IE 343 Engineering Economics

Lecture 14: Chapter 5 Evaluating a

Single Project

Instructor: Tian Ni
Sep.23, 2011

IE 343 Fall 2011
1
New Plan:
5
th
Week Sep 19 Sep 21 Sep 23
(Quiz 3&Chap4, 5) (Hw4 due &Chap 5)
6
th
Week Sep 26 Sep 28 Sep 30
(Table&Excel&VBA (Quiz 4& (Exam 1
&Chap 4 Problems) Review 1) &HW5 out)
7
th
Week Oct 3 Oct 5 Oct 7

8
th
Week Oct 10 Oct 12 Oct 14
(Oct Break) (HW5 due
& HW6 Out)


IE 343 Fall 2011
Exam 1 Date Change!
2
No homework next week.
Homework 5 will be assigned next Friday Sep. 30
after Exam 1. Homework 5 is due Oct. 14
Exam 1 will have two parts: (Chapter 1 4)
Part 1: Old problems randomly picked from Homework,
Lecture Notes and Textbook. (Just like Quizzes)
Part 2: New problems to test your understanding
Details will be announced next Monday
You can start to review Homework, Lecture Notes
and Textbook now!


IE 343 Fall 2011
Announcement
3
Textbook Tables (Appendix C)
Excel
VBA
Solve some Practice Problems in Chapter 4
Note: Mondays class is part of review 1. I will
teach how to use textbook tables (appendix C),
Excel, and VBA to simply the computations, which
is very useful in the Exam 1.
IE 343 Fall 2011
Next Class Monday (Sep. 26)
4
Question: What is the corresponding present
equivalent value of the cash flow diagram below
under a nominal interest rate r = 12% compounded
annually, monthly and continuously? Is it a good
investment?

IE 343 Fall 2011
*Example 4.22*
5
IE 343 Fall 2011
*Example 4.22*
0 1 13 14 15
A = 3,000
..
22 23 24
.....
12
$19,000
2 3 4 5
A A
1.06A
A 06 . 1
2
A 06 . 1
9
A 06 . 1
10
A 06 . 1
11
EOY
6
IE 343 Fall 2011
*Example 4.22* - Decomposition
0 1
$19,000
2 3
23 24
0 1
A = 3,000
...
2 3 4 5
12
A
Single Cash Flow
Deferred Annuities Start at EOY 3
23 24
PS
PD
7
IE 343 Fall 2011
*Example 4.22* - Decomposition
Geometric Gradient Series
Start at the end of year 13
13 14 15
..
22 23 24
A
1.06A
A 06 . 1
2
A 06 . 1
9
A 06 . 1
10
A 06 . 1
11
0 1
PG
12
..
8
Basic Idea: Evaluate the present equivalent value of the
three decomposed cash flow diagrams separately and
then sum them up.
Notation:
PS : Present Value for the single cash flow
PD : Present Value for the Deferred Annuities
PG : Present Value for the Geometric Gradient Series
iA : Effective interest rate with annual compounding
iM : Effective interest rate with monthly compounding
iC : Effective interest rate with continuous compounding


IE 343 Fall 2011
*Example 4.22* Solution
9
General Solution:
PS = -19,000
PD = 3,000(P/A, i%, 10)(P/F, i%, 2)
f = 6%, r = 12%, f r
PG = (P/F, i%, 12)

P = PS + PD + PG
IE 343 Fall 2011
*Example 4.22* Solution
06 . 0 %
)] 12 , 06 . 0 , / )( 12 %, , / ( 1 [ 000 , 3

i
P F i F P
10
Solution: Annual Compounding
iA = r = 12% per year
PS = -19,000
PD = 3,000(P/A, 12%, 10)(P/F, 12%, 2) = 13,513
f = 6%, i = 12%, f i
PG = (P/F, 0.12, 12)
= 6,205
P = PS + PD + PG = 718
It is a good investment since P > 0!

