Basic concepts in Engineering Economics

1. Definition and Scope of Engineering Economics: Engineering Economics applies

economic principles to engineering projects for cost-effective decision-making.

2. Importance of Engineering Economics: Helps in selecting the best alternative by

evaluating costs and benefits.

3. Role of Engineers in Economic Decision-Making: Engineers must consider financial

feasibility, cost estimation, and return on investment.

4. Scarcity and Choice: Resources are limited, requiring optimal allocation in engineering
decisions.

5. Opportunity Cost: The value of the best alternative foregone when making a decision.

6. Cost Concepts in Engineering@ Includes fixed costs, variable costs, direct costs, indirect
costs, and sunk costs.

7. Time Value of Money (TVM): A fundamental principle stating that money today is worth
more than the same amount in the future.

8. Simple Interest: Interest calculated on the original principal only.

9. Compound Interest: Interest calculated on both the principal and previously accumulated
interest.

10. Present Worth (PW) Analysis: A technique to compare different alternatives by

discounting future cash flows to the present.

11. Future Worth (FW) Analysis: Evaluates how much an investment will be worth in the
future.

12. Annual Worth (AW) Analysis{ Converts all cash flows into equal annual amounts over a
project’s lifespan.

13. Discounted Cash Flow (DCF) Analysis: Method of valuing an investment by discounting
future cash flows.

14. Net Present Value (NPV): The sum of discounted future cash flows minus the initial
investment.

15. Internal Rate of Return (IRR): The discount rate that makes the NPV of a project zero.

1
16. Payback Period: The time required for an investment to recover its initial cost.

17. Benefit-Cost Ratio (BCR): A ratio comparing benefits to costs, used in project
evaluation.

18. Capital Budgeting: The process of planning and managing long-term investments.

19. Economic Life of a Project: The period during which an asset remains economically
viable.

20. Depreciation: A decrease in the value of an asset over time due to wear and tear.

21. Straight-Line Depreciation: Equal depreciation expense assigned to each year of an

asset’s life.

22. Declining Balance Depreciation{ Higher depreciation in the early years and lower in later
years.

23. Salvage Value: The estimated value of an asset at the end of its useful life.

24. Sunk Cost: A cost that has already been incurred and cannot be recovered.

25. Incremental Analysis: A method of comparing the additional costs and benefits of
different alternatives.

26. Break-Even Analysis: Determines the point at which total revenue equals total cost.

27. Inflation in Engineering Economics: The impact of rising prices on project costs and
future cash flows.

28. Real vs. Nominal Interest Rates; Real interest rate is adjusted for inflation, while
nominal interest rate is not.

29. Risk and Uncertainty in Decision-Making: Engineering projects face uncertainty due to
market, technical, and economic factors.

30. Sensitivity Analysis: Examines how changes in input variables affect project outcomes.

31. Monte Carlo Simulation: A statistical method for modeling uncertainties in project
evaluation.

32. Decision Trees in Engineering Economics: A tool for evaluating multiple decision paths
under uncertainty.

2
33. Life Cycle Costing (LCC): Evaluating total costs over a product’s entire life, including
maintenance and disposal.

34. Cost-Effectiveness Analysis: Compares the cost of alternatives relative to their

effectiveness.

35. Productivity and Efficiency in Engineering: Measures how effectively resources are
used in production.

36. Marginal Cost and Marginal Revenue: The additional cost and revenue from producing
one more unit.

37. Engineering Economy and Environmental Impact: Considers sustainable and

environmentally friendly project alternatives.

38. Public vs. Private Sector Engineering Projects: Public projects focus on social benefits,
while private projects emphasize profitability.

39. Engineering Contracts and Financial Terms: Legal agreements that define project
costs, payments, and risk allocation.

40. Funding Sources for Engineering Projects: Includes loans, venture capital, public
funding, and private investments.

41. Economic Optimization in Engineering Design: Selecting the best design considering
costs, performance, and constraints.

42. Decision Criteria for Engineering Investments: Using NPV, IRR, and BCR to evaluate
projects.

43. Capital Cost Estimation Methods: Techniques include parametric, analogous, and
bottom-up estimating.

44. Engineering Feasibility Studies; Analyzing technical, economic, and legal viability
before project approval.

45. Value Engineering: A systematic approach to improving value by reducing costs without
sacrificing quality.

46. Cost-Benefit Analysis in Public Infrastructure: Evaluating public projects based on

economic and social impacts.

47. Engineering Project Financing Models: Includes Build-Operate-Transfer (BOT) and

Public-Private Partnerships (PPP).
3
48. Utility Theory in Engineering Decision-Making: Quantifies preferences and risk
attitudes in economic choices.

49. Financial Metrics for Project Evaluation: Includes ROI, ROE, and profitability index.

50. Ethical Considerations in Engineering Economics: Ensuring fair pricing, environmental

responsibility, and long-term sustainability.

Concepts in Elementary Economics

Elementary economics provides a foundational understanding of how economies function,

including basic principles of supply and demand, market structures, and economic systems.
Below are some concepts in elementary economics:

Basic Economic Concepts

1. Economics – The study of how individuals and societies allocate scarce resources.
2. Scarcity – The fundamental economic problem of having limited resources but
unlimited wants.
3. Choice – The decision-making process due to scarcity.
4. Opportunity Cost – The next best alternative forgone when making a decision.
5. Trade-off – The sacrifice of one good or service for another.

Types of Resources

6. Land – Natural resources used in production (e.g., minerals, water).

7. Labor – Human effort used in production.
8. Capital – Man-made tools, equipment, and technology used in production.
9. Entrepreneurship – The ability to organize and manage production resources.

Economic Systems

10.Traditional Economy – Economic decisions based on customs and traditions.

11.Command Economy – An economic system where the government makes all
economic decisions.
12.Market Economy – An economy where supply and demand determine prices and
production.
13.Mixed Economy – A combination of market and government-controlled economic
systems.

4
Supply and Demand

14.Demand – The quantity of a good or service that consumers are willing to buy at
different prices.
15.Supply – The quantity of a good or service that producers are willing to offer at
different prices.
16.Law of Demand – As price decreases, demand increases (and vice versa).
17.Law of Supply – As price increases, supply increases (and vice versa).
18.Equilibrium Price – The price where quantity demanded equals quantity supplied.
19.Surplus – When supply exceeds demand at a given price.
20.Shortage – When demand exceeds supply at a given price.

Market Structures

21.Perfect Competition – A market with many sellers and buyers, where no single firm
can influence prices.
22.Monopoly – A market with only one seller.
23.Oligopoly – A market dominated by a few large firms.
24.Monopolistic Competition – A market with many sellers offering differentiated
products.

Factors of Production and Productivity

25.Production – The process of creating goods and services.

26.Productivity – The efficiency of production, measured as output per unit of input.
27.Division of Labor – The breakdown of production into smaller tasks to increase
efficiency.
28.Specialization – Focusing on a specific task or product to improve efficiency.

