ENGINEERING ECONOMICS

UNIT 3
USE OF DEVELOPED EQUATIONS
A) Present worth analysis of alternative investments
• Jubilee investment Ltd accepts Kshs 10,000 at the end of every year for 20 years and pays the investor Ksh
800,000 at the end of the 20th year. Equity investment Ltd accepts Kshs 10,000 at the end of the every year for
20 years and pays investors Kshs 1.5 Million at the end of 25 year. Which is the best investment alternative,
using present worth method. I=12%.
Ans
• For Jubilee Present worth= -10,000 (P/A, 12%, 20) + 800,000 (P/F 12%, 20)
• =Kshs 8,266
• For Equity =-10,000 (P/A, 12%, 20) +1,500,000 (P/F, 12%, 25) =Kshs 13,506
• Ans-EQUITY
• Future Worth Analysis of alternative investments
• Consider the following two mutually exclusive projects. At i=18%, select the bests alternative based on
future worth method.
Alternative 0 1 2 3 4

A (Kshs) -5M 2M 2M 2M 2M

B (Kshs) -4.5M 1.8M 1.8M 1.8M 1.8M

Alternative A
FWA (18%)= -5M (F/P, 18%,4) +2M (F/A,18%,4) = 735,000

Alternative B
FWB=-4.5M (F/P,18%,4) +1.8M (F/A, 18%,4) = 661,500
Hence future worth of A is higher
 • Annual Equivalent Method
• A company invests in one of the two mutually exclusive alternatives. The life of both alternatives is
estimated to be 5 years with the following investment annual returns and salvage values
Alternative A Alternative B

Investment Kshs -150,000 -175,000

Annual equal return 60,000 70,000

Salvage value 15,000 35,000

Determine best alternative based on the annual equivalent method by assuming i=25%
Illustrate the case in a cashflow diagram

Annual equivalent for A =AEA = -150,000 (A/P,

60,000 60,000 60,000 60,000 60,000 +15,000
25%, 25%,5) + 60,000 + 15,000 (A/F, 25%, 5)
= Kshs 6,057
0 1 2 3 4 5
Similarly for B = Kshs 9,198
Best=B
150,000
CAPITAL INVESTMENT DECISIONS
• What are they- involves current outlays in return for stream of benefits in future
• Why they are important (ie need be implemented carefully)
• Involve large amount of money
• Long term-future uncertain
• Influence firms growth
• Unreversible, or reversible at high costs
• Classification of investments-many ways (to cover 2)
• by size (small, medium, large)
• By degree of dependence
a. Mutually exclusive-serve one purpose and compete with each; if A then B not executed

b. Independent investments-opposite of above-e.g. manufacturing additional excavators, and also commercial vehicles

c. Complementary projects-taking project A increases cash flow of project B

d. Contingent investment-dependent projects-investment in factory could require investment in workers facilities

Capital investment decisions are part of capital budgeting process which has
typically the following process:-
1. Generation of investment ideas or proposals.
2. Estimate cash flows
3. Evaluation or appraisal of cash flows (use e.g. NPV, IRR, PI, Pay Back period, break even analysis) .
4. Consideration of qualitative factors
5. Approval/ratification of projects

EVALUATION/APPRAISAL OF CASH FLOWS

Once cash flows have been determined, the next step is appraising the cash flows to determine whether
proposed project are viable. The methods used can be divided into two
1. Discounted cash flows-NPV, IRR and Profitability Index or Cost benefit ratios
2. Non discounted cash flows-break even analysis, pay back period etc
Discounted cash flows
• Usually resources used up or generated in early years are preferred or valued more than
resources in latter years since (1) people have preference for consumption sooner than latter, (2)
money will earn interest in future and to compensate for money now, you need to earn more in
future; and (3) inflation erodes the value of money
• Discounting recognizes the time value of money. It gives the present value of future cash
Ft= P(1+r)t
Then P=Ft/(1+r)t

NET PRESENT VALUE (NPV)

This is a superior or classic method of investment appraisal. It measures the extent to which the wealth of
share holders will be maximized. It is defined as the value of projects future cash flows discounted at
company’s cost of capital (discount rate) minus initial outlay (discounted project costs).
NPV cont.
NPV= Σ FcF - C or Σ FcF - Σ Ct
(1+r)t (1+r)t (1+r)t

