CMGT 547 – Managerial Engineering Economics

Week #4 – Chapters 5 & 6

 Lecture Overview
• Assignment #1 Review
• Chapter 3 & 4 Review
• Time Value of Money, Elements of Interest Transaction, Cash Flow Diagrams,
Variable Convention, Economic Equivalence, Expect Financial Risk
• Engineering Economics Excel Formulas
• Chapter 5 Lecture
• Chapter Topics
• Example Problems
• Chapter 6 Lecture
• Chapter Topics
• Example Problems
 Time Value of Money
 Money has a time value because
it can earn more money over time
(earning power).
 Money has a time value because
its purchasing power changes
over time (inflation).
 These dynamics are driven by the
concept of interest.

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 Elements of Transactions Involving Interest
• Principal – an initial amount of money in transaction involving debt or
investments
• Interest Rate – measures the cost or price of money and is expressed as a
percentage per period of time
• Interest Period – determines the frequency that interest is calculated
• Number of Interest Periods – a specified length of time marks the duration
of the transaction and thereby establishes…
• Plan for Receipts or Disbursements – yields a particular case flow pattern
over a specified length of time
• Future Amount of Money – results from the cumulative effects of the
interest rate over a number of periods.
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 The Market Interest Rate
o Interest is the cost of money, a cost
to the borrower and a profit to the
lender.
o Time value of money is measured in
terms of market interest rate, which
reflects both earning and purchasing
power in the financial market.
o In the United States, the Federal
Reserve plays a significant role in
the Market Interest Rate based on
interest rates of their securities.

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 Cash Flow Diagram
(A Graphical Representation of Cash Transactions over Time)

Borrow $20,000 at 9% interest over 5 years,

requiring $200 loan origination fee upfront.
The required annual repayment is
$5,141.85 over 5 years.

o n = 0: $20,000
o n = 0: $200
o n = 1 ~ 5: $5,141.85

o Sign convention:
o Above Bar - + - cash inflow
o Below Bar - - - cash outflow

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 End-of-Period Convention
 Convention: Any cash
flows occurring during the
interest period are
summed to a single
amount and placed at the
end of the interest period.
 Logic: This convention
allows financial
institutions to make
interest calculations
easier.

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 Variable Convention
• Use these standard variables in assignments:
• An – a discrete payment or receipt occurring at the end of some interest period
• i – the interest rate per interest period
• n – a specific period within the analysis period
• N – the total number of interest periods
• P – a sum of money at a time chosen at time zero (now) for purposes of analysis;
present value or present worth
• F- a future sum of money at the end of the analysis period
• A – an end of period payment or receipt in a uniform series that continues for N
periods. A1 = A2 = … = An
• Vn – an equivalent sum of money at the end of a specified period n that considers the
effect of the time value of money.
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What is “Economic Equivalence?”

Economic equivalence exists between cash

flows that have the same economic effect and
could therefore be traded for one another.

Even though the amounts and timing of the

cash flows may differ, the appropriate interest
rate makes them equal in the economic sense.

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 How to Determine Expected Financial Risk
• Risk refers to the chance that some unfavorable event will occur.
• Volatility measures the deviation from the expected value, or
sudden swings in value, from high to low or the reverse.
• Standard deviation measures the degree of volatility when you
have the probabilistic information about the uncertain event.
• Beta measures how closely a fund’s performance correlates with
broader stock market movement.
• Alpha shows whether a fund is producing better or worse
returns than expected, given the risk it takes.

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 Engineering Economics Excel Functions
• PV(rate,nper,pmt,[fv],[type])
• Gives the present value for a series of equal payments
• FV is optional and for a cash balance obtained after the last payment
• Type is used for end of period payment convention (0 or omitted) or beginning
of period payment convention (1)
• FV(rate,nper,pmt,[pv],[type])
• Gives the present value for a series of equal payments
• FV is optional and for a cash balance obtained after the last payment
• Type is used for end of period payment convention (0 or omitted) or beginning
of period payment convention (1)
 Engineering Economics Excel Functions
• PMT(rate,nper,pv,[fv],[type])
• Gives payments for a loan based on constant payments and rate.
• FV is optional and for a cash balance obtained after the last payment
• Type is used for end of period payment convention (0 or omitted) or beginning
of period payment convention (1)
• NPV(rate,value1,[value2],…)
• Gives net present value for a series of cash flows based upon a rate.
 Common Cash Flow Equivalences
• Equivalent Present Worth (PW)
– A measure of future cash flow relative to the time point “now”
• Equivalent Future Worth (FW)
– A measure of cash flow at some future planning horizon and offers a consideration
of the earning opportunities of intermediate cash flows.
• Equivalent Annual Worth (AW)
– A measure of cash flow in terms of equivalent equal payments made on an annual
basis.

