AAIT
School of Civil and Environmental
Engineering
Engineering Economics (CEng 5211)
Chapter 3:Economic Evaluation
Contents
Economic Evaluation
- Present worth analysis
- Future worth analysis
- Payback period
- Internal rate of return
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3.1 Present Worth Analysis
Present Worth (Net Present Value) Method
Alternatives with Infinite lives: Capitalized equivalence method
• In the present worth analysis, sometimes an infinite analysis period (n = ∞) is
encountered. Alternatives such as roads, dams, bridges or whatever is
sometimes considered permanent. In these situations a PW analysis would
have an infinite analysis period. This analysis is called capitalized equivalence
method. A capitalized cost is the present sum of money that would need to be set
aside now, at some interest rate, to yield the funds required to provide the
service indefinitely.
• Capitalized equivalent (CE) is the present (at time zero) worth of cash inflows
and outflows. CE analysis is very useful to compare long-term projects.
• In other words, CE is a single amount determined at time zero, which at a given
rate of interest, will be equivalent to the net difference of receipts and
disbursements if the given cash flow pattern is repeated in perpetuity (in
perpetuity the period assumed is infinite).
Mathematically, CE = A x (P/A, i, n=∞)
= A x [((1+i)∞-1)/ i(1+i)∞]= A/i
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3.1 Present Worth Analysis
Present Worth (Net Present Value) Method
Alternatives with Infinite lives: Capitalized equivalence method
• Example:
1. A city plans a pipeline to transport water from a distant watershed area
to the city. The pipeline will cost $8 million and have an expected life of
seventy years. The city anticipates it will need to keep the water line in
service indefinitely. Compute the capitalized cost assuming 7% interest.
Solution:
• We have the capitalized cost equation P = A/i, which is simple to apply when
there are end-of-period disbursements A. in this case, the $8 million
repeats every 70 years. We can find A first based on a present $8 million
disbursement.
A = P(A/P, i, n) = $8,000,000(0.0706) = $565,000
Now, the infinite series payment formula could be applied for n = ∞ :
• Capitalized cost P = A / i = 565,000 / 0.07 = $8,071,000
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3.1 Present Worth Analysis
Present Worth (Net Present Value) Method
Example
2. A new computer system will be used for the indefinite future, find the
equivalent value now if the system has an installed cost of $150,000 and an
additional cost of $50,000 after 10 years. The annual maintenance cost is
$5,000 for the first 4 years and $8,000 thereafter. In addition, it is expected to
be a recurring major upgrade cost of $15,000 every 13 years. Assume that i =
5% per year.
Solution:
i=5% per year
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3.1 Present Worth Analysis
Present Worth (Net Present Value) Method
Solution: Draw the cash flow diagram for two cycles.
CC1=-150,000-50,000(P/F,5%,10)-5,000(P/A,5%,4)-(8,000/0.15)(P/F,5%,4)
=-150,000-50,000(0.6139)-5,000(3.5460)-160,000(0.8227)=-330,057
– Convert the recurring cost of 15,000 every 13 years into an annual
worth A, for the first 13 years.
A1= -15,000(A/F,5%,13) = -847
The same value, A1=-847, applies to all the other 13 years period as well.
CC2 A1 847 -16,940
i 0.05
CC=(-330,057)+(-16,940)= - 346,997
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3.1 Present Worth Analysis
Present Worth (Net Present Value) Method
Comparing more than two alternatives using Incremental Net Present
Value [INPV]
Step 1: Order the alternatives by increasing initial capital investment.
Step 2: Find a base alternative [current best alternative]: Cost alternatives: the
first alternative in the ordered list [the one with the least capital investment].
Step 3: Evaluate the difference between the next alternative and the current
best alternative. If the incremental cash flow is positive, choose the next
alternative as the current best alternative. Otherwise, keep the current best
alternative [i.e.negative] and drop the next alternative from further
consideration.
Step 4: Repeat Step 3 until the last alternative is considered. Select the current
best alternative as the preferred one.
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3.2 Future Worth Analysis
Future Worth (Net Future Value) Method
A corollary to the present value and net present worth is the future value
and the net future worth (NFW).
In this method all cash inflows and outflows of a given project (having a
given project life) are brought to time n. If the difference between the
inflows minus the outflows is positive then the project is acceptable.
NFW>0, Accept the investment
NFW=0, remain indifferent to the investment
NFW<0, reject the investment
Future worth analysis calculates the future worth of an investment
undertaken.
If it is to compare among various projects, the one having more
positive value is economically the best alternative.
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3.2 Future Worth Analysis
Future Worth (Net Future Value) Method
Example
Your company is looking at purchasing the front-end loader at cost of $120,000.
The loader would have a useful life of five years with a salvage value of $12,000 at
the end of the fifth year. The annual profit of loader [revenue less operation cost]
is $48,000. Determine the future worth for the purchase of the loader using a
MARR of 20%. Should your company purchase the loader?
Solution:
The future value of the purchase price is determined by using SPCAF as follows:
FPP = $120,000 [1+0.20)5 =$120,000*2.4883= - $298,598
The future value of the purchase price is negative because it is a cash
disbursement.
The FW of the annual profits is determined by using USCAF as follows:
FAP = $48,000* [(1+0.20)5 -1] / 0.20 = $48,000*74416=$357,197
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3.2 Future Worth Analysis
Future Worth (Net Future Value) Method
Solution:
FAP = $48,000* [(1+0.20)5 -1] / 0.20 = $48,000*74416=$357,197
• The FW of the annual profits is positive because it is a cash receipt.