Key Concepts in Cost Theory

Cost theory in economics analyzes the behaviour of costs in relation to production and output.
Below are key concepts related to cost theory

1. Fixed Cost (FC) – Costs that do not change with output (e.g., rent).
2. Variable Cost (VC) – Costs that vary with output (e.g., raw materials).
3. Total Cost (TC) – The sum of fixed and variable costs (TC = FC + VC).
4. Average Fixed Cost (AFC) – Fixed cost per unit of output (AFC = FC/Q).
5. Average Variable Cost (AVC) – Variable cost per unit of output (AVC = VC/Q).
5
6. Average Total Cost (ATC) – Total cost per unit of output (ATC = TC/Q).
7. Marginal Cost (MC) – The additional cost of producing one more unit (MC =
ΔTC/ΔQ).
8. Opportunity Cost – The cost of the next best alternative forgone.
9. Explicit Cost – Actual out-of-pocket expenses (e.g., wages, rent).
10.Implicit Cost – Opportunity cost of using resources owned by the firm.
11.Accounting Cost – Total explicit costs recorded in financial statements.
12.Economic Cost – The sum of explicit and implicit costs.
13.Sunk Cost – Costs that cannot be recovered once spent.
14.Incremental Cost – The additional cost of changing production or business operations.
15.Shutdown Cost – Costs incurred if a business ceases operations temporarily.
16.Avoidable Cost – Costs that can be eliminated if production stops.
17.Unavoidable Cost – Costs that must be paid regardless of production levels.
18.Short-Run Cost – Costs when at least one factor of production is fixed.
19.Long-Run Cost – Costs when all factors of production are variable.
20.Production Cost – Costs associated with producing goods/services.
21.Selling Cost – Costs incurred to promote sales (e.g., advertising).
22.Social Cost – The total cost to society due to production (includes externalities).
23.Private Cost – The cost incurred by firms or individuals in production.
24.External Cost – Costs imposed on others without compensation (e.g., pollution).
25.Total Fixed Cost (TFC) – The sum of all fixed costs in production.
26.Total Variable Cost (TVC) – The sum of all variable costs in production.
27.Break-even Point – The level of output where total revenue equals total cost.
28.Cost Function – A mathematical representation of cost-output relationships.
29.Diminishing Returns – Increased input leads to lower marginal output.
30.Economies of Scale – Reduction in per-unit cost as production increases.
31.Diseconomies of Scale – Increase in per-unit cost when production expands
excessively.
32.Constant Returns to Scale – When increasing inputs leads to proportional output
growth.
33.Learning Curve – Declining cost per unit due to experience and efficiency.
34.Total Revenue (TR) – The total income from sales (TR = P × Q).
35.Profit Maximization – The level of output where MR = MC.
36.Marginal Revenue (MR) – The additional revenue from selling one more unit.
37.Revenue Maximization – The output level where revenue is highest.
38.Total Profit – The difference between total revenue and total cost (TR – TC).
39.Normal Profit – The minimum profit needed to keep a firm in business.
6
 40.Supernormal Profit – Profit above normal profit (also called economic profit).
41.Cost-Benefit Analysis – A comparison of costs and benefits of a decision.
42.Price Discrimination – Charging different prices to different consumers.
43.Marginal Cost Pricing – Setting prices equal to marginal cost.
44.Full Cost Pricing – Setting prices based on total cost plus a markup.
45.Cost-Push Inflation – Inflation caused by rising production costs.
46.Opportunity Cost Principle – The basis for rational decision-making in economics.
47.Overhead Cost – Indirect costs of production (e.g., utilities, insurance).
48.Joint Cost – Costs shared between two or more products.
49.Activity-Based Costing (ABC) – Allocating costs based on activities that drive them.
50.Marginal Cost Curve – A graphical representation of marginal cost changes.

Some Concepts in Criteria for Project Evaluation

Project evaluation is a systematic assessment of a project’s performance, feasibility, and

impact based on various criteria. Below are some criteria commonly used in project
evaluation:

1. Relevance – The extent to which the project aligns with the organization’s goals.
2. Feasibility – The practicality of implementing the project with available resources.
3. Cost-effectiveness – Whether the project provides maximum benefits for the cost
incurred.
4. Sustainability – The project's ability to continue delivering benefits over time.
5. Impact – The extent to which the project produces significant changes or benefits.
6. Efficiency – The ratio of outputs to inputs in project implementation.
7. Scalability – The ability to expand the project to a larger scale.
8. Return on Investment (ROI) – The financial gain compared to the cost of the project.
9. Stakeholder Satisfaction – How well the project meets the needs of stakeholders.
10.Risk Assessment – The identification and mitigation of potential risks.
11.Economic Viability – The project's potential to generate economic benefits.
12.Technical Viability – The availability of technology required for project success.
13.Timeframe – Whether the project is completed within the scheduled timeline.
14.Social Acceptability – How well the project aligns with societal values and norms.
15.Environmental Impact – The project’s effects on the environment.
16.Legal Compliance – Adherence to relevant laws and regulations.
17.Innovation – The level of new and creative approaches used in the project.
18.Productivity – The level of output generated from project activities.

7
 19.Alignment with Policies – Whether the project follows national or organizational
policies.
20.Transparency – The openness in project implementation and reporting.
21.Funding Availability – The sufficiency of financial resources to support the project.
22.Monitoring and Evaluation – The effectiveness of tracking project performance.
23.Adaptability – The ability to adjust to changes and unforeseen circumstances.
24.Benchmarking – Comparison with best practices in similar projects.
25.Resilience – The project’s ability to withstand challenges and external shocks.
26.Competence of Project Team – The skill level and experience of those managing the
project.
27.Data Utilization – The use of accurate data in decision-making and planning.
28.Ethical Considerations – The moral and ethical implications of the project.
29.Quality of Deliverables – The standard of outputs produced by the project.
30.Community Engagement – The involvement of local communities in the project.

PROJECT EVALUATION TECHNIQUES

Project evaluation criteria are the standards or benchmarks used to assess and measure the
success, progress, or quality of a project. These criteria ensure that the project meets its
objectives and delivers value. Most project evaluation criteria include:

1. Scope and Objectives: Are the project’s objectives aligned with the overall goals of the
organization or stakeholders? Are the project’s scope and objectives clearly defined and
achievable?
2. Budget and Financial Performance: Was the project completed within the allocated
budget? Does the value delivered by the project justify its financial costs?
3. Schedule and Timeliness: Was the project completed on time or with minimal delays?
Were key milestones met according to the established schedule?
4. Quality of Deliverables: Do the project’s outputs meet the required standards and
specifications? Were quality control processes followed to ensure the final product is
reliable and functional?
5. Stakeholder Satisfaction: Are the stakeholders or clients satisfied with the project's
outcomes? Were stakeholder expectations properly managed throughout the project?
6. Risk Management: Were potential risks identified and adequately addressed during the
project lifecycle? How effectively were unexpected issues or crises managed?