• Treatment of measures of investment worth is divided into three chapters.

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 Bank Loan vs. Project Cash Flows

The similarity between the loan cash flow and the project cash flow brings us
to an important conclusion: We can use the same equivalence techniques
developed in Chapter 3 to measure worth.

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 Example 5.1: Describing Project Cash Flows:
A Computer-Process Control Project
Year Cash Inflows Cash Outflows Net
(n) (Benefits) (Costs) Cash Flows

0 0 $650,000 -$650,000

1 215,500 53,000 162,500

2 215,500 53,000 162,500

… … … …

8 215,500 53,000 162,500

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 Cash Flow Diagram for the Computer
Process Control Project

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 Independent versus Mutually Exclusive Investment Projects
• Independent – the decision regarding any one project has no effect on the
decision to accept or reject another project
– The economic attractiveness of each of these projects can be measured, and a decision
to accept or reject the project can be made without reference to an of the other projects.
• Mutually Exclusive – it is not desirable to choose more than one project in this
situation, and the acceptance of one automatically entails the rejection of all of
the others.
– Selecting the most economically attractive project from a number of alternative projects
all of which solve the same problem or meet the same need. It is not desirable to choose
more than one project in this situation in this situation.
• Investment framing for this course general ignores more complex investment
relationships.

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 Payback Period
 Principle
How fast can I recover my initial investment?
 Method
Based on the cumulative cash flow (or accounting
profit)
 Screening Guideline
If the payback period is less than or equal to some
specified bench-mark period, the project would be
considered for further analysis.
 Weakness
Does not consider the time value of money

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 Example 5.3: Payback Period
N Cash Flow Cum. Flow

0 −$105,000+$20,000 −$85,000
1 $15,000 −$70,000
2 $25,000 −$45,000
3 $35,000 −$10,000
4 $45,000 $35,000
5 $45,000 $80,000
6 $35,000 $115,000

Payback period should occurs somewhere

between N = 3 and N = 4.

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 $45,00 $45,000
$35,00 0 $35,00

Annual cash
$25,00 0 0
$15,00 0

flow
0 0
1 2 3 4 5 6
Year
s
$85,00
0
150,0
3.2 years
Cumulative cash flow ($)

00
100,0 Payback
00 period
50,0
00
0
-
50,00
0-
100,00
0
0 1 2 3 4 5 6
Years
(n)
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 Benefits and Flaws of Payback Screening
• The simplicity of the payback method is one of its most appealing qualities.
• The principle objection to the method is that it fails to measure profitability.
Simply measuring how long it will take to recover the initial investment outlay
contributes little to gauging the earning power of a project.
• Payback period ignores differences in the timing cash flows, it fails to recognize
the difference between the present and future worth of money.
• Because payback screening ignores all proceeds after the payback period, it
does not allow for possible advantages of a project with a longer economic life.

• Discounted Payback Period

– The procedure can be modified to account for the time value of money.

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 Net Present Worth Measure
 Principle: Compute the
equivalent net surplus at n = 0
for a given interest rate of i.
 For Single Project Evaluation:
Accept the project if the net
surplus is positive.
 For Comparing Multiple
Alternatives: Select the
alternative with the largest net
present worth.
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 Example 5.5: Tiger Machine Tool Company

 Given: Cash flow and i = 15%

 Find: Net present worth

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 Solution

$35,560 $37,360
$31,850 $34,400

0 inflow
1 2 3
outflow
$76,000

PW(12%)inflow $35,560(P / F ,12%,1)  $37,360(P / F ,12%,2)

$31,850(P / F ,12%,3)  $34,400(P / F ,12%,4)
$
PW (12%)outflow $76,000
PW (12%) $106,065  $76,000
$30,065  0, Accept

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 Net Present Worth Procedure
• Determine the interest rate that the firm wishes to earn on its investments. The
interest rate you determine represents the rate at which the firm can always
invest the money in its investment pool. This interest rate is often referred to as
either a required rate of return or a minimum attractive rate of return (MARR).
• Estimate the service life of the project.
• Estimate the cash inflow for each period over the service life.
• Estimate the cash outflow over each service period.
• Determine the net cash flows (net cash flow = cash inflow – cash outflow)
• Find the present worth of each net cash flow at the MARR. Add up all the
present-worth figures.