NPV= FcF1 + FcF2 +…….FcFt - C

(1+r)1 (1+r)2 (1+r)3

FcF= Future cash flows; r = Cost of capital-discount rate; C = Initial capital outlay
Ct = Cost in period t. (t ranges from 0 to n)

Example 1 Year Project A Project B

0 -1000,000 -1000,000
Cash Flow of a project A and B
1 400,000 100,000
have been estimated as
2 500,000 600,000
follows
3 300,000 400,000
4 100,000 200,000

Calculate the NPV and decide which of the two projects to invest in. For similar risk projects owners earn
10 % P.a
Ans
NPV= 400,000 + 500,000 + 300,000 +100,000 - 1000,000
(1+0.1)1 (1+0.1)2 (1+0.1)3 (1+0.1)4

NPV =1,070,555-1,000,000= 70, 555

Using Discounted Tables

Year Project A Pvf Discounted

cash flows
1 400,000 0.909 363,636
2 500,000 0.826 413,223
3 300,000 0.751 225,394
4 100,000 0.683 68,301
1,070,555

The NPV for A = 1,070,555-1,000,000= 70,555

Calculate for B and make the decision
EXAMPLE 2
A Juja irrigation horticultural farm is considering buying a new piece of pump to help in the irrigation of its
crop. It would cost Sh 40,000 and this would help save sh 7500 each year on labour for the next 10 years.
However at the end of fifth year a one time maintenance of sh 5000 would be incurred. If effective annual
discount rate is 8% should the farm buy the pump
NPV Decision Rule
1. Positive NPV means project increase value of firm or wealth of share holders
2. For two projects with positive NPV, take one with the highest NPV

Advantage of NPV
• It considers time value of money
• It tells whether an investment increases wealth of share holders
• Considers all expected cash flows-unlike e.g. pay back period
• Can be calculated for all projects even when there are changes in sign of cash flow-unlike IRR
• Can incorporate component of risk-included in the discount factor

Disadvantage of NPV
• Requires the estimation of cost of capital in order to calculate; which is an intricate exercise
• Expressed say in shs, yet manager are used to percentages
INTERNAL RATE OF RETURN (IRR)
Known also as yield to maturity, expected rate of return and cash flow rate of return. It is defined as the
discounting rate r which equates the present value of the projects expected cash flows/future cash flows to the
project initial outlays

Σ FcFt - C = 0 or Σ FcFt - Σ Ct =0 (t=0 to n)

(1+r)t (1+r)t (1+r)t

At times written as Σ FcFt = Σ Ct

(1+IRR)t (1+IRR)t

Method of calculating IRR; (1) Trial and error method (2) Graphic method. Plot cash flow against
initial cost (3) Using calculators and (4) Computer programme
For earlier examples-Calculate by trial and error IRR for project A and B and select the best investment

400,000 + 500,000 + 300,000 +100,000 - 1000,000

(1+0.15)1 (1+0.15)2 (1+0.15)3 (1+0.15)4

Get -19,671

We also know from earlier exercise that at 10% NPV =70,550

Get -19,671
We extrapolate to get the IRR
(15-10) = X-10 70.555
70,555-(-19,671) 0-(-19,671) x =11.09
0 10 x 15

19,671

Calculate for project B Ans 13.9% B has higher IRR= so better

IRR Decision Rule
• Accept r if IRR is greater than cost of capital. i.e. if higher than the risk free rate of return
• For mutually exclusive project take one with highest IRR.
Advantage of IRR
• It takes into account the time value of money
• It is simple and easy to understand since it is expressed in percentages
• It is a profitability measure, the higher the IRR, the more profitable
Disadvantages of IRR
• Not linked to goal of maximizing wealth.
• Can give you misleading signals,
– Could for example make you reject a project whose NPV is higher
– At time give you multiple rate of return and as result difficult to make decision
Non discounting Cash flow Methods
• They are used to supplement the discounted, cash flow methods. Include

