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Section 4

Fundamentals and theories of financial analysis


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  P1  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-1 18,000 850 2 45000


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.

Cost Effectiveness Ratio 


 all cos ts
 all measured health effect

18
 Example of Cost-effectiveness analysis

Options Initial Total Bacteria Variable Cost/


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.
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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.

Real interest rate = Nominal interest rate – Inflation 24


Nominal and real interest rate

 For example, if you are earning 4% interest per year on the


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.

 When, the Inflation is positive, the real interest rate is lower


than the nominal interest rate.

 If the inflation rate is negative (i.e. deflation), then the real


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  P1  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  P1  i 
n

 Engineering economics analysis uses the compound interest


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

Fig: Cash flow diagram of equal-payment series sinking fund


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.

Fig: 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)

• The two most-used measures for evaluating an investment


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.

Generalized cash flow diagram

 In the above cash flow diagram, P represents an initial


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.

 Now, the above function is to be evaluated for different


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

• The discount rate can mean an interest rate a central bank


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

The factor "1 / (1 + i)n" is known as the "single payment


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

• In this method of comparison, the cash flow of each


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.

The present worth for cost is as follows:

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.

Here, PW is present worth. P represents an initial


investment, Rj the net-revenue at the end of the jth year, and
S the salvage value at the end of the nth year.

 A generalized cost-dominated equation to demonstrate the


future worth method of comparison is given below.

Here, P represents an initial investment, Cj the net cost of


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

 Organizations provide goods/services use several facilities


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 present value (NPV)


• 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

Power sales/year 10,000,000 12,000,000 18,000,000


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?

Table. Cost items for the two projects

Initial outlay Annual Life


(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)

• The net future value is a way of rendering cost and benefit


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.

• For example, assuming a compound rate of 8 %, present


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:

NFV = d0NB0 + d1NB1 + d2NB2 + ….+ dn-1NBn-1 +


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:

NFV  NB1 1  r   NB2 1  r   NB3 1  3   NBn 1  r 


n1 n 2  n3 nn 
72
The NFV

• For example, if an investment promises to generate a cash


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 
n1 n 2  n3 nn 

NFV  100 * 1  i   200 * 1  i   500 * 1  i 


 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

• The word ‘net’ in ‘net present value’ indicates that the


calculation includes the initial costs as well as the
subsequent cost and benefit.

• Costs and benefits of a development project or a


technology frequently occur at different times.

• The NPV of the time-phased costs over the economic life of


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

• If we assume that income comes (benefit) or goes (cost) in


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:

NPV = NB0+ d1NB1+ d2NB2 +….….+ dn-1NBn-1 + dnNBn

=
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:

NB0 NB1 NB2 NB3 NBn


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

• the initial investment is a cost, it is treated as negative


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

• With net-positive cash flows, NPV decreases from maximum


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)

• Analysis of net present value requires four basic steps:


– 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

NPVn = net present value for the year 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

• In the above equation, the time dependent weighting factor,


is termed as discounting factor.
1
(1  r) n

• In NPV calculation, for simplicity, it is assumed that the


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

Cost (RM) 25000 500 500 500 500 500 1000

Revenue (RM) 0 7000 10000 10000 7000 4000 7000

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.

Table: Cash flow of a industrial 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