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 Project Evaluation
• Single Project Evaluation
– If PW(i) > 0, accept the project
– If PW(i) = 0, remain indifferent
– If PW(i) < 0, reject the investment
• Comparing Multiple Alternatives
– Perform calculations for each alternative, and select the one with the
largest PW(i).
– If reviewing on cost-basis only, accept the project with the smallest
negative (least negative) PW(i).

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 Excel Solution
A B C
1 Period Cash Flow
2 0 ($76,000)
3 1 $35,560
4 2 $37,360
5 3 $31,850
6 4 $34,400
7 PW(12%) $30,065

=NPV(12%,B3:B6)+B
2
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 PW at Varying Interest Rates

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Can You Explain What $30,065 Really Means?

 Project Balance Concept

 Investment Pool Concept

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 Project Balance Concept
o Suppose that the firm has no internal funds to finance the
project, so will borrow the entire investment from a bank at
an interest rate of 12%.
o Then, any proceeds from the project will be used to pay off
the bank loan.
o Then, our interest is in seeing how much money would be left
over at the end of the project period.

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 Calculating Project Balances

End of Year (n ) 0 1 2 3 4

Beginning Project Balance $ (76,000) $ (49,560) $ (18,147) $ 11,525

Interest Charged (12%) $ (9,120) $ (5,947) $ (2,178) $ 1,383

Payment $ (76,000) $ 35,560 $ 37,360 $ 31,850 $ 34,400

Ending Project Balance $ (76,000) $ (49,560) $ (18,147) $ 11,525 $ 47,308

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 Project Balance Diagram:
Four Pieces of Information
$75,000 Net profit (surplus)
if you kept the
$50,000 project until its life

$25,000 Profit potential

after recovering
the investment
0 1 2 3 4 5
Exposure
-$25,000 to financial risk
Discounted
-$50,000 payback period

-$75,000

-$100,000

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 Investment Pool Concept
o Suppose the company has $76,000. It has two options:
(1) take the money out and invest it in the project or (2)
leave the money in the pool and continue to earn a 12%
interest.
o If you take option 1, any proceeds from the project will
be returned to the investment pool and earn 12%
interest yearly until the end of the project period.
o Let’s see what the consequences are for each option.

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 Option A
If $76,000 were left
$76,000(F/P,12%,4) $119,587
in the investment pool
for 4 years
Option B
$35,650(F/
• $49,959
If $76,000 withdrawal
P,12%,3)
1

from the investment $37,360(F/

P,12%,2) 2
• $46,864
pool were invested in $31,850(F/ 3
• $35,672
the project
P,12%,1)

• $34,400
Year • Amount $34,400(F/
4

P,12%,0)

1 • $35,650 $166,896
2 • $37,360 $166,89
6

3 • $31,850 Investment Pool

$47,309
4 • $34,400
$119,587

PW(12%) = $47,309(P/F,12%,4) = $30.065

The net benefit of
investing in the project

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 Selecting an MARR in Project Evaluation
(Minimum Acceptable Rate of Return)

• Cost of capital
o The required return necessary to
make an investment project
worthwhile.

premium
o Viewed as the rate of return that

Risk
a firm would receive if it
invested its money someplace

MARR
else with a similar risk

Cost of capital
• Risk premium
o The additional risk associated
with the project if you are
dealing with a project with
higher risk than normal project

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 Practice Problem
• An electrical motor rated at 15HP needs to be
purchased for $1,000.
• The service life of the motor is known to be 10 years
with negligible salvage value.
• Its full load efficiency is 85%.
• The cost of energy is $0.08 per Kwh.
• The intended use of the motor is 4,000 hours per year.
• Find the total present worth cost of owning and
operating the motor at 10% interest.

