IEDA 3230: Engineering Economy

Evaluating an Engineering Project (deterministic models)

Agenda

Is an investment/project profitable?
Measures (metrics) for evaluation:
Present Worth (PW)
Future Worth (FW)
Annual Worth (AW)

Internal Rate of Return (IRR)

External Rate of Return (ERR)
Payback period
Motivating Example

HKUST is considering to switch from individual air-

conditioning to central air conditioning in a student dorm. How
can they economically justify the investment required?
Motivating Example

Recently the HK govt provided an investment scheme for

residents to purchase 15 year government bonds with the
following terms:

Maturity: March 2032

Coupon: nominal rate of 1.89% paid semi-annually

Would you buy this bond?

Motivating example

[image source: scmp.com]

Kowloon Motor Bus is evaluating whether it should switch to

using electric buses on some of its routes instead of the current
ones using hydrocarbon fuel (diesel). How can they evaluate
the economic viability?
 Present Worth

Consider the following cash flow diagram for an engineering

project

salvage value (S)

revenue (Ri)

0 1 2 3 4
fixed cost/
investment (Cf)
operating cost (Ci)

Is this a good investment?

 Present Worth

(𝑅𝑖 − 𝐶𝑖 ) 𝑆
Present worth = PW = −𝐶𝑓 + σ𝑁
𝑖=1 + , (𝑎𝑏𝑜𝑣𝑒, 𝑁 = 4)
(1+𝑟)𝑖 (1+𝑟)𝑁

Present Worth criterion: the investment is good if PW  0

What value of r should we use?

Present Worth Method: MARR

Different projects have different returns

Total Budget or Capital is limited

Minimum Attractive Rate of Return (MARR) is the highest

return rate that
could have been obtained, but
was rejected because of the limited capital

This is the concept of the “opportunity cost”

Example:
Three potential projects, each requiring $100K investment
The return after 1 year:
Project 1: $9000 (9%)
Project 2: $7000 (7%)
Project 3: $4000 (4%)
If we only have $200K to invest, the MARR is 4%
If we only have $100K to invest, the MARR is 7%
Examples of MARR

Suppose we are deciding whether to invest $X on a project.

If the alternative is to leave the money in the bank, then the MARR is equal
to the interest rate offered by the bank.

Suppose we wish to take a loan of $X and invest it on a project.

Then the MARR is equal to the interest rate charged by the bank.

RULE: A project should be carried out only if the return is  MARR

 The rate r used in the Present Worth calculation should be = MARR
 Different methods of evaluating a project

Given the cash flow of a project, and the MARR:

Present Worth (PW) rule:

A project is acceptable only if its PW using the MARR as the
interest rate  0

Future Worth (FW) rule:

A project is acceptable only if its FW using the MARR as the
interest rate  0

Annual Worth (AW) rule:

A project is acceptable only if the annuity equivalent to its
cash flow, using the MARR as the interest rate is  0
PW example

A project needs an investment of $10,000

Its output is a uniform annual revenue of $5310
After 5 years, it has a salvage value of $2000
Annual expense of the project is $3000

Is this project acceptable under an MARR of 9%?

PW = (5310 – 3000)(P/A, 0.09, 5) + 2000(P/F, 0.09, 5) – 10000

= 285 > 0
 Acceptable.

Is it acceptable if the MARR is 10%?

PW = -1  ??
Example, continued..

A project needs an investment of $10,000

Its output is a uniform annual revenue of $5310
After 5 years, it has a salvage value of $2000
Annual expense of the project is $3000

Is the project acceptable @ MARR of 9% using the FW rule?

How about under the AW rule?

[Hint: If PW > 0, then is it possible for FW ≤ 0? AW ≤ 0?]