8
 7. Team Performance and Collaboration: Did the project team work cohesively and
meet deadlines? Was there effective communication and coordination between team
members and stakeholders?
8. Sustainability and Long-term Impact: Is the project’s outcome sustainable over time,
and will it continue to deliver value beyond its completion? What is the long-term
impact of the project on the target audience or community?
9. Innovation and Creativity: Did the project introduce innovative ideas or solutions?
How effectively did the project address challenges or solve problems in new ways?
10. Compliance and Legal Adherence: Did the project comply with all relevant laws,
regulations, and industry standards? Was the project executed in an ethically
responsible manner?

Traditional Criteria and Discounted Cash Flow (DCF) Criteria are two common
approaches that are normally used in project evaluation, especially when assessing the
financial feasibility and profitability of a project. Each method provides insights into a
project’s financial performance, but they approach it in different ways.

Any project evaluation criterion to be adopted should possess the following

characteristics:

1) It should provide a means to distinguish between acceptable and unacceptable projects.

2) It should also be able to rank projects in order of their desirability.
3) It should be a criterion that is applicable to any conceivable project.
4) It should recognise that bigger cash flows are preferable to smaller ones.
5) It should recognise that early cash flows or benefits are preferable to later cash flows or
benefits.

The most widely acceptable criteria amongst all these existing criteria are the traditional
criteria and the discounted cash flow (DCF) criteria

Traditional Criteria

Traditional criteria, also known as non-discounted criteria, are simpler and focus on basic
financial metrics that do not consider the time value of money. These criteria evaluate a
project based on raw data like costs, revenues, and timeframes, without adjusting for the
changing value of money over time.

Key Traditional Criteria:

9
Payback Period: The time it takes for a project to recover its initial investment through cash
inflows or profits. That is, the time required for a project or investment to recover its initial
cost through cash inflows.

It is one of the simplest methods used for evaluating the financial feasibility of a project,
though it does not consider the time value of money.

Example 1: Simple Payback Period Calculation (Equal Annual Cash Inflows)

Scenario: Initial Investment: N100, 000

Annual Cash Inflow: N25, 000

Payback Period Calculation:

Interpretation: The project will payback its initial investment of N100,000 in 4 years.

Example 2: Payback Period Calculation with Unequal Annual Cash Inflows

Scenario:

Initial Investment: N120, 000

Year 1 Cash Inflow: N40, 000

Year 2 Cash Inflow: N50, 000

Year 3 Cash Inflow: N40, 000

Payback Period Calculation:

1. After Year 1: N120,000 - N40,000 = N80,000 remaining.

2. After Year 2: N80,000 - N50,000 = N30,000 remaining.
3. After Year 3: N30,000 - N40,000 = N0 remaining.

The payback occurs during Year 3.

To find the exact time within Year 3:

10
Remaining after Year 2 = N30,000.

Cash inflow in Year 3 = N40,000.

Total Payback Period:

Payback Period =2 years + 0 .75 years = 2.75 years

Interpretation: The project will pay back its initial investment of N120,000 in 2.75 years.

Example 3:

Payback Period Calculation with Unequal Cash Inflows and Negative Cash Flow

Scenario:

 Initial Investment: N200,000

 Year 1 Cash Inflow: N50,000
 Year 2 Cash Inflow: N60,000
 Year 3 Cash Inflow: N70,000
 Year 4 Cash Outflow: - N30,000 (negative cash flow due to unexpected costs)

Payback Period Calculation:

1. After Year 1: N200,000 - N50,000 = N150,000 remaining.

2. After Year 2: N150,000 - N60,000 = N90,000 remaining.
3. After Year 3: N90,000 - N70,000 = N20,000 remaining.
4. Year 4 has a negative cash flow of -N30,000. This increases the amount remaining to
recover:

Remaining = 20,000 + 30,000 = 50,000

Interpretation:

11
 The project cannot fully recover its investment in Year 4. The negative cash flow means
it will take longer to recover the remaining amount. To calculate, we would continue
further into Year 5 to determine the exact time.

Example 4: Payback Period with Constant Annual Cash Inflows and Fractional Year
Calculation

Scenario:

Initial Investment: N80,000

Annual Cash Inflow: N22,000

Payback Period Calculation:

Interpretation:

This means the project will pay back its initial investment after approximately 3 years and
7.63 months

(0.636 years X 12 months).

Advantages of The payback period

i. Simple to calculate and understand;

ii. provides a quick estimate of how long it will take to break even.
iii. it costs less than most of the other sophisticated methods.

Limitations

i. Does not account for cash flows beyond the payback period or the time value of money.
ii. it fails to consider the pattern of cash inflows and that early cash inflows rather than
later cash inflows.

Despite its weakness, the payback period is very popular analogy. It tries to emphasizes early
recovery of an investment. This means that it gives an insight into the cash inflows of the
project.

12
Accounting Rate of Return (ARR):

The ARR measures the expected return on investment, expressed as a percentage of the initial
investment or average investment. That is, it measure the profitability of an investment.

Calculation: ARR = (Average Annual Profit / Initial Investment) × 100

Example: If a project’s average annual profit is N20,000, and the initial investment is
N100,000, the ARR would be 20%

(N20,000 / N100,000 × 100).

Another Example

A project costs N100,000 and has a scrap value of N40,000. The stream of income before
depreciation and taxes are N40,000, N50,000, N60 , 000 for the first three years. The tax rate
is 50% and depreciation is on straight line basis.

Calculate the accounting rate of return for the project.

To calculate the Accounting Rate of Return (ARR) for the project, we need to follow these
steps:

Step 1: Calculate Depreciation

Since depreciation is on a straight-line basis, it is calculated as follows:

Here:

 Initial Cost = N100,000

 Scrap Value = N40,000
 Useful Life = 3 years (since we have 3 years of income data)

Step 2: Calculate Annual Profit After Tax (PAT)

13
The income before depreciation and taxes is provided for each year. We need to calculate the
profit after tax for each year.

The formula for calculating profit after tax (PAT) is:

PAT = (Income before Depreciation and Taxes − Depreciation)× (1−Tax Rate)

Since the tax rate is 50%, the profit after tax (PAT) will be 50% of the income after
depreciation is deducted.

Year 1:

 Income Before Depreciation and Taxes: N40,000

 Depreciation: N20,000
 Tax Rate: 50%

PAT1 = (40,000 − 20,000) × (1−0.50) = 20,000 × 0.50 =10,000

Year 2:

 Income Before Depreciation and Taxes: N50,000

 Depreciation: N20,000

PAT2 = (50,000 − 20,000) × (1−0.50) = 30,000 × 0.50 =15,000

Year 3:

 Income Before Depreciation and Taxes: N60,000

 Depreciation: N20,000

PAT3 = (60,000 − 20,000) × (1−0.50) = 40,000 × 0.50 = 20,000

Step 3: Calculate Average Annual Profit After Tax

Now, we calculate the average annual profit after tax (PAT) over the 3 years:

14
Step 4: Calculate Accounting Rate of Return (ARR)

Finally, the Accounting Rate of Return (ARR) is calculated as follows:

Where:

 Average Annual Profit After Tax = N15,000

 Initial Investment = N100,000

Final Answer: The Accounting Rate of Return (ARR) for the project is 15%.