– Pay back period

– Break even analysis

Pay back period

– It is defined as the number of years required to recover the original cash outlay
invested in a project
Example Year Project A Project B
1 600,000 50,000
Two project are to be decided upon for investment. Expected
2 400,000 150,000
cash flows are. If the investor has 1.2m, based on pay back
3 400,000 400,000
period select the best project
4 200,000 800,000
5 100,000 1,000,000
ANS
Pay back of A= 2 years and 200/400X 12 months=6months
• Project B is 3 years and 9 months Hence project A is the best
Advantages of Pay Back period
– Simple
– Provide some risk measure against time
– Its good for evaluating industries where technology become obsolete
– Gives some measure of liquidity-how fast we will get cash
Disadvantages of Pay Back period
• Doesn't consider time value of money-unless discounting (improved version)
• Ignores cash flow beyond PBP
• Doesn’t indicate whether wealth is created

• Ignore risk of future cash flows

Break even analysis
• Did in Entrepreneurship course
• It’s a device for determining the point at which sales will just cover total
costs. Those that vary with production (VC) and those that don’t (FC)
Assume: X=Units produced; P= Selling price; b= variable costs; a = fixed Costs

Net profit NP =total revenue –total costs = PX- (a +bX)

At Break even point (B.E.P) profit=0
a+bX=PX, or X= a/(p-b)
Example
Suppose a company has the following information. FC=Sh6M, Answer
unit selling price =Sh2000, unit variable cost=Sh 1000, existing • B.E.P = FC/ contribution margin. 6M/(2000-1000) = 6,000
sale =8,000 units • Profit = (8000-6000) X (2000-1000) = 2M
A) What is the B.E.P (B) What is current profit. (c) if existing • (3000-6000) X (1000)(vcm) = -3M
sale was 3,000 what would be the profit NB: Read on Profitability Index, Accounting rate of return, Benefit
Cost ratio –BCR (discounted and non discounted)
FINAL EXAMPLE
• You have been approached by an entrepreneur who wants to start a waste disposal business. Currently he uses human
labour that cost him Ksh 30,000 per month. He gets revenues of Ksh 50,000 per month. He currently pays no taxes. He
intends to purchase an exhauster at a cost of Kshs 2.5 Million. He wants to do this by acquiring a loan of Kshs 2 million which
he will repay in 5 years, the balance of investment cost will be met by entrepreneur. Loan to be paid from the 1st year.
Interest rate on loan is 5% and on reducing balance. With new investment, you have estimated that labour cost will be Ksh
20,000 per month and cost of maintenance and fuel will be Ksh 10,500 p.m. Revenues will increase by Ksh 100,000 p.m. He
will now pay tax on income at 20%. Assume depreciation for each years is 0.2% of cost of exhauster. The machine will be
disposed at the end of 5th year at 10% of purchase price. Cost of capital = 12%
1. Develop a cash flow for the new investment
2. Determine; NPV, IRR, Payback period. Various BCR
3. Discuss whether the investor should continue with the investment.

Answer
• Increase in revenue= 100,000-50,000=50,000 p.m
• Incremental cost=20,000+10,500-30,000= 500 p.m
• Depreciation = 0.2% of 2.5 m= 5000, Salvage value =(250,000)
• Next Page
 Year

Inflows 0 1 2 3 4 5

Inc Revenue 0 600,000 600,000 600,000 600,000 600,000

Loan 2,000,000

TOTAL INFLOWS 2,000,000 600,000 600,000 600,000 600,000 600,000

Outflows

Investment cost 2,500,000 Calculate IRR

Incremental cost 0 6,000 6,000 6,000 6,000 6,000
By trial =about 13.3%
Loan repayment 0 400,000 400,000 400,000 400,000 400,000
Pay back period?
Interest on loan 0 100,000 80,000 60,000 40,000 20,000

TOTAL OUTFLOWS 2,500,000 506,000 486,000 466,000 446,000 426,000

NET FLOWS (500,000) 94,000 114,000 134,000 154,000 174,000

Less depreciation (500,000) 89,000 109,000 129,000 149,000 169,000

Less Tax 20% + Dep (500,0000 76,200 92,200 108,200 124,200 140,200

NET FLOWS- Add salvage (500,000) 76,200 92,200 108,200 124,200 390,200
(250,000)

NPV= -500,000 + 76,200/(1.12)1 + 92,200/(1.12)2 + 108,200/(1.12)3 + 124,200/(1.12)4 + 390,200/(1.12)5 =

18,892.9