PW example: Bond pricing

If a company (or government) wants to borrow money,

they may issue an IOU, called a bond.
A bond is a certificate (piece of paper) which states the
legal obligation to pay a stated amount of money (face
value) at a stated time in the future (maturity date).
Typically the issuer of the bond also pays an agreed
amount of money (coupon) periodically until maturity.
Bond terminology
Z: face value (= redemption value)
r: nominal interest rate per period paid by the bond
N: number of periods until maturity
i: bond yield rate until maturity
VN: value (price) of the bond N periods before maturity
 PW example: Bond pricing

A bond certificate can be traded (bought/sold) by its holder at any

time before maturity. The present worth of the bond
VN = Z(P/F, i%, N) + rZ(P/A, i%, N)

Common questions for the investor are:

- How much should you pay for the bond if you want some desired yield rate
- Given a purchase price, what is the yield

We wish to buy a 10-year US T-bond with face value Z = $10,000,

maturing in 8 years and paying nominal interest of 8% per annum
every quarter (i.e. each coupon is 2% of Z).
How much should you be willing to pay for the bond if your desired
yield is nominally 10% earned quarterly.

Answer:
i = 10/4 = 2.5%; 8 years = 32 quarters.
VN = 10000(P/F, 2.5%, 32) + 10,000*0.02(P/A, 2.5%, 32) = $8908
The Capitalized Worth

A special case of the PW evaluation is when we

consider an infinite number of periods

Capitalized Worth = CW = PWN∞ = A(P/A, i%, ∞)

(1+𝑖)𝑁 −1 𝐴
=𝐴 lim =
𝑁→∞ 𝑖(1+𝑖)𝑁 𝑖

Q: What are practical examples of cash flows over infinite

periods?
Internal Rate of Return

Given a cash flow, the internal rate of return (IRR) is

the interest rate that makes the PW of all cash outflow
equal to the PW of all cash inflow
IRR rule: A project is acceptable only if IRR ≥ MARR
120 20 20 120 144

IRR = 20% IRR = 20% IRR = 20%

100 100 100

20 40 100

100 IRR = ?
 IRR example

A project needs an investment of $10,000

Its net (= revenue – expense) annual revenue = $2310
After 5 years, it has a salvage value of $2000

2310 4310

10000

2310 2310 2310 2310 4310

If IRR = i, then: 10000     
1  i (1  i) 2 (1  i)3 (1  i) 4 (1  i)5

How to solve?
 IRR Example (cont.)

2310 2310 2310 2310 4310

How to solve? 10000     
1  i (1  i) 2 (1  i)3 (1  i) 4 (1  i)5

This is a degree-5 polynomial equation in i.

High degree-polynomial equation  numerical
techniques to solve

Can use Excel solver..

Function: irr( range of cells [, guess])

Solving for IRR

In general, a polynomial of degree n may have up to n

solutions (real or complex; distinct or coincident)
1100
100

250 250 250

500

i = 4% and i = 98% both satisfy the IRR equation

Which one should be used to evaluate the project?

In fact, if A6 = 200, then both, IRR = -6% and IRR = 99% solve
the equation 
Can we have a negative IRR?
IRR – remarks

The investment-balance interpretation of IRR

i' (= IRR) is the interest rate at which the net

investment in the project becomes zero after N periods
(= project's life span).

dashed lines represent the

opportunity cost of the
residual investment

[source: Fig 5-4, Engineering Economy, Sullivan, Wicks, Koelling]

IRR – remarks (cont.)

IRR is the most popular method used in industry for

evaluating single investments

IRR calculation is difficult (requires solving high order

polynomial equations)

IRR formulations often have multiple solutions [Why?],

and further analysis is required to identify the correct
one
External Rate of Return (ERR)

IRR computation assumes that the residual investment is re-

invested (into the project) at rate = i' [Why?]

In practice, the reinvestment return may be closer to the MARR

(e.g. suppose a project's IRR = 40%, while the firm's MARR =
20%, can the firm reinvest the residual value at 40%?

