00 voturi pozitive00 voturi negative

3 vizualizări88 paginiengineering economics

May 14, 2019

© © All Rights Reserved

PPTX, PDF, TXT sau citiți online pe Scribd

engineering economics

© All Rights Reserved

3 vizualizări

00 voturi pozitive00 voturi negative

engineering economics

© All Rights Reserved

Sunteți pe pagina 1din 88

and engineering project evaluation

• Contents

– Background

– Different financial indices and related terminologies

– Expression of cost and benefit

– Analysis of net present value (NPV)

– The NPV curve

– Discounting / compounding formula under different

perspectives

– Other factors to be considered

1

Background

Economic analysis

The main purpose of project economic analysis is to help

design and select projects that contribute to the welfare of a

country.

Economic analysis is most useful when used early in the

project cycle, to catch bad projects and bad project

components.

Economic analysis is only one part of the overall analysis of

the project; it takes for granted that the project is technically

sound and its institutional arrangements will be effective

during implementation.

The purpose of economic analysis of engineering (and also

for other) projects is to increase the net output measured at

economic prices in the national economy.

2

Economic evaluations

• Economic Evaluation (also called Appraisal, Assessment or

Analysis) refers to methods to determine the value of a good,

service, activity, policy, program or project.

• Economic evaluations involve the identification, measurement

and valuation of cost and benefit, and then comparison of the

inputs (costs) and outcomes (benefits).

• Economic evaluation is one of the tools available to help

choose wisely from a range of alternatives and implement

efficient resources.

• An investment or intervention is said to be economically

efficient when it maximizes the value of output from the

resources available.

• The choice of treatment (economical evaluation) is a very

important part of the evaluation process.

3

An economic evaluation is not useful if a potential treatment

of greater benefits and lesser costs has been omitted.

Full economic evaluations should only be undertaken after

an initial analysis to gauge the usefulness of the study.

This can help to guide decisions toward optimality, which

refers to maximum social benefit.

Economic evaluation is not limited to market (measured in

monetary units) impacts it can also incorporate nonmarket

resources such as personal time, health and environmental

quality.

In economic and financial decision making, we need the

following types of evaluation (Several specific techniques are used for

economic evaluation):

testing the economic viability of a project

choice of the best project among alternatives

choice of the least-cost option for achieving the same benefit

4

Different financial indices and related terminologies

Present value

Present value is the amount of money measured at the

present time.

This is the amount of money in an account at a present time.

Present value tells the current worth of a future sum of

money.

It’s also referred to as present discount value. The

calculation of discounted or present value is extremely

important in many financial calculations. For example, net

present value, bond yields etc.

Present value or worth (P) is the current value of a given

future cash-flow stream, discounted at a given rate. The

formula for calculating a present value is:

F

P

1 i n 5

P = present value, F = future value, i = interest rate, n = number of investment or loan periods.

Future value

Future value is the amount of money at a future point in

time.

This is the amount of money in an account at some time

in the future.

Future value gives one the future value (at a future date)

of cash that one have now.

It is important for them to know the accurate value of their

cash flows.

A future amount of money results from the cumulative

effects of the interest rate over a number of interest

period. The formula for future value is:

F P1 i

n

6

Exercise 1

A person wishes to have a future sum of RM 1,000,000 for his

child’s education after 10 years from now. The bank gives

15% interest rate compounded annually. What is the single-

payment that he should deposit now so that he gets the

desired amount after 10 years?

7

Exercise 2

A person deposits a sum of RM 20,000 at the interest rate of

8% compounded annually for 10 years. Find the maturity

value after 10 years.

8

Least cost analysis

• A least cost analysis is an effective method of evaluating two

alternative materials with different service life for economic

equivalence.

• The analysis of least cost shows the most efficient choice to

achieve these relatively similar benefits.

• Least-cost analysis aims at identifying the least-cost project

option for supplying output to meet forecasted demand.

• This method applies to projects where the benefits can be

valued or to projects where the benefits take the form of a

single commodity.

• Least-cost analysis involves comparing the costs of the

various mutually exclusive, technically feasible project

options and selecting the one with the lowest cost.

9

• The choice of the least-cost option will be based on the lowest

present value of incremental economic costs.

• Least-cost analyses generally deal with the ranking of

mutually exclusive options or alternative ways of producing

the same output of the same quality

• The selection of the least-cost alternative in economic terms

from the technically feasible options promotes production

efficiency and ensures the most economically optimum

choice.

• For multi-year project, the alternative with the lowest present

value of costs (for desired output) is the least-cost

alternatives.

• For example, it may be that the cheapest way of increasing

water supply is through more efficient management of the

existing supply rather than through augmenting/increasing

capacity. 10

Exercise 3

To transfer 30 tons of building materials from its original

position to 125 m apart, three options are available: robot,

mechanical and manual. The respective time required for each

option and associated costs are in Table below. Find out the

least cost option.

Table

Option Time required (hr) Cost per hr (RM)

Robot 3 90

Mechanical 1.6 200

Manual 2 150

11

Exercise 4

The initial cost and running cost of 3 different machines, and the

product per year under the machines are given in Table below.