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 Solution
1HP=0.7457kW
15HP = 15 0.7457 = 11.1855kW
Required input power at 85% efficiency rating:
11.1855kW
13.1594kW
0.85
Required total kWh per year
13.1594kW 4,000 hours/year =52,638 kWh/yr
Total annual energy cost to operate the motor
52,638kWh $0.08/kWh =$4,211/yr
 The total present worth cost of owning and operating the motor
PW (10%) $1,000  $4,211(P / A,10%,10)
= $26,875

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Cash Flow Series Associated with Owning
and Operating the Motor

0 1 2 3 4 5 6 7 8 9 10

$1,000

$4,211

PW(10%) $1,000  $4,211(P / A,10%,10)

$26,875

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 Future Worth Criterion
Given
$47,309
Cash flows and MARR (i)
Find
The net equivalent worth at
a specified period other
than the “present,”
commonly at the end of the $35,560 $37,360 $31,850 $34,400
project life 0
Decision Rule 1 2 3
Accept the project if the
equivalent worth is
positive. $76,000

Project
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 Excel Solution
A B C
1 Period Cash Flow
2 0 ($76,000)
3 1 $35,650
4 2 $37,360
5 3 $31,850
6 4 $34,400 =FV(12%,4,0,-
7 PW(12%) $30,145 B7)
8 FW(12%) $47,434

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 Example 5.6: Future Equivalent at an
Intermediate Time

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Figure 5.14 Analysis period implied in comparing mutually exclusive alternatives.

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Example 5.8: Project’s
Service Life is • B u ilt a
Extremely Long personal s
hydroelec
tric plant
us ing h is
avings of
$ 8 0 0 ,0 0 0
• Powe
r generati
kwhs ng capacit
y of 6 mill
io n
o Q1: Was Bracewell's
• Estim
$800,000 investment a ated annu
taxes − $1 al power s
wise one?
2 0 ,0 0 0 ales after
o Q2: How long does he • Expec
have to wait to recover ted servic
e life of 50 y
his initial investment, ears
and will he ever
make a profit?

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 Mr. Bracewell’s Hydroelectric Project
V1  V2  $1,101K  $1, 468 K
$367 K  0
V2 120 K ( P / A,8%,50)
$1, 468 K

V1  $50 K ( F / P,8%,9)  $50 K ( F / P,8%,8)

  $100 K ( F / P,8%,1)  60 K
 $1,101K

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Find P for a Perpetual Cash Flow Series, A

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 Capitalized Equivalent Worth
A
 Principle: PW for a project
with an annual receipt of A
over infinite service life


0
Equation n

CE(i) = A(P/A, i,N → ∞)

= A/i
 P
=CE(i
)
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 A Bridge Construction Project

• Construction cost = $2,000,000

• Annual maintenance cost = $50,000
• Renovation cost = $500,000 every 15 years
• Planning horizon = infinite period
• Interest rate = 5%

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Cash Flow Diagram for the Bridge Construction Project

Years
0 15 30 45 60

$50,000

$500,000 $500,000 $500,000 $500,000

$2,000,0
00
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 Solution
• Construction Cost
P1 = $2,000,000
• Maintenance Costs
P2 = $50,000/0.05 =
$1,000,000
• Total Present Worth
• Renovation Costs
P = P1 + P2 + P3
P3 = $500,000(P/F, 5%,
= $3,463,423
15)
+ $500,000(P/F, 5%,
30)
+ $500,000(P/F, 5%,
45)
+ $500,000(P/F, 5%,
60)
Park
:
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 Alternate Way to Calculate P3

o Concept: Find the

Effective interest rate
effective interest rate for a 15-year period
per payment period.
o Interest rate: Find the
effective interest rate
for a 15-year cycle. 0 15 30 45 60

i = (1 + 0.05)15 − 1
= 107.893%
$500,000 $500,000 $500,000 $500,000
o Capitalized equivalent
worth
P3 = $500,000/1.0789
= $463,423
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 Comparing Mutually Exclusive
Projects: Basic Terminologies

Mutually
Exclusive Projects

Alternative vs.
Project

Do-Nothing
Alternative

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 Revenue Versus Service Projects

Revenue Projects Service Projects

o Project revenues o Project revenues do not
depend on the choice depend on the choice
of alternatives of alternatives
o Revenue and cost o Fixed (or constant)
streams vary with the revenues for all
choice of alternatives alternatives

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Analysis Period Versus Required Service Period

Analysis Period Required Service Period

• The time span over • The time span over
which the economic which the service of
effects of an investment equipment (or
will be evaluated (study investment) will be
period or planning needed
horizon)

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Road Map: A Process of Making a Choice Among
Mutually Exclusive Alternatives

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Comparing Mutually Exclusive Projects

 Principle: Projects must be compared over an

equal time span.