The ERR method uses an externally specified interest rate (e).

e is the rate at which the firm can invest revenue generated by the
project (equivalently, the rate at which the firm may borrow
capital)
The ERR method

Step 1. Find the equivalent Present Worth (time = 0) of all net

cash outflows using rate = e per compounding period

Step 2. Find the equivalent Future Worth (time = N) of all the net
inflows using rate = e per compounding period

Step 3. Find the rate i' (= ERR) that makes the PW from step 1
equivalent to the FW form step 2, by solving:

σ𝑁 𝐸
𝑘=0 𝑘 (P/F, e %, k)(F/P, i'%, N) = σ 𝑘=0 𝑅𝑘 (F/P, e %, N-k)
𝑁

Ek = Expense in period k FW
Rk = Revenue in period k
N = Project life
PW
ERR method: example

8000 13000

25000

Suppose the MARR=20%. What is ERR?

FW for cash inflow
8000(F/A,20%,5)+(13000-8000) = 64533
PW for cash outflow = 25000
Solve the equation: PW(1+ERR)5=FW
25000(1+ERR)5 = 64533  ERR = 0.2088

Notice: we used the MARR for the discounting rate

[Why?]
ERR method: remarks

Advantages of ERR
Easy to solve
Always has a unique solution

ERR Rule: A project is acceptable only if ERR ≥ MARR

The Excel function mirr( ) can calculate the ERR:

mirr (cell range, ε1, ε2)
Interest rate ε1: for cash outflows
Interest rate ε2: for cash inflows
ERR method: remarks (cont.)

8000 13000

25000

Suppose the MARR=20%, is the project acceptable?

IRR method: irr = 21.58% > 20%  acceptable

ERR method: mirr(…,0.2,0.2) = 20.88% > 20%  ??

ERR method: example

1100
200

250 250 250

500

Recall that we obtained two values for IRR

i = -6% and i = 99%
Suppose we assume that e = MARR = 2%
Using the Excel function mirr(…,0.02,0.02), we get
ERR=2.88% > 2%  project is acceptable
 ERR method compared with the PW method

5000 2000 2000

7000

If ε = 12% and MARR=15%

then ERR = 21.7% > MARR  project is acceptable

PW = 5000 - 7000(P/F,0.15,1) + 2000(P/F,0.15,2) + 2000(P/F,0.15,3)

=1740.36 > 0

Note: IRR does not exist (in this case)

 The Payback Period Method

This is another simple method to estimate if a project is

acceptable.

(Simple) Payback period: is the smallest number of periods (q')

after which the net (discounted) residual value of the project = 0.
′
𝜃
σ𝑘=1(𝑅𝑘 − 𝐸𝑘 )(P/F, MARR%, k) – E0  0

In other words, it is the time required to recover all the costs

incurred so far.

Payback rule: project is acceptable if

payback period < minimum acceptable life span.

In the inequality above, E0 is the initial investment; we solve for q'.

The Payback Period Method: example

MARR=20%
Year Cash Sum of cash PW for Sum of PW
flow flow to year k year k of cash flow
0 -25000 -25000 -25000 -25000
1 8000 -17000 6667 -18333
2 8000 -9000 5556 -12777
3 8000 -1000 4630 -8147
4 8000 7000 3858 -4289
5 13000 5223 934

discounted payback period: θ’=5

The undiscounted payback period (MARR = 0%)  θ = 4
Concluding remarks

- Learnt several simple techniques for evaluating a single project for

economical viability
- In all methods, since there is no other alternative to compare with, an
exogenous comparison standard was required (e.g. MARR,
maximum allowable number of years for payback, …
- The different methods are not mutually consistent – a project may be
viable under one criterion, but not so under another
- All methods in these notes were deterministic – interest rates,
(expected) income and expenses, investment amount, redemption
value were assumed to be known/given.

Acknowledgements:
1. Most of the lecture notes for this course are adapted from those of Prof Xiangtong Qi
2. Course text: Engineering Economy by Sullivan, Wicks, Koelling

Next: Comparing alternatives

Summary

- We saw various different types of cash flows, and how to model them
- Derived equivalence formulae for different cash flows types

Acknowledgements:
1. Most of the lecture notes for this course are adapted from those of Prof Xiangtong Qi
2. Course text: Engineering Economy by Sullivan, Wicks, Koelling

Next: Evaluating investments/projects (deterministic)