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BAKR FAHAD AL-HAJRI

Senior Project Engineer


Saudi Aramco Company
Mobile: 054-241-9000
e-mail: bakr.ags@gmail.com
Bakr holds BS and MEG degrees in Architectural Engineering from KFUPM. He is accredited by the
Saudi Council of Engineers as a Consultant Engineer (CE-SCE). Also, Bakr is a Project Management
Professional (PMP), a Certified Cost Engineer (CCE) and an Associate Value Specialist (AVS).
Bakr has more than 33 years of professional experience in areas of engineering and project
management. Since 1983, he has been an Architect, Engineering Office Manager, Project Engineer,
Lead Project Engineer and Senior Project Engineer. He worked with Zamil & Turbag / Brown & Root,
Saudi Arabian Bechtel Company, Bakr Al-Hajri Engineering, Saudi Consulting Services and Saudi
Chevron Phillips Company. Currently Bakr is working as a Senior Project Engineer in Community and
Industrial Projects Division, Saudi Aramco, responsible for Project Management of Plants Infrastructure
Projects.
Bakr is an active member of AACEI-Arabian Gulf Section and served the association as Director of
Public Relations (2007-08), Vice President Technical (2008-09), President (2009-10) and currently he is
a member of the current AACEI-AGS Board . In addition, Bakr is a photographer and a writer.

Prepared, Compiled & Presented by


Bakr Fahad Al-Hajri, CE-SCE PMP CCP AVS
November 2013 Revision

Outline
Objectives /Introduction /Symbols
Equivalence & Conventions
Interest
Discount Factors
Equivalent Worth
Cash Flow Analysis
Multiple Alternatives
Incremental Analysis
Tax Consideration

Objectives
Equivalence &
Conventions

Interest

Discount
Factors

Equivalent
Worth

Cash Flow
Analysis

Multiple
Alternatives

Incremental
Analysis

Tax
Considerations

Calculate simple and compounded interest rates and solve interest


problems using basic single payments, uniform series, and gradient
formulas.
Calculate present value, future value, and equivalent uniform annual
value of cash flow series.
Determine the discounted rate of return of a cash flow series.
Evaluate and select the best alternative using present value, future
value, equivalent uniform annual value and discounted rate of return.
Compare alternatives using the benefit-cost ratio.

20 March 2015

Economic Analysis

Introduction
Equivalence &
Conventions

Interest

Discount
Factors

Equivalent
Worth

Cash Flow
Analysis

Multiple
Alternatives

Engineers are confronted with two


important interconnected
environments, the physical and the
economics.
Select from among multiple
alternatives.

Alternative
2

Need arises to quantify alternatives


objectively and equate them in some
numerical value such as money.

Incremental
Analysis

Tax
Considerations

Alternative
1

Alternative
3

Economic selection criteria will be


either:

Maximization of benefit.
Minimization of cost.
or Maximization of the net profit.

20 March 2015

Economic Analysis

Symbols
Equivalence &
Conventions

Discount
Factors

Interest

Cash Flow
Analysis

Annual amount or Annuity

Benefits or income

Cost or expenses

The base of natural logarithms ( 2.71828)

EOY

Equivalent uniform annual benefits

EUAC

Equivalent uniform annual cost

EUAW

Equivalent uniform annual worth

Future value

Uniform or arithmetic gradient amount

Interest rate per period

Number of compounding periods per year

Incremental
Analysis

Tax
Considerations

Minimum attractive rate of return

Total number of compounding period, or life of assets

Present value

Nominal annual interest rate

ROR

Multiple
Alternatives

End-of-year, usually followed by a number indicating which year

EUAB

MARR

20 March 2015

Equivalent
Worth

Rate of return

Sn

Expected salvage value at end of year n

Effective interest rate (r/k)

Economic Analysis

Equivalence & Convention

Equivalence
Equivalence &
Conventions

Interest

Discount
Factors

Equivalent
Worth

Cash Flow
Analysis

Multiple
Alternatives

Incremental
Analysis

Tax
Considerations

An essential concept in engineering economic analysis is that of


equivalence or the ability to compare cash flows at different points in
time. Equivalence is based on the time value of money, and the
cardinal rule is that two cash flows or alternatives only can be
compared at a common interest rate.
The model used for engineering economic analysis is based on the
conversion of an existing cash flow to an equivalent cash flow at a
particular interest rate through the application of predefined factors.
The conversion factors are called discount factors and are readily
available in either algebraic form or in tables.

20 March 2015

Economic Analysis

Conventions
Equivalence &
Conventions

Interest

Discount
Factors

Equivalent
Worth

Cash Flow
Analysis

Multiple
Alternatives

Incremental
Analysis

Tax
Considerations

Cash Flow Representation


Cash flow occurs whenever cash or something of monetary value flows from
one party to another.
It can be either cash flow in, for example cash receipts, or when payments or
disbursements are made, which is a cash flow out.
It can be shown in tabular format or cash flow diagram.

20 March 2015

Economic Analysis

10

Conventions
Equivalence &
Conventions

Interest

Discount
Factors

Equivalent
Worth

Cash Flow
Analysis

Multiple
Alternatives

Incremental
Analysis

Tax
Considerations

Salvage Value
Residual value resulting in income at the end of the useful life of an alternative.
The resale or salvage value may be associated with the anticipated market value
of the asset at that point in time.
It is shown as an upward arrow on the cash flow diagram.
Any significant costs associated with disposal at the end of useful life also can be
shown on the diagram as a downward arrow.

20 March 2015

Economic Analysis

11

Conventions
Equivalence &
Conventions

Interest

Discount
Factors

Equivalent
Worth

Cash Flow
Analysis

Multiple
Alternatives

Incremental
Analysis

Tax
Considerations

Example:
An investor bought an equipment and paid an advance payment of $ 20,000.
He is required to pay annual operation cost of $ 500 at the end of each year.
He is required to pay maintenance cost of $0, $100, $200, $300, and $400 at
the end year 1, 2, 3, 4 and 5 respectively.
He is expecting a revenue of $5,000 at the end of each year from renting the
equipment to outside users.
At the end of the fifth year he is planning to sell it for $10,000.

