(c) 2001 Contemporary Engineering

Economics
1
EVALUATING BUSINESS
AND ENGINEERING ASSETS
Present Worth Analysis
Annual Equivalent Analysis

(c) 2001 Contemporary Engineering
Economics
2
Looking back..economic analysis problems
Capital Investment project

PW analysis - equivalence computed
relative to the present or time zero
AE analysis equivalent annual worth is
determined
ROR analysis measure of yield from a
project

(c) 2001 Contemporary Engineering
Economics
3
Looking back..economic analysis problems
Pay back period exclude Time value of money
What is NPW?
To find NPW of a project an interest rate is
needed to discount future cash flows
What is the most appropriate value to use this
int. rate?
The selection of this rate is a policy decision.
MARR
PW = CF0 + CF1(P/F,i%,1)+CF2(P/F,
%,2)+..+CFn(P/F,i%,n)


(c) 2001 Contemporary Engineering
Economics
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Looking back..economic analysis problems

AE Measure investment worth on annual
basis
The equation for AE is:
AE(i) = PW(i)(A/P, i, N).

By knowing annual equivalent worth, we can:
Seek consistency of report format
Determine unit cost (or unit profit)
Facilitate unequal project life
comparison
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Economics
5
Rate of Return Analysis
Rate of Return
Methods for Finding
ROR
Internal Rate of
Return (IRR) Criterion
Incremental Analysis
Mutually Exclusive
Alternatives

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Economics
6
Rate of Return
Definition: A relative percentage method which
measures the yield as a percentage of investment
over the life of a project

Example: Vincent Goghs painting Irises
John bought the art at $80,000.
John sold the art at $53.9 million in 40 years.
What is the rate of return on Johns investment?
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Economics
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Rate of Return
Given: P =$80,000, F
= $53.9M, and N = 40
years
Find: i
Solution:

$80,000
$53.9M
$53. $80, ( )
.
9 000 1
17 68%
40
M i
i
= +
=
0
40
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Economics
8

In 1970, when Wall Mart Inc. went
public, an investment of 100 shares cost
$1,650. That investment would have
been worth $13,312,000 on January 31,
2000.

What is the rate of return on that
investment?
Meaning of Rate of Return
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Economics
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Solution:
0
30
$13,312,000
$1,650
Given: P = $1,650
F = $13,312,000
N = 30
Find i:

$13,312,000 = $1,650 (1 + i )
30
i = 34.97%
N
i P F ) 1 ( + =
Rate of Return
(c) 2001 Contemporary Engineering
Economics
10
Suppose that you invested that amount ($1,650) in
a savings account at 6% per year. Then, you could
have only $9,477 on January, 2000.

What is the meaning of this 6% interest here?

This is your opportunity cost if putting money in
savings account was the best you can do at that
time!
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Economics
11
So, in 1970, as long as you earn more than 6%
interest in another investment, you will take that
investment.

Therefore, that 6% is viewed as a minimum
attractive rate of return (or required rate of return).

So, you can apply the following decision rule, to see
if the proposed investment is a good one.

ROR > MARR


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Economics
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Why ROR measure is so popular?
This project will bring in a 15% rate of return on
investment.

This project will result in a net surplus of $10,000
in NPW.

Which statement is easier to understand?
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Economics
13
Return on Investment
Definition 1: Rate of return (ROR) is defined
as the interest rate earned on the unpaid balance
of an installment loan.

Example: A bank lends $10,000 and receives
annual payment of $4,021 over 3 years. The
bank is said to earn a return of 10% on its loan
of $10,000.
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Economics
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Loan Balance Calculation:
A = $10,000 (A/P, 10%, 3)
= $4,021
Unpaid Return on Unpaid
balance unpaid balance
at beg. balance Payment at the end
Year of year (10%) received of year
0
1
2
3
-$10,000
-$10,000
-$6,979
-$366
-$1,000
-$698
-$366
+$4,021
+$4,021
+$4,021
-$10,000
-$6,979
-$3,656
0
A return of 10% on the amount still outstanding at the
beginning of each year
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Economics
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Rate of Return:
Definition 2: Rate of return (ROR) is the
break-even interest rate, i
*
, which equates the
present worth of a projects cash outflows to the
present worth of its cash inflows.