Find the least cost Machine.

Table

Type Initial cost Running cost Product per

(RM/year) (RM/month) year (nos)

Machine-A 5400 425 8000

Machine-B 6000 417 8300

Machine-C 7000 400 8500

12

Exercise 5

A business firm is considering to set up a “Ready-made Garment

Factory” to a low labor-cost country in Asia. Suppose, you are the

Chief of firm’s engineering department and you have been given the

job to evaluate various alternatives. In the industry (also termed as

‘Factory’), 1000 machines will be in operation, and that will require

1000 operators. The initial/first cost is the same for all options. Other

variable cost elements of various options are given in Table below.

Assume that the quality/grade of the product, and also the price, will

be same for all options. Find out the ‘least cost option’.

Table: Variable cost in different countries

Country Operating cost other than Wage of unit Finished cloth Transportation cost to

the machine operator (RM operator (RM per operator per carry the product at target

per month) per month) month (nos) location (RM per month)

India 12000 200 200 15000

Bangladesh 12000 190 210 14000

Pakistan 12500 210 205 15500

China 15000 220 220 16000

Indonesia 13000 180 205 13500 13

Exercise 6

A manufacturing company is planning to buy a machine to

produce ‘spare parts’ of the car. Three options/machines are

available. The features of the machines are given in Table

below. The economic life of the machines and the quality of the

products are similar. Which machine will you suggest to buy?

Table: Features of the machines

Type Annualized Total product Defective product Annualized value of

value of initial (spare parts) per (% of total) per operating &

cost (RM) month (nos) month (nos) maintenance cost (RM)

Machine-2 17,500 750 3 50000

Machine-3 19,000 875 2 51000

14

Cost effectiveness

Background

• Cost-effectiveness is typically expressed as an incremental

cost-effectiveness ratio (ICER), the ratio of change in costs to

the change in effects.

• The concept of cost effectiveness is applied to the planning

and management of many types of organized activity.

• In some cases, the benefits or outcomes of a project cannot

be valued (or not directly measurable), but can be quantified

or have a specific outcome.

• For example, in a pollution control project, the outcome is

pollution control (having specific quality or grade), with a

specific cost.

• To attain a specific grade of pollution control, different

methods or techniques can be employed and their cost may

be different. 15

Cost-effectiveness analysis

• Cost-effectiveness analysis (CEA) is a form

of economic analysis that compares the relative costs and

effect (outcomes) of two or more courses of action.

• Cost-effectiveness analysis is one of a number of techniques

of economic evaluation, where the choice of technique

depends on the nature of the benefits specified.

• The concept of cost effectiveness is applied to the planning

and management of many types of organized activity.

• Cost-effectiveness analysis is an analysis that seeks to find

the best alternative activity, process, or intervention that

minimizes cost.

• A measure of the cost effectiveness is obtained by

measuring costs against outcome (average incremental

economic cost).

16

Example

Suppose that a city council is considering the possibility of

using a central crash barrier as a means for reducing

accidents on a high-density stretch of highway through the

city. The barrier could be made of reinforced concrete or

wire mesh or could simply be a landscaped space

separation between opposing lanes. Each form of barrier

will have a defined cost with different expectancies on the

number of accidents alleviated over time. The measure of

effectiveness is reduction of accidents, and relating the

measure of effectiveness to the cost of project

implementation is the cost effectiveness determination.

This technique is also used in health economics to compare

the financial costs of therapies whose outcomes can be

measured purely in terms of their health effect.

17

• Cost effectiveness analysis is also applied to many other

areas of human activity, including the economics of

automobile usage.

• The technique or method that needs minimum cost to attain

targeted outcome is most cost effective.

• Analysis of cost effectiveness allows choosing the least-cost

project evaluating various options.

• Cost-effectiveness is typically expressed as an incremental

cost-effectiveness ratio (ICER), the ratio of change in costs to

the change in effects.

all cos ts

all measured health effect

18

Example of Cost-effectiveness analysis

Cost (RM) variable Reduction in ppm Reduction

Cost (RM) water (ppm) (RM/ppm)

Method-1 500 1000 100 10.00

Method-2 500 1500 155 9.68

Method-3 500 2000 160 12.50

19

Relevant Terminologies

Initial investment

• An initial investment is the money a business owner needs to

start up a firm.

• It may include the business owner's own money, money borrowed

from a variety of sources including family and friends or banks, or

money raised from investors.

• Initial investment is the total first cost of all assets and services

required to initiate the alternative.

• When portions of these investments take place over several

years, their present worth is an equivalent initial investment.

• An initial investment is the first cost of capitalized properties.

• This includes the purchase price, the delivery cost, the installation

cost, hardware, software, startup costs, licensing fees, and any

other costs that must be incurred before the asset can be put into

production.

• This is also called the basis. 20

Salvage value

Salvage value is the money that can be gained by selling the

hardware or instruments at the end of the project.

The estimated value of the asset when it is no longer used

by the organization.

This is the terminal estimated value of assets at the end of

their useful life.