IE 343 Fall 2011
*Example 4.22* Solution
06 . 0 12 . 0
)] 12 , 06 . 0 , / )( 12 , 12 . 0 , / ( 1 [ 000 , 3

P F F P
11
Solution: Monthly Compounding
r = 12% per year
iM = > iA = 0.12
PS = -19,000
PD = 3,000(P/A, 0.126825, 10)(P/F, 0.126825, 2) =
12985
f = 6%, i = 12.6825%, f i
PG = (P/F,
0.126825, 12)
= 5,569

IE 343 Fall 2011
*Example 4.22* Solution
06 . 0 126825 . 0
)] 12 , 06 . 0 , / )( 12 , 126825 . 0 , / ( 1 [ 000 , 3

P F F P
126825 . 0 1
12
12 . 0
1
12
=
|
.
|

\
|
+
12
Solution: Monthly Compounding
r = 12% per year
iM = > iA = 0.12

P = PS + PD + PG = -446

It is a bad investment since P < 0!


IE 343 Fall 2011
*Example 4.22* Solution
126825 . 0 1
12
12 . 0
1
12
=
|
.
|

\
|
+
13
Solution: Continuous Compounding
r = 12% per year
iM = > iM = 0.126825 (> iA = 0.12)
PS = -19,000
PD = 3,000(P/A, 0.1275, 10)(P/F, 0.1275, 2) = 12,934
f = 6%, i = 12.75%, f i
PG = (P/F, 0.1275,
12)
= 5,510

IE 343 Fall 2011
*Example 4.22* Solution
06 . 0 1275 . 0
)] 12 , 06 . 0 , / )( 12 , 1275 . 0 , / ( 1 [ 000 , 3

P F F P
( ) 1275 . 0 1
12 . 0
= e
14
Solution: Continuous Compounding
r = 12% per year
iM = > iM = 0.126825 (> iA = 0.12)

P = PS + PD + PG = -556

It is a bad investment since P < 0!


IE 343 Fall 2011
*Example 4.22* Solution
( ) 1275 . 0 1
12 . 0
= e
15
Chapter 5 - Evaluating a Single
Project
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Time value of money -
Application
IE 343 Fall 2011 17
We will learn how to evaluate the profitability and
liquidity of a single problem solution (or
alternative). Minimum Attractive Rate of Return
(MARR) is useful for this analysis. MARR ("hurdle
rate") is usually organization-specific and
determined based on the following:
Cost of money available for investment
Number of good projects available for investment
Risks involved in investment opportunities
IE 343 Fall 2011
Time value of money - Applications
18
How to use MARR?
Use it as an interest rate to convert cash flows into
equivalent worth at some point in time. The
proposed problem solution (project or alternative) is
profitable if it generates sufficient cash flow to
recover the initial investment and earn an interest
rate that is at least as high as MARR.
IE 343 Fall 2011
Time value of money - Applications
19
Methods to evaluate profitability
Present Worth (PW)
Future Worth (FW)
Annual Worth (AW)
Internal Rate of Return (IRR)
External Rate of Return (ERR)
Methods to evaluate liquidity
Simple payback period
Discounted payback period
IE 343 Fall 2011
Methods
20
Present Worth method (PW)
IE 343 Fall 2011 21
Discount all cash flows to the present time by using
the MARR as the interest rate.


IE 343 Fall 2011
Present Worth (PW) method
N
N
i F i F i F i F i PW

+ + + + + + + + = ) 1 ( ... ) 1 ( ) 1 ( ) 1 ( %) (
2
2
1
1
0
0

+ =
N
k
k
k
i F i PW
0
) 1 ( %) (
22



: represents future cash flow at the end of the
compounding period k;
i: is the effective interest rate (MARR) per
compounding period, which is assumed to be
constant;
N represents the number of compounding periods in
the planning horizon (i.e., study period).
IE 343 Fall 2011
Present Worth (PW) method
N
N
i F i F i F i F i PW

+ + + + + + + + = ) 1 ( ... ) 1 ( ) 1 ( ) 1 ( %) (
2
2
1
1
0
0

+ =
N
k
k
k
i F i PW
0
) 1 ( %) (
k
F
23
Rule:
If PW(MARR) 0, the project is profitable
If PW(MARR)< 0, the project is not profitable.







