Beruflich Dokumente
Kultur Dokumente
Hugh Miller
Colorado School of Mines
Mining Engineering Department
Fall 2007
Introduction
As we have addressed the fundamental concepts associated with
engineering economics and cash flows, is now time to convert these
estimates into measures of desirability as a tool for investment
decisions.
PV
Annual Receipts
$40,000(P/A, 12%, 10) $ 226,000
Salvage Value
$20,000(P/F, 12%, 10) $ 6,440
Annual Disbursements
$22,000(P/A, 12%, 10) -$124,000
Initial Investment (t=0) -$100,000
FV
T=0 +/- Cash Flows
Future Value Example
Annual Receipts
$40,000(F/A, 12%, 10) $ 701,960
Salvage Value
$20,000(year 10) $ 20,000
Annual Disbursements
$22,000(F/A, 12%, 10) -$386,078
Initial Investment
$100,000(F/P, 12%, 10) -$310,600
PV of $ 25,282
$25,282(P/F, 12%, 10) $ 8,140
FV of $8,140
$8,140(F/P, 12%, 10) $ 25,280
Annual Value
Benefits:
$10,000 per year $10,000
Salvage
$2,000(P/F, 10%, 10)(A/P, 10%,10) $ 125
Costs:
$5,000 per year -$ 5,000
Investment:
$40,000(A/P, 10%, 10) -$ 6,508
Net Annual Value -$1,383
The Payback Period is simply the number of years required for the
cash income from a project to return the initial cash investment in the
project.
The investment decision criteria for this technique suggests that if the
calculated payback is less than some maximum value acceptable to
the company, the proposal is accepted.
Alternative A
(45,000) 10,500 11,500 12,500 13,500 13,500 13,500 13,500 13,500 13,500 13,500
Alternative A
(120) 10 10 50 50 50 50 50 50 50 50
Alternative A
(120) 10 10 50 50 50 50 50 50 50 50
Alternative A
(120) 10 10 50 50 50 50 50 50 50 50
Alternative A
(250) 86 50 77 52 41 70 127 24 6 40
Alternative A
(250) 86 50 77 52 41 70 127 24 6 40
Alternative A
(250) 86 50 77 52 41 70 127 24 6 40
Disadvantages:
A) This criterion fails to consider cash flows after the payback period,
therefore, it can’t be regarded as a suitable measure of profitability.
B) It doesn’t consider the magnitude or timing of the of cash flows during the
payback interval.
Advantages
1. Simple and easy to calculate, providing a simple number which
can be used as an index of proposal profitability.
2. Prevents management from exposure to excessive risk
The shorter the payback the less risk associated with the
investment
3. Measure of lost opportunity risk
Projects with short payback will minimize opportunity risk since
early cash flows will be returned to the firm within a short span of
time. (Liquidity)
4. Payback period represents a break even point.
Projects with life greater than the payback period will
contribute profit to the firm
Engineering Economics
EIT Review
IRR & Discount Rates
Investment Rate of Return
These terms are special versions of the more generic term, Internal
Rate of Return (IRR) or sometimes called marginal efficiency of capital
Internal Rate of Return refers to the interest rate that the investor
will receive on the investment principal
IRR is defined as that interest rate (r) which equates the sum of
the present value of cash inflows with the sum of the present
value of cash outflows for a project. This is the same as defining
the IRR as that rate which satisfies each of the following
expressions:
Year 0 1 2 3 4 5 6 7 8 9
Cash Flow (30.0) (1.0) 5.0 5.5 4.0 17.0 20.0 20.0 (2.0) 10.0
Solution:
Step 1. Pick an interest rate and solve for the NPV. Try r =15%
Since the NPV>0, 15% is not the IRR. It now becomes necessary to select a
higher interest rate in order to reduce the NPV value.
Step 2. If r =20% is used, the NPV = - $ 1.66 and therefore this rate is too high.
Step 3. By interpolation the correct value for the IRR is determined to be r =18.7%
IRR using Excel
There are several reasons for the widespread popularity of the IRR as
an evaluation criterion:
where X = 1/(1 + r)
For a polynomial of this type there may be n different real roots, or values of
r, which satisfy the equation. Multiple positive rates of return may occur when
the annual cash flows have more than one change in sign.
Multiple Roots Case
Year 0 1 2 3 4 5 6 7 8
Difference (15.0) 6.0 6.0 6.0 6.0 5.0 5.0 (10.0) (10.0)
If both rates were above the firm's required rate of return there
would be no problem and the firm would accept the project.
ROR NPV
2% 1,941
6% 1,581
10% 1,283
15% 981
20% 739
IRR 47.82% 0
What is in the Discount Rate?