alternative.

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Total-investment approach Incremental-investment approach

Total-investment approach: applying the evaluation criterion


to each project individually and then comparing the results
Incremental-investment approach: we consider the
differences among the alternatives considered (chapter 7)

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Figure 5.12 Diagram illustrating the process of making a choice among mutually exclusive alternatives.

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Scale of investment
The disparity in scale of investment should not be of concern
in comparing mutually exclusive alternatives, as long as:
funds not invested in the project will continue to earn interest
at the MARR.
We will look at mutually exclusive alternatives that require
different levels of investments for both service projects and
revenue projects.

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Scale of investment

Figure 5.13 Comparing mutually exclusive revenue projects requiring different levels of investment.

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Figure 5.13 Comparing


mutually exclusive
revenue projects
requiring different levels
of investment.

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5.5.2 - Analysis period


= study period = planning horizon
Its the time span over which the economic effects of an
investment will be evaluated.
The analysis period = the required service period

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Analysis period
If required service period is not specified analysis
period = useful life
If useful life required service period

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Figure 5.14 Analysis period implied in comparing mutually exclusive alternatives.

Ex. 5.11

Ex. 5.10

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5.5.4 - Analysis period differs from project lives


1. Projects life is longer than analysis period (Ex. 5.10)

2. Projects life is shorter than analysis period (Ex. 5.11)


3. Analysis period coincides with longest project life (Ex. 5.12)

REMEMBER: we must analyze each project for the required


service period (analysis period) !

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1. Projects life is longer than analysis period

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Figure 5.15 (a) Cash flow for model A; (b) cash flow for model B; (Example 5.10).

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NEW salvage
value = 125000 * 2

NEW salvage
value = 45000 * 2

Original salvage
value = 25000 * 2

Original salvage
value = 30000 * 2
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Figure 5.15 (a) Cash flow for model A; (b) cash flow for model B; (c) comparison of service projects with unequal lives
when the required service period is shorter than the individual project life (Example 5.10).

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2. Projects life is shorter than analysis period

We need replacement projects: additional projects to be


implemented when the initial project has reached the limits
of its useful life.
Options:
Assume that the replacement project will be exactly the
same as the initial project, with the same costs and
benefits (including investment)
Use new technology
We can buy/lease the necessary equipment.
If we lease we dont need to worry about salvage values.

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2. Projects life is shorter than analysis period

Example 5.11

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Figure 5.16 Comparison for service projects with unequal lives when the required service period is longer than the
individual project life (Example 5.11).

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3. Analysis period coincides with longest project life

In some situations revenue projects with different lives can


be compared directly if they require only a one-time
investment, because the task within the firm is a one-time
task.
Example: extraction of a fixed quantity of a natural
resource, such as oil or coal.
Because of the time value of money: the revenues must be
included.
The two projects could be compared by using the NPW of
each over its own life (but the analysis period = longest
project life).
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3. Analysis period coincides with longest project life

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Figure 5.17 Comparison of revenue projects with unequal lives when the analysis period coincides with the project
with the longest life in the mutually exclusive group (Example 5.12). In our example, the analysis period is five years,
assuming no cash flow in years 4 and 5 for the lease option.

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Figure 5.14 Analysis period implied in comparing mutually exclusive alternatives.

Ex. 5.11

Ex. 5.10

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5.5.5 - Analysis period is not specified


The analyst should choose the appropriate analysis period:
on the basis of the useful lives of the alternatives.
If alternatives have equal useful life this is the analysis
period.
When at least the life of one alternative differs we need a
common service period:
1. Lowest common multiple of project lives
2. Other common analysis periods.
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5.5.5 - Lowest common multiple of project lives


We select a finite analysis period by using the lowest
common multiple of project lives.
Example:
Alternative A has a 3-year useful life
Alternative B has a 4-year useful life
Which is our analysis period?

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1.

