engineering economics ise460 session 10 chapter 5, june 15, 2015 geza p. bottlik page 1 outline...

ENGINEERING ECONOMICS ISE460SESSION 10

CHAPTER 5, June 15, 2015

Geza P. Bottlik

OUTLINE

• Questions?

• News?

• Quiz results

• Go over quiz

• Homework due tonight

• Next Homework due 6/17

• Recommendation

• Chapter 5



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Quiz Results

• The good news:

– Substantial improvement over quiz 1

– Did not change class GPA (very good – it usually drops)

– No scores below 70%, also a good sign

• Cautions

– Some of you are still somewhat unsure about the use of

the formulas

– You need to fix this to do well in the rest of the class!



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Quiz Results



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Recommendation

• British Library (on Euston, next to St. Pancras)

– Treasures exhibit

» Gutenberg Bible

» Mozart manuscript

» Leonardo Da Vinci sketches

» Beatles’ notes

» And much more

• And of course free! About a 15 minute walk from Accent



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CHAPTER 5 PRESENT WORTH ANALYSIS

• PROJECT CASH FLOWS

• PAYBACK PERIOD

• NET PRESENT WORTH

• CAPITALIZED EQUIVALENT METHOD

• MUTUALLY EXCLUSIVE ALTERNATIVES

• PROJECT LIVES



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PROJECT CASH FLOWS

• INVESTMENTS ARE MADE EARLY IN THE PROJECT

• BENEFITS ARE EXPECTED OVER A PERIOD OF YEARS IN THE

FUTURE

• LOAN CASH FLOW - PAYMENTS RECEIVED BY THE LENDER

• PROJECT CASH FLOW - INCOME LESS EXPENSES

• PAYBACK PERIOD - THE TIME THAT IT TAKES TO RECOVER THE

ORIGINAL COST, e.g., A WAREHOUSE COSTS $4M TO BUILD AND

YIELDS A PROFIT OF $500,000/YEAR. THE PAYBACK IS 8 YEARS.

THIS IS THE SIMPLEST ANALYSIS

• DISCOUNTED PAYBACK PERIOD – REDUCE THE VALUE OF THE

INVESTMENT BY THE DISCOUNT RATE



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PROJECT CASH FLOWS (CONTINUED)

• FOR UNEQUAL CASH FLOWS, DETERMINE THE TIME WHEN

CASH FLOW EQUALS THE INITIAL INVESTMENT

• SALVAGE VALUE - WHAT YOU CAN GET FOR USED

EQUIPMENT

• THE SALVAGE VALUE OF THE OLD EQUIPMENT IS

SUBTRACTED FROM THE INITIAL INVESTMENT

• DO NOT USE PAYBACK PERIOD FOR COMPARING

PROJECTS, -- ONLY FOR ROUGH SCREENING



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NET PRESENT WORTH

• DISCOUNTED CASH FLOW TECHNIQUES (DCF)

• ONE SUCH METHOD IS NET PRESENT WORTH (NPV)

• BRING ALL INVESTMENTS AND BENEFITS BACK TO TIME

ZERO

• COMPARE THEM

• COMPARE TO OTHER ALTERNATIVES

• SELECT LARGEST PRESENT WORTH PROJECT



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NET PRESENT WORTH

• WHAT INTEREST RATE DO WE USE?

• COMPANIES DETERMINE WHAT THEY CALL:

– MINIMUM ATTRACTIVE RATE OF RETURN (MARR)

– MANY COMPANIES INSIST ON A HIGH RATE OF RETURN BECAUSE THEY HAVE LIMITED RESOURCES AND WANT TO INVEST IN THE BEST PROJECTS

• NET PRESENT WORTH SHOULD BE POSITIVE TO ACCEPT A PROJECT

• INVESTMENT POOL - ALL AVAILABLE FUNDS FOR INVESTMENT

• IF THERE ARE NO FUNDS, THEY MUST BE BORROWED



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NET PRESENT WORTH (CONTINUED)

