Engineering Economics - EIT Review

Cash Flow Evaluation

Hugh Miller
Colorado School of Mines
Mining Engineering Department
Fall 2008
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.

We will use the following criteria:

 Present & Future Value
 Annual Value
 Benefit / Cost Ratio
 Payback period
 Internal Rate of Return
 Variations of IRR
Present Value
The Present value or present worth method of evaluating
projects is a widely used technique. The Present Value
represents an amount of money at time zero representing
the discounted cash flows for the project.

PV

T=0 +/- Cash Flows

 Net Present Value (NPV)
The Net Present Value of an investment it is simply the difference between cash
outflows and cash inflows on a present value basis.
In this context, the discount rate equals the minimum rate of return for the
investment
Where:
NPV = ∑ Present Value (Cash Benefits) - ∑ Present Value (Cash Costs)
Present Value Example

 Initial Investment:$100,000
 Project Life: 10 years
 Salvage Value: $ 20,000
 Annual Receipts: $ 40,000
 Annual Disbursements: $ 22,000
 Annual Discount Rate: 12%

What is the net present value for this project?

Is the project an acceptable investment?
Present Value Example Solution

 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

 Net Present Value $ 8,140

 Greater than zero, therefore acceptable project
Future Value
The future value method evaluates a project
based upon the basis of how much money will be
accumulated at some future point in time. This is
just the reverse of the present value concept.

FV
T=0 +/- Cash Flows
Future Value Example

 Initial Investment:$100,000
 Project Life: 10 years
 Salvage Value: $ 20,000
 Annual Receipts: $ 40,000
 Annual Disbursements: $ 22,000
 Annual Discount Rate: 12%

What is the net future value for this project?

Is the project an acceptable investment?
Future Value Example Solution

 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

 Net Future Value $ 25,280

 Positive value, therefore acceptable project
 Can be used to compare with future value of other projects
PV/FV Example
No theoretical difference if project is evaluated in
present or future value

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

 Sometimes it is more convenient to evaluate a

project in terms of its annual value or cost. For
example, it may be easier to evaluate specific
components of an investment or individual
pieces of equipment based upon their annual
costs as the data may be more readily available
for analysis.
Annual Analysis Example

 A new piece of equipment is being evaluated for

purchase which will generate annual benefits in
the amount of $10,000 for a 10 year period, with
annual costs of $5,000. The initial cost of the
machine is $40,000 and the expected salvage is
$2,000 at the end of 10 years. What is the net
annual worth if interest on invested capital is
10%?
Annual Example Solution

 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

Since this is less than zero, the project is expected to

earn less than the acceptable rate of 10%, therefore
the project should be rejected.
Benefit/Cost Ratio

 The benefit/cost ratio is also called the

profitability index and is defined as the ratio of
the sum of the present value of future benefits to
the sum of the present value of the future capital
expenditures and costs.
B/C Ratio Example
 Present value cash inflows
Project A Project B
$500,000 $100,000

 Present value cash outflows (costs)

$300,000 $ 50,000

 Net Present Value

$200,000 $ 50,000

 Benefit/Cost Ratio
1.67 2.0
Payback Period
This is one of the most common evaluation criteria used by engineering
and resource companies.

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.

The following example illustrates five investment proposals having

identical capital investment requirements but differing expected annual
cash flows and lives.
Payback Period
 Example
Calculation of the payback period for a given investment proposal.
a) Prepare End of Year Cumulative Net Cash Flows
b) Find the First Non-Negative Year
c) Calculate How Much of that year is required to cover the previous period
negative balance
d) Add up Previous Negative Cash Flow Years

Initial Annual Net Cash Flows

Investment 1 2 3 4 5 6 7 8 9 10

Alternative A
(45,000) 10,500 11,500 12,500 13,500 13,500 13,500 13,500 13,500 13,500 13,500

a End of Year Cummulative Net Cash Flow

(45,000) (34,500) (23,000) (10,500) 3,000 16,500 30,000 43,500 57,000 70,500 84,000
b
Pay Back Period
Fraction of First Positive Year 0.78 c) 0.78 = 10,500/13,500
Pay Back Period 3.78 d) 3 + 0.78
Example:
Calculate the payback period for the following investment proposal

Initial Annual Net Cash Flows

Investment 1 2 3 4 5 6 7 8 9 10

Alternative A
(120) 10 10 50 50 50 50 50 50 50 50

End of Year Cummulative Net Cash Flow

(120) (110) (100) (50) 0 50 100 150 200 250 300

Pay Back Period

Fraction of First Positive Year 1.00
Pay Back Period 4.00
Example:
Calculate the payback period for the following investment proposal