Another Question:

A project costs N150, 000 and has a scrap value of N30,000. The stream of income before
depreciation and taxes is N60, 000, N80, 000, and N90,000 for the first three years. The tax
rate is 40%, and depreciation is calculated using the declining balance method at a rate of
20%.

Solution:

Step 1: Calculate Depreciation (Declining Balance Method)

The formula for depreciation using the declining balance method is:

Depreciation in Year 1 = Initial Cost ×Depreciation Rate

Depreciation in subsequent years = Book Value at the start of the year × Depreciation Rate

1. Year 1 Depreciation: Depreciation 1 = 150,000 × 20% =30,000

2. Year 2 Depreciation: Book Value at the beginning of Year 2 = 150,000 − 30,000

=120,000

Depreciation 2 =120,000 × 20% = 24,000

15
 3. Year 3 Depreciation: Book Value at the beginning of Year 3 =120,000 −24,000 =
96,000

Depreciation 3 = 96,000×20% =19,200

Step 2: Calculate Profit After Tax (PAT) for Each Year

Year 1: PAT1 = (60,000−30,000) × (1−0.40) =30,000 × 0.60 = 18,000

Year 2: PAT2 = (80,000 − 24,000) × (1−0.40) = 56,000 × 0.60 = 33,600

Year 3: PAT3 = (90,000 − 19,200) × (1−0.40) = 70,800 × 0.60 = 42,480

Step 3: Calculate Average Annual Profit After Tax

Step 4: Calculate Accounting Rate of Return (ARR)

Answer: The ARR for the project is 20.91%.

Question 3:

A project costs N200,000 and has a scrap value of N50,000. The stream of income before
depreciation and taxes is N100,000, N120,000, and N140,000 for the first three years. The tax
rate is 25%, and depreciation is on straight-line basis. Calculate the ARR.

As an accept or reject criterion, the ARR method will accept all those projects whose ARR is
greater than the minimum rate established by management.

If the ARR is lower than the minimum rate established by management, then the project
should be rejected.

The ARR method is very simple to understand and use. It can also be easily calculated using
accounting information.

However, the ARR suffers from three main weaknesses.

16
First it uses accounting profits not cash flows in appraising projects.

Secondly ARR ignores the time value of money. The profits occurring in different periods are
valued equally.

Thirdly, it does not allow the fact that profit can be reinvested to earnmore profits.

Summary of Traditional Criteria:

 Focus on simple calculations like payback period and ARR.

 Do not consider the time value of money.
 May be helpful for evaluating smaller projects or short-term investments.
 Provide quick and easy insights but lack the depth needed for comprehensive financial
analysis.

Discounted Cash Flow (DCF) Methods

We have discussed two of the traditional methods used in the evaluation of projects. One is the
payback period while the other is the accounting rate of return (ARR). Although two of them
are simple to use and understand, they are not theoretically sound. Both of them fail to
consider the timing of cash flows. Both fail to consider the time value of money.

Because of these limitations, we shall consider two superior investment criteria which fully
recognise the timing of cash flows.

The two methods are the net present value (NPV) method and the internal rate of return (IRR)
method. These two methods are referred to as discounted cash flow (DCF) methods or the
time-adjusted methods.

The Net Present Value (NPV) Method

This method correctly recognises the fact that cash flows arising different time periods differ
in value and are comparable only when their equivalent- present values are found out.

The following steps are followed when computing the net present value

(NPV).

1. A discount rate is selected to discount the cash flows. The correct discount rate should
be the firm‘s cost of capital which is the minimum rate of return expected by the
investors to be earned by the firm.

17
 2. The present value of cash inflows and outflows are computed using cost of capital as
the discounting rate.
3. The net present value (NPV) is the present value of cash inflows less present value of
cash outflows.
4. The acceptance rule using the NPV method is to accept a project if the NPV is positive,
and to reject it if the NPV is negative.

If NPV is greater than zero, then the value of the firm is expected to increase.

It is also important for us to understand the interpretation of NPV.

The net present value may be interpreted to mean the immediate increase in the wealth of a
firm if the investment proposal is accepted. It is equal to an unrealised capital gain.

The net present value can also be interpreted to represent the amount the firm could raise at a
required rate of return in addition to the initial cash outlay to distribute immediately to its
shareholders and by the end of the project life to have paid off all the capital raised plus
interest on it.

Example

Calculate the net present value of a project which cost N500,000. But generates cash inflows
of N150,000, N300,000 and N400,000 over a three year period. The required rate of return is
10%.

A company requires a N150,000 initial investment for a project that is expected to generate
cash inflows for the next five years.

It will generate N10,000 in the first two years, N15,000 in the third year, N25,000 in the
fourth year, and N20,000 with a terminal value of N100,000 in the fifth year.

Assuming the cost of capital is 5%, and no further investment is required during the term.
Calculate the NPV and IRR

Solution

Let's break down how to calculate the Net Present Value (NPV) and Internal Rate of
Return (IRR) for the project based on the provided details.

1. Net Present Value (NPV)

18
The NPV is the sum of the present values of all future cash inflows and outflows. The formula
for NPV is:

Where:

 Ct is the cash inflow at time t,

 r is the discount rate (cost of capital, which is 5% or 0.05),
 t is the year (time),
 C0 is the initial investment (N150,000).

Cash inflows:

 Year 1: N10,000
 Year 2: N10,000
 Year 3: N15,000
 Year 4: N25,000
 Year 5: N20,000 + terminal value of N100,000 = N120,000

Steps:

19
Now, sum the present values:

NPV = 9,523.81 + 9,070.29 + 12,948.89 + 20,578.70 + 94,000.45 − 150,000

NPV= 146,121.14 − 150,000

NPV= −3,878.86

So, the NPV is -N3,878.86.

The Internal Rate of Return (IRR) Method

The internal rate of return (IRR) can be defined as that rate which equates the present value of
cash inflows with the present value of cash outflows of an investment. Put in another way, the
internal rate of return is the rate at which the NPV of an investment is zero. It is called the
internal rate because it depends solely on the outlay and the resulting cash inflows of the
project and not any rate determined outside the investment.

Calculation of Internal Rate of Return (IRR)

The Internal Rate of Return (IRR) is the discount rate (r) that makes the Net Present Value
(NPV) of cash flows equal to zero.

=0

where:

C0 = −150,000 (Initial Investment)

C1 =10,000

C2= 10,000

20
C3= 15,000

C4 = 25,000

C5 = 20,000+100,000=120,000 (including terminal value)

r = IRR (to be determined)

t = year number

So, the IRR equation is:

Since IRR cannot be solved algebraically, we use trial and error or iterative numerical
methods.

Step 1: Estimating IRR Using Trial and Error

We try different values of r until NPV ≈ 0

Case 1: Trying r = 5% (0.05)

=−150,000 + 9,524 + 9,070 + 12,956 + 20,571+ 94,02

= −150,000+146,146 = −3,854

Since NPV < 0, IRR must be slightly lower than 5%.