20 March 2015

Economic Analysis

12

Conventions
Equivalence &
Conventions

Discount
Factors

Interest

YEAR

20 March 2015

Equivalent
Worth

Cash Flow
Analysis

Multiple
Alternatives

INCOME

Incremental
Analysis

EXPENSE

$20,000

$5,000

$500

$5,000

$600

$5,000

$700

$5,000

$800

$15,000

$900

Economic Analysis

Tax
Considerations

13

Conventions
Equivalence &
Conventions

Discount
Factors

Interest

Equivalent
Worth

Cash Flow
Analysis

Multiple
Alternatives

Incremental
Analysis

Tax
Considerations

CASH IN : INCOME/ BENEFITS / RECEIPTS / SALVAGE

$15,000
$5,000

Time Line

$5,000

2
$500

$5,000

3
$600

$5,000

$700

$800

Time Line

$900

$20,000
CASH OUT : COST / EXPENDITURE / DISBURESMENTS
20 March 2015

Economic Analysis

14

Conventions
Equivalence &
Conventions

Discount
Factors

Interest

Equivalent
Worth

Cash Flow
Analysis

Multiple
Alternatives

Incremental
Analysis

Tax
Considerations

CASH IN : INCOME/ BENEFITS / RECEIPTS / SALVAGE


$10,000
$5,000

Time Line

$5,000

2
$500

$5,000

3
$500
$100

$5,000

4
$500
$200

$5,000

5
$500
$300

Time Line
$500

$400

$20,000
CASH OUT : COST / EXPENDITURE / DISBURESMENTS
20 March 2015

Economic Analysis

15

Conventions
Equivalence &
Conventions

Discount
Factors

Interest

Equivalent
Worth

Cash Flow
Analysis

Multiple
Alternatives

Incremental
Analysis

Tax
Considerations

CASH IN : INCOME/ BENEFITS / RECEIPTS / SALVAGE

S = $10,000
A = $5,000

Time Line

Time Line

A = $500
G = $100
$20,000
CASH OUT : COST / EXPENDITURE / DISBURESMENTS
20 March 2015

Economic Analysis

16

Interest

Interest
Equivalence &
Conventions

Interest

Discount
Factors

Equivalent
Worth

Cash Flow
Analysis

Multiple
Alternatives

Incremental
Analysis

Tax
Considerations

Time Value of Money


There is usually a cost associated with the use of the money. Since money is a
valuable asset, people are willing to pay to have it available for their immediate
use. With money, the charge for its use is called interest.

Interest Types:

Simple Interest
Compound Interest
Nominal Interest Rate
Effective Interest Rate
Continuous Compounding
Minimum Attractive Rate of Return (MARR)

20 March 2015

Economic Analysis

18

Interest
Equivalence &
Conventions

Interest

Discount
Factors

Equivalent
Worth

Cash Flow
Analysis

Multiple
Alternatives

Incremental
Analysis

Tax
Considerations

Simple Interest
The interest due is proportional to the length of time the principal is
outstanding and does not accrue or compound on previous interest. Each
subsequent interest payment is calculated based on the total principal, ignoring
accumulated interest to date.
SIMPLE INTEREST (i = 10%)

20 March 2015

Principal

$1,000

Interest accrued EOY1

$100

Interest accrued EOY2

$100

Total at EOY2

$1,200

Economic Analysis

19

Interest
Equivalence &
Conventions

Interest

Discount
Factors

Equivalent
Worth

Cash Flow
Analysis

Multiple
Alternatives

Incremental
Analysis

Tax
Considerations

Compound Interest
The interest is considered an increased increment of principal earning
additional interest with time. Each subsequent interest payment is calculated
based on total principal plus accumulated interest to date.
COMPOUND INTEREST (i = 10%)
Principal

$1,000

Interest accrued EOY1

$100

New principal with accrued interest $1,100

20 March 2015

Interest accrued EOY2

$110

Total at EOY2

$1,210

Economic Analysis

20

Interest
Equivalence &
Conventions

Interest

Discount
Factors

Equivalent
Worth

Cash Flow
Analysis

Multiple
Alternatives

Incremental
Analysis

Tax
Considerations

Nominal Interest Rate


The annual interest rate, r, disregarding the effects of compounding periods
that are more frequent than annually.
Common practice is to express interest rates at the nominal rate even though
there is compounding such as quarterly, monthly, or daily.
The nominal rate, r, is not the same as the annual rate, i, except in the case of
annual compounding.

20 March 2015

Economic Analysis

21

Interest
Equivalence &
Conventions

Discount
Factors

Interest

Equivalent
Worth

Cash Flow
Analysis

Multiple
Alternatives

Incremental
Analysis

Tax
Considerations

Effective Interest Rate


If the effective interest rate per period, , is given, it can be converted easily to
the effective annual interest rate, i, which includes the effects of compounding
over k periods per year.
In general, it can be assumed that the rate given in a problem is annual unless
stated otherwise. If compounding is annual, the rate given is the effective rate.
If compounding is anything other than annual, the rate given is the nominal
rate.

k
= ( 1 + r/k)

i
20 March 2015

- 1

k
= ( 1 + ) -

(equation 27.1)
(equation 27.2)

Economic Analysis

22

Interest
Equivalence &
Conventions

Interest

Discount
Factors

Equivalent
Worth

Cash Flow
Analysis

Multiple
Alternatives

Incremental
Analysis

Tax
Considerations

Q1: If a monthly interest rate is compounded to yield an effective 12%


annual rate of return, then that monthly interest rate must be:
a.
b.
c.
d.

