UNIT-IV

Replacement Analysis
The analysis to determine whether an in-place item requires replacement due to:
Obsolescence
New requirements / Inadequacy
Deterioration
Definitions
Defender - Currently owned (in place) item.
Challenger - The new possible replacement item /alternative.
Outsider perspective - Analyst neither owns nor uses either the defender or challenger.
Analysis uses EAC for comparison.
First cost of defender is :
Current market value.
Trade in value which is the actual value obtained. This is the actual first cost.
The owner foregoes this amount of capital by not trading in the asset.
Do not include "Sunk Costs" which are unrecoverable due to loss of value prior to beginning of study
period.
No past costs are used.
Bought 10 years ago for $1,000,000
Trade in now $ 100,000 = First cost
Sunk costs $ 900,000
Example:
Ex Machine bought 3 years ago for $100,000.
8 years life remaining.
Annual operating cost = $23,000/year.
Salvage value = $10,000 (In 8 years)
Sell existing machine for $75,000
Buy more efficient machine for $150,000.
New machine operating costs = $10,000/yr
New machine life = 8 years (with no salvage).
Keep old machine or replace with new? MARR = 10%
Defender Challenger
P $75,000 $150,000
AOC $23,000 $10,000
S $10,000 $0
N 8 8
Note that defender first cost is the current price obtained by selling it.
Defender EACD = $23,000 + $75,000(A/P,10,8) -$10,000(A/F,10,8)
= $23,000 + $75,000(0.18744) -$10,000(0.08744)
= $36,184
Challenger EACC = $10,000 + $150,000(A/P,10,8)
= $10,000 + $150,000(0.18744)
= $38,116
The Defender is less cost. Keep the old machine.
UNIT-III
SCOPE OF ECONOMIC ANALYSIS:
Definition of 'Economies of Scope'

An economic theory stating that the average total cost of production decreases as a result of
increasing the number of different goods produced.
Investopedia explains 'Economies of Scope'
For example, McDonalds can produce both hamburgers and French fries at a lower average cost than
what it would cost two separate firms to produce the same goods. This is because McDonalds
hamburgers and French fries share the use of food storage, preparation facilities, and so forth during
production.

Another example is a company such as Proctor & Gamble, which produces hundreds of products
from razors to toothpaste. They can afford to hire expensive graphic designers and marketing experts
who will use their skills across the product lines. Because the costs are spread out, this lowers the
average total cost of production for each product.



The best way to understand project risk or project deferral risk is to characterize the risk by
describing the range of possible outcomes, estimating when they will occur (risk timing), and
assessing probabilities. If relevant data are available (e.g., as might be the case for system failure
probabilities for evaluating reliability maintenance projects), probabilities for characterizing risks
can be derived using statistical analysis. In the absence of such data, probabilities must still be
assigned, and it makes sense to do so directly based on professional judgment.
Although quantifying risks requires more inputs to describe proposed projects, note that the
additional inputs need not be very complex. In the case of unlikely, (discrete) risk events, it is far
less time-consuming yet normally entirely adequate to forsake precision and seek only rough,
order-of-magnitude estimates of probabilities and consequences (e.g., is the probability between
one-chance-in-one-hundred and one-chance-in-one-thousand?). Likewise, if some aspect of a
project's performance is uncertain (a continuous risk), instead of obtaining only a middle-value,
point estimate, get a range of possible values (e.g., a 90% confidence interval) as well as a mean
or most-likely value. (As indicated in the section of this paper on errors and biases, techniques
should be used to guard against overly narrow ranges caused by overconfidence.) With practice,
it takes no more time to specify an order-of-magnitude probability or range than it does to
generate a single point estimate. The necessary probabilities can be generated based on rough
estimates or from a range and a mean or most-likely value.
TYPES OF DEPRICIATION:
The capital cost allowance (CCA) is a rate of depreciation used for income tax purposes only. This term
primarily relates to Canadian taxation. The CCA rate that can be claimed depends on the asset itself;
The simplest and most commonly used method, straight-line depreciation is calculated by taking
the purchase or acquisition price of an asset, subtracting the salvage value (value at which it can
be sold once the company no longer needs it) and dividing by the total productive years for
which the asset can reasonably be expected to benefit the company (or its useful life).

Example: For $2 million, Company ABC purchased a machine that will have an estimated useful
life of five years. The company also estimates that in five years, the company will be able to sell
it for $200,000 for scrap parts.
Depreciation Expense
= Total Acquisition Cost Salvage Value / Useful Life


Straight-line depreciation produces a constant depreciation expense. At the end of the asset's
useful life, the asset is accounted for in the balance sheet at its salvage value.
Accelerated Depreciation
Accelerated depreciation allows companies to write off their assets faster in earlier years than the
straight-line depreciation method and to write off a smaller amount in the later years. The major benefit
of using this method is the tax shield it provides. Companies with a large tax burden might like to use the
accelerated-depreciation method, even if it reduces the income shown on the financial statement.

This depreciation method is popular for writing off equipment that might be replaced before the end of
its useful life if it becomes obsolete ( computers, for example).