It may be positive, negative, or zero. The salvage value is

zero if no salvage is anticipated; salvage is negative when it

will cost money to deposit of the assets.

Calculating salvage value is an important part of asset

management, as well as tax calculation.

Calculating salvage value is a regular accounting exercise,

as one needs to determine the depreciation of asset value.

Salvage value is also considered in the calculation for tax

deductions and therefore, it is vital that you know what it

means. 21

Nominal Value

Nominal value in economics refers to a value expressed in

monetary terms for a specific year or years, without

adjusting for inflation.

A nominal variable is one where the effects of inflation have

not been accounted for.

Nominal values are the face value of currency over long

periods of time (years), Nominal value is fixed and does

never change.

Real Value

The real values are the actual values of something.

It adjusts nominal value to remove effects of price changes

over time.

The real value is one where the effects of inflation have

been factored, and real values have been corrected for

inflation.

To account for inflation, either real or nominal values may be

22

used, but with consistently.

Nominal Cost

Nominal cost is the money cost of production. It is also

called expenses of production.

Nominal costs are those that do not account for inflation.

Nominal costs are useful when considering the changes in

prices over a given time.

In economics, the difference between nominal and real costs

is the adjustment for inflation.

Real Cost

Real cost are used to better understanding the change of the

value of a good or service over time.

Because they account for inflation, real costs are good

barometer for the scarcity inherent in the market for that

particular commodity.

Real costs are considered when trying to understand the full

picture of the economic situation at a given time.

23

Nominal Interest Rates

The nominal interest rates refer to the rate of interest prior to

taking inflation into account.

The nominal interest rate is an interest rate that does not

include any consideration of compounding.

Depending on its application, an inflation and risk premium

must be added to the real interest rate in order to obtain the

nominal rate.

Nominal Interest Rate = Real Interest Rate + Inflation Premium

+ Risk Premium

Real Interest Rate

The real interest is one where the effects of inflation have

been factored in.

The real interest rate is the rate of interest an investor

expects to receive after allowing for inflation.

Nominal and real interest rate

savings in your bank account, and inflation is currently 3%

per year, then the real interest rate you are receiving is 1%

(4% - 3% = 1%).

The real value of your savings will only increase by 1% per

year, when purchasing power is taken into consideration.

than the nominal interest rate.

interest rate will be larger than the nominal interest rate.

25

Income stream

An income stream is an investment product which allows you

to receive regular payments that are made up of income and

a return of the capital you used to buy or acquire the product.

An income stream is a series of amounts of money.

You generally receive the payment from the product as a

pension or as an annuity.

Income streams may be purchased using savings or lump

sum superannuation entitlements.

Each amount of money comes in or goes out at some

specific time, either now or in the future.

Year 0 1 2 3 4 5

Income

amounts -$2000 $500 $600 $700 $600 $600

26

Cash flow

Cash flows represent the flow, or movement, of money at

some specific time or over some period of time.

Cash flow refers to money coming in (cash inflow) and

money going out (cash outflow).

Thus, a cash flow represents the economic effects of an

alternative in terms of money spent or received.

In business as in personal finance, cash flows are essential

to solvency. If a business or person does not have enough

cash to support its operations, it is said to be insolvent, and

a likely candidate for bankruptcy should the insolvency

continue.

Outflows represent cash that is leaving an account, such as

a withdrawal. Outflows are often referred to as expenses or

disbursements.

Inflows represent cash that is entering an account, such as a

deposit. Inflows are often called revenues or receipts. 27

Cash flow diagram

A cash flow diagram is a picture of a financial problem that

shows all cash inflows and outflows plotted along a

horizontal time line.

A cash flow diagram is a tool used by accountants,

engineers to represent the transactions of cash which will

take place over the course of a given project.

It is also used to help the decision maker to understand and

solve the financial problems.

The costs and benefits of engineering projects over time are

summarized on a cash flow diagram (CFD).

Cash flow diagram does not show balances in an account.

It only shows cash flows into and out of the account.

Constructing a cash-flow diagram

A cash flow diagram summarizes an engineering project’s

economics aspects.

As shown in Figure, the cash flow diagram’s horizontal axis

represents time (marked off the number of interest periods).

The vertical axis represent dollar, and arrows show the

timing and amount of receipts and expenses.

Arrows also represent the cash flow over time at relevant

periods.

Positive cash flows are receipts (those arrows point up).

Negative cash flows are expenses (those arrows point

down).

The time line is a horizontal line divided into equal periods

such as days, months, or years.

Cash flow diagram

As shown in the figure below, the initial investment of 50,000

(RM) and annual expenses of 100 (RM) are cash outflow.

Annual expenses will be 100 (RM) at the end of each year for

operating and maintaining the project.

Whether a cash flow is positive or negative (positive above

the axis and negative below) depends on whose viewpoint is

portrayed.

30

Interest formulation

Interest rates are used to quantify the time value of money,

which may be defined as the value of capital committed to a

project or business over a period of time.

Interest rate is the rental value of money.

It represents the growth of capital per unit period.

Interest paid is the cost on borrowed money, and interest

earned is the benefit on saved or invested money.

Interest rates can be calculated as simple rates or

compound rates.