 Rule of Thumb: If the required service period is

given, the analysis period should be the same as
the required service period.

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Analysis Period Implied in Comparing Mutually
Exclusive Alternatives

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 Summary
• Present worth is an equivalence method of analysis in
which a project’s cash flows are discounted to a lump
sum amount at the present time.
• The MARR, or minimum attractive rate of return, is the
interest rate at which a firm can always earn or borrow
money.
• MARR is generally dictated by management and is the
rate at which NPW analysis should be conducted.
• Two measures of investment, the net future worth and
the capitalized equivalent worth, are variations of the
NPW criterion.

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 • The term mutually exclusive means that when one of
several alternatives that meet the same need is selected,
the others will be rejected.
• Revenue projects are those for which the income
generated depends on the choice of project.
• Service projects are those for which income remains the
same, regardless of which project is selected.
• The analysis period (study period) is the time span over
which the economic effects of an investment will be
evaluated.

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• The required service period is the time span over which the service
of equipment (or investment) will be needed.
• The analysis period should be chosen to cover the required service
period.
• When not specified by management or company policy, the analysis
period to use in a comparison of mutually exclusive projects may be
chosen by the individual analyst.

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 Annual Worth Analysis
Principle: Measure an • Annual Equivalent
investment’s worth on Conversion
an annual basis.
Benefits: By knowing
the annual equivalent
worth, we can:
oSeek consistency of
report format.
oDetermine the unit
cost (or unit profit).
oFacilitate the unequal
project life comparison.

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 Fundamental Decision Rules
For Single Project:
For Mutually Exclusive Alternatives:

• If AE(i) > 0, accept the investment. • Service projects: Select the

alternative with the minimum
• If AE(i) = 0, remain indifferent to annual equivalent cost (AEC).
the investment.
• Revenue projects: Select the
• If AE(i) < 0, reject the investment. alternative with the maximum
AE(i).

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 Example 6.1: Economics of Installing a
Feed-water Heater
• Install a 150MW unit
• Initial cost = $1,650,000
• Service life = 25 years
• Salvage value = 0
• Expected improvement in fuel efficiency = 1%
• Fuel cost = $0.05kWh
• Load factor = 85%
• Determine the annual worth for installing the unit at
i = 12%.
• If the fuel cost increases at the annual rate of 4%, what is AE(12%)?

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Solution: Calculation of Annual Fuel Savings
• Required input power before
adding the second unit

150,000kW
272,727kW Annual Fuel
0.55
• Required input power after
Savings
adding the second unit
Afuel savings (reduction in fuel requirement) (fuel cost)
150,000kW :
267,857kW (operating hours per year)
0.56
• Reduction in energy
consumption . =(4,870kW) ($0.05/kWh)
272,727kW − 7,446 hours/year 
267,857kW =
4,870 kW =$1,813,101/year
• Annual operating hours
Operating hours = (365)(24)(0.85)
=7,446 hours/year

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 Solution: Annual Worth Calculations
 (a) with constant fuel price • Cash Flow Diagrams
PW(12%)  $1,650,000  $1,813,101(P / A,12%,25)
$12,570,403
AE(12%) $12,573,321(A / P ,12%,25)
$1,602,726

 (b) with escalating fuel price

A1 =$1,813,101
PW (12%)  $1,650,000  $1,813,101(P / A1 ,4%,12%,25)
$17,459,783
AE(12%) $17,459,783(A / P ,12%,25)
$2,226,122

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 Analysis Period

• We must consider two situations:

1. The analysis period equals project lives
2. The analysis period differs from project lives
• When analysis period equals project lives, we compute AE (for revenue projects) or AEC (for
service projects) for each project and select the project with the largest AE for revenue (or
the least AEC for service projects).
• When the analysis period differs from project lives, we need to consider the issue of unequal
project lives.
• For the special situation of an indefinite service period and replacement with identical projects, we can
avoid this complication by the use of AE analysis, provided that the following criteria are met.
1. The service of the selected alternative is required on a continuous basis.
2. Each alternative will be replaced by an identical asset that has the same costs and performance.
• When these criteria are met, we may solve for the AE of each project on the basis of its initial life span,
rather than on that of the lowest common multiple of the projects’ lives.