More than 1%
Equal to1%
Less than 1%
None of the above is correct

A1: C, The monthly interest rate must be less than 1. Were it 1% per
month and not compounded at all, then the annual return would be 12 X
1% = 12%, which the stated effective rate. But the monthly rate is
compounded in this case, so the annual rate would exceed 12%, if the
monthly rate were 1%. Since the effective annual rate is 12%, not more,
then the compounded monthly rate must be less than 1%.
20 March 2015

Economic Analysis

23

Interest
Equivalence &
Conventions

Discount
Factors

Interest

Equivalent
Worth

Cash Flow
Analysis

Multiple
Alternatives

Incremental
Analysis

Tax
Considerations

Q2: Given the interest rate of 12%, find the effective and annual rate for
yearly, semi annual, and monthly compounding.
A2:

i = (1 +

k
)

1 where = r/k

The nominal rate (r) = 12%


For yearly compounding:
k = 1 & = 0.12/1 = 0.12
1
i = (1 + 0.12) -1 = 1.120 1 = 12%
For semi-annual compounding:
k = 2 & = 0.12/2 = 0.06
2
i = (1 + 0.06) -1 = 1.124 1 = 12.4%
For monthly compounding:
k = 12 & = 0.12/12 = 0.01
12
i = (1 + 0.01) -1 = 1.127 1 = 12.7%
20 March 2015

Economic Analysis

24

Interest
Equivalence &
Conventions

Discount
Factors

Interest

Equivalent
Worth

Cash Flow
Analysis

Multiple
Alternatives

Incremental
Analysis

Tax
Considerations

Continuous Compounding
Discrete compounding occurs when interest payments are made at the end of
finite compounding periods such as annually, monthly, quarterly, or daily.
As the duration of the interest period becomes infinitely short, the number of
compounding periods per year becomes infinite and is referred to as
continuous compounding.

20 March 2015

r
= e

- 1

(equation 27.3)

Economic Analysis

25

Interest
Equivalence &
Conventions

Interest

Discount
Factors

Equivalent
Worth

Cash Flow
Analysis

Multiple
Alternatives

Incremental
Analysis

Tax
Considerations

Minimum Attractive Rate of Return (MARR)


The interest rate used in feasibility studies is often called the minimum
attractive rate of return, or MARR. This represents the minimum rate of return
at which the owner is willing to invest.
The selection of a suitable rate of return can be quite complex and could vary
from problem to problem. Simply stated, it involves the analysis and selection
of the highest one of the following:

Cost of borrowed money from banks, insurance companies, etc.


Cost of capital or the composite value for the capital structure of the firm
Opportunity cost or the rate-of-return of the best project that is rejected

When there is risk or uncertainty in a project, a commonly used method is to


increase the MARR, thus diminishing the effect of future costs and benefits.

20 March 2015

Economic Analysis

26

Discount Factors

Discount Factors
Equivalence &
Conventions

Interest

FACTOR
Single Payment
Compound Amount
Single Payment
Present Worth
Uniform series
Sinking Fund
Uniform Series
Capital Recovery
Uniform Series
Compound Amount
Uniform Series
Present worth
Arithmetic Gradient
Uniform Series
Arithmetic Gradient
Present Worth
20 March 2015

Discount
Factors

CONVERT
S

P to F
F to P
F to A
P to A
A to F
A to P
G to A
G to P

Equivalent
Worth

Cash Flow
Analysis

Multiple
Alternatives

NOTATION

(F/P, i, n)
(P/F, i, n)

(1 +

n
i)

(1 +

-n
i)
n
i)

i / ( (1 +

(A/P, i, n)

i (1 +

n
i)

/ ( (1 +

( (1 +

n
i)

1) / i

( (1 +

n
i)

(P/A, i, n)

Tax
Considerations

FORMULA

(A/F, i, n)

(F/A, i, n)

Incremental
Analysis

1)
n
i)

1)

1)/ ( i (1 +

(A/G, i, n)

( 1 / i) ( n / ((1

n
+i)

(P/G, i, n)

n
i)

2
i

( ( (1 +

Economic Analysis

n
i)

1)

1)/ ( (1 +

n
i)

) ) ( n / ( i (1 +

n
i)
28

Discount Factors
Equivalence &
Conventions

Interest

Discount
Factors

Equivalent
Worth

Cash Flow
Analysis

Multiple
Alternatives

Incremental
Analysis

Tax
Considerations

Discrete Compound Interest Table with i = 5%


n

F/P

P/F

A/F

A/P

F/A

P/A

A/G

P/G

1.0500

0.9524

1.0000

1.0500

1.0000

0.9524

0.0000

0.0000

1.1025

0.9070

0.4878

0.5378

2.0500

1.8594

0.4878

0.9070

1.1576

0.8638

0.3172

0.3672

3.1525

2.7232

0.9675

2.6347

1.2155

0.8227

0.2320

0.2820

4.3101

3.5460

1.4391

5.1028

1.2763

0.7835

0.1810

0.2310

5.5256

4.3295

1.9025

8.2369

1.3401

0.7462

0.1470

0.1970

6.8019

5.0757

2.3579

11.9680

1.4071

0.7107

0.1228

0.1728

8.1420

5.7864

2.8052

16.2321

1.4775

0.6768

0.1047

0.1547

9.5491

6.4632

3.2445

20.9700

1.5513

0.6446

0.0907

0.1407

11.0266

7.1078

3.6758

26.1268

10

1.6289

0.6139

0.0795

0.1295

12.5779

7.7217

4.0991

31.6520

20 March 2015

Economic Analysis

29

Discount Factors
Equivalence &
Conventions

Interest

Discount
Factors

Equivalent
Worth

Cash Flow
Analysis

Multiple
Alternatives

Incremental
Analysis

Tax
Considerations

Discrete Compound Interest Table with i = 6%


n

F/P

P/F

A/F

A/P

F/A

P/A

A/G

P/G

1.0600

0.9434

1.0000

1.0600

1.0000

0.9434

0.0000

0.0000

1.1236

0.8900

0.4854

0.5454

2.0600

1.8334

0.4854

0.8900

1.1910

0.8396

0.3141

0.3741

3.1836

2.6730

0.9612

2.5692

1.2625

0.7921

0.2286

0.2886

4.3746

3.4651

1.4272

4.9455

1.3382

0.7473

0.1774

0.2374

5.6371

4.2124

1.8836

7.9345

1.4185

0.7050

0.1434

0.2034

6.9753

4.9173

2.3304

11.4594

1.5036

0.6651

0.1191

0.1791

8.3938

5.5824

2.7676

15.4497

1.5938

0.6274

0.1010

0.1610

9.8975

6.2098

3.1952

19.8416

1.6895

0.5919

0.0870

0.1470

11.4913

6.8017

3.6133

24.5768

10

1.7908

0.5584

0.0759

0.1359

13.1808

7.3601

4.0220

29.6023

20 March 2015

Economic Analysis

30

Discount Factors
Equivalence &
Conventions

Interest

Discount
Factors

Equivalent
Worth

Cash Flow
Analysis

Multiple
Alternatives

Incremental
Analysis

Tax
Considerations

The functional notation illustrates a standardized notation that


simplifies the calculation and permits the use of tabulated factors.
The notation is in the form (X/Y, i, n) which can be read as to find
the equivalent amount X given amount Y, interest rate i, and the
number of discounting or compounding periods n.