Step 2: Trying r = 4.36% (0.0436)

Using numerical methods, we found: IRR ≈ 4.36%

This means at 4.36% discount rate, NPV = 0, making it the project’s IRR.
21
 The Internal Rate of Return (IRR) = 4.36%. Since the company's cost of capital (5%) is
higher than the IRR (4.36%), the project is not financially viable, as the return is lower
than the required rate.

In terms of merit, the NPV method is very significant since it recognizes the time value of
money.

It also is consistent with the objective of maximising the wealth of shareholders.

However, the NPV suffers from the following limitations.

Firstly, it is fairly difficult to use.

Secondly, in computing the NPV, it is assumed that the discount rate which usually is a firm‘s
cost of capital is known. But as we know, the cost of capital is a fairly difficult concept to
measure in real life.

Thirdly, NPV may not yield a consistent answer when the projects being compared involve
different amounts of investment.

The Profitability Index (PI) is a measure of a project's attractiveness. It is calculated as the

ratio of the present value of future cash inflows to the initial investment.

The formula for PI is:

Example

A company invests N150, 000 in a project that will generate cash inflows of N50, 000
annually for four years. If the discount rate is 8%, what is the profitability index?

Given:

Initial investment C0 = N150,000

Annual cash inflows Rt = N50,000 for t =1, 2, 3, 4

Discount rate r =8%

First, we calculate the present value (PV) of each cash inflow:

22
Next, we sum these present values to get the total PV of future cash inflows:

N46,296.30 + N42,870.65 + N39,686.71 + N36,751.58 = N165,605.24

Finally, we calculate the PI: = 1.10

The Profitability Index (PI) of the project is 1.10. Since the PI is greater than 1, this indicates
that the project is expected to generate more value than its cost and is therefore considered a
good investment.

A company invests N200,000 in a project that will generate cash inflows of N60,000 annually
for five years. If the discount rate is 10%, what is the profitability index (PI)?

Solution:

The profitability index (PI) is given by:

23
Using the Present Value of Annuity Formula:

Substituting values:

PV = 60,000 × (1− 0.6209) ÷ 0.10

PV = 60,000 × 3.7908 = 227,448

Now,

Answer: The profitability index is 1.14

A firm undertakes a project costing N250,000, which is expected to generate cash inflows of
N80,000 annually for four years. The required rate of return is 9%. Compute the
profitability index (PI).

A business invests N180,000 in a project that promises to return N55,000 annually for five
years at a discount rate of 7%. Find the profitability index (PI).

24
 A company embarks on a project with an initial cost of N120,000. The expected cash inflows
are N40,000 per year for four years, and the discount rate is 6%. Compute the profitability
index (PI).

A project requires an initial investment of N300,000 and is expected to generate N90,000

annually for six years. If the discount rate is 11%, determine the profitability index (PI).

Cost-Benefit Analysis (CBA): It is a systematic process to compare the benefits and costs of
a project, expressed in monetary terms.

Steps:

1. Identify and quantify costs (initial investment, operating expenses).

2. Identify and quantify benefits (revenue, social impact, environmental gains).
3. Discount future costs and benefits to their present value.
4. Calculate the net benefit (Total Benefits - Total Costs).

Key Metrics:

o Benefit-Cost Ratio (BCR)

o Net Present Value (NPV)

It is used to determine whether the benefits outweigh the costs and by how much.

Example

The following are details of a Road Construction Project

 Initial Cost:N10 million

 Annual Benefits: N3 million
 Annual Costs (Maintenance, Operations): N500,000
 Project Life: 5 years
 Discount Rate: 8%

Carry out Cost-Benefit Analysis (CBA) for the project

Solution

Step 1: Calculate Net Benefit per Year

25
 Net Benefit = Annual Benefits −Annual Costs

Net Benefit = 3,000,000 − 500,000 = 2,500,000

Step 2: Calculate Present Value (PV) of Net Benefits

Using the Present Value formula:

PV = 2,314,815 + 2,144,277 + 1,986,370 + 1,839,240 + 1,701,148 = 9,986,000

Step 3: Compute Net Present Value (NPV)

NPV = PV − Initial Cost

NPV = 9,986,000 −10,000,000= −14,000

Conclusion:

Since NPV is negative (-N14,000), the project is not financially viable under these
assumptions.

Example 2: Solar Energy Project

Project Details:

 Initial Investment: N2 million

 Annual Revenue from Electricity Sales: N500,000
 Annual Operating Cost: N100,000
 Project Life: 6 years
 Discount Rate: 10%

Solution
26
Step 1: Compute the Net Benefit per Year

Net Benefit = Annual Benefits −Annual Costs

Net Benefit = 500,000 −100,000 = 400,000

Step 2: Calculate Present Value (PV) of Net Benefits

Using the Present Value formula:

PV= 363,636 +330,596 + 300,542 + 273,220 + 248,382 + 225,802 = 1,742,178

Step 3: Compute Net Present Value (NPV)

NPV = PV − Initial Cost

NPV = 1,742,178 − 2,000,000 = −257,822

Conclusion:

The NPV is negative, meaning the project is not financially viable under these conditions.

Sensitivity Analysis

Examines how changes in key variables (e.g., costs, revenues, discount rates) impact project
outcomes.

Steps:

1. Identify key variables.

2. Alter one variable while keeping others constant.
3. Assess the impact on NPV, IRR, or other metrics.

Evaluates project robustness under different scenarios.

27
 A company is considering investing in a new manufacturing plant. The key financial details
are:

 Initial Investment: N5,000,000

 Annual Revenue: N2,500,000
 Annual Operating Costs: N1,200,000
 Project Life: 5 years
 Discount Rate: 8%

Salvage Value at the End of Year 5: N500,000

We will perform sensitivity analysis by assessing how changes in key variables (Revenue,
Operating Costs, and Discount Rate) affect the project's Net Present Value (NPV).

Step 1: Calculate the Base Case NPV

Net Cash Flow per Year

Net Cash Flow = Revenue − Operating Costs

=2,500,000 − 1,200,000 = 1,300,000

Calculate Present Value (PV) of Cash Flows

Using the Present Value formula:

PV = 1,203,704 + 1,114,545 + 1,032,916 + 956,409 + 885,567 + 340,300

PV=5,533,441

28
Calculate NPV

NPV = PV − Initial Investment

NPV = 5,533,441− 5,000,000 = 533,441

Since NPV is positive, the project is viable under the base case.

Step 2: Sensitivity Analysis

Now, we analyze how changes in key variables affect NPV.

Case 1: Revenue Increases by 10%

 New Revenue = N2,750,000

 New Net Cash Flow = N1,550,000

Recalculating NPV:

PV = 1,435,185 +1,328,875 +1,231,201+1,141,369 +1,058,684 +340,300

NPV = 6,535,614−5,000,000 =1,535,614

Result: If revenue increases by 10%, NPV rises to N1, 535,614 (better profitability).

Case 2: Operating Costs Increase by 10%

 New Operating Costs = N1,320,000

 New Net Cash Flow = N1,180,000

Recalculating NPV:

PV= 1,092,593+1,011,661+936,668+867,282 +803,037+340,300

29
 PV = 5,051,541

NPV = 5,051,541 - 5,000,000 = 51,541

Result: If operating costs increase by 10%, NPV drops to N51, 541 (borderline viable).