EXAMPLE - ALL PAYMENTS AT THE END OF THE PERIODMARR= 1.00%

PERIOD0 1 2 3 4 5 6 7

IN MILLIONS OF DOLLARSINVESTMENT $4.5 $1.5 $1.0EXPENSES $2.0 $1.5 $1.5 $1.0 $0.5 $0.5 $0.5 $0.5INCOME $0.0 $0.5 $1.0 $2.0 $3.0 $4.0 $3.0 $2.0

NET ($6.5) ($2.5) ($1.5) $1.0 $2.5 $3.5 $2.5 $1.5

NPW $0.01NET W/O INV ($2.00) ($1.00) ($0.50) $1.00 $2.50 $3.50 $2.50 $1.50CUM CASH ($2.00) ($3.00) ($3.50) ($2.50) $0.00 $3.50 $6.00 $7.50TOTAL INVESTMENT $7.0PAYBACK 6+ YEARS



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Example



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CAPITALIZED EQUIVALENT METHOD

• APPLIES TO LONG HORIZONS OR PERPETUAL

INVESTMENTS

• COMPUTING THE PRESENT WORTH OF AN INFINITE SERIES

IS CALLED THE CAPITALIZATION OF THE PROJECT’S COST

• APPLYING L’HOPITAL’S RULE TO THE (P/A,i,N), WE GET A/i

• SO THE PRESENT WORTH OF A SERIES OF CONSTANT

PAYMENT STRETCHING OUT TO INFINITE IS A/i



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Capitalized Equivalent Method



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MUTUALLY EXCLUSIVE ALTERNATIVES

• IF ONE ALTERNATIVE IS SELECTED, ALL OTHERS ARE

REJECTED

• “DO NOTHING’ IS AN ALTERNATIVE

• REVENUE PROJECT -- INCOME DEPENDS ON THE CHOICE

OF THE ALTERNATIVE

• SERVICE PROJECT -- REVENUES ARE THE SAME

REGARDLESS OF THE CHOICE OF ALTERNATIVE



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PROJECT LIVES

• ANALYSIS PERIOD, STUDY PERIOD OR PLANNING

HORIZON:

– TIME PERIOD OVER WHICH THE IMPACT OF THE

PROJECT WILL BE EVALUATED

• WE HAVE TO CONSIDER:

– REQUIRED SERVICE PERIOD

– USEFUL LIFE OF THE PROJECT

• FOR MULTIPLE PROJECTS WE MUST COMPARE THEM

OVER AN EQUAL TIME SPAN



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PROJECT LIVES (CONTINUED)

• EXAMPLES

– PROJECT LIVES LONGER THAN ANALYSIS PERIOD (5.11)

– PROJECT LIVES SHORTER THAN ANALYSIS PERIOD (5.10)

– ANALYSIS PERIOD = LONGEST LIFE (5.12)

– UNEQUAL LIVES - LOWEST COMMON MULTIPLE METHOD

(5.13)



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Example 5.11 – Project lives longer than the analysis period

• THIS ONE IS VERY STRAIGHT FORWARD:

• WE ANALYZE FOR THE LENGTH OF TIME THAT WE ARE INTERESTED IN.

WHATEVER THE EQUIPMENT IS WORTH AT THE END OF THE ANALYSIS

PERIOD, WE CONSIDER AS SALVAGE VALUE



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Example 5.10 Project lives shorter than analysis period

• THIS EXAMPLE HAS TWO OPTIONS, ONE THAT WILL LAST 3 YEARS, THE OTHER

4. UNFORTUNATELY WE HAVE TO PLAN FOR 5 YEARS.

• WE HAVE TO CHOOSE AN APPROACH THAT WILL FILL IN THE LAST TWO

YEARS OF THE FIRST OPTION, AND THE LAST YEAR OF THE SECOND OPTION



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Example 5.12 Analysis period = longest life



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Example 5.13 Unequal lives - lowest common multiple method

• Option A has a life of 3 years, Option B 4 years.

• We use a lowest common denominator (12) as the analysis period

• For each option we calculate NPV and the end of its life and then repeat the

investment until we have reached the common denominator



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A FUN NOTE TO END ON (GARY LARSEN) “Notice all the computation, theoretical scribbling, and lab

equipment, Norm … Yes, curiosity killed these cats

engineering economics ise460 session 10 chapter 5, june 15, 2015 geza p. bottlik page 1 outline...

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