20 March 2015

Economic Analysis

31

Discount Factors
Equivalence &
Conventions

Discount
Factors

Interest

Equivalent
Worth

Cash Flow
Analysis

Multiple
Alternatives

Incremental
Analysis

Tax
Considerations

The functional notation illustrates a standardized notation that


simplifies the calculation and permits the use of tabulated factors.
The notation is in the form (X/Y, i, n) which can be read as to find
the equivalent amount X given amount Y, interest rate i, and the
number of discounting or compounding periods n.
EOY

20 March 2015

Time Line

$1,000 (F/P ,5% ,5)

F = $1,000 X 1.2763 = $1,276

P = $1,276 X 0.7835 = $1,000

$1,276 (P/F ,5% ,5)

Economic Analysis

32

Equivalent Worth

Equivalent Worth
Equivalence &
Conventions

Interest

Discount
Factors

Equivalent
Worth

Cash Flow
Analysis

Multiple
Alternatives

Incremental
Analysis

Tax
Considerations

In most types of engineering economic problems, the primary


calculation is determining the present worth or equivalent uniform
annual cost of a cash flow to provide a basis for analysis.
Present Worth: The present worth of a cash flow can be compared given a
lump-sum future value, a uniform series, or an arithmetic gradient series.
Future Worth : The future worth method uses the end of the planning
horizon as a reference point.
Annual Worth : The basis of this method is the conversion of all cash flows to
an equivalent uniform annual worth (EUAW).

20 March 2015

Economic Analysis

34

Equivalent Worth
Equivalence &
Conventions

Discount
Factors

Interest

Equivalent
Worth

Cash Flow
Analysis

Multiple
Alternatives

Incremental
Analysis

Tax
Considerations

A contractor is considering the acquisition of a piece of equipment


with anticipated financial impact as shown in the table below.

20 March 2015

YEAR

EXPENSE

INCOME

$38,000

$11,000

$1,000

$11,000

$2,000

$11,000

$3,000

$11,000

Economic Analysis

35

Equivalent Worth
Equivalence &
Conventions

Interest

Discount
Factors

Equivalent
Worth

Cash Flow
Analysis

Multiple
Alternatives

Incremental
Analysis

Tax
Considerations

If the contractors minimum attractive rate of return (MARR) is 6


percent, should the investment be made?
Use the Present worth.

By computing the present value of the net cash flow for each year.
By using the cash flow diagram.

Use the Future worth.

By computing the future value of the net cash flow for each year.
By using the cash flow diagram.

Use the Annual worth.

20 March 2015

By using the cash flow diagram.


By computing the Annual value of the net present value.
By computing the Annual value of the net future value.

Economic Analysis

36

Equivalent Worth
Equivalence &
Conventions

Interest

Discount
Factors

Equivalent
Worth

Cash Flow
Analysis

Multiple
Alternatives

Incremental
Analysis

Tax
Considerations

Cash Flow Table

20 March 2015

YEAR

EXPENSE

INCOME

NET

$38,000

($38,000)

$11,000

$11,000

$1,000

$11,000

$10,000

$2,000

$11,000

$9,000

$3,000

$11,000

$8,000

TOTALS

$44,000

$44,000

Economic Analysis

37

Equivalent Worth
Equivalence &
Conventions

Discount
Factors

Interest

Equivalent
Worth

Cash Flow
Analysis

Multiple
Alternatives

Incremental
Analysis

Tax
Considerations

Cash Flow Diagram


A = $11,000

EOY

Time Line

G = $1,000
$38,000
20 March 2015

Economic Analysis

38

Equivalent Worth
Equivalence &
Conventions

Interest

Discount
Factors

Equivalent
Worth

Cash Flow
Analysis

Multiple
Alternatives

Incremental
Analysis

Tax
Considerations

Present Worth Calculations Using Annual Net Present Worth


YEAR

EXPENSE

INCOME

NET

$38,000

FACTOR

PW

($38,000)

1.0000

($38,000)

$11,000

$11,000

F (P/F, 6%, 1)

0.9434

$10,377

$1,000

$11,000

$10,000

F (P/F, 6%, 2)

0.8900

$8,900

$2,000

$11,000

$9,000

F (P/F, 6%, 3)

0.8396

$7,556

$3,000

$11,000

$8,000

F (P/F, 6%, 4)

0.7921

$6,337

TOTALS

$44,000

$44,000

20 March 2015

NOTATION

Economic Analysis

($4,829)

39

Equivalent Worth
Equivalence &
Conventions

Interest

Discount
Factors

Equivalent
Worth

Cash Flow
Analysis

Multiple
Alternatives

Incremental
Analysis

Tax
Considerations

Present Worth Calculations Using Cash Flow Diagram


P
P0
P1
P2
TOTALS

20 March 2015

NET

NOTATION

FACTOR

PW

1.0000

($38,000)

($1,000) G (P/G, 6%, 4)

4.9455

($4,946)

$11,000 A (P/A, 6%, 4)

3.4651

$38,116

($38,000)

P = P0 + P1 + P2 =

Economic Analysis

($4,829)

40

Equivalent Worth
Equivalence &
Conventions

Interest

Discount
Factors

Equivalent
Worth

Cash Flow
Analysis

Multiple
Alternatives

Incremental
Analysis

Tax
Considerations

Future Worth Calculations Using Annual Net Future Worth


YEAR

EXPENSE

INCOME

$38,000

$11,000

$11,000

$1,000

$11,000

$2,000

4
TOTALS

20 March 2015

NET

NOTATION

FACTOR

($38,000) P (F/P, 6%, 4)

1.2625

($47,975)

P (F/P, 6%, 3)

1.1910

$13,101

$10,000

P (F/P, 6%, 2)

1.1236

$11,236

$11,000

$9,000

P (F/P, 6%, 1)

1.0600

$9,540

$3,000

$11,000

$8,000

1.0000

$8,000

$44,000

$44,000

Economic Analysis

FW

($6,098)