Simple Interest

Simple interest is interest paid only on the principal,

whereas compound interest is interest paid on both the

principal and the accrued interest.

In general, for a deposit of P dollars at a simple interest rate

of i for N periods, the total earned interest I would be 31

I iP N

The total amount available at the end of N periods, F, thus would

be

F P I P1 iN

Simple interest is commonly used with add-on loans or bonds.

Compound Interest

Under a compound interest scheme, the interest earned in each

period is calculated based on the total amount at the end of the

previous periods.

This total amount includes the original principal plus the

accumulated interest that has been left in the account.

In this case, increasing the deposit amounts by the amount of

interest earn.

In general, for a deposit of P dollars at an interest rate i for n

periods, the total accumulated value F will be computed as:

F P1 i

n

scheme exclusively, as it is most frequently practiced in the real

world. 32

Equal-payment series sinking fund

In this type of investment mode, the objective is to find the

equivalent amount (A) that should be deposited at the end of every

interest period for n interest periods to realize a future sum (F) at

the end of the nth interest period at an interest rate of i.

The corresponding cash flow is shown in figure

i

A F

1 i n 1

Here,

A = equal amount to be deposited at the end of each interest period

n = No. of interest periods

i = rate of interest

F = single future amount at the end of the nth period 33

Exercise 7

A company has to replace a present facility after 15 years at an

outlet of RM 5,000,000. It plans to deposit an equal amount at

the end of every year for the next 15 years at an interest rate of

18% compounded annually. Find the equivalent amount that

must be deposited at the end of every year for the next 15

years.

34

Uniform series present worth factor

The uniform series present worth factor is used to calculate the

present worth equivalent, P, of a series of equal end-of- period

amounts, A.

Figure shows the uniform series cash flow.

The derivation of the formula uses the finite sum of the present

worths of the individual amounts in the uniform series cash flow,

as follows: n

P A(1 i )

t

t 1

1 i n 1

A n

i 1 i 35

Exercise 8

The sum of RM 12000 must be withdrawn from an account to

meet the annual operating expenses of a multiyear project. The

project account pays interest at 7.5% per year compounded on

an annual basis. The project is expected to last 10 years. The

project fund is expected to be depleted to zero by the end of the

last year of the project. The first withdrawal will be made 1 year

after the project account is opened, and no additional deposits

will be made in the account during the project life cycle. How

much must be deposited in the project account now so that the

operating expenses of RM 12000 can be withdrawn at the end

of every year for 10 years.

36

Uniform series capital recovery factor

The capital recovery formula is used to calculate the uniform

series of equal end-of-period payments, A, that are

equivalent to a given present amount, P.

This is the converse of the uniform series present amount

factor.

The equation for the uniform series capital recovery factor is

obtained by solving for A in the uniform series present

amount factor. That is,

i 1 i n

A P

1 i 1

n

37

Exercise 9

A piece of equipment needed to launch a project must be

purchased at a cost of RM 50,000. The entire cost is to be

financed at 13.5% per year and repaid on a monthly installment

schedule over 4 years. It is assumed that the first loan payment

will be made exactly 1 month after the equipment is financed.

The interest rate of 13.5% per year is compounded monthly.

Calculate the monthly loan payments for the project.

38

Internal rate of return (IRR)

• The internal rate of return for a cash flow is defined as the

interest rate that equates the future worth at time n or

present worth at time 0 of each cash flow to zero.

• Internal rate of return is traditionally defined as the discount

rate at which NPV is equal to zero.

• The IRR is the interest rate at which the revenues and costs

of an investment or project are equivalent.

• It is sometimes called by several others names, such as the

investor’s method, the discounted cash flow method or the

rate of return (ROR),and the profitability index.

• It is one of the capital budgeting methods used by firms to

decide whether they should make long-term investments.

39

Internal rate of return (IRR)

are the net present value and the internal rate of return.

• The IRR method is the most widely used rate-of-return

method for performing engineering economic analysis.

• It helps making decision about which project is most

economical for a particular situation.

• The internal rates of return are commonly used to evaluate

the desirability of investments or projects.

• Assuming all other factors are equal among the various

projects, the project with the highest IRR would probably be

considered the best and undertaken first.

40

RATE OF RETURN METHOD

Rate of return is interest rate i, at which the net present

value (worth) of a project is zero.

The rate of return of a cash flow pattern is the interest rate

at which the present worth of that cash flow pattern

reduces to zero.

In this method of comparison, the rate of return for each

alternative is computed.

Then the alternative which has the highest rate of return is

selected as the best alternative.

In this type of analysis, the expenditures are always

assigned with a negative sign and the revenues/inflows

are assigned with a positive sign.

41

A generalized cash flow diagram to demonstrate the rate of

return method of comparison is presented in Figure below.

investment, Rj the net revenue at the end of the jth year,

and S the salvage value at the end of the nth year.

42

The first step is to find the net present worth of the cash flow

diagram using the following expression at a given interest

rate, i.

values of i until the present worth function reduces to zero, as

shown in Figure below.

43

Present worth function graph

In the figure, the present worth goes on decreasing when the

interest rate is increased.

