Chapter Opening

Story – GE’s
Healthymagination
Project
GE Unveils $6 Billion
Health-Unit Plan:
• Goal: Increase the
market share in the
healthcare sector.
• Strategies: Develop
products that will lower
costs, increase access
and improve health-care
quality.
• Investment required:
$6 billion over six years
• Desired project
outcome: Would help
GE’s health-care unit
grow at least twice as
fast as the broader
economy.
Ultimate Questions
GE’ s Point of View:
Would there be enough demand for their
products to justify the investment required in new
facilities and marketing?
What would be the potential financial risk if the
actual demand is far less than its forecast or
adoption of technology is too slow?
If everything goes as planned, how long does it
take to recover the initial investment?
Bank Loan vs. Project Cash Flows
 Principle:
How fast can I recover my initial investment?
 Method:
Based on the cumulative cash flow (or accounting
profit)
 Screening Guideline:
If the payback period is less than or equal to some
specified bench-mark period, the project would be
considered for further analysis.
 Weakness:
Does not consider the time value of money
N Cash Flow Cum. Flow

0 -$105,000+$20,000 -$85,000
1 $15,000 -$70,000
2 $25,000 -$45,000
3 $35,000 -$10,000
4 $45,000 $35,000
5 $45,000 $80,000
6 $35,000 $115,000

Payback period should occurs somewhere

between N = 3 and N = 4.
Practice Problem
How long does it take to recover the initial
investment for the computer process control system
project in Example 5.1?
 Discounted Payback Period
 Principle:
How fast can I recover my initial investment plus
interest?
 Method:
Based on the cumulative discounted cash flow
 Screening Guideline:
If the discounted payback period (DPP) is less than
or equal to some specified bench-mark period, the
project could be considered for further analysis.
 Weakness:
Cash flows occurring after DPP are ignored
Discounted Payback Period Calculation
Period Cash Flow Cost of Funds Ending Cash
(n) (An) (15%)* Balance
0 -$85,000 0 -$85,000

1 15,000 -$85,000(0.15) = -$12,750 -82,750

2 25,000 -$82,750(0.15) = -12,413 -70,163

3 35,000 -$70,163(0.15) = -10,524 -45,687

4 45,000 -$45,687(0.15) =-6,853 -7,540

5 45,000 -$7,540(0.15) = -1,131 36,329

6 35,000 $36,329(0.15) = 5,449 76,778

* Cost of funds = (Unrecovered beginning balance) X (interest rate)

 Principle: Compute the equivalent net surplus at n = 0 for a given
interest rate of i.
 Decision Rule for Single Project Evaluation: Accept the project if the
net surplus is positive.
Decision Rule for Comparing Multiple Alternatives: Select the
alternative with the largest net present worth.

Inflow
0 1
2 3 4 5
Net surplus
Outflow

PW(i)inflow PW(i) > 0

0
PW(i)outflow 0
Example 5.5 - Tiger Machine Tool Company

$35,560 $37,360
$31,850 $34,400

0 inflow
1 2 3 4
outflow
$76,000

PW (12%)inflow  $35,560(P / F ,12%,1)  $37,360(P / F ,12%,2)

$31,850(P / F ,12%,3)  $34,400(P / F ,12%,4)
$
PW (12%)outflow  $76,000
PW (12%)  $106,065  $76,000
 $30,065  0, Accept
 Future Worth Criterion
 Given: Cash flows and
MARR (i) $47,309
 Find: The net equivalent
worth at a specified
period other than
“present”, commonly
$35,560 $37,360 $31,850 $34,400
the end of project life
0
 Decision Rule: Accept 1 3
2
the project if the
equivalent worth is
positive. $76,000
Project life
Example 5.9 Project’s Service Life is Extremely
Long
• Built
a hydroel
ectric plan
 Q1: Was personal s
avings of t using his
$800,000
Bracewell's $800,000 • Powe
investment a wise r generati
kwhs ng capacit
y of 6 mill
one? i on
• Estim
ated annu
 Q2: How long does taxes - $1 al power s
2 0, 0 00 ales after
he have to wait to • Expe
cted servi
recover his initial ce life of 5
0 years
investment, and will
he ever make a
profit?
Ex. 5.9: Mr. Bracewell’s Hydroelectric Project
V1  V2  $1,101K  $1, 468 K
 $367 K  0
V2  120 K ( P / A,8%,50)
 $1, 468 K

V1  $50 K ( F / P,8%,9)  $50 K ( F / P,8%,8)

  $100 K ( F / P,8%,1)  60 K
 $1,101K
 Capitalized Equivalent Worth
 Principle: PW for a
A
project with an
annual receipt of A
over infinite service


life 0

Equation:
CE(i) = A(P/A, i, ) P =CE(i)
= A/i
 Construction cost = $2,000,000

 Annual Maintenance cost = $50,000

 Renovation cost = $500,000 every 15 years

 Planning horizon = infinite period

 Interest rate = 5%
 Years
0 15 30 45 60

$50,000

$500,000 $500,000 $500,000 $500,000

$2,000,000
 Construction Cost
P1 = $2,000,000
 Maintenance Costs
P2 = $50,000/0.05 = $1,000,000
 Renovation Costs
P3 = $500,000(P/F, 5%, 15)
+ $500,000(P/F, 5%, 30)
+ $500,000(P/F, 5%, 45)
+ $500,000(P/F, 5%, 60)
.
= {$500,000(A/F, 5%,15)}/0.05
= $463,423
 Total Present Worth
P = P1 + P2 + P3 = $3,463,423
 Alternate way to calculate P3
 Concept: Find the
effective interest Effective interest rate
rate per payment for a 15-year period
period
Effective interest 0 15 30 45 60
rate for a 15-year
cycle
i = (1 + 0.05)15 - 1 $500,000 $500,000 $500,000 $500,000
= 107.893%
Capitalized equivalent worth
P3 = $500,000/1.0789
= $463,423