Case 3: Discount Rate Increases to 10%

 Keeping all other variables constant.

Recalculating PV using 10% discount rate:

PV=1,181,818+1,074,380+976,709+887,008+805,462+310,460
PV=5,235,837

NPV = 5,235,837 − 5,000,000 = 235,837

Result: If the discount rate increases to 10%, NPV drops to N235, 837 (still viable but
reduced profitability).

Step 3: Summary Table of Sensitivity Analysis

Scenario New NPV (N) Impact on Decision

Base Case 533,441 Viable
Revenue +10% 1,535,614 More Profitable
Operating Costs +10% 51,541 Borderline Viable
Discount Rate ↑ to 10% 235,837 Still Viable

30
Key Insights from Sensitivity Analysis

1. Revenue Changes Have a Large Impact: A 10% increase in revenue significantly

boosts NPV, making the project highly profitable.
2. Higher Operating Costs Reduce Viability: If costs increase by 10%, the project
becomes almost unprofitable with an NPV close to zero.
3. Higher Discount Rates Reduce NPV: A higher discount rate decreases future cash
flow value, reducing NPV but not eliminating viability.

Conclusion:

The project is viable under the base case but is highly sensitive to revenue and operating
costs. A cost increase could make it risky, while increased revenue makes it highly
profitable.

Scenario Analysis

Evaluates project outcomes under different scenarios (e.g., best-case, worst-case, and
most-likely scenarios).

Helps in understanding potential risks and preparing mitigation strategies.

Example of Scenario Analysis in Project Evaluation

Scenario: Investment in a Solar Power Plant

A company is considering investing in a solar power plant. The project involves the
following financial parameters:

 Initial Investment: N10,000,000

 Project Life: 10 years
 Discount Rate: 8%
 Salvage Value at Year 10: N1,000,000
 Three Different Scenarios: Best Case, Base Case, and Worst Case

We analyze how changes in revenue and operating costs affect the project’s Net Present
Value (NPV).

31
Step 1: Define Three Scenarios

Scenario Annual Revenue (N) Annual Operating Costs (N) Net Cash Flow ($)
Best Case 3,000,000 1,000,000 2,000,000
Base Case 2,500,000 1,200,000 1,300,000
Worst Case 2,000,000 1,400,000 600,000

Step 2: Calculate NPV for Each Scenario

Formula for NPV

Where:

 r = 8% (Discount Rate)
 Salvage Value =1,000,000
 t =1 to 10

Base Case NPV Calculation (Net Cash Flow = N1,300,000)

PV = 1,203,704 + 1,114,545 +1,032,916 + 956,409 +885,567 + 819,963 +759,225 +702,984+

650,913 + 602,701 + 463,193

PV=9,182,120

NPV = 9,182,120 − 10,000,000 = −817,880

Result: Base case has an NPV of - N817, 880, meaning the project is not profitable.

32
Best Case NPV Calculation (Net Cash Flow = N2, 000,000)

PV=1,852,776+1,715,535+1,588,450+1,470,787+1,361,841+1,260,963+1,167,561+1,081,075
+1,001,005+926,863+463,193

PV=14,890,049

NPV=14,890,049−10,000,000=4,890,049

Result: Best case has an NPV of N4,890,049, meaning the project is highly profitable.

Worst Case NPV Calculation (Net Cash Flow = $600,000$)

PV = 555,556 + 514,380 + 476,454 + 441,296 + 408,679 + 378,482 + 350,536 + 324,674 +

300,753 + 278,556 + 463,193

PV=4,492,559

NPV = 4,492,559 − 10,000,000 = −5,507,441

Result: Worst case has an NPV of - N5, 507,441, meaning the project would be a significant
loss.

tep 3: Summary Table of Scenario Analysis

Scenario NPV ($) Investment Decision

Best Case 4,890,049 Highly Profitable ✅
Base Case -817,880 Not Profitable ✅
Worst Case -5,507,441 Huge Loss ✅

33
Key Insights from Scenario Analysis

1. High Sensitivity to Revenue and Costs: The project can be very profitable ($4.89
million) in the best case but suffer losses in normal or worst-case conditions.
2. Break-Even Analysis Needed: The base case shows a small loss. We may need to
adjust pricing, reduce costs, or increase revenue sources.
3. Risk Mitigation Strategies: Since there is a high risk of losses in the worst case, the
company may consider:
o Cost reduction (e.g., efficient operations, government incentives).
o Revenue diversification (e.g., selling excess electricity to the grid).
o Alternative financing methods (e.g., subsidies, investor partnerships).

Conclusion

The project is only viable under optimistic conditions. If actual costs exceed projections or
revenue falls short, it will become unprofitable. Decision-makers should conduct further
risk analysis before investing.

Multi-Criteria Decision Analysis (MCDA)

A framework for evaluating projects based on multiple criteria (financial, social,

environmental).

Steps:

1. Identify criteria and assign weights.

2. Score the project against each criterion.
3. Calculate a weighted average score.

Useful for projects with significant non-monetary benefits.

Economic Rate of Return (ERR)

34
Measures the economic benefits of a project relative to its costs, considering broader societal
impacts (e.g., job creation, public health improvements).

Often used for public sector or development projects.

Elementary Economic Analysis

Elementary Economic Analysis involves the basic evaluation of costs, benefits, and economic
feasibility of decisions related to resource allocation, production, and consumption. It helps in
making rational choices by comparing alternatives based on economic principles.

Key Components of Elementary Economic Analysis

Elementary Economic Analysis involves fundamental principles used to evaluate economic

decisions and optimize resource allocation. Below are

key components that help in understanding and applying economic analysis effectively.

1. Cost Analysis: Evaluates the total cost of production, including fixed costs (e.g., rent,
machinery) and variable costs (e.g., labour, raw materials). It helps in determining
pricing strategies and profitability.
2. Benefit Analysis: Assesses the advantages or gains from an economic decision. This
includes tangible benefits (e.g., revenue increase) and intangible benefits (e.g., customer
satisfaction).
3. Opportunity Cost: The cost of the next best alternative foregone when making a
decision. It helps in prioritizing the most economically viable option.
4. Break-even Analysis: Identifies the point where total revenue equals total cost (no
profit, no loss).Useful for determining the minimum sales volume required for
sustainability.
5. Profitability Analysis: Evaluates financial performance using metrics like profit
margin, return on investment (ROI), and net present value (NPV). Helps businesses
understand how profitable a product, project, or investment is.
6. Demand and Supply Analysis: Examines how the price and quantity of goods/services
are determined in the market. Helps businesses adjust pricing strategies based on market
trends.

