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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

I. Introduction

1.1. The Value of Water

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

 We can also become more efficient

What do we mean by ‘economic value?’

A commodity has an economic value when people are

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.

People would pay any price. This is not useful

information for policymakers.

But after basic needs are met, people buy water based
on its price compared to other goods they might buy.
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 household pay for drinking water?

 How much will a farmer pay for irrigation water?
 How much will a factory pay for clean water?

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Why value water?

Water as an Economic Good:

 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
Water value provides critical information for
decisions about

• Efficient and equitable allocation of water among

competing users,

• Efficient and equitable infrastructure investment in the

water sector (how much, where, when)

• Efficient degree of treatment of wastewater

• Design of economic instruments: water pricing,

property rights, taxes on water depletion and pollution,
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1.2. Engineering Economy/Economic

 It deals with the concepts and techniques

of analysis useful in evaluating the worth
of systems, products, and services in
relation to their costs.

 Economic analysis is important and useful

for decision-support in connection with
investment, efficiency improvement and
other management tasks.
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Fundamental Principles of Engineering Economics

 An instant dollar is worth more than a

distant dollar…

 Marginal revenue must exceed marginal cost, in

order to carry out a profitable increase of

 Additional risk is not taken without an

expected additional return of suitable
Economic decisions 9

Any person involved in decision making must be

able to analyze the financial and/or economic
outcome of his or her decision.

The decision is based on analyzing and evaluating

the costs and benefits of the activities involved in
producing the outcome of the project.

The decisions may involve either

• To proceed or not to proceed with a project

• 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.

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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

Economic analysis methods will give us this capability.

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
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Economic analysis is a critical element of the planning

The objective of economic analysis is to determine if a

project represents the best use of resources over the
analysis period.

This process requires defining feasible alternatives and

then applying a discounting technique to select the best
alternative or courses of action.

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In order to perform economic analysis, several

basic concepts such as;

 equivalence of kind,
 equivalence of time, and
 discounting factors must be understood.


The major obstacles to express the consequences of

alternative courses of action in commensurable units are
differences in kind and differences in time.

Thus the concept of equivalence of kind and equivalence

of time is important.

One of the first steps in economic analysis is to find a

common value unit such as monetary unit. This will avoid
the differences in kind.

Importance of Time (Time Value of Money)
Money can have different values at different
 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.

It is like renting a house.

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2.2. Cash Flow Diagram (CFD)

The graphic presentation of the costs and benefits

over the time is called the cash flow diagram.

This is the time profile of all the costs and benefits.

It is a presentation of what costs have to be incurred

and what benefits are received at all points in time.

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The following conventions are used in the
construction of the cash flow diagram:

• The horizontal axis represents time

• The vertical axis represents costs and
• Costs are shown by downward arrows
• Benefits are shown by upward arrows

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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
 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
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).

• Specifically, a CFD illustrates the size, sign, and

timing of individual cash flows.

• The CFD is the basis for engineering economic


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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 2

$580 $540

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2.3. Discounting Factors

The monetary evaluation of alternatives generally occurs

over a number of years.

Money at different times cannot be directly combined

and compared but must first be made equivalent through
the use of discount factors.

Discount factors convert a monetary value at

one date to an equivalent value at another date.
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Discounting factors are described using the
i is the annual interest rate (discounting
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.

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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 

The Single-payment compound amount factor is

F F 
 (1  i )   , 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

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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(PA,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

• If you wished to have $800 in a savings account at

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

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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)

 Using the compound interest formulas bring all

benefits and costs to present worth

 Select the alternative if its net present worth

(Present worth of benefits – Present worth of
costs) ≥ 0

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B. Steps to do present worth analysis for selecting a
single alternative (investment) from among
multiple alternatives

Step 1: Select a desired value of the return on

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)
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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

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Present Worth Analysis
• Present worth of benefits = $9,000(PA,9%,10) =
$9,000(6.418) = $57,762
• Present worth of costs = $50,000 +
$2,000(PA,9%,10) - $10,000(PF,9%,10)= $50,000 +
$2,000(6.418) - $10,000(0.4224) = $58,612
• Net present worth = $57,762 - $58,612 < 0  do not
• What should be the minimum annual benefit for
making it a worthy of investment at 9% rate of

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Present Worth Analysis

• Present worth of benefits = A(PA,9%,10) =

• Present worth of costs = $50,000 +
$2,000(PA,9%,10) - $10,000(PF,9%,10)=
$50,000 + $2,000(6.418) - $10,000(0.4224) =
• A(6.418) = $58,612  A = $58,612/6.418 =

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III. Economic Analysis Methods

Three common methods of economic

analysis are
1. cost effectiveness,
2. Benefit cost analysis i.e either using benefit-cost
ratio, or Net benefit
3. Internal rate of return

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3.1. cost effectiveness

A cost-effectiveness analysis identifies the least costly

method for achieving specific physical objectives.

It is particularly important when the objective cannot

be expressed in monetary terms and therefore cannot
be included in a traditional benefit-cost analysis.

A good example of this in water resources planning is

ecosystem restoration.

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3.2. Benefit-cost analysis

A benefit-cost analysis determines whether the social

benefits of a proposed project or plan outweigh its social
costs over the analysis period.

The comparison can be displayed as either the quotient of

benefits divided by costs (the benefit-cost ratio), or the
difference between benefits and costs (net benefits), or
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.
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Net Benefit anaylsis

• Net benefits are determined by estimating discounted

benefits and costs over the study period, and then
subtracting the discounted costs from the discounted
benefits to obtain discounted net benefits.

• Net benefits are at a maximum when the benefits added

by the last increment of a project are equal to the cost
of adding that increment. In other words, marginal
benefits equal marginal costs.

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Anaylsis of Benefit-cost ratio

Benefit/cost (B/C) ratio can be expressed as a ratio by

dividing discounted benefits by discounted costs.

A project is economically justified if its B/C ratio is greater

than 1.00.

The B/C ratio is a measure of relative rather than absolute

merit, thus it can be used to select from projects of
different scales and objectives.

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Example. Determine the optimum scale of
development for a hydroelectric project using the
benefit-cost analysis procedure.

The various alternative size projects and

corresponding benefits are listed in Table below.

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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)
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
B 3000
  1.3
C 2400

The optimum scale of development is the

100,000kW project which also has the largest net

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3.3. Internal rate of return (IRR)

• The internal rate of return (IRR) is the estimated

rate of return from an investment.

• The investment is regarded as 'acceptable' if the

IRR is higher than the market rate of interest.

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Rate of Return Analysis

 Single alternative case

 In this method all revenues and costs of the
alternative are reduced to a single percentage
 This percentage number can be compared to other
investment returns and interest rates inside and
outside the organization

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Rate of Return Analysis

 Steps to determine rate of return for a single

stand-alone investment

Step 1: Take the dollar amounts to the same point

in time using the compound interest

Step 2: Equate the sum of the revenues to the sum

of the costs at that point in time and solve for i
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Example on Rate of Return Analysis

 An initial investment of $500 is being considered. The

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?

 In this example we will take benefits and costs to the present

time and their present values are then equated

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Rate of Return Analysis
 $500 = $300(PF, i, n=1) + 300(PF, i, n=2) + $200(PF, i,
 Now solve for i using trial and error method
 Try 10%: $500 = ? $272 + $247 + $156 = $669 (not
 Try 20%: $500 = ? $250 + $208 + $116 = $574 (not
 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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For further understanding you may

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