41

Equivalent Worth
Equivalence &
Conventions

Interest

Discount
Factors

Equivalent
Worth

Cash Flow
Analysis

Multiple
Alternatives

Incremental
Analysis

Tax
Considerations

Future Worth Calculations Using Cash Flow Diagram


F
F0
F1
F2

NET

FACTOR

FW

($38,000)

1.2625

($47,975)

($1,000)

4.9455 X 1.2625 = 6.2437

($6,244)

4.3746

$48,121

$11,000

NOTATION

G (P/G, 6%, 4) (F/P, 6%, 4)


A (F/A, 6%, 4)

TOTALS

20 March 2015

F = F0 + F1 + F2 =

Economic Analysis

($6,098)

42

Equivalent Worth
Equivalence &
Conventions

Interest

Discount
Factors

Equivalent
Worth

Cash Flow
Analysis

Multiple
Alternatives

Incremental
Analysis

Tax
Considerations

Annual Worth Calculations Using Cash Flow Diagram


A

NET

NOTATION

A0

($38,000)

P (A/P, 6%, 4)

0.2886

($10,967)

A1

($1,000)

G (A/G, 6%, 4)

1.4272

($1,427)

A2

$11,000

1.0000

$11,000

A = A0 + A1 + A2 =

($1,394)

TOTALS

20 March 2015

Economic Analysis

FACTOR

AW

43

Equivalent Worth
Equivalence &
Conventions

Discount
Factors

Interest

Equivalent
Worth

Cash Flow
Analysis

Multiple
Alternatives

Incremental
Analysis

Tax
Considerations

Annual Worth Calculations Using Present / Future Values


PW

NOTATION

($4,829) P (A/P, 6%, 4)

FW

NOTATION

($6,098) F (A/F, 6%, 4)

20 March 2015

FACTOR

AW

0.2886

($1,394)

FACTOR

AW

0.2286

($1,394)

Economic Analysis

44

Equivalent Worth
Equivalence &
Conventions

Discount
Factors

Interest

EOY

Equivalent
Worth

Cash Flow
Analysis

Multiple
Alternatives

Incremental
Analysis

Tax
Considerations

Time Line

A = $1,394
$4,829

20 March 2015

$6,098

Economic Analysis

45

Equivalent Worth
Equivalence &
Conventions

Interest

Discount
Factors

Equivalent
Worth

Cash Flow
Analysis

Multiple
Alternatives

Incremental
Analysis

Tax
Considerations

Q1: The following chart shows ending of period cash flows for expenses.
The interest rate is 10%:
YEAR

EXPENSE

$100

$100

$100

$100

$100

A1:

NPW

What is the net present worth (value) of this cash flow?


a.
b.
c.
d.

$500
$269
$316.99
$379.08

= $100 (P/A,10%,5)
= $100 (3.7908)
= $379.08

20 March 2015

Economic Analysis

46

Equivalent Worth
Equivalence &
Conventions

Discount
Factors

Interest

Equivalent
Worth

Cash Flow
Analysis

Multiple
Alternatives

Incremental
Analysis

Tax
Considerations

Q2:You are evaluating an alternative that requires an initial investment of


$50,000. The following chart shows ending of period cash flows of
annual savings. The interest rate is 10%.
YEAR

SAVINGS

$2,667

$14,292

$19,181

$13,114

A2:NPW

What is the net present worth (value) of this investment


alternative at end of year 4?
a.
b.
c.
d.

$746
$5,223
$9,296
$12,397

= -$50,000 + $2,667 (P/F,10%,1) + $14,292 (P/F,10%,2) + $19,181 (P/F,10%,3) + $13,114 (P/F,10%,4)


= -$50,000 + $2,667 ( 0.9091) + $14,292 (0.8264) + $ 19,181 (0.7513) + $13,114 ( 0.6830)
= -$50,000 + $2,424.57 + $11,810.91 + $14,410.69 + $8,956.86
= -$12,396.97

20 March 2015

Economic Analysis

47

Cash Flow Analysis

Cash Flow Analysis


Equivalence &
Conventions

Interest

Discount
Factors

Equivalent
Worth

Cash Flow
Analysis

Multiple
Alternatives

Incremental
Analysis

Tax
Considerations

There are two fundamental approaches to the analysis of a given cash


flow: equivalent worth, and rate-of-return.
Equivalent Worth
The equivalent worth method simply converts to one of the basic forms, i.e.,
the equivalent present worth, or annual worth, using previously-developed
techniques and the required MARR as learned in last session.

Rate of Return (ROR)


The ROR is the interest rate at which benefits are equivalent to costs.
Thus the cash flow is solved for the unknown value, i.

20 March 2015

Economic Analysis

49

Cash Flow Analysis


Equivalence &
Conventions

Interest

Discount
Factors

Equivalent
Worth

Cash Flow
Analysis

Multiple
Alternatives

Incremental
Analysis

Tax
Considerations

A $10,000 investment returned $2,342 per year over a 5-year period.


What was the rate of return on this investment?
A = $2,342
YEAR

INCOME

0
1

EXPENSE

$10,000
$2,342

$2,342

$2,342

$2,342

$2,342

EOY

$10,000
20 March 2015

Economic Analysis

50

Cash Flow Analysis


Equivalence &
Conventions

Interest

Discount
Factors

Equivalent
Worth

Cash Flow
Analysis

Multiple
Alternatives

Incremental
Analysis

Tax
Considerations

1. Set present worth (PW) of benefits equal to the present worth (PW)
of costs.
Benefits PW = Cost PW
Benefits PW = $2,342 (P/A, I, 5)
Cost PW = $10,000
$2,342 (P/A, i, 5) = $10,000
(P/A, i, 5) = $10,000 / $2,342
(P/A, i, 5) = 4.270

20 March 2015

Economic Analysis

51

Cash Flow Analysis


Equivalence &
Conventions

Interest

Discount
Factors

Equivalent
Worth

Cash Flow
Analysis

Multiple
Alternatives

Incremental
Analysis

Tax
Considerations

2. Look at the compound interest factors tables and read the factor
value where the P/A column intersect with the row where n = 5 for
a factor equal to or around the value of 4.270.
I = 5%
n

F/P

P/F

A/F

A/P

F/A

P/A

A/G

P/G

1.2763

0.7835

0.1810

0.2310

5.5256

4.3295

1.9025

8.2369

I = 6%
n

F/P

P/F

A/F

A/P

F/A

P/A

A/G

P/G

1.3382

0.7473

0.1774

0.2374

5.6371

4.2124

1.8836

7.9345

20 March 2015

Economic Analysis

52

Cash Flow Analysis


Equivalence &
Conventions

Interest

Discount
Factors

Equivalent
Worth

Cash Flow
Analysis

Multiple
Alternatives

Incremental
Analysis

Tax
Considerations

3. Since there is no exact factor with that amount, then we need to


interpolate between 2 values in order to get the value of i.
i

(P/A, i, 5)

i1 = 5.0%

F1 = 4.379

i = ?