Mathematical Relation:
PW i PW i PW i ( ) ( ) ( )
* * *
=
=
cash inflows cash outflows
0
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Economics
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Return on Invested Capital
Definition 3: Return on invested capital is
defined as the interest rate earned on the
unrecovered project balance of an investment
project. It is commonly known as internal rate
of return (IRR).

Example: A company invests $10,000 in a
computer and results in equivalent annual labor
savings of $4,021 over 3 years. The company is
said to earn a return of 10% on its investment of
$10,000.
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Economics
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Project Balance Calculation:
0 1 2 3


Beginning
project balance

Return on
invested capital

Payment
received

Ending project
balance
-$10,000 -$6,979 -$3,656


-$1,000 -$697 -$365


-$10,000 +$4,021 +$4,021 +$4,021


-$10,000 -$6,979 -$3,656 0
The firm earns a 10% rate of return on funds that remain internally
invested in the project. Since the return is internal to the project, we
call it internal rate of return.
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Economics
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Methods for Finding Rate of Return
Investment Classification
Simple Investment
Nonsimple Investment
Computational Methods
Direct Solution Method
Trial-and-Error Method
Computer Solution Method


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Economics
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Investment Classification
Simple Investment
Def: Initial cash flows
are negative, and only
one sign change
occurs in the net cash
flows series.
Example: -$100, $250,
$300 (-, +, +)
ROR: A unique ROR
Nonsimple Investment
Def: Initial cash flows
are negative, but more
than one sign changes
in the remaining cash
flow series.
Example: -$100, $300,
-$120 (-, +, -)
ROR: A possibility of
multiple RORs
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Economics
20

Period
(N)

Project A

Project B

Project C
0 -$1,000 -$1,000 +$1,000
1 -500 3,900 -450
2 800 -5,030 -450
3 1,500 2,145 -450
4 2,000
Project A is a simple investment.
Project B is a nonsimple investment.
Project C is a simple borrowing.
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Economics
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Computational Methods
Direct
Solution
Direct
Solution
Trial &
Error
Method
Computer
Solution
Method
Log Quadratic
n Project A Project B Project C Project D
0 -$1,000 -$2,000 -$75,000 -$10,000
1 0 1,300 24,400 20,000
2 0 1,500 27,340 20,000
3 0 55,760 25,000
4 1,500
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Economics
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Direct Solution Methods
Project A

Project B
PW i
i i
x
i
PW i x x
x
x
i
i
i
i
i
i i
( ) $2,
$1,
( )
$1,
( )
,
( ) , , ,
:
.
. .
,
*
= +
+
+
+
=
=
+
= + +
=
=
+
= =
+
=
< < =
000
300
1
500
1
0
1
1
2 000 1 300 1500
08
08
1
1
25%, 1667
1
1
160%
100% 25%.
2
2
Let then
Solve for
or - 1.667
Solving for yields

Since the project' s
$1, $1, ( / , , )
$1, $1, ( )
. ( )
ln .
ln( )
. ln( )
.
.
000 500 4
000 500 1
0 6667 1
0 6667
4
1
0101365 1
1
1
4
4
0 101365
0 101365
=
= +
= +

= +
= +
= +
=
=

P F i
i
i
i
i
e i
i e
10.67%
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Economics
23
Trial and Error Method Project C
Step 1: Guess an interest
rate, say, i = 15%
Step 2: Compute PW(i)
at the guessed i value.

PW (15%) = $3,553

Step 3: If PW(i) > 0, then
increase i. If PW(i) < 0,
then decrease i.

PW(18%) = -$749

Step 4: If you bracket the
solution, you use a linear
interpolation to approximate
the solution
3,553
0
-749
15% i 18%
(

+
+ =
749 553 , 3
553 , 3
% 3 % 15 i
% 45 . 17 =
(c) 2001 Contemporary Engineering
Economics
24
Graphical Solution Project D
Step 1: Create a NPW plot
using Excel.
Step 2: Identify the point
at which the curve crosses
the horizontal axis closely
approximates the i*.
Note: This method is
particularly useful for
projects with multiple
rates of return, as most
financial softwares would
fail to find all the multiple
i*s.