Example 5.13

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Example 5.11

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Figure 5.18

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Do not confuse:
Capitalized equivalent-worth analysis: It is useful
when the proposed project is perpetual or the
planning horizon is extremely long. We invest only
once.
A

PW (i )

Analysis period is not specified: we repeat the project


we repeat the investment. We have cycles. We
calculate the PW with n = lowest common multiple of
project lives.
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5.5.5 - Other common analysis periods


If the useful lifes are: 7 and 12 the lowest common
multiple of project lives is 84 years
In a case like this, it could be reasonable to use the useful
life of one of the alternatives by either factoring in a
replacement project or salvaging the remaining useful life.
The important idea is that we must compare both projects
on the same time basis.

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Exercise
Find the capitalized cost of a present cost of $300.000,
annual costs of $35.000, and periodic costs every 5 years
of $75.000. Use an interest rate of 12% per year.

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Question 5.51 (modified) from Park (2010)


Consider the cash flows for two types of models given below. Both models will
have no salvage value upon their disposal (at the end of their respective service
lives). The firms MARR is known to be 12%.
n
0
1
2
3

Model A
-8000
3500
3500
3500

Model B
-15000
10000
10000
-

a)Notice that the models have different service lives. However, model A will be
available in the future with the same cash flows. Model B is available at one time
only. If you select model B now, you will have to replace it with model A at the end
of year 2. If your firm uses the present worth as a decision criterion, which model
should be selected, assuming that the firm will need either model for 3 years?
Salvage Value for Model A, at the end of 1 one year is $6000.
b)Suppose that your firm will need either model for only two years. Determine the
salvage value of model A at the end of year 2 that makes both models indifferent
(equally likely).
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Question 5.53 from Park (2010)


Consider the following two investment alternatives given in the table below. The
firms MARR is known to be 15%.
n
0
1
2
3

Project A1
-15000
9500
12500
7500

Project A2
-25000
0
X
X

PW (15%) Project A1 = ?
PW (15%) Project A2 = 9300
a)Compute PW (15%) for project A1.
b)Compute the unknown cash flow X in years 2 and 3 for project A2.
c)Compute the project balance (at 15%) of project A1 at the end of period 3.
d)If these two projects are mutually exclusive alternatives, which one would you
select?
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Question 5.55 from Park (2010)


A mall with two levels is under construction. The plan is to install only 9 escalators
at the start, although the ultimate design calls for 16. The question arises as to
whether to provide necessary facilities (stair supports, wiring conduits, motor
foundations, etc.) that would permit the installation of the additional escalators at the
mere cost of their purchase and installation or to defer investment in these facilities
until the escalators need to be installed:
Option 1: Provide these facilities now for all 7 future escalators at $300,000.
Option 2: Defer the investment in the facility as needed. Install 2 more escalators in
two years, 3 more in five years, and the last 2 in eight years. The installation of
these facilities at the time they are required is estimated to cost $140,000 in year 2,
$160,000 in year 5, and $180,000 in year 8.
Additional annual expenses are estimated at $7,000 for each escalator facility
installed. Assume that these costs begin on the year subsequent to the actual
addition. At an interest rate of 12% compare the net present worth of each option
over eight years.
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Question 5. 57 From Park (2010)


A large refinery-petrochemical complex is to manufacture caustic soda, which will
use feedwater of 10,000 gallons per day. Two types of feedwater storage
installation are being considered over the 40 years of their useful life.
Option 1: Build a 20,000-gallon tank on a tower. The cost of installing the tank and
tower is estimated to be $164,000. The salvage value is estimated to be negligible.
Option 2: Place a tank of 20,000-gallon capacity on a hill, which is 150 yards away
from the refinery. The cost of installing the tank on the hill, including the extra length
of service lines, is estimated to be $120,000 with negligible salvage value. Because
of the tanks location on the hill, an additional investment of $12,000 in pumping
equipment is required. The pumping equipment is expected to have a service life of
20 years with a salvage value of $1,000 at the end of that time. The annual
operating and maintenance cost (including any income tax effects) for the pumping
operation is estimated at $1,000.
If the firms MARR is known to be 12%, which option is better on the basis of the
present-worth criterion?
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