• The future value of the salvage value is equal to the salvage value because the
future value is measured at the end of the study period. The FW of the salvage
value is positive because it is a cash receipt.
• The future worth for purchasing the loader equals the sum of the future values
of the individual cash flows and is calculated as follows:
• FW = - $298,598 + $357,197+ $12,000= $70,599 > MARR
So, it is attractive for the company to purchase
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3.3 Payback Period Analysis
Estimates the time (payback period) required to recover the initial investment
in a project.
Payback period is the period of time required for the project’s benefit to
equal to the project’s cost.
It is an approximate, rather than an exact, economic analysis calculation.
Often used as a screening technique/ preliminary analysis tool. May or may
not select the correct alternative.
All the economic consequences beyond the payback period are completely
ignored.
Two forms:
Ignoring TVOM, with 0% interest: conventional PB method
With an assumed interest rate : discounted payback analysis
It is important to note that PBA is not an end to itself, but rather a method
of screening out certain obvious unacceptable investment alternatives before
progressing to an analysis of potentially acceptable ones.
Compare PBP Vs maximum acceptable PBP.
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3.3 Payback Period Analysis
Example: Payback period:
A. Ignoring TVOM(i=0%)
B. Perform Discounted payback at i=10%
A. i=0%
E.O.Y CF Cumulative CF
0 -30,000 -30,000
1 -4,000 -34,000
2 15,000 -19,000
3 16,000 -3,000
4 8,000 5,000
5 8,000 13,000
13,000
np=3.375 years
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3.3 Payback Period Analysis
Example:
B. i=10%
CF (P/F,i%,t) Dis. Inc Accum. Disc. Amts.
E.O.Y
(1) (2) (3)=(1)*(2) (4)=Cuml. Sum of (3)
0 -30,000 1 -30,000.00 -30,000
1 -4,000 0.9091 -3,636.36 -33,636.36
2 15,000 0.8265 12,396.69 -21,239.67
3 16,000 0.7513 12,021.04 -9,218.63
4 8,000 0.6806 5,464.11 -3,754.52
5 8,000 0.6209 4,967.37 1,212.85
np=4.76 years
At 10% the PB is b/n years 4 and 5 (4.76 years).
At 0% the PB is b/n years 3 and 4 (3.375 years).
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3.3 Payback Period Analysis
Example: Suppose the company requires a rate of return of 15%.
Determine the period necessary to recover both the capital investment and
the cost of funds required to support the investments given the cash flow
(Column 2)in table below.
Cost of fund
Period CF Cumulative CF
15%
0 (85,000) 0 (85,000)
1 15,000 -85,000*0.15=-12,750 (82,750)
2 25,000 -82,750 *0.15=-12,413 (70,163)
3 35,000 -70,163*0.15=-10,524 (45,687)
4 45,000 -45,687*0.15=-6,853 (7,540)
5 45,000 -7,540*0.15=-1,131 36,329
6 35,000 36,329*0.15=5,449 76,778
The project must remain in use for about 4.2 years in order for the company
to cover the cost of capital and also recover the fund invested in the project
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3.3 Payback Period Analysis
Interpretation of PBA
A managerial philosophy is: a shorter payback period is preferred to a longer
payback period.
Not a preferred method for final decision making – rather, use as a screening
tool.
Ignores all cash flows after the payback time period.
Example: Three investments are available but only one can be purchased.
CF CF CF
E.O.Y
(1) (2) (3)
0 -10,000 -10,000 -10,000
1 5,000 5,000 2,500
2 5,000 4,000 2,500
3 0 3,000 2,500
4 0 2,000 2,500
5 1,000 1,000 12,500 15
3.3 Payback Period Analysis
Example: Three investments are available but only one can be purchased.
CF C. C.F CF C. C.F CF C.C.F
E.O.Y
(1) (1) (2) (2) (3) (3)
0 -10,000 -10,000 -10,000 -10,000 -10,000 -10,000
1 5,000 -5,000 5,000 -5,000 2,500 -7,500
2 5,000 0 4,000 -1,000 2,500 -5,000
3 0 0 3,000 2,000 2,500 -2,500
4 0 0 2,000 4,000 2,500 0
5 1,000 1,000 1,000 5,000 12,500 12,500
PBP 2yrs 2.33yrs 4yrs
PW(10%) -701.39 2,092.13 5,686.18
PBP: 1>2>3
PW: 3>2>1
Shorter payback period is preferred to a longer payback period.
Not a preferred method for final decision making – rather, use as a screening
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tool.
3.3 Payback Period Analysis
Example:
Accum. Disc.
CF Cumulative P/F,i%,t Dis. Inc Amts.
E.O.Y
(1) C.F. (2) (3)=(1)*(2)
(4)=Cuml. Sum of (3)
0 -10,000 -10,000 1 -10,000 -10,000
1 2,000 -8,000 0.9259 1,851.85 8,148.15
2 6,000 -2,000 0.8573 5,144.03 -3,004.12
3 8,000 6,000 0.7938 6,350.66 3,346.54
4 4,000 10,000 0.7350 2,940.12 6,286.66
5 1,000 11,000 0.6806 680.58 6,967.25
PB is b/n years 2 and 3 (2.45 years=3years). The C.F of years 4 and 5 are not
used in the calculations.
None of the cash flows AFTER the payback period are considered.
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Thank You
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