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 Repeating Cash Flow Cycles

• First Cycle

PW(12%)  $1,000,000
[($800,000  $100,000(A G ,12%,4)](P A ,12%,4)
 $1,000,000  $2,017,150.
$1,017,150.

• Repeating Cycles
AE 12%  = $1,017,150  A P , 12%, 4 
= $334,880.

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 Solution
• Required assumptions
• The service life of the selected alternative is required on a
continuous basis.
• Each alternative will be replaced by an identical asset that has the
same costs and performance.
• Model A
PW 15%  =  $22,601
AEC 15%  = $22,601  A P , 15%, 3 
= $9,899.
• Model B
PW 15%  =  $25,562
AEC 15%  = $25,562  A P , 15%, 4 
= $8,954.

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 Annual Equivalent Cost (AEC)
When only costs are
involved, the AE method is

Equivalent Costs
called the annual Capit
equivalent cost (AEC). al
Revenues must cover two costs
+
kinds of costs: operating

Annual
Operati
costs and capital costs.
ng
costs

Annual equivalent cost = Capital cost + Operating costs

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 Capital (Ownership) Cost
• Def: Owning equipment
associated with two S
transactions—(1) its initial 0
cost (I), and (2) its salvage N
value (S).
• Capital costs: Taking these
items into consideration, we I
calculate the capital costs as:
0 1 2 3 N
CR(i) I(A / P , i , N)  S(A / F , i , N)
CR(i)
(I  S)(A / P , i , N)  iS
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 Example 6.4: Required Annual Revenue
• Cost of Owning and Operating
 Given: Capital cost $4,000
o I = $20,000
0
o S = $4,000 1 2 3 4 5
o N = 5 years
o i = 10%
$20,000
Find: See if an annual +
revenue of $5,000 is large
enough to cover both the 0 1 2 3 4 5

capital and operating costs.

$500
.
Operating cost

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 Solution

Need additional revenue in the amount of $120.76 to

justify the investment

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 Benefits of AE Analysis

1. Consistency of report formats. Financial managers commonly work with annual rather
than overall costs in any number of internal and external reports. Engineering managers
may be required to submit project analyses on an annual basis for consistency and ease of
use by other members of corporation and stockholders.
2. Need for unit costs or profits. In many situations, projects must be broken into unit costs
(or profits) for ease of comparison with alternatives. Make-or-buy and reimbursement
analyses are key examples.
3. Life-cycle cost analyses. When there is no need for estimating the revenue stream for a
proposed project, we can consider only the cost streams of the project. In that cause, it is
common to convert this life-cycle cost (LCC) into an equivalent annual cost for the
purposes of comparison. Industry has used the LCC to help determine which design option
will cost less over the life of a product. LCC analysis has had a long tradition with the
Department of Defense, having been applied to virtually every new weapon system
proposed or under development.

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Where to Apply the AE Analysis
• Unit cost (or profit)
calculation
• Outsourcing (make-
buy) decision
• Pricing the use of an
asset

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 Unit Cost (Profit) Calculation
• Step 1: Determine the number of units (annual volume) to be
produced (or serviced) each year over the life of the asset.
• Step 2: Determine the annual equivalent cost (or worth) of owning
and operating the asset.
• Step 3: Divide the equivalent cost (worth) by the annual volume.

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Example 6.5: Unit Profit per Machine Hour When Annual Operating
Hours Remain Constant

Project Cash Flows and Operating

Hours

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 Solution
• Step 1: Determine the annual volume. • Project Cash Flows and Operating
• 3,000 hours per year Hours
• Step 2: Obtain the equivalent annual worth.
• PW (12%) = $30,065 $35,560 $37,360
$31,850 $34,400
• AE (12%) = $30,065 (A/P, 12%, 4)
= $9,898 0

• Step 3: Determine the unit profit (savings per 1 2 3 4

machine hour).
Savings per machine hour
$76,000
= $9,898/3,000
= $3.30/hour Year • 3,000 Year • 3,000 Year • 3,000 Year • 3,000
1 • hours 2 • hours 3 • hours 4 • hours