Fi = 4.270

i2= 6.0%

F2 = 4.212

By interpolation i = 5.5%

20 March 2015

Economic Analysis

53

Multiple Alternatives

Multiple Alternatives
Equivalence &
Conventions

Interest

Discount
Factors

Equivalent
Worth

Cash Flow
Analysis

Multiple
Alternatives

Incremental
Analysis

Tax
Considerations

Many projects will require a selection from among several mutuallyexclusive alternatives. The selection of one alternative will preclude
the selection of any other alternative. Two simple rules will help
identify the preferred alternative:
Compute the net present worth of each alternative at the required minimum
attractive rate of return (MARR).
Select the alternative having the highest net worth

20 March 2015

Economic Analysis

55

Multiple Alternatives
Equivalence &
Conventions

Interest

Discount
Factors

Equivalent
Worth

Cash Flow
Analysis

Multiple
Alternatives

Incremental
Analysis

Tax
Considerations

Given the following mutually-exclusive alternatives and a minimum


attractive rate of return (MARR) of 5 percent, which one would be
chosen?
YEAR

ALTERNATIVE B

ALTERNATIVE C

-$2,500

-$2,700

-$3,000

$650

$650

$350

$650

$700

$650

$1050

$3,100

$650

$1400

$600

$550

$500

TOTAL
20 March 2015

ALTERNATIVE A

Economic Analysis

56

Multiple Alternatives
Equivalence &
Conventions

Discount
Factors

Interest

Equivalent
Worth

Cash Flow
Analysis

Multiple
Alternatives

Incremental
Analysis

Tax
Considerations

1. Compute the Present Worth for each alternative.


I = 5%
n

F/P

P/F

A/F

A/P

F/A

P/A

A/G

P/G

1.2763

0.7835

0.1810

0.2310

5.5256

4.3295

1.9025

8.2369

ALTERNATIVE

NOTATION

FACTOR

NPW

- $2,500 + $3,100 (P/F, 5%, 5)

0.7835

-$71

- $2,700 + $650 (P/A, 5%, 5)

4.3295

$114

- $3,000 + $350 (P/G, 5%, 5)

8.2369

-$117

2. Select the alternative with the highest value.

20 March 2015

Economic Analysis

57

Multiple Alternatives
Equivalence &
Conventions

Interest

Discount
Factors

Equivalent
Worth

Cash Flow
Analysis

Multiple
Alternatives

Incremental
Analysis

Tax
Considerations

Analysis Period
When comparing alternatives using present worth methods, it is necessary to
analyze over a common planning horizon.
In the event that alternatives do not have equal lives, consideration must be
given to the difference. A common technique is to select an analysis period
equal to the least common multiple of the alternative lives.
Another approach is to select an analysis period and determine the salvage
value for each alternative at that point in time.
When using annual worth methods there is no need to establish equal lives.

20 March 2015

Economic Analysis

58

Multiple Alternatives
Equivalence &
Conventions

Interest

Discount
Factors

Equivalent
Worth

Cash Flow
Analysis

Multiple
Alternatives

Incremental
Analysis

Tax
Considerations

Capitalized Cost
Problems occasionally arise involving extremely long analysis periods. For
example, in governmental analysis of permanent structures such as roads, dams,
and pipelines, the required maintenance can be spread over an infinite period (n
= ). In these cases the analysis is called capitalized cost.
Simply stated, capitalized cost is the present sum of money that would have to
be set aside now, at a given interest rate, to provide a perpetual uniform cash
flow.

20 March 2015

Economic Analysis

59

Incremental Analysis

Incremental Analysis
Equivalence &
Conventions

Interest

Discount
Factors

Equivalent
Worth

Cash Flow
Analysis

Multiple
Alternatives

Incremental
Analysis

Tax
Considerations

Assume that you have the following two alternatives. Which one
would you select?

20 March 2015

ALTERNATIVE

ROR

100%

20%

Economic Analysis

61

Incremental Analysis
Equivalence &
Conventions

Interest

Discount
Factors

Equivalent
Worth

Cash Flow
Analysis

Multiple
Alternatives

Incremental
Analysis

Tax
Considerations

What if the investment on alternatives is as shown on the table


below:
ALTERNATIVE

INITIAL INVESTMENT

ROR

EOY PROFIT

$100

100%

$100

$10,000

20%

$2,000

Will you change your decision after this new data?

What if your MARR is 25%.

What if your MARR is 15%.

20 March 2015

Economic Analysis

62

Incremental Analysis
Equivalence &
Conventions

Interest

Discount
Factors

Equivalent
Worth

Cash Flow
Analysis

Multiple
Alternatives

Incremental
Analysis

Tax
Considerations

This illustrate the need for a procedure to evaluate the return on the
increment of initial investment if one alternative requires a higher
initial investment than the other.
This process should also apply to multiple alternatives. By examining
the differences between alternatives, we can determine whether or
not the differential costs are justified based on the differential
benefits.

20 March 2015

Economic Analysis

63

Incremental Analysis
Equivalence &
Conventions

Interest

Discount
Factors

Equivalent
Worth

Cash Flow
Analysis

Multiple
Alternatives

Incremental
Analysis

Tax
Considerations

Rate of Return
This technique is based on the paired comparison of alternatives. The following
steps should be followed in an incremental rate-of-return analysis:
1.

Identify all alternatives. Be sure to consider the do nothing option.

2.

Compute ROR for each alternative and discard any alternative with ROR < MARR.

3.

Arrange remaining alternatives in ascending order of initial cost.

4.

Calculate the ROR on the difference between the first two (lowest initial cost) alternatives. If
this ROR MARR, retain the higher cost alternative, otherwise retain the lower cost
alternative.

