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- The Total Money Makeover: Classic Edition: A Proven Plan for Financial Fitness
- Principles: Life and Work
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- I Will Teach You to Be Rich, Second Edition: No Guilt. No Excuses. No BS. Just a 6-Week Program That Works
- Awaken the Giant Within: How to Take Immediate Control of Your Mental, Emotional, Physical and Financial
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- Secrets of the Millionaire Mind: Mastering the Inner Game of Wealth
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- The Total Money Makeover Workbook: Classic Edition: The Essential Companion for Applying the Book’s Principles
- Secrets of Six-Figure Women: Surprising Strategies to Up Your Earnings and Change Your Life
- MONEY Master the Game: 7 Simple Steps to Financial Freedom
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Objectives of this chapter are:

• To understand the concept of economic value

• To know the purposes of economic analysis

• To understand concept of equivalence and

the importance of cashflow driagram to

economic analysis

• To know some common methods of

ecomonic analysis

8/20/2019

I. Introduction

2

When do we say a resource is cheap?

A resource is cheap when it is plentiful:

The price goes up as it becomes scarce

As the price goes up, we begin to substitute:

one product for another

one location for another

8/20/2019

What do we mean by ‘economic value?’

3

willing to pay for it, rather than go without.

Water is an essential commodity, so the value of a

small/basic amount for survival is infinite.

information for policymakers.

But after basic needs are met, people buy water based

on its price compared to other goods they might buy.

8/20/2019

Water’s value is the willingness to pay for water.

It is observed when people make a choice between

different products

How much will a farmer pay for irrigation water?

How much will a factory pay for clean water?

4 8/20/2019

Why value water?

5

After basic needs are met, water should be

allocated to the highest value uses

The times of “easy water” are over. The

available fresh water is limited.

Water is intimately linked to health,

agriculture, industry, energy, and

biodiversity.

8/20/2019

Water value provides critical information for

decisions about

competing users,

water sector (how much, where, when)

property rights, taxes on water depletion and pollution,

etc.

8/20/2019 6

1.2. Engineering Economy/Economic

analysis

of analysis useful in evaluating the worth

of systems, products, and services in

relation to their costs.

for decision-support in connection with

investment, efficiency improvement and

other management tasks.

8/20/2019 7

Fundamental Principles of Engineering Economics

distant dollar…

order to carry out a profitable increase of

operations

expected additional return of suitable

magnitude

8/20/2019

Economic decisions 9

able to analyze the financial and/or economic

outcome of his or her decision.

the costs and benefits of the activities involved in

producing the outcome of the project.

8/20/2019

The decisions may involve either

or

• Sometimes it may confronted with two

or more courses of actions (alternatives);

in this situation, the analysis helps to know

which alternative produces the greatest

net benefit and make a choice.

8/20/2019 10

To make a decision, we have to find a common measure to

reflect all the costs and benefits and their time of

occurrence.

The economic analysis should answer questions such as,

Should the project be built at all?

Should it be built now?

Should it be built to a different configuration or size?

Will the project have a net positive socioeconomic

value?

8/20/2019 11

Economic analysis is a critical element of the planning

process.

project represents the best use of resources over the

analysis period.

then applying a discounting technique to select the best

alternative or courses of action.

8/20/2019 12

II. BASIC ECONOMIC CONCEPTS 13

basic concepts such as;

equivalence of kind,

equivalence of time, and

discounting factors must be understood.

8/20/2019

14

2.1. CONCEPT OF EQUIVALENCE OF KIND AND TIME

alternative courses of action in commensurable units are

differences in kind and differences in time.

of time is important.

common value unit such as monetary unit. This will avoid

the differences in kind.

8/20/2019

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.

8/20/2019 15

The time value of money results from the

willingness of people to pay interest for

the use of money.

8/20/2019 16

2.2. Cash Flow Diagram (CFD)

over the time is called the cash flow diagram.

and what benefits are received at all points in time.

8/20/2019 17

The following conventions are used in the

construction of the cash flow diagram:

• The vertical axis represents costs and

benefits

• Costs are shown by downward arrows

• Benefits are shown by upward arrows

8/20/2019 18

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

8/20/2019

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).

timing of individual cash flows.

analysis.