35
 7. Marginal Analysis: Compares marginal cost (MC) and marginal revenue (MR) to
decide whether to increase or decrease production. A firm should continue producing as
long as MR > MC.
8. Elasticity of Demand and Supply: Measures how sensitive quantity demanded or
supplied is to price changes. Determines pricing strategies and tax implications.
9. Comparative Advantage: The ability of an individual, firm, or country to produce a
good/service at a lower opportunity cost than others. Important for trade decisions and
specialization.
10. Time Value of Money (TVM): Recognizes that money today is worth more than the
same amount in the future due to its earning potential. Used in investment decisions,
project evaluation, and financial planning.
11. Risk and Uncertainty Analysis: Assesses possible risks (e.g., market fluctuations,
competition, economic downturns). Helps in risk mitigation strategies like
diversification and hedging.
12. Productivity and Efficiency Analysis: Measures how efficiently inputs (labor,
capital, technology) are converted into outputs. Higher productivity reduces costs and
improves profitability.
13. Cost-Benefit Analysis (CBA): Compares total expected costs and benefits of a project
or decision. Used in public policy, business investment, and economic planning.
14. Pricing Strategies and Market Structure: Evaluates how firms set prices based on
competition (perfect competition, monopoly, oligopoly). It helps in maximizing
revenue while remaining competitive.
15. Investment and Capital Budgeting: Involves evaluating long-term investments using
methods like Net Present Value (NPV), Internal Rate of Return (IRR), and
Payback Period. It ensures efficient allocation of financial resources.

.Examples of Elementary Economic Analysis

1. Material Selection for a Product

Scenario: A furniture manufacturer is deciding between using wood or plastic for producing
chairs.

Wood:

Cost per chair: N30

36
 Durable, high aesthetic value, but higher maintenance cost

Selling price: N80

Plastic:

Cost per chair: N15

Lightweight, low maintenance, but less durable

Selling price: N50

Economic Analysis:

If the target market values durability and premium aesthetics, wooden chairs are preferred
despite higher costs.

If on the other hand, cost-cutting and mass production are priorities, plastic chairs are a
better option due to lower costs and higher sales volume.

2. Design Selection for a Product

Scenario: A company wants to produce an affordable mobile phone and must decide between
a basic model and a feature-rich model.

Basic Model:

Production cost: N80

Selling price: N150

Target market: Budget-conscious customers

Estimated demand: 50,000 units

Feature-Rich Model:

Production cost: N200

Selling price: N400

37
 Target market: Tech-savvy customers

Estimated demand: 20,000 units

Economic Analysis:

 If the goal is to maximize sales volume, the basic model is better.

 If the focus is on higher profit margins, the feature-rich model is preferred.
 A mixed strategy might be optimal, targeting both market segments.

Elementary Economic Analysis provides a structured way to make informed economic

decisions. Whether selecting materials, designing products, or optimizing production,
businesses use these basic economic principles to maximize efficiency and profitability.

Types of Economic Analysis

Economic analysis is broadly categorized based on the scope, purpose, and methods used to
evaluate economic decisions.

Below are the major types:

1. Microeconomic Analysis: It focuses on individual economic units such as consumers,

firms, and industries. It examines: pricing, demand, supply, production decisions, and
consumer behaviour.

Examples: Price determination in a competitive market.

Consumer purchasing decisions based on income and preferences.

2. Macroeconomic Analysis: It Studies the economy as a whole, considering national and

global trends. Its focus is on GDP, inflation, unemployment, fiscal and monetary policies.
Examples:

 The impact of inflation on economic growth.

 Effects of government spending on employment levels.

3. Cost-Benefit Analysis (CBA): Compares the total expected costs and benefits of a project,
policy, or investment. It helps in decision-making by determining feasibility and profitability.
Examples:

 Assessing whether to build a new highway.

38
  Evaluating the economic impact of healthcare programs.

4. Comparative Economic Analysis: It compares different economic systems, policies, or

time periods. It helps in selecting the most efficient economic model or strategy. Examples:

 Comparing socialist vs. capitalist economies.

 Analyzing the impact of different tax policies across countries.

5. Financial Economic Analysis: It evaluates investment decisions, financial risks, and

capital budgeting. It Uses tools like Net Present Value (NPV), Internal Rate of Return
(IRR), and Payback Period. Examples:

 Determining whether to invest in a new factory.

 Analyzing stock market trends.

6. Risk and Uncertainty Analysis: It assesses the potential risks in economic decisions due
to unpredictable factors. It helps in risk mitigation strategies like diversification and
hedging. Examples:

 Evaluating the risks of entering a new market.

 Assessing the impact of exchange rate volatility on exports.

7. Input-Output Analysis: It examines how different industries interact within an economy.

It helps in resource allocation and economic planning. Examples:

 How increased demand for steel affects the automobile industry.

 Studying the economic impact of supply chain disruptions.

8. Econometric Analysis: It uses statistical and mathematical models to analyze economic

data. It helps in making forecasts and testing economic theories. Examples:

 Predicting future inflation rates using past data.

 Analyzing the impact of interest rate changes on investments.

9. Development Economic Analysis: It examines economic growth, poverty, income

distribution, and policy impacts. It focuses on sustainable development and economic
progress. Examples:

 Evaluating the effectiveness of microfinance in poverty reduction.

 Analyzing the role of infrastructure in economic growth.
39
10. Welfare Economic Analysis: It studies how economic policies affect social welfare and
income distribution. It focuses on equity, fairness, and social well-being. Examples:

 Evaluating the impact of minimum wage laws on poverty.

 Assessing the effectiveness of healthcare subsidies.

Different types of economic analysis help in making informed decisions across various
sectors. Whether it's for business investment, government policy, or economic forecasting,
selecting the right type of analysis ensures efficient resource allocation and economic
stability.

Present Worth Method of Comparison

The Present Worth (PW) Method is a technique used in capital budgeting to compare
different investment alternatives by determining the present value of all future cash inflows
and outflows associated with each alternative. The goal is to find the option with the highest
present value, which reflects the most beneficial investment from a financial standpoint.

Formula for Present Worth (PW):

The present worth is calculated as the sum of the present values of all cash flows, both
positive (revenues or inflows) and negative (costs or outflows). The formula for calculating
the present worth is:

Where:

PW = Present Worth

Ct = Cash flow at time t

i = Interest rate or discount rate per period

t = Time period (usually years)

The calculation is done by discounting all future cash flows back to the present time using the
interest rate, which reflects the time value of money.

40
Revenue-Dominated Cash Flow Diagram

In a Revenue-Dominated Cash Flow, the inflows (revenues) are more significant compared
to the outflows (costs). This situation occurs when the investment generates substantial returns
over time, making the revenue the dominant factor. The cash inflows in a revenue-dominated
scenario typically have a longer duration and higher amounts than the cash outflows.

Key Features of a Revenue-Dominated Cash Flow Diagram

A Revenue-Dominated Cash Flow Diagram represents an investment or project where the

inflows (revenues) significantly outweigh the outflows (costs). The revenue increases over
time, making it the dominant factor in the project’s financial viability.