IE 343 Fall 2011
Present Worth (PW) method
24
Consider a project that has the following cash flows
over a study period of 5 years:
Initial investment: $100,000
Annual revenues: $40,000
Annual expenses: $5,000
Salvage value: $20,000
MARR: 20%.





IE 343 Fall 2011
Present Worth (PW) method - Example 5.1
25
IE 343 Fall 2011
Example 5.1 - Cash Flow Diagram
0 1 2 3 4
$100,000
5
MARR = 2%
$40,000
$5,000
S=$20,000
26
Solution:
PW(20%)=-100,000+(40,000-
5,000)(P/A,20%,5)+20,000(P/F,20%,5)=$12,709.
Is this a profitable project?
Yes!
Because: We recovered $100,000 (investment). We
earned an interest rate of 20% which was desired.
We even made a profit that has a present equivalent
value of $12,709, which is beyond what was
required.



IE 343 Fall 2011
Example 5.1 Solution
27
Suppose we had an interest rate higher than 20%.
For example, 20% nominal interest rate
compounded continuously. Then, the effective
interest rate is
PW(i=22.14% discrete compounding)
= PW(r= 20% continuous compounding)
= $7,285.7
Still profitable but PW is lower when the effective
interest rate increases.



IE 343 Fall 2011
Example 5.1 Contd
%. 14 . 22 1
2 . 0
= = e i
28
Note: If the first cash flow of a project is negative
and its subsequent cash flows are positive, then PW
is a decreasing function of the effective interest rate
i.
For a general pattern of cash flows, PW may not be
the decreasing function of i.



IE 343 Fall 2011
Example 5.1 Contd
29
Future Worth method (FW)
IE 343 Fall 2011 30
Find the equivalent worth of all cash flows at the
end of the study period by using the MARR as the
interest rate.




Note that FW and PW of a project are equivalent at
the interest rate of i%, i.e., FW=PW(F/P,i%,N).



IE 343 Fall 2011
Future Worth (FW) method
0 2
2
1
1 0
) 1 ( ... ) 1 ( ) 1 ( ) 1 ( %) ( i F i F i F i F i FW
N
N N N
+ + + + + + + + =

+ =
N
k
k N
k
i F i FW
0
) 1 ( %) (
31
Rule:
If FW(MARR) 0, the project is profitable
If FW(MARR)< 0, the project is not profitable.







IE 343 Fall 2011
Future Worth (FW) method
32
Back to Example 5.1 with the following project:
Initial investment: $100,000
Annual revenues: $40,000
Annual expenses: $5,000
Salvage value: $20,000
MARR: 20%.
N: 5 years.




IE 343 Fall 2011
Future Worth (FW) method - Example 5.1
33
IE 343 Fall 2011
Example 5.1 - Cash Flow Diagram
0 1 2 3 4
$100,000
5
MARR = 2%
$40,000
$5,000
S=$20,000
34
Solution:
FW(20%)=-100,000(F/P,20%,5)+(40,000-
5,000)(F/A,20%,5)+20,000=$31,624.
Since FW(20%) 0, the project is profitable.




IE 343 Fall 2011
Future Worth (FW) method - Example 5.1
35
Capitalized Worth method (CW)
IE 343 Fall 2011 36
Definition: CapitalizedWorth method involves
determining the PW of all revenues or expenses
over an infinitely length of time.