8/20/2019 20

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)

8/20/2019 21

Cash Flow Diagram

$1,000

1 2

0

$580 $540

8/20/2019 22

2.3. Discounting Factors

over a number of years.

and compared but must first be made equivalent through

the use of discount factors.

one date to an equivalent value at another date.

8/20/2019 23

Discounting factors are described using the

notation:

i is the annual interest rate (discounting

rate);

n is the number of years;

P is the present amount of money;

F is the future amount of money; and

A is the annual amount of money.

8/20/2019 24

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

F F

(1 i ) , i %, n

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

8/20/2019 25

Other Discounting Factors

8/20/2019 26

Some examples on applications of the discounting

factors

8/20/2019 27

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.

8/20/2019 28

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

8/20/2019 29

An Example of Present Value

the end of four years, and 5% interest paid annually,

how much should you put into the savings account?

n = 4, F = $800, i = 5%, P = ?

P = PV(5%,4,,800) = $658.16

You should put P = $658.16

8/20/2019 30

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)

benefits and costs to present worth

(Present worth of benefits – Present worth of

costs) ≥ 0

8/20/2019 31

B. Steps to do present worth analysis for selecting a

single alternative (investment) from among

multiple alternatives

investment (i)

Step 2: Using the compound interest formulas

bring all benefits and costs to present

worth for each alternative

Step 3: Select the alternative with the largest net

present worth (Present worth of

benefits-Present worth of costs)

8/20/2019 32

Example on Present Worth Analysis

• A construction enterprise is investigating the

purchase of a new dump truck. Interest rate is 9%.

The cash flow for the dump truck are as follows:

• First cost = $50,000, annual operating cost = $2000,

annual income = $9,000, salvage value is $10,000, life

= 10 years. Is this investment worth undertaking?

• P = $50,000, A = annual net income = $9,000 - $2,000

= $7,000, S = 10,000, n = 10.

• Evaluate net present worth = present worth of

benefits – present worth of costs

8/20/2019 33

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?

8/20/2019 34

Present Worth Analysis

A(6.418)

• 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

• A(6.418) = $58,612 A = $58,612/6.418 =

$9,312.44

8/20/2019 35

III. Economic Analysis Methods

analysis are

1. cost effectiveness,

2. Benefit cost analysis i.e either using benefit-cost

ratio, or Net benefit

3. Internal rate of return

8/20/2019 36

3.1. cost effectiveness

method for achieving specific physical objectives.

be expressed in monetary terms and therefore cannot

be included in a traditional benefit-cost analysis.

ecosystem restoration.

8/20/2019 37

3.2. Benefit-cost analysis

benefits of a proposed project or plan outweigh its social

costs over the analysis period.

benefits divided by costs (the benefit-cost ratio), or the

difference between benefits and costs (net benefits), or

both.

A project is economically justified if the present value of

its benefits exceeds the present value of its costs over the

life of the project.

8/20/2019 38

Net Benefit anaylsis

benefits and costs over the study period, and then

subtracting the discounted costs from the discounted

benefits to obtain discounted net benefits.

by the last increment of a project are equal to the cost

of adding that increment. In other words, marginal

benefits equal marginal costs.

8/20/2019 39

Anaylsis of Benefit-cost ratio

dividing discounted benefits by discounted costs.

than 1.00.

merit, thus it can be used to select from projects of

different scales and objectives.

8/20/2019 40

8/20/2019 41

Example. Determine the optimum scale of

development for a hydroelectric project using the

benefit-cost analysis procedure.

corresponding benefits are listed in Table below.

8/20/2019 42

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

8/20/2019 43

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

100,000kW project which also has the largest net

benefits.

8/20/2019 44

3.3. Internal rate of return (IRR)

rate of return from an investment.

IRR is higher than the market rate of interest.

8/20/2019 45

Rate of Return Analysis

In this method all revenues and costs of the

alternative are reduced to a single percentage

number

This percentage number can be compared to other

investment returns and interest rates inside and

outside the organization

46 8/20/2019

Rate of Return Analysis

stand-alone investment

in time using the compound interest

formulas

of the costs at that point in time and solve for i

47 8/20/2019

Example on Rate of Return Analysis

revenues from this investment are $300 at the end of the

first year, $300 at the end of the second, and $200 at the end

of the third. If the desired return on investment is 15%, is

the project acceptable?

time and their present values are then equated

48 8/20/2019

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

49 8/20/2019

50

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