Initial Annual Net Cash Flows

Investment 1 2 3 4 5 6 7 8 9 10

Alternative A
(120) 10 10 50 50 50 50 50 50 50 50

End of Year Cummulative Net Cash Flow

(120) (110) (100) (50) 0 50 100 150 200 250 300

Pay Back Period

Fraction of First Positive Year 1.00
Pay Back Period 4.00
Example:

Calculate the payback period for the following investment proposal

Initial Annual Net Cash Flows

Investment 1 2 3 4 5 6 7 8 9 10

Alternative A
(120) 10 10 50 50 50 50 50 50 50 50

End of Year Cummulative Net Cash Flow

(120) (110) (100) (50) 0 50 100 150 200 250 300

Pay Back Period

Fraction of First Positive Year 1.00
Pay Back Period 4.00
Example:
Calculate the payback period for the following investment proposal

Initial Annual Net Cash Flows

Investment 1 2 3 4 5 6 7 8 9 10

Alternative A
(250) 86 50 77 52 41 70 127 24 6 40

End of Year Cummulative Net Cash Flow

(250) (164) (115) (38) 14 55 124 252 276 282 322

Pay Back Period

Fraction of First Positive Year 0.73
Pay Back Period 3.73
Example:

Calculate the payback period for the following investment proposal

Initial Annual Net Cash Flows

Investment 1 2 3 4 5 6 7 8 9 10

Alternative A
(250) 86 50 77 52 41 70 127 24 6 40

End of Year Cummulative Net Cash Flow

(250) (164) (115) (38) 14 55 124 252 276 282 322

Pay Back Period

Fraction of First Positive Year 0.73
Pay Back Period 3.73
Example:

Calculate the payback period for the following investment proposal

Initial Annual Net Cash Flows

Investment 1 2 3 4 5 6 7 8 9 10

Alternative A
(250) 86 50 77 52 41 70 127 24 6 40

End of Year Cummulative Net Cash Flow

(250) (164) (115) (38) 14 55 124 252 276 282 322

Pay Back Period

Fraction of First Positive Year 0.73
Pay Back Period 3.73
Effect of Pre-production Period
When calculating the payback period for a new project we typically
have several years of negative cash flows (investment) prior to positive
cash flows.

Two Approaches: Total Payback and Payback After 1st Production

Effect of Pre-production Period
The total payback period is calculated from the start of the project and
represents the commitment of the investor throughout the pre-production
period, particularly the opportunity cost associated with the investment
during this period.

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

In mineral evaluation, any reference to rate of return normally refers to

the discounted cash flow return on investment (DCF-ROI) or the
discounted cash flow rate of return (DCF-ROR)

These terms are special versions of the more generic term, Internal
Rate of Return (IRR) or sometimes called marginal efficiency of capital

Besides NPV, is probably the most common evaluation technique used

in the minerals industry
 Internal Rate of Return

 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:

∑ PV cash inflows - ∑ PV cash outflows = 0

NPV = 0 for r
∑ PV cash inflows = ∑ PV cash outflows

In general, the calculation procedure involves a trial-and-error solution

unless the annual cash flows subsequent to the investment take the form of an
annuity. The following examples illustrate the calculation procedures for determining
the internal rate of return.
 Example
Given an investment project having the following annual cash flows; find the IRR.

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%

NPV = -30(1.0) -1(P/F,1,15%) + 5(P/F,2,15) + 5.5(P/F,3,15) + 4(P/F,4,15)

+ 17(P/F,5,15) + 20(P/F,6,15) + 20(P/F,7,15) - 2(P/F,8,15) + 10(P/F,9,15)
= + $5.62

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

Using Excel you should insert the following function in the

targeted cell C6:
Analysis

The acceptance or rejection of a project based on the IRR

criterion is made by comparing the calculated rate with the required rate
of return, or cutoff rate established by the firm. If the IRR exceeds the
required rate the project should be accepted; if not, it should be rejected.

If the required rate of return is the return investors expect the

organization to earn on new projects, then accepting a project with an
IRR greater than the required rate should result in an increase of the
firms value.
Analysis

There are several reasons for the widespread popularity of the IRR
as an evaluation criterion:

 Perhaps the primary advantage offered by the technique is

that it provides a single figure which can be used as a
measure of project value.

 Furthermore, IRR is expressed as a percentage value.