5.

Take the retained alternative from the previous step and compare it to the next higher
alternative.

6.

Repeat this process until all alternatives have been evaluated.

20 March 2015

Economic Analysis

64

Incremental Analysis
Equivalence &
Conventions

Interest

Discount
Factors

Equivalent
Worth

Cash Flow
Analysis

Multiple
Alternatives

Incremental
Analysis

Tax
Considerations

Given the following mutually-exclusive alternatives and a minimum


attractive rate of return (MARR) of 5 percent, which one should be
chosen? Use the incremental rate-of-return method and assume the
do nothing alternative is not available.
YEAR

20 March 2015

ALTERNATIVE A

ALTERNATIVE B

ALTERNATIVE C

-$2,500

-$2,738

-$3,000

$650

$650

$350

$650

$700

$650

$1,050

$3,190

$650

$1,400

Economic Analysis

65

Incremental Analysis
Equivalence &
Conventions

Discount
Factors

Interest

Equivalent
Worth

Cash Flow
Analysis

Multiple
Alternatives

Incremental
Analysis

Tax
Considerations

1. Identify all alternatives. Be sure to consider the do nothing option.


2. Compute ROR for each alternative and discard any alternative with
ROR < MARR.
i = 5%
n
5

F/P
1.2763

P/F
0.7835

A/F
0.1810

A/P
0.2310

F/A
5.5256

P/A
4.3295

A/G
1.9025

P/G
8.2369

F/A
5.6371

P/A
4.2124

A/G
1.8836

P/G
7.9345

i = 6%
n
5

F/P
1.3382

ALTERNATIVE

P/F
0.7473

A/F
0.1774

A/P
0.2374

NOTATION

FACTOR

(P/F, i, 5) = $2,500 / $3,190

0.7835

5%

(P/A, i, 5) = $2,738 / $650

4.2124

6%

(P/G, i,5) = $3,000 / $350

8.5714

ROR<MARR

20 March 2015

Economic Analysis

66

Incremental Analysis
Equivalence &
Conventions

Interest

Discount
Factors

Equivalent
Worth

Cash Flow
Analysis

Multiple
Alternatives

Incremental
Analysis

Tax
Considerations

3. Arrange remaining alternatives in ascending order of initial cost.


4. Calculate the ROR on the difference between the first two (lowest
initial cost) alternatives by setting present worth of benefits equal to
present worth of cot. If this ROR MARR, retain the higher cost
alternative, otherwise retain the lower cost alternative.
YEAR

ALTERNATIVE A

ALTERNATIVE B

B - A

-$2,500

-$2,738

-$238

$650

$650

$650

$650

$650

$650

$650

$650

$3,190

$650

-$2,540

$650 (P/A, i%, 4) = $238 + $2,540 (P/F, i%, 5)


20 March 2015

Economic Analysis

67

Incremental Analysis
Equivalence &
Conventions

Interest

Discount
Factors

Equivalent
Worth

Cash Flow
Analysis

Multiple
Alternatives

Incremental
Analysis

Tax
Considerations

5. Since we have two unknown discount factors in this equation, it must


be solved by trial and error by using the appropriate factors for
varying values of i. The first try should be the MARR of 5 percent,
which results in:
i = 5%
n
4
5

F/P
1.2155
1.2763

P/F
0.8227
0.7835

A/F
0.2320
0.1810

A/P
0.2820
0.2310

F/A
4.3101
5.5256

P/A
3.5460
4.3295

A/G
1.4391
1.9025

P/G
5.1028
8.2369

YEAR 0 COST

-$238

YEAR 5 COST

-2,540 X 0.7835

-$1,990

YEAR 1-4 BENEFITS

$650 X 3.5460

$2,305

TOTAL BENEFITS LESS COST


20 March 2015

Economic Analysis

$77
68

Incremental Analysis
Equivalence &
Conventions

Interest

Discount
Factors

Equivalent
Worth

Cash Flow
Analysis

Multiple
Alternatives

Incremental
Analysis

Tax
Considerations

6. Since the benefits are greater than the costs, or in other words, the
net present worth of the increment is greater than 0, the rate-ofreturn on the increment must be something greater than 5 percent
and we therefore accept the increment and retain the higher cost
alternative, B.

20 March 2015

Economic Analysis

69

Incremental Analysis
Equivalence &
Conventions

Interest

Discount
Factors

Equivalent
Worth

Cash Flow
Analysis

Multiple
Alternatives

Incremental
Analysis

Tax
Considerations

Benefit-Cost Ratio
The incremental approach for the analysis of two or more alternatives will
follow the same procedure as that for rate-of-return analysis.
1.
2.
3.
4.

5.
6.

Identify all alternatives. Be sure to consider the do nothing option.


Compute Benefit/Cost ratio for each alternative and discard any alternative with B/C< 1.
Arrange remaining alternatives in ascending order of initial cost.
Calculate the ratio of the present worth of Benefits and Costs on the difference between the
first two (lowest initial cost) alternatives. If this B/C> 1, retain the higher cost alternative,
otherwise retain the lower cost alternative.
Take the retained alternative from the previous step and compare it to the next higher
alternative.
Repeat this process until all alternatives have been evaluated.

PW of benefits - PW of costs > 0

OR

EUAB - EUAC > 0

B/C = PW of benefits/ PW of Costs = EUAB/ EUAC > 1


20 March 2015

Economic Analysis

70

Incremental Analysis
Equivalence &
Conventions

Interest

Discount
Factors

Equivalent
Worth

Cash Flow
Analysis

Multiple
Alternatives

Incremental
Analysis

Tax
Considerations

Given the following mutually-exclusive alternatives and a MARR of 5


percent, which one should be chosen? Use the benefit-cost method
and assume the do nothing alternative is not available.
YEAR

