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I. Introduction
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But after basic needs are met, people buy water based
on its price compared to other goods they might buy.
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Water’s value is the willingness to pay for water.
It is observed when people make a choice between
different products
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Why value water?
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The decisions may involve either
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To make a decision, we have to find a common measure to
reflect all the costs and benefits and their time of
occurrence.
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II. BASIC ECONOMIC CONCEPTS 13
equivalence of kind,
equivalence of time, and
discounting factors must be understood.
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2.1. CONCEPT OF EQUIVALENCE OF KIND AND TIME
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Importance of Time (Time Value of Money)
Money can have different values at different
times.
The same amount of money is worth more today
than tomorrow
For example, $10,000 now is worth more than
$10,000 a year from now.
Comparison of amounts of money must be made
based on a common time reference
So, The first and foremost thing to realize is that money
has time value.
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The time value of money results from the
willingness of people to pay interest for
the use of money.
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2.2. Cash Flow Diagram (CFD)
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The following conventions are used in the
construction of the cash flow diagram:
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Drawing a Cash Flow Diagrams
A Cash Flow Diagram is created by first
drawing a segmented time-based horizontal
line, divided into appropriate time units.
The time units on the CFD can be years,
months, quarters or any other consistent time
unit
Then at each time when there is a cash flow, a
vertical arrow is added
-pointing down for costs and up for revenues
or benefits.
These cash flows are drawn to relative
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scale. 19
Importance of Cash Flow
• The costs and benefits of engineering projects
occur over time and are summarized on a Cash
Flow Diagram (CFD).
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An Example of Cash Flow Diagram
• A man borrowed $1,000 from a bank at 8%
interest. Two end-of-year payments: at the
end of the first year, he will repay half of the
$1000 principal plus the interest that is due.
At the end of the second year, he will repay
the remaining half plus the interest for the
second year.
• Cash flow for this problem is:
End of year Cash flow
0 $1000
1 580 ($500 +$80)
2 $540 ($500 + $40)
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Cash Flow Diagram
$1,000
1 2
0
$580 $540
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2.3. Discounting Factors
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For example consider an amount of money P that is to
be invested for n years at i percent interest rate. The
future sum F at the end of n years is determined using
the equation:
F P 1 i
n
P P
This factor defines the number of Birrs which
accumulates after n years for each Birr initially invested
at an interest rate of i percent
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Other Discounting Factors
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Some examples on applications of the discounting
factors
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Given the choice of these two plans which
would you choose?
Year Plan A Plan B
0 $4,000
1 $1,000
2 $1,000
3 $1,000
4 $1,000
5 $1,000
Total $5,000 $4,000
To make a choice the cash flows must be altered so a comparison
may be made.
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Resolving Cash Flows to Equivalent Present Values
Plan A
• P = $1,000(PA,10%,5)
• P = $1,000(3.791) = $3,791
Plan B
• P = $4,000
• Alternative B is better than
alternative A since
alternative B has a greater
present value
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An Example of Present Value
n = 4, F = $800, i = 5%, P = ?
P = PV(5%,4,,800) = $658.16
You should put P = $658.16
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Present Worth Analysis
A.Steps to do present worth analysis for a single
alternative (investment)
Select a desired value of the return on
investment (i)
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B. Steps to do present worth analysis for selecting a
single alternative (investment) from among
multiple alternatives
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Present Worth Analysis
• Present worth of benefits = $9,000(PA,9%,10) =
$9,000(6.418) = $57,762
• Present worth of costs = $50,000 +
$2,000(PA,9%,10) - $10,000(PF,9%,10)= $50,000 +
$2,000(6.418) - $10,000(0.4224) = $58,612
• Net present worth = $57,762 - $58,612 < 0 do not
invest
• What should be the minimum annual benefit for
making it a worthy of investment at 9% rate of
return?
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Present Worth Analysis
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III. Economic Analysis Methods
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3.1. cost effectiveness
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3.2. Benefit-cost analysis
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Anaylsis of Benefit-cost ratio
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Example. Determine the optimum scale of
development for a hydroelectric project using the
benefit-cost analysis procedure.
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Determination of optimum scale of development of
a hydroelectric project
1 2 3 4 5 Incremental
Scale Cost C Benefit B Net B/C Cost Benefit ΔB/ΔC
(KW) ($000) ($000) Benefit ΔC ($000) ΔB($000)
($000)
50,000 15,000 18,000 3000 1.2 __ __ __
60,000 17,400 21,000 3600 1.2 2400 3000 1.3
75,000 21,000 26,700 5700 1.3 3600 5700 1.6
90,000 23,400 29,800 6400 1.3 2400 3100 1.3
100,000 26,000 32,700 6700 1.3 2600 2900 1.1
125,000 32,500 38,500 6000 1.2 6500 5800 0.9
150,000 37,500 42,500 5000 1.1 5000 4000 0.8
200,000 50,000 50,000 __ 1.0 12500 7500 0.6
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Referring to the Table in the previous slide, the
B/Cs for the alternatives are the incremental
benefit-cost ratios, given in column 8. Comparing
the 50,000 and 60,000kW alternatives, the ΔB/ΔC
is
B 3000
1.3
C 2400
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3.3. Internal rate of return (IRR)
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Rate of Return Analysis
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Rate of Return Analysis
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Rate of Return Analysis
$500 = $300(PF, i, n=1) + 300(PF, i, n=2) + $200(PF, i,
n=3)
Now solve for i using trial and error method
Try 10%: $500 = ? $272 + $247 + $156 = $669 (not
equal)
Try 20%: $500 = ? $250 + $208 + $116 = $574 (not
equal)
Try 30%: $500 = ? $231 + $178 + $91 = $500 (equal) i
= 30%
The desired return on investment is 15%, the project
returns 30%, so it should be implemented
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