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31 Aufrufe83 SeitenEconomic Analysis

Mar 31, 2015

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Economic Analysis

© All Rights Reserved

Als PDF, TXT **herunterladen** oder online auf Scribd lesen

31 Aufrufe

Economic Analysis

© All Rights Reserved

Als PDF, TXT **herunterladen** oder online auf Scribd lesen

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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.

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

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

important interconnected

environments, the physical and the

economics.

Select from among multiple

alternatives.

Alternative

2

objectively and equate them in some

numerical value such as money.

Incremental

Analysis

Tax

Considerations

Alternative

1

Alternative

3

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

Benefits or income

Cost or expenses

EOY

EUAC

EUAW

Future value

Incremental

Analysis

Tax

Considerations

Present value

ROR

Multiple

Alternatives

EUAB

MARR

20 March 2015

Equivalent

Worth

Rate of return

Sn

Economic Analysis

Equivalence

Equivalence &

Conventions

Interest

Discount

Factors

Equivalent

Worth

Cash Flow

Analysis

Multiple

Alternatives

Incremental

Analysis

Tax

Considerations

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 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

$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

$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

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

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

$100

$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

$100

20 March 2015

$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

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

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

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

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

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 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

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

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

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

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

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

Economic Analysis

32

Equivalent Worth

Equivalent Worth

Equivalence &

Conventions

Interest

Discount

Factors

Equivalent

Worth

Cash Flow

Analysis

Multiple

Alternatives

Incremental

Analysis

Tax

Considerations

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

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

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.

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

By using the cash flow diagram.

20 March 2015

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

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

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

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

P

P0

P1

P2

TOTALS

20 March 2015

NET

NOTATION

FACTOR

PW

1.0000

($38,000)

4.9455

($4,946)

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

YEAR

EXPENSE

INCOME

$38,000

$11,000

$11,000

$1,000

$11,000

$2,000

4

TOTALS

20 March 2015

NET

NOTATION

FACTOR

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

F

F0

F1

F2

NET

FACTOR

FW

($38,000)

1.2625

($47,975)

($1,000)

($6,244)

4.3746

$48,121

$11,000

NOTATION

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

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

PW

NOTATION

FW

NOTATION

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

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

$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

alternative at end of year 4?

a.

b.

c.

d.

$746

$5,223

$9,296

$12,397

= -$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

Equivalence &

Conventions

Interest

Discount

Factors

Equivalent

Worth

Cash Flow

Analysis

Multiple

Alternatives

Incremental

Analysis

Tax

Considerations

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.

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

Equivalence &

Conventions

Interest

Discount

Factors

Equivalent

Worth

Cash Flow

Analysis

Multiple

Alternatives

Incremental

Analysis

Tax

Considerations

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

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

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

Equivalence &

Conventions

Interest

Discount

Factors

Equivalent

Worth

Cash Flow

Analysis

Multiple

Alternatives

Incremental

Analysis

Tax

Considerations

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

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

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

0.7835

-$71

4.3295

$114

8.2369

-$117

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

below:

ALTERNATIVE

INITIAL INVESTMENT

ROR

EOY PROFIT

$100

100%

$100

$10,000

20%

$2,000

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.

2.

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

3.

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.

20 March 2015

Economic Analysis

64

Incremental Analysis

Equivalence &

Conventions

Interest

Discount

Factors

Equivalent

Worth

Cash Flow

Analysis

Multiple

Alternatives

Incremental

Analysis

Tax

Considerations

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

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

0.7835

5%

4.2124

6%

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

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

20 March 2015

Economic Analysis

67

Incremental Analysis

Equivalence &

Conventions

Interest

Discount

Factors

Equivalent

Worth

Cash Flow

Analysis

Multiple

Alternatives

Incremental

Analysis

Tax

Considerations

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

$650 X 3.5460

$2,305

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.

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.

OR

20 March 2015

Economic Analysis

70

Incremental Analysis

Equivalence &

Conventions

Interest

Discount

Factors

Equivalent

Worth

Cash Flow

Analysis

Multiple

Alternatives

Incremental

Analysis

Tax

Considerations

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

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

$3190 X 0.7835 / $2,500 = 1

Acceptable

$650 X 4.3295/ $2,738 = 1.03

Acceptable

$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

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

20 March 2015

Economic Analysis

73

Incremental Analysis

Equivalence &

Conventions

Interest

Discount

Factors

Equivalent

Worth

Cash Flow

Analysis

Multiple

Alternatives

Incremental

Analysis

Tax

Considerations

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

problems and should be considered.

Because taxes have been ignored in our analysis, the results are

considered a before-tax cash flow.

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

Interest

Discount

Factors

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

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

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

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