The value of i at which the present worth curve cuts the X-

axis is the rate of return of the given proposal/project.

It will be very difficult to find the exact value of i at which the

present worth function reduces to zero.

So, one has to start with an intuitive value of i and check

whether the present worth function is positive.

If so, increase the value of i until PW(i) becomes negative.

Then, the rate of return is determined by interpolation method

in the range of values of i for which the sign of the present

worth function changes from positive to negative.

44

Exercise 10

A company is planning to expand its present business activity.

It has two alternatives for the expansion programme and the

corresponding cash flows are tabulated below. Each alternative

has a life of five years and a negligible salvage value. The

minimum attractive rate of return for the company is 11%.

Suggest the best alternative to the company based on the rate

of return (IRR) method of comparison.

Project 1 Project 2

Investment (RM) 210,000 255,000

Annual net income (RM) 58,260 69,000

45

Discounting

• Discounting is a financial mechanism in which a debtor obtain

the right to delay payments to a creditor, for a defined period

of time, in exchange for a charge or fee.

• Finding the present worth of a future sum is simply the

reserve of compounding and is known as the discounting

process.

• It is the process by whereby the values of future effects are

adjusted to render them comparable to the values place on

current costs and benefits.

• It is accomplished by multiplying the future value(s) by

discount factor / discount rate.

• The discounting is usually associated with a discount rate,

which is also called the discount yield.

46

Discount rate

charges depository institutions that borrow reserves from

it.

• Discount rates are established by each Reserve Bank's

board of directors, subject to the review and determination

of the Board of Governors of the Federal Reserve System.

• A percentage rate representing the rate at which the value

of equivalent benefits and costs decrease in the future

compared to the present.

• The discount rate is used to determine the present value

of the future benefit and cost streams.

• The economic net present value is generally calculated for

each project alternative using the Bank interest rate.

47

Discounted cash flow (DCF)

Discounted cash flow is a means of determining the

present value of future cash flows by using the concept of

time value of money.

According to time value of money, money now (due to its

earning potential) is worth more than money in the future.

For example, $100 of today's money invested for one year

and earning 5% interest will be worth $105 after one year.

Therefore, $100 paid now or $105 paid exactly one year

from now both have the same value to the recipient who

assumes 5% interest; using time value of money

terminology, $100 invested for one year at 5% interest has

a future value of $105.

All future cash flows are estimated and discounted to give

them a present value (PV).

48

DCF uses the interest value to reduce each alternative’s

future revenues and costs to a present worth.

Discounting cash flow is similar to present worth method.

In finance, discounted cash flow (DCF) analysis is a

method of valuing a project, company, or asset using the

concepts of the time value of money.

Discounted cash flow analysis is widely used in investment

finance, real estate development, and corporate

financial management.

There are two standard financial techniques used in

discounted cash flow analysis: net present value (NPV) and

internal rate of return (IRR).

49

Present worth method

• Present value or present worth describes how much a future

sum of money is worth today

• The value of future money can be calculated to present

worth or present value with the "discount rate" as

P = F / (1 + i)n ……………. (1)

Where

› F = future cash flow (positive for receipts, negative for

disbursements)

› PV = present value

› i = discount rate

› n = number of interest periods

present worth factor".

50

Present Value Comparison

• Present Worth (PW) is used to establish a means for

comparing projects with different cash flows over different

periods.

• Present worth is the excess present value of one project

over another

• Negative present worth projects use a minimization of loss

criteria

• A negative Present-worth equivalence indicates a negative

decision toward making the investment alternative

• Positive present worth projects use a maximization of return

on capital criteria

51

Present worth method of comparison

alternative will be reduced to time zero by assuming an

interest rate i.

• Then, depending on the type of decision, the best alternative

will be selected by comparing the present worth amount of the

alternatives.

• In case the decision is to select the alternative with the

minimum cost, then the alternative with the least present

worth amount will be selected.

• On the other hand, if the decision is to select the alternative

with the maximum profit, then the alternative with the

maximum present worth will be selected.

52

Figure: Revenue dominated cash flow diagram to demonstrate the

present worth method of comparison

53

Figure: Cost dominated cash flow diagram to demonstrate the

present worth method of comparison

54

The present worth for revenue is as follows:

1 1 1 1 1

PW P R1 1

R 2 2

Rj j

Rn n

S n

1 i 1 i 1 i 1 i 1 i

Here,

P represents an initial investment

Rj the net revenue at the end of the jth year.

The interest rate is i, compounded annually.

S is the salvage value at the end of the nth year.

Here,

P represents an initial investment

Cj the net cost of operation and maintenance at the end of the jth year.

The interest rate is i, compounded annually.

S is the salvage value at the end of the nth year 55

Exercise 11

Sinha industry is planning to expand its production operation. It

has identified three different technologies for meeting the goal.

The initial outlay and annual revenues with respect to each of

the technologies are summarized in Table. Suggest the best

technology which is to be implemented based on present worth

method of comparison assuming 20% interest rate,

compounded annually.