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 Example 6.6: Unit Profit per Machine Hour When
Annual Operating Hours Fluctuate

$35,560 $37,360 $34,400

$31,850

0
1 2 3 4

$76,000

Year • 3,500 Year • 4,000 Year • 1,700 Year • 2,800

1 • hours 2 • hours 3 • hours 4 • hours

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 Solution
• Step 1: Determine the annual
volume.  Step 3: Determine the unit profit
• Year 1: 3,500 hours (savings per machine hour)
• Year 2: 4,000 hours C = $9,898/3,062.95
• Year 3: 1,700 hours = $3.23/hour
• Year 4: 2,800 hours
• Step 2: Obtain the equivalent
annual worth.
AE (12%) = $30,065 (A/P, 12%, 4) = $9,898

C[(3,500)(P/F,12%,1) +
(4,000)(P/F,12%,2) + (1,700)(P/F,12%,3) +
(2,800)(P/F,12%,4)] x (A/P,12%,4) =
3,062.95C

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 Make or Buy Decision
• Step 1: Determine the time span (planning horizon)
for which the part (or product) will be needed.
• Step 2: Determine the annual volume of the part (or
product).
• Step 3: Obtain the unit cost of purchasing the part (or
product) from an outside firm.
• Step 4: Determine the equipment, manpower, and all
other resources required to make the part (or
product).

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• Step 5: Estimate the net cash flows associated with
the “make” option over the planning horizon.
• Step 6: Compute the annual equivalent cost of
producing the part (or product).
• Step 7: Compute the unit cost of making the part
(or product) by dividing the annual equivalent cost
by the required annual volume.
• Step 8: Choose the option with the minimum unit
cost.

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Example 6.7: Outsourcing Production of Electric
Compressors
Investment and Other Financial Date
Related to Outsourcing
• Electric compressor: $42 per unit
• Required investment: $325,000
• Salvage value: $60,000
• Service life: 7 years
• Annual maintenance cost: $120,000
• MARR: 18%

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 Solution

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 Pricing the Use of an Asset
• The cost per square foot for owning and operating a real property
(example, user fee)
• The cost of using a private car for business (cost per mile)
• The cost of flying a private jet (cost per seat)
• The cost of using a parking deck (cost per hour)

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Example 6.8: Pricing an Apartment Rental Fee

Investment Problem: Building a 50-unit apartment complex

o Land investment cost = $1,000,000
o Building investment cost = $2,500,000
o Annual upkeep cost = $150,000
o Property taxes and insurance = 5% of
total
investment
o Occupancy rate = 85%
o Study period = 25 years
o Salvage value = Only land cost can be
recovered in full
o Interest rate = 15%
 At Issue: How to price the monthly rental per unit?

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 Solution
• Ownership cost CR(15%) ($3,500,000  $100,000)(A / P ,155,25)
($100,000)(0.15)
$401,749
• Annual O&M Cost O&M cost = (0.05)($3,500,000) + $150,000
= $325,000

• Total Equivalent Annual Cost AEC(15%) $401,749  $325,000

$726.749

• Required Monthly Charge $726,749

Required monthly charge =
(12 50)(0.85)
$1,425
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 Why Life-Cycle Cost (LCC) Analysis?

Why? Fundamental Principle

• To select from among • When comparing different
design alternatives that design alternatives, we
fulfill the same need to consider both non-
performance requirements, recurring as well as
but differ with respect to recurring costs over the life
initial and operating costs span of each design
• To predict the most cost- alternative.
effective solution

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 Stages of Life-Cycle Cost

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 Example 6.10: Pumping System with a
Problem Valve
Decision Problem:
Fixing a pumping system
with a faulty valve. Sketch of a Pumping
Design options: System
in Which the Control
o Option A: Buy a new Valve Fails
control valve.
o Option B: Trim the
pump impeller to
reduce the pressure.
o Option C: Install a
variable-frequency
drive (VFD).
o Option D: Repair the
valve as needed.

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 Engineering Solution Alternatives
• Option A: A new control valve can be installed to
accommodate the high pressure differential.
• Option B: The pump impeller can be trimmed so that the
pump does not develop as much head, resulting in a
lower pressure drop across the current valve.
• Option C: A variable frequency drive (VFD) can be
installed, and the flow control valve removed. The VFD
can vary the pump speed and thus achieve the desired
process flow.
• Option D: The system can be left as it is, with a yearly
repair of the flow control valve to be expected.