Most managers and engineers prefer to think of economic
decisions in terms of percentages as compared with
absolute values provided by present, future, and annual
value calculations.
Analysis
Another advantage offered by the IRR method is related to the
calculation procedure itself:
As its name suggests, the IRR is determined internally for
each project and is a function of the magnitude and timing of
the cash flows.
Some evaluators find this superior to selecting a rate
prior to calculation of the criterion, such as in the profitability
index and the present, future, and annual value
determinations. In other words, the IRR eliminates the need to
have an external interest rate supplied for calculation purposes.
Multiple Roots Case
One of the disconcerting aspects associated with the internal rate of return is
that more than one interest rate may satisfy the calculation. The solution
procedure for IRR is essentially the solution for an nth degree polynomial of the
form:

NPV = 0 = A0 + A1X + A2X2 + A3X3 + .... + AnXn

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
The following example illustrates the possibility of multiple rates which satisfy the definition of IRR:

Suppose a mining operation has a remaining life of eight years, but an investment is considered to increase the production rate. This will result in depleting the
deposit Year
in six years. Assuming0the following cash
1 flows, is the 2 3
investment justified? 4 5 6 7 8

Existing 10.0 10.0 10.0 10.0 10.0 10.0 10.0 10.0

Proposed (15.0) 16.0 16.0 16.0 16.0 15.0 15.0 - -

Difference (15.0) 6.0 6.0 6.0 6.0 5.0 5.0 (10.0) (10.0)

Because there are two sign reversals in the cash flows, Descartes‘ Rule of Signs indicates there are a
maximum of two real roots to the IRR polynomial.

Solving for these roots by trial and error yields the following:
 Multiple Roots Case
Graphically this appears as shown in the following figure:

The rates at which NPV = 0 are, by definition, the internal rates of return. By interpolation, the two solving rates of return for this example are approximately 4.5 and 12.3%

Rate 0% 4% 5% 10% 12% 15%

NPV (1.00) (0.07) 0.06 0.05 0.03 (0.25)

Multiple Roots Case
Should the firm invest in the project or not?

If both rates were above the firm's required rate of return there would be no
problem and the firm would accept the project.

However, what if the required rate of return is 10%? Which of the calculated
IRR values is correct? The answers to these questions are that they are both
mathematically correct, but they are meaningless from an economic standpoint.

Neither of these rates can be considered an adequate measure of the

project's rate of return because a project can not earn more than one rate of
return over its life. Therefore, the calculation of an IRR value(s) does not
always enable the decision-maker to make accept/reject decisions on
investment proposals.
Multiple Roots Case
How often this problem of multiple rates actually occurs?

The possibility of multiple-rate occurrences is perhaps more prevalent in

the case of new mining ventures than in most other industries. The negative
cash flows are typically the result of anticipated periods of reduced market
prices, major capital expenditures for equipment replacement, expansion
programs, and/or major environmental expenditures, particularly at the end of
project life.

Because of the possibility of multiple rates and the reinvestment

assumption when using-the IRR to rank projects, the evaluator must carefully
consider the exclusive use of this technique for decision-making.
Selecting a Discount Rate
“There is nothing so disastrous as a rational investment
policy in an irrational world” John Maynard Keynes

We have discussed the time value of money and illustrated

several examples of its use. In all cases an interest rate or
“discount rate” is used to bring the future cash flows to the
present (NPV - Net Present Value)

The selection of the appropriate discount rate has been the

source of considerable debate and much disagreement. In
most companies, the selection of the discount rate is
determined by the accounting department or the board of
directors and the engineer just uses the number provided to
him, but short of just being provided with a rate, what is the
correct or appropriate rate to use?
Example
What is the impact of the discount rate on the investment?

Cash Cash Cash Cash Cash Cash

Flow Yr 0 Flow Yr 1 Flow Yr 2 Flow Yr 3 Flow Yr 4 Flow Yr 5
-500 -500 +750 +600 +800 +1000

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?

According to practice, the discount rate has to cover the following

items:
 Opportunity Costs
 Transaction Costs
 Compensate for Risk
 Cover anticipated Inflation

Some of these items can be accounted for in other financial analysis

methods and do not have to be address in the discount rate itself.
Financial Cost of Capital

The financial cost of capital is based on the assumption

that financing is unlimited and the company can always
pay off loans or buy stock back, so the financial cost of
capital rate of return is the average cost of debt after tax
(remember interest is tax deductible) and the cost of
equity (what the share holders desired return is using the
capital asset pricing model CAPM)
Marginal Weighted Average Cost of Capital

The cost of capital is the minimum rate of return that a

firm needs to earn on new investments to maintain the
existing value of it’s shares of common stock. To
determine the cost of capital a weighted average of all
sources of capital must be evaluated. The weighted
average should include a mix of debt and equity on an
after tax basis.
Hurdle Rate

The hurdle rate is a common term used by companies as

an expression of their rate of return used for financial
analysis.

This is generally a higher number than the FCC rate as

they add an imposed “economic hurdle” for the project to
overcome. This helps companies express that a project
that just achieves a FCC rate of return does not add real
value to the company.
Opportunity Cost of Capital

The opportunity cost of capital is the most

common method of establishing the investor’s
minimum rate of return.

This is based upon the expected returns that the

company will generate in the next 1 to 15 years.
It is the average return that investors expect to
make over the next few years expressed as a
compound interest.