Here are the key features:

1. Initial Investment (Outflow): The project usually begins with a substantial initial
investment or upfront cost represented by an outflow at time zero (Year 0). This is the
amount spent to initiate the project or investment. Example: Capital expenditure to
purchase machinery or set up infrastructure.
2. High Revenues (Inflows): The most defining feature of a revenue-dominated cash flow
is the large inflows over time that exceed the initial investment and operating costs.
These inflows typically come from the project’s revenues, sales, or services provided.
Example: Sales revenue, rental income, or service fees.
3. Positive Net Cash Flow: As the project generates higher revenue, the net cash flow
becomes positive. This indicates that the project is generating more income than
expenses. Example: The revenue in later years outweighs initial costs, leading to
profitability.
4. Increasing Cash Flows Over Time: In many cases, revenue-dominated projects
experience growing cash inflows over time. This could result from factors like price
increases, expansion of market share, or scaling of operations. Example: Annual sales
increase due to market growth or rising demand.
5. Long-Term Revenue Generation: These projects typically have long-term revenue
generation, continuing for several years or decades. The inflows often persist well
beyond the initial costs. Example: Long-term infrastructure projects like toll roads or
energy plants.
6. Present Worth Calculation: The Present Worth (PW) of future inflows is a crucial
factor. In revenue-dominated projects, the discounted value of future inflows will

41
 likely be high, leading to a positive present worth. Example: The present value of cash
flows from a long-term service contract.
7. Time Value of Money: Since revenues are spread over time, the time value of money
is crucial. The future inflows are discounted to their present value, and the project’s
financial attractiveness is measured by how much those future revenues are worth
today. Example: The application of an appropriate discount rate to forecasted cash
flows.
8. Profitability: These projects typically exhibit strong profitability due to the
dominance of revenue over costs. The revenues generated are sufficient to not only
cover initial and operating costs but also yield a profit. Example: A product or service
with a high demand that generates substantial returns.
9. Lower Risk of Loss: Since the revenue generation is dominant, financial risks tend to
be lower in such projects. If the project can generate consistent revenue streams, the risk
of failing to recover the initial investment is reduced. Example: A utility project that
provides essential services with guaranteed demand.
10. Positive Cash Flow in Later Years: As the project matures, cash flows from revenues
typically exceed costs, and the cumulative net cash flow becomes increasingly positive
in the later years. Example: A new technology product that generates growing market
share over time and increases sales significantly in later years.
Example of a Revenue-Dominated Cash Flow Diagram:

Cash Flow

| Inflow

| (Revenue)

Year 0 | ┌──────────────────┐

| | -₦500,000 | Initial Investment

| └──────────────────┘

Year 1 | +₦200,000 | Revenue Inflow

Year 2 | +₦250,000 | Revenue Inflow

42
Year 3 | +₦300,000 | Revenue Inflow

Year 4 | +₦350,000 | Revenue Inflow

In this diagram, the initial outflow of ₦500,000 is followed by revenue inflows that increase
over time, making the project financially favorable as the years go on.

In a Revenue-Dominated Cash Flow Diagram, the inflows generated by the project exceed
the outflows over time, often increasing as the project matures. The positive net cash flow,
growing revenues, and long-term profitability make these projects financially attractive.
The Present Worth of these future revenues helps in determining whether the investment is
worthwhile.

Key Features of a Cost-Dominated Cash Flow Diagram

A Cost-Dominated Cash Flow Diagram represents a scenario where cash outflows (costs)
exceed cash inflows (revenues) over the life of a project or investment. This is common in
projects with high initial and ongoing costs, such as infrastructure development, research and
development, or regulatory compliance projects.

1. High Initial Investment (Outflow): The project starts with a large upfront
investment, which could be for purchasing equipment, constructing infrastructure, or
acquiring assets. Example: A company building a new manufacturing plant incurs
significant construction and machinery costs before any revenue is generated.
2. High Recurring Costs: The project requires continuous expenditures for
maintenance, operation, labor, or raw materials. These ongoing costs dominate the cash
flow. Example: A nuclear power plant incurs heavy maintenance and safety costs
throughout its operation.
3. Low or Delayed Revenue Inflows: Revenue inflows, if present, are minimal or
delayed in comparison to the outflows. Some projects might not generate revenue at all.
Example: A government-funded road project that doesn’t generate toll revenue until
years after completion.
4. Negative Net Cash Flow: Since costs dominate, the net cash flow is negative,
meaning more money is being spent than earned. Example: A research lab that
continuously spends on experiments without selling any products.

43
 5. Declining Cash Reserves Over Time: Due to high costs and little or no revenue, cash
reserves shrink over time, increasing the risk of financial instability. Example: A
startup burning through investor funds without generating sufficient sales.
6. High Financial Risk: Cost-dominated projects face a high risk of financial loss,
particularly if external funding sources dry up. Example: A company investing in space
exploration with high costs and uncertain future profits.
7. Requires Strong External Funding: These projects often require loans, government
grants, or investor funding to sustain operations due to limited revenue generation.
Example: Public infrastructure projects funded by government budgets instead of direct
revenue.
8. Negative or Low Present Worth (PW): When discounting future cash flows using the
Present Worth (PW) method, the result is often negative, indicating a financial loss.
Example: A factory that never breaks even due to excessive maintenance costs.
9. Longer Payback Period (If Any Revenue Exists): If revenues exist, the payback
period is extended, meaning it takes longer for the project to recover its initial
investment. Example: An oil refinery that takes 20+ years to cover its billion-dollar
construction costs.
10.May Serve Non-Profit or Strategic Goals: Some cost-dominated projects are not
designed for profitability but rather for public good, strategic advantage, or legal
compliance. Example: A government investing in climate change mitigation programs
with no direct financial return.

Example of a Cost-Dominated Cash Flow Diagram:

Cash Flow

| Outflow (Costs)

| ┌──────────────────┐

Year 0 | | -₦1,500,000 | High Initial Investment

| └──────────────────┘

Year 1 | | -₦500,000 | Maintenance & Operation Cost

44
Year 2 | | -₦400,000 | Ongoing Expenses

Year 3 | | -₦300,000 | Ongoing Expenses

Year 4 | | +₦200,000 | Small Revenue

In this diagram, the project incurs high initial costs, followed by recurring expenses, with
only small revenue appearing in later years.

A Cost-Dominated Cash Flow Diagram highlights projects with high expenditures, minimal
revenue, and extended financial recovery periods. These projects often require external
funding, strategic justification, or government support to sustain them. The high financial
risk and negative net cash flow make them challenging investments unless justified by long-
term social, strategic, or regulatory benefits.

Comparison Using the Present Worth Method

To compare the two alternatives using the Present Worth Method, we would calculate the
Present Worth (PW) for each cash flow diagram. The option with the higher present worth is
considered the more beneficial investment.

For Revenue-Dominated Projects, the present value of the inflows would typically be high,
as the cash flows in later years are significant and they are discounted less due to the time
value of money.

For Cost-Dominated Projects, the present value of inflows would be lower, and the project
may even have a negative present worth if the costs outweigh the benefits.

The Present Worth Method provides a way to evaluate and compare different investment
alternatives by determining the current value of future cash flows. By analyzing both
Revenue-Dominated and Cost-Dominated projects, you can choose the alternative that
provides the best financial return based on present worth.

45
46