Table

Initial Outlay (RM) Annual Revenue (RM) Life (Years)

Technology 1 1,200,000 400,000 10

Technology 2 2,000,000 600,000 10

Technology 3 1,800,000 500,000 10

56

Future worth method of comparison

The Future Worth Analysis (FW) of an alternative may be

determined directly from the cash flow, or by multiplying the

Present Worth (PW) value by the F/P factor, at the established

interest.

In this method, the future worth of various alternatives will be

computed.

Then, the alternative with the maximum future worth of net revenue

or the minimum future worth of net cost will be selected as the best

alternative for implementation.

The Future Worth method evaluates the desirability of an

alternative relative to some future point in time, such as the end of

the study period.

Analysis of alternatives using Future Worth (FW) values is

especially applicable to large capital investment decisions.

57

A generalized revenue-dominated equation to demonstrate

the future worth method of comparison is presented below.

investment, Rj the net-revenue at the end of the jth year, and

S the salvage value at the end of the nth year.

future worth method of comparison is given below.

operation and maintenance at the end of the jth year, and S

the salvage value at the end of the nth year 58

Replacement of existing asset with a new asset

like equipment and machinery which are directly required in

their operations.

Sometimes, the capacity of existing facilities may be

inadequate to meet the current demand.

Under such situation, the following alternatives will be

considered.

Replacement of existing equipment with a new one.

Augmenting the existing one with an additional equipment.

In this analysis, the annual equivalent cost of each

alternative should be computed first.

Then the alternative which has the least cost should be

selected as the best alternative.

59

The annual equipment cost are analyzed by the equation or

the formula for the annual equivalent (AE or AW) cost is

AE (i ) ( P SV ) ( A / P, i, n) SV i A

or

AE (i ) ( P SV )( A / P, i, n) SV x i A

Where,

› P = Purchase price of the machine

› S = Salvage value of the machine at the end of the machine

life,

› n = economic life or life of the machine in years, and

› i = interest rate, compounded annually

› A = annual operating and maintenance cost/ annual revenue

This equation is also represents the capital recovery with return.

60

The reasons for replacement of an existing asset

with a new asset

There are two basic reasons for considering the

replacement of equipment

• Physical impairment of the various parts or

• obsolescence of the equipment.

Physical impairment refers only to changes in the physical

condition of the machine itself.

This would lead to a decline in the value of the service

rendered, increased operating cost, increased maintenance

cost or a combination of these.

Obsolescence is due to improvement of the tools of

production, mainly improvement in technology.

So, it would be uneconomical to continue production with

the same machine under any of the above situations.

Hence, the machines are to be periodically replaced.

61

Exercise 12

A steel highway bridge must either be reinforced or replaced.

Reinforcement would cost RM 660,000 and would make the

bridge fit for an additional five years of service. If it is reinforced,

it is estimated that its net salvage value would be RM 400,000

at the time it is retired from service. The new prestressed

concrete bridge would cost RM 1,500,000 and would meet the

foreseeable requirements of the next 40 years. Such a bridge

would have no salvage value. It is estimated that the annual

maintenance cost of the reinforced bridge would exceed that of

the concrete bridge by RM 96,000. If the bridge is replaced by a

new prestressed concrete bridge, the scrap value of the steel

would exceed the demolition cost by RM 420,000. Assume that

the money costs the state 10%. What would you recommend.

62

Cost-benefit analysis

Cost-benefit analysis (CBA) sometimes called benefit-cost

analysis (BCA), is a systematic process for calculating and

comparing benefits and costs of a project, decision or

government policy.

Benefit-cost analysis (BCA) is a technique for evaluating a

project or investment by comparing the economic benefits

with the economic costs of the activity.

Cost-benefit analysis is often used by governments and

others, e.g. businesses, to evaluate the desirability of a

given policy.

Cost-benefit analysis has two purposes:

i. Cost benefit analysis can be used to evaluate the

economic merit of a project.

ii. The results from a series of cost-benefit analyses can

be used to compare competing projects. 63

Importance of cost-benefit analysis

Cost-benefit analysis is a key solution for engineering

economic analysis.

It involves analyzing all the benefits and costs of an

engineering project and deciding whether the benefits

outweigh the costs or vice versa.

Usually, the costs and benefits are expressed in terms of

money.

A cost benefit analysis is done to determine how well, or

how poorly, a planned action will turn out.

Although a cost benefit analysis can be used for almost

anything, it is most commonly done on financial questions.

So, comparison of investment costs of a project with the

project’s potential benefits, a process known as cost benefit

analysis, is an important feature of the economic analysis

method.

64

Cost-benefit analysis measures

Several variations on the basic benefit-cost rule can be used

to compare the benefits and costs of investments, projects, or

decisions.

There are different ways to express and compare costs and

benefits that occur in multiple time periods on a consistent

basis.

Procedures for calculating cost and benefit that occur in more

than one time period are:

• Net future value (NFV)

• Annualized value

65

Annualized Value

• Annualized value, AV (or Annual equivalent value) is the

value of an equivalent uniform annual series of cash flow.

• That is, in annualized approach, the total value is spread up

throughout its effective life uniformly.