IE 343 Fall 2011
Capitalized Worth (CW) Method
37
CW of a perpetual series of end-of-period uniform
payments A, with interest at i% per period is A(P/A,
i%, )






IE 343 Fall 2011
Capitalized Worth (CW) Method
0
A A A . . . . . . . . . . . . . . . . . . . . . . . . . .
1 2 3 . . . . . . . . . . . . . . . . . . . . . . . . .
To find P?
38
CW of a perpetual series of end-of-period uniform
payments A, with interest at i% per period is A(P/A,
i%, )






IE 343 Fall 2011
Capitalized Worth (CW) Method
|
.
|

\
|
=
(

+
+
=
= =


i
A
i i
i
A i CW
i A P A PW i CW
N
N
N
N
1
) 1 (
1 ) 1 (
lim %) (
) %, , / ( %) (
39
A practical approximation of forever (infinity) is
dependent on the interest rate i%
E.g.1: i=8% (1/i = 12.5000), (P/A,8%,N) = 12.4943
when N = 100. So a good approximation for infinity
when i=8% is N 100
E.g.2: i=20% (1/i =5.0000), (P/A,20%,N) = 4.9966
when N = 40. So a good approximation for infinity
when i=20% is N 40





IE 343 Fall 2011
Capitalized Worth (CW) Method
40
Annual Worth method (AW)
IE 343 Fall 2011 41
The AW of a project is an equal annual series of
dollar amounts, for a stated study period, that is
equivalent to the cash inflows and outflows at an
interest rate that is generally the MARR.
AW(i%)=R E CR(i%)
R: Annual equivalent revenues
E: Annual equivalent expenses
CR: Annual equivalent Capital Recovery cost

IE 343 Fall 2011
Annual Worth (AW) method
42
CR includes the loss in value of asset and interest
on invested capital.
The CR can be computed by:
CR(i%)=I(A/P,i%,N)-S(A/F,i%,N)
I: Initial investment
S: Salvage value.




IE 343 Fall 2011
Annual Worth (AW) method
43
The above formula of CR can be interpreted in the
way that the annual equivalent of the initial capital
investment minus the annual equivalent of the
salvage value.




IE 343 Fall 2011
Annual Worth (AW) method
44
Back to Example 5.1:
Initial investment (I): $100,000
Annual revenues (R): $40,000
Annual expenses (E): $5,000
Salvage value (S): $20,000
MARR (i%): 20%.
N: 5 years.




IE 343 Fall 2011
Annual Worth (AW) method - Example 5.1
45
Back to Example 5.1:
I = $100,000
R = $40,000
E = $5,000
S = $20,000
MARR = 20%.
N: 5 years.
CR(20%)=100,000(A/P,20%,5)-20,000(A/F,20%,5)
=$30,750.




IE 343 Fall 2011
Annual Worth (AW) method - Example 5.1
46
IE 343 Fall 2011
CR cost calculation - Example 5.1
Year
Value of
investment
at BOY
Uniform loss
in value of
year (A)
Interest on BOY
(B) investment
(i=20%)(B)
CR cost
for year
(A+B)
PW of CR
amount at
i=20%
1 100,000 16,000 20,000 36,000 30000
2 84,000 16,000 16,800 32,800 22777.78
3 68,000 16,000 13,600 29,600 17129.63
4 52,000 16,000 10,400 26,400 12731.48
5 36,000 16,000 7,200 23,200 9323.56
Sum= 91962.45
Assume that the loss in value is uniform per year. So loss
per year is (I S)/N = (100,000 20,000)/5 = 16,000
47
BOY stands for Beginning-of-Year.
PW of CR cost= 36,000(P/F,20%,1)
+32,800(P/F,20%,2)+...+23,200(P/F,20%,5)
=91,961.44
Uniform annual equivalent of CR cost
=91,961.44(A/P,20%,5) = $30,750


IE 343 Fall 2011
CR cost calculation - Example 5.1
48
AW(i%)= R E CR(i%)
AW(20%)=40,000-5,000-30,750=4,250
Since AW(20%) 0, the project is profitable.

IE 343 Fall 2011
Annual Worth (AW) method - Example 5.1
49
Note that AW, PW, and FW are equivalent
measures of profitability of a project:
AW=PW(A/P,i%,N),
AW=FW(A/F,i%,N),
PW=FW(P/F,i%,N),
FW=PW(F/P,i%,N).
(Check that these expressions hold for the project in
Example 5.1.)
Therefore if PW 0, then FW 0, and AW 0.
IE 343 Fall 2011
Annual Worth (AW) method
50