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 Life-Cycle Cost Elements

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Cost Comparison for Options A–D

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Comparison of LCC for Options A–D

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 Minimum Cost Analysis
 Concept: Total cost is given in terms of a specific
design parameter.
 Goal: Find the optimal design parameter that
will minimize the total cost.
 Typical Mathematical Equation
c
AE(i) a  bx 
x
where x is the common design parameter
 Analytical Solution
* c
x 
b
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 Typical Graphical Relationship

Total Cost
Capital Cost
($)
Cost

O&M Cost

Design Parameter (x)

Optimal Value (x*)

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 Example 6.11: Optimal Cross-Sectional
Area
Decision Problem: A constant • Power Transmission
electric current of 5,000 amps
is to be transmitted a distance
of 1,000 feet from a power
station to a substation.
Find: The optimal size of a
Power
copper conductor Substation
Relevant Physical and Plant
Financial Data:
•Copper price: $8.25/lb
•Resistance:
0.8145x10-5Ωin2/ft
•Cost of energy: $0.05/kWh 1,000 ft.
•Density of copper: 555 lb/ft 5,000
•Useful life: 25 years amps
•Salvage value: $0.75/lb 24 hours
365 days Cross-sectional
•Interest rate: 9%
area
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 Operating Cost (Energy Loss)
• Energy loss in kilowatt-hours (L)
I = current flow in
I 2R
L T
amperes
1000 A R = resistance in ohms
T = number of
operating hours
50002 (0.008145)
L (24
A= 365)
cross-sectional
1000 A
area
1,783,755
 kWh
A
1,783,755
Energy loss cost  kWh($0.05)
A
$89,188
=
A

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 Material Costs
• Material weight in pounds

1000(12)(555)A
3
3,854 A
12
• Material cost (required
investment)
Total material cost =
3,854A($8.25)
=
31,797A
Park • Salvage value after 25 years:
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 Capital Recovery Cost
Given:
Initial cost = 2,890.6 A
$31,797A 0
Salvage value =
$2,890.6A 25
Project life = 25 31,797 A
years
Interest rate = 9%

CR(9%) = (31,797 A - 2,890.6 A) (A/P , 9%, 25)

Find: CR(9%)
+ 2,890.6 A (0.09)
= 3,203 A

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 Total Equivalent Annual Cost
• Total equivalent annual cost
AEC = Capital cost + Operating cost
= Material cost + Energy loss
• Find the minimum annual equivalent cost
89,188
AEC(9%) 3, 203 A 
A
dAEC(9%) 89,188
3, 203 
dA A2
0
89,188
A* 
3, 203
5.276 in 2

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 Optimal Cross-Sectional Area

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 Summary
• Annual equivalent worth analysis, or AE, is—along with present
worth analysis—one of two main analysis techniques based on
the concept of equivalence. The equation for AE is:
AE(i) = PW(i)(A/P, i, N)
• AE analysis yields the same decision result as PW analysis.
• The capital recovery cost factor, or CR(i), is one of the most
important applications of AE analysis in that it allows managers
to calculate an annual equivalent cost of capital for ease of
itemization with annual operating costs.
• The equation for CR(i) is:
CR(i)= (I − S)(A/P, i, N) + iS
• where I = initial cost and S = salvage value.

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 • AE analysis is recommended over NPW analysis in many
key real-world situations for the following reasons:
1. In many financial reports, an annual equivalent value is
preferred to a present worth value.
2. Unit costs often must be calculated to determine reasonable
pricing for items that are on sale.
3. Calculation of cost per unit of use is required to reimburse
employees for business use of personal cars.
4. Make-or-buy decisions usually require the development of
unit costs for the various alternatives.
5. Minimum cost analysis is easy to do when based on annual
equivalent worth.

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 Assignment #3
• Due Tuesday 26Sept22
• Problems:
• 5.5, 5.10, 5.27
• 6.3, 6.15, 6.42, 6.48

• For all problems draw cash flow diagrams prior to attempting the
problem. Consider providing sketches of other relevant components.
• Hint: Cash flow diagrams help to express patterns accurately.