• The annualized value is calculated from the present value

by using the following formula:

i 1 i n

AV PV

1 i n

1

Here,

AV = annualized value

PV = present value

i = interest rate or discount rate

n = number of periods

Exercise 13

A project is estimated to cost RM 12,000,000 at the Muda

Irrigation Project area in Malaysia. The life of the project is

expected as 50 years. The interest on capital is 8% and the

operation and maintenance cost is 3%. The salvage value

from the project will be nil after 50 years. The project is

targeted to serve the irrigation demand only. The annual net

benefit for the project is RM 2,243,000. Find:

i. The annual cost of the project and the benefit-cost

ration for the project.

ii. Is this project economically viable?

67

Exercise 14

A government is planning a hydroelectric project for a river basin.

In addition to the production of electric power, this project will

provide flood control, irrigation and recreation benefits. The

estimated benefits and costs that are expected from the three

alternatives under consideration are given in the Table below. If the

interest rate is 9% and the life of the projects estimated to be 50

years.

i. Determine the benefit cost ratio (BCR) for all projects

ii. Which project should be selected?

Table

Description of cost Project A Project B Project C

(RM)

Initial cost 150,000,000 250,000,000 400,000,000

Operating and maintenance 2,000,000 2,500,000 3,500,000

cost

Flood control savings 2,500,000 3,500,000 5,000,000

Irrigation benefits 3,500,000 4,500,000 6,000,000

68

Recreation benefits 1,000,000 2,000,000 3,500,000

Exercise 15

A state government is planning a hydroelectric project for a river

basin. In addition to the production of electric power, this project

will provide flood control, irrigation and recreation benefits. The

estimated benefits and costs that are expected to be derived

from this project are as follows:

• Initial cost = RM 80,000,000

• Annual power sales = RM 6,000,000

• Annual flood control savings = RM 3,000,000

• Annual irrigation benefits = RM 5,000,000

• Annual recreation benefits = RM 2,000,000

• Annual operating and maintenance costs = RM

3,000,000

If the interest rate is 12% and the life of projects is estimated to

be 50 years, by comparing the BC ratios, suggest whether the

project should implement. 69

Exercise 16

Two mutually exclusive projects are being considered for

investment. The estimated benefits, useful life and initial outlay

of the two projects are given in Table below. There is no salvage

value associated with either of the projects. The bank interest

rate is 10%, compounded annually. Determine the benefit cost

ratio (BCR) for the two projects and which project would you

select?

(RM) Benefits (RM) (Years)

Project A 3,000,000 900,000 5

Project B 6,000,000 1,500,000 7

70

Net future value (NFV)

that occur in more than one time period.

• NFV is the total future value of all cash flows.

• It is an estimate of what the principal will become over time.

value of $5000 ten years from now would be $ 10794.62.

71

The NFV

• The NFV value of a projected stream of current and future

costs and benefits is obtained by multiplying the benefits and

costs in each year by a time dependent weight, dt, and

adding all of the weighted as follows:

dnNBn

Where, NBt is the difference between benefits and costs that

accrue in year t, and the accumulation weights (also termed as

compound factor), dt. dt, is given by: dt = (1+r)(n-t), where, r is

the discount rate. Thus, the NFV can be written as:

n1 n 2 n3 nn

72

The NFV

flow of $100 at the end of the first year, $200 at the end of

the second and $500 as a closing payment then the Net

Future Value is:

NFV NB1 1 r NB2 1 r NB3 1 3 NBn 1 r

n1 n 2 n3 nn

n 1 n 2 n 3

NFV=100*(1+i)^2+200*(1+i)^1+500

• where i is the effective annual rate of interest.

• If i is assumed to be 8% then the NFV is $832.64 which

should be compared to the total income of $800 and the NPV

of $660.98. You should be able to see from this example that

the NFV really is just the amount you accumulate by

investing each of the cash flows as they arrive. 73

Net present value (NPV)

• Net present value is the difference between the present

value of the benefit stream and the present value of the cost

stream for a project [Net present value = PV(benefits) –

PV(costs)] .

• The NPV is the difference between the present value of cash

inflows and the present value of cash outflows.

• The net present value (NPV) or net present worth (NPW) is

the sum of the present values for each cash flow in a cash

flow series.

• To calculate the NPV, one must select an economic life for

the option/project, an n, and a discount rate, i (r), for

calculation.

• The NPV analysis evaluates projects by converting all future

cash flows into their present equivalent.

74

The NPV

calculation includes the initial costs as well as the

subsequent cost and benefit.

technology frequently occur at different times.

an investment project is the best single-number measure of

its life-cycle cost.

• Among the three procedures, net present value method is

widely used.

75

Derivation of NPV

annual bursts, the net present value (NPV) value of a

projected stream of current and future costs and benefits is

obtained by multiplying the benefits and costs in each year

by a time dependent weight, dt, and adding all of the

weighted as follows:

=

Where:

NBt is the difference between benefits and costs that accrue in

year t,

n is the final period in the future (n= t),

76

Derivation of NPV

Discounting weight (also termed as discount factor), dt, is

given by:

dt = 1/(1+r)t

where, r is the discount rate.