20 March 2015

ALTERNATIVE A

ALTERNATIVE B

ALTERNATIVE C

-$2,500

-$2,738

-$3,000

$650

$650

$350

$650

$700

$650

$1,050

$3,190

$650

$1,400

Economic Analysis

71

Incremental Analysis
Equivalence &
Conventions

Interest

Discount
Factors

Equivalent
Worth

Cash Flow
Analysis

Multiple
Alternatives

Incremental
Analysis

Tax
Considerations

1. Identify all alternatives. Be sure to consider the do nothing option.


2. Compute the benefit-cost ratio for each alternative and discard
alternatives with B/C < 1.
i = 5%
n
5

F/P
1.2763

ALTERNATIVE

P/F
0.7835

A/F
0.1810

A/P
0.2310

F/A
5.5256

BENEFIT/COST RATIO

P/A
4.3295

A/G
1.9025

P/G
8.2369

NOTES

$3,190 X (P/F, i, 5) / $2,500 =


$3190 X 0.7835 / $2,500 = 1

Acceptable

$650 X (P/A, i, 5) / $2,738 =


$650 X 4.3295/ $2,738 = 1.03

Acceptable

$350 X (P/G, i,5) / $3,000 =


$350 X 8.2369/ $3,000 = 0.96

Not
Acceptable

20 March 2015

Economic Analysis

72

Incremental Analysis
Equivalence &
Conventions

Interest

Discount
Factors

Equivalent
Worth

Cash Flow
Analysis

Multiple
Alternatives

Incremental
Analysis

Tax
Considerations

3. Arrange remaining alternatives in ascending order of initial cost.


4. Calculate Benefit/Cost ratio of the difference. If this B/C > 1, retain
the higher cost alternative, otherwise retain the lower cost
alternative.
YEAR

ALTERNATIVE A

ALTERNATIVE B

B - A

-$2,500

-$2,738

-$238

$650

$650

$650

$650

$650

$650

$650

$650

$3,190

$650

-$2,540

B/C = $650 X 3.5460/ ($238 + $2,540 X 0.7835) = 1.03


20 March 2015

Economic Analysis

73

Incremental Analysis
Equivalence &
Conventions

Interest

Discount
Factors

Equivalent
Worth

Cash Flow
Analysis

Multiple
Alternatives

Incremental
Analysis

Tax
Considerations

5. Since the B/C > 1,the rate-of-return on the increment must be


something greater than 5 percent and we therefore accept the
increment and retain the higher cost alternative, B.

20 March 2015

Economic Analysis

74

Tax Consideration

Tax Consideration
Equivalence &
Conventions

Interest

Discount
Factors

Equivalent
Worth

Cash Flow
Analysis

Multiple
Alternatives

Incremental
Analysis

Tax
Considerations

The effects of taxes on investments are significant part of all real


problems and should be considered.

Because taxes have been ignored in our analysis, the results are
considered a before-tax cash flow.

If the consequences of income tax and other tax effects are


incorporated into the economic analysis we will have an after-tax
analysis.

20 March 2015

Economic Analysis

76

Tax Consideration
Equivalence &
Conventions

Equivalent
Worth

Cash Flow
Analysis

Multiple
Alternatives

Incremental
Analysis

Tax
Considerations

The following relationships are involved:

Interest

Discount
Factors

before-tax cash flow


depreciation
taxable income = (before-tax cash flow) - (depreciation)
income taxes = (taxable income) x (incremental tax rate)
after-tax cash flow = (before-tax cash flow) - (income taxes)

Tax laws are complex and changing. All of the principles and
techniques that have been developed can be applied to an after-tax
analysis.

20 March 2015

Economic Analysis

77

AACE International
Arabian Gulf Section
CCP Certification
Exam Preparation Workshop

Discrete Compound Interest Table


Equivalence &
Conventions

Interest

Discount
Factors

Equivalent
Worth

Cash Flow
Analysis

Multiple
Alternatives

Incremental
Analysis

Tax
Consideration

Problem
Solving

i = 6%
n

F/P

P/F

A/F

A/P

F/A

P/A

A/G

P/G

1.0600

0.9434

1.0000

1.0600

1.0000

0.9434

0.0000

0.0000

1.1236

0.8900

0.4854

0.5454

2.0600

1.8334

0.4854

0.8900

1.1910

0.8396

0.3141

0.3741

3.1836

2.6730

0.9612

2.5692

1.2625

0.7921

0.2286

0.2886

4.3746

3.4651

1.4272

4.9455

1.3382

0.7473

0.1774

0.2374

5.6371

4.2124

1.8836

7.9345

1.4185

0.7050

0.1434

0.2034

6.9753

4.9173

2.3304

11.4594

1.5036

0.6651

0.1191

0.1791

8.3938

5.5824

2.7676

15.4497

1.5938

0.6274

0.1010

0.1610

9.8975

6.2098

3.1952

19.8416

1.6895

0.5919

0.0870

0.1470

11.4913

6.8017

3.6133

24.5768

10

1.7908

0.5584

0.0759

0.1359

13.1808

7.3601

4.0220

29.6023

20 March 2015

Economic Analysis

79

Uniform Gradient
Equivalence &
Conventions

Interest

Discount
Factors

Equivalent
Worth

Cash Flow
Analysis

Multiple
Alternatives

Incremental
Analysis

Tax
Consideration

Problem
Solving

Uniform Gradient
EOY

Time Line

$300
$400
$500
$600
$700

20 March 2015

Economic Analysis

80

Uniform Gradient
Equivalence &
Conventions

Interest

Discount
Factors

Equivalent
Worth

Cash Flow
Analysis

Multiple
Alternatives

Incremental
Analysis

Tax
Consideration

Problem
Solving

Uniform Gradient
EOY

1
$400

$400

$400

$400

Time Line

$300

P = $300
A = $400
G = $100
20 March 2015

$100
$200
$300

Economic Analysis

81

Uniform Gradient
Equivalence &
Conventions

Interest

Discount
Factors

Equivalent
Worth

Cash Flow
Analysis

Multiple
Alternatives

Incremental
Analysis

Tax
Consideration

Problem
Solving

Uniform Gradient
EOY

Time Line

G = $100

20 March 2015

Economic Analysis

82

Linear Interpolation
Equivalence &
Conventions

Interest

Discount
Factors

Equivalent
Worth

Cash Flow
Analysis

Multiple
Alternatives

Incremental
Analysis

Tax
Consideration

Problem
Solving

1. Consider determining f(2.5). Since 2.5 is


midway between 2 and 3, it is reasonable
to take f(2.5) midway between f(2) =
0.9093 and f(3) = 0.1411, which yields
0.5252.
2. Generally, linear interpolation takes two
data points, say (xa,ya) and (xb,yb), and the
interpolant is given by:

20 March 2015

Economic Analysis

83