Companies that have used accelerated depreciation will declare fewer earnings in the beginning years
and will seem more profitable in the later years. Companies that will be raising financing (via an IPO or
venture capital) are more likely to use accelerated depreciation in the first years of operation and raise
financing in the later years to create the illusion of increased profitability (and therefore higher
valuation).
TIME VALUE OF MONEY:
The time value of money is the principle that the purchasing power of money can vary over
time; money today might have a different purchasing power than money a decade later. The
value of money at a future point in time might be calculated by accounting for interest earned or
inflation accrued. The time value of money is the central concept in finance theory. However,
the explanation of the concept typically looks at the impact of interest, and for simplicity,
assumes that inflation is neutral.
For example, 100 invested for one year, earning 5% interest, will be worth 105 after one year;
therefore, 100 paid now and 105 paid exactly one year later both have the same value to a
recipient who expects 5% interest. That is, 100 invested for one year at 5% interest has a future
value of 105.
[1]
This notion dates back at least to Martn de Azpilcueta (14911586) of the
School of Salamanca.
This principle allows for the valuation of a likely stream of income in the future, in such a way
that annual incomes are discounted and then added together, thus providing a lump-sum "present
value" of the entire income stream; all of the standard calculations for time value of money
derive from the most basic algebraic expression for the present value of a future sum,
"discounted" to the present by an amount equal to the time value of money. For example, the
future value sum to be received in one year is discounted at the rate of interest to give the
present value sum :

BUDGET CONSIDERATIONS:
Unlike static budget entries, budget considerations are dynamic concepts that guide you in meeting your
financial goals. The reality of your income and expenses will determine how much money you have to
spend or save, but your personal flexibility will decide what you can do with excess cash or how you will
handle shortfalls. Create several budget scenarios using different considerations to be prepared for
best- and worst-case financial scenarios.
RISK ANALYSIS:
Risk analysis is a technique used to identify and assess factors that may jeopardize the success
of a prppojectpro or achieving a goal. ( of a ..Project)
This technique also helps to define preventive measures to reduce the probability of these factors
from occurring and identify countermeasures to successfully deal with these constraints when
they develop to avert possible negative effects on the competitiveness of the company.
One of the more popular methods to perform a risk analysis in the computer field is called
facilitated risk analysis process (FRAP).FACILITATED RISK ANALYSIS PROCESS
UNIT-IV
PAYBACK:
The length of time required to recover the cost of an investment. The payback period of a given
investment or project is an important determinant of whether to undertake the position or project, as
longer payback periods are typically not desirable for investment positions.

Calculated as:

Payback Period = Cost of Project / Annual Cash Inflows
Investopedia explains 'Payback Period'

All other things being equal, the better investment is the one with the shorter payback period. For
example, if a project costs $100,000 and is expected to return $20,000 annually, the payback period
will be $100,000/$20,000, or five years. There are two main problems with the payback period
method:
1. It ignores any benefits that occur after the payback period and, therefore, does not measure
profitability.

2. It ignores the time value of money.

Because of these reasons, other methods of capital budgeting, like net present value, internal rate of
return or discounted cash flow, are generally preferred.
ANNUALIZED COST:
In finance the equivalent annual cost (EAC) is the cost per year of owning and operating an
asset over its entire lifespan.
EAC is often used as a decision making tool in capital budgeting when comparing investment
projects of unequal lifespans. For example if project A has an expected lifetime of 7 years, and
project B has an expected lifetime of 11 years it would be improper to simply compare the net
present values (NPVs) of the two projects, unless neither project could be repeated.
EAC is calculated by dividing the NPV of a project by the present value of an annuity factor.
Equivalently, the NPV of the project may be multiplied by the loan repayment factor.

The use of the EAC method implies that the project will be replaced by an identical project.
INVESTORS RATE OF RETURN
Rate of return is a profit on an investment over a period of time, expressed as a proportion of
the original investment.
[2]
The time period is typically a year, in which case the rate of return is
referred to as annual return.
Return, in the second sense, and rate of return, are commonly presented as a percentage.
The return, or rate of return, can be calculated over a single period, or where there is more than
one time period, the return and rate of return over the overall period can be calculated, based
upon the return within each sub-period.Single-period Return -The return over a single period is:
where:
= final value, including dividends and interest
= initial value
Logarithmic or continuously compounded return
The logarithmic return or continuously compounded return, also known as force of interest,
is:

and the logarithmic rate of return is:

or equivalently it is the solution to the equation:

where:
= logarithmic rate of return
= length of time period
For example, if a stock is priced at 3.570 USD per share at the close on one day, and at 3.575
USD per share at the close the next day, then the logarithmic return is: ln(3.575/3.57) = 0.0014,
or 0.14%.
Annualisation of logarithmic return
Under an assumption of reinvestment, the relationship between a logarithmic return and a
logarithmic rate of return over a period of time of length is:

INTERNAL RATE OF RETURN:
The internal rate of return (IRR) or economic rate of return (ERR) is a rate of return used in
capital budgeting to measure and compare the profitability of investments. It is also called the
discounted cash flow rate of return (DCFROR).
[1]
In the context of savings and loans the IRR is
also called the effective interest rate. The term internal refers to the fact that its calculation does
not incorporate environmental factors (e.g., the interest rate or inflation).
Example
If an investment may be given by the sequence of cash flows


then the IRR is given by

In this case, the answer is 5.96% (in the calculation, that is, r = .0596).
Numerical solution
Since the above is a manifestation of the general problem of finding the roots of the equation
, there are many numerical methods that can be used to estimate . For example,
using the secant method, is given by

25.5 PROS & CONS OF EACH
FINANCIAL ARRANGEMENT
This section presents a brief summary of the Prosand Cons of each financial arrangement
from the hosts perspective.LoanPros: host keeps all savings, depreciation & interest
payments are tax-deductible, host owns the equipment, and the arrangement is good for long-
term use of equipmentCons: host takes all the risk, and must install and manage project

Year ( ) Cash flow ( )
0 -123400
1 36200
2 54800
3 48100