• Thus, the equation can be written as:

NPV

1 r

0

1 r 1

1 r

2

1 r

3

1 r n

n

NBt

NPV NB0

t 1 (1 r ) t

benefit. That is,

NPV = (- Initial investment) + (Net cash flows at

year t)/ (1+r)t

77

The NPV curve

The NPV curve shows the relationship between the

discount rate and the net present value for a range of

discount rates (Fig.).

300

Net present value ('000 US$)

200

100

0

0 0.02 0.04 0.06 0.08 0.1 0.12

-100

-200

-300

-400

Discount rate (r)

78

The NPV curve

at a zero percent discount rate and converges on zero as it

increases.

• Once past zero NPV, where IRR is determined, NPV is

negative at all discount rate.

• The curve shows the net present value for a discount of 0 to

0.12.

• The curve crosses the horizontal line (indicating NPV = 0)

between 0.04 to 0.06.

• So the internal rate of return is between 0.04 and 0.06.

• Thus the internal rate of return is 0.05.

79

Analysis of Net Present Value (NPV)

– forecast the benefits and costs in each year

– determine a discount rate

– use a formula to calculate the NPV

– compare the NPVs of the alternatives.

80

Analysis of Net Present Value

Step 1: Forecasting the benefits and costs

• Accurate forecasting of future costs and benefits can be the

most difficult and critical step in NPV and as a whole in

project financial analysis.

• All possible costs and benefits of the proposed project

should be taken into account, including non-monetary costs

and benefits.

• A sunk cost should be ignored in the analysis. It is the cost

that will be same regardless of alternate options. For

example, cost for survey of the project area.

• Some cost should be consider such as input cost,

operational cost, maintenance cost, opportunity cost of the

inputs/resources, uncertain cost.

81

Analysis of NPV

Step 2: Determination of discount rate

• The discount rate converts the stream of future costs and

benefits into their value today.

• The process of discounting is needed due to the time value

of money and inflation, and therefore discount rate should

be determined based on the aforementioned two factors.

• For convenience, sometimes it is taken equal to the bank

interest rate.

• The same discount rate must be used for both benefit and

cost, if net benefit is not used.

• Moreover, the same discount rate must be used for different

alternative options.

82

Step 3: Calculation of net present value

• At first, calculate the net benefit for each year by subtracting

the cost from the benefit.

• Then, calculate the net present value for the net benefit of

each year using the formula given below:

NBn

NPVn

Where: (1 r ) n

NBn = net benefit for the year n

n =chronological serial number of the year in the

cash flow series for which the NPV is calculating

83

Analysis of NPV

is termed as discounting factor.

1

(1 r) n

discount rate will not change over the life of the project.

• If the situation is that the discount rate will vary substantially

over time, the variable discount rate should be used.

• Sum up the NPVs to get total NPV.

• Similarly, calculate NPVs for the alternatives.

• The main limitation of NPV analysis is the difficulty of

accurately forecasting future costs and benefits.

84

Step 4: Compare the NPVs of the alternatives

• The NPVs of the alternatives are compared and a decision is

taken.

• The net present value calculated at the Banks discount rate

should be greater than zero for a project to be acceptable.

• A positive net present value means the investment is better.

• A negative net present value means the alternative

investment, or not borrowing, is better.

85

Exercise 17

The cash flow of a project is given in Table below. Assume that

the discount rate is 8%. Calculate the Net Present Value (NPV)

and BCR of the project.

Table: Cash flow of project

Year 0 1 2 3 4 5 6

86

Exercise 18

The cash flow of an industrial project is given Table below.

Assume, the discount rate is 8%. Calculate the Net Present

Value (NPV) and Benefit Cost ratio (BCR) of the project.

Year 0 1 2 3 4 5 6 7 8 9 10 11 12

Cost (RM) 50000 7000 1000 1000 1000 1500 1500 1500 1500 1500 1500 2000 2000

Product Unit

0 2000 2000 3000 3000 3000 3000 3000 3000 3000 2500 2200 2000

(Nos)

Unit price of

0 10 10 10 10 10 10 10 10 11 11 11 11

products (RM)

87

Exercise 19

The Jadita construction Sdn. Bhd. has got a highway

construction work from Kajang to Seremban. There are two

sites/options to set up ‘construction haul’. The temporary

facility development cost for both sites are similar. Other

relevant information and cost items of the sites are given in

Table below. As an Engineering Economist, you are asked to

give consultancy service to the construction company. Which

construction site should be selected?

Table: Particulars and cost items for two sites

No Description / cost items Site-A Site-B

.

1 Rental/lease value of the land RM 7000 RM 8500

for work period

2 Average travel distance of the 3.5 km 2.7 km

spot from the haul (for carrying

the construction materials)

3 Estimated total materials to be 103 ton

carried

4 Carrying (fuel) cost of the RM RM

materials to the spot 7/ton/km 6/ton/km 88

## Mult mai mult decât documente.

Descoperiți tot ce are Scribd de oferit, inclusiv cărți și cărți audio de la editori majori.

Anulați oricând.