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Economics
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Basic Decision Rule:
If ROR > MARR, Accept
This rule does not work for a situation where
an investment has multiple rates of return
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Economics
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Multiple Rates of Return Problem
Find the rate(s) of return:



PW i
i i
( ) $1,
$2, $1,
( )
= +
+


+
=
000
300
1
320
1
0
2
$1,000
$2,300
$1,320
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Economics
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Let Then,
Solving for yields,
or
Solving for yields
or 20%
x
i
PW i
i i
x x
x
x x
i
i
=
+
= +
+

+
= +
=
= =
=
1
1
000
300
1
320
1
000 300 320
0
10 11 10 12
10%
2
2
.
( ) $1,
$2,
( )
$1,
( )
$1, $2, $1,
/ /
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Economics
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NPW Plot for a Nonsimple Investment with
Multiple Rates of Return
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Economics
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Project Balance Calculation
n = 0 n = 1 n = 2
Beg. Balance
Interest
Payment


-$1,000
-$1,000
-$200
+$2,300
+$1,100
+$220
-$1,320
Ending Balance -$1,000 +$1,100 $0
i* =20%
Cash borrowed (released) from the project is assumed to
earn the same interest rate through external investment
as money that remains internally invested.
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Economics
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Critical Issue: Can the company be able to invest the money
released from the project at 20% externally in
Period 1?

If your MARR is exactly 20%, the answer is yes, because it
represents the rate at which the firm can always invest
the money in its investment pool. Then, the 20% is also true
IRR for the project.
.
Suppose your MARR is 15% instead of 20%. The assumption
used in calculating i* is no longer valid.

Therefore, neither 10% nor 20% is a true IRR.
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Economics
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If NPW criterion is used at MARR = 15%
PW(15%) = -$1,000
+ $2,300 (P/F, 15%, 1)
- $1,320 (P/F, 15%, 2 )
= $1.89 > 0
Accept the investment
How to Proceed: If you encounter multiple
rates of return, abandon the IRR analysis
and use the NPW criterion (or use the procedures
outlined in Appendix A).
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Economics
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Decision Rules for Nonsimple
Investment
A possibility of multiple RORs.
If PW (i) plot looks like this,
then, IRR = ROR.

If IRR > MARR, Accept



If PW(i) plot looks like this,
Then, IRR = ROR (i*).
Find the true IRR by using
the procedures in Appendix
A or,
Abandon the IRR method
and use the PW method.


i*
i
i
i*
i*
P
W

(
i
)

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Economics
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(c) 2001 Contemporary Engineering
Economics
34
Comparing Mutually Exclusive
Alternatives Based on IRR
Issue: Can we rank the mutually exclusive
projects by the magnitude of IRR?
n A1 A2
0

1

IRR
-$1,000 -$5,000

$2,000 $7,000

100% > 40%

$818 < $1,364
PW (10%)
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Economics
35
Incremental Investment
Assuming MARR of 10%, you can always earn that rate from other
investment source, i.e., $4,400 at the end of one year for $4,000
investment.

By investing the additional $4,000 in A2, you would make additional
$5,000, which is equivalent to earning at the rate of 25%. Therefore,
the incremental investment in A2 is justified.


n


Project A1


Project A2
Incremental
Investment
(A2 A1)
0
1
-$1,000
$2,000
-$5,000
$7,000
-$4,000
$5,000
ROR
PW(10%)
100%
$818
40%
$1,364
25%
$546
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Economics
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Incremental Analysis (Procedure)
Step 1: Compute the cash flows for the difference
between the projects (A,B) by subtracting
the cash flows for the lower investment
cost project (A) from those of the higher
investment cost project (B).
Step 2: Compute the IRR on this incremental
investment (IRR ).
Step 3: Accept the investment B if and only if

IRR
B-A
> MARR
B-A
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Economics
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Example 9.7 - Incremental Rate of Return
n B1 B2 B2 - B1
0
1
2
3
-$3,000
1,350
1,800
1,500
-$12,000
4,200
6,225
6,330
-$9,000
2,850
4,425
4,830
IRR 25% 17.43% 15%
Given MARR = 10%, which project is a better choice?
Since IRR
B2-B1
=15% > 10%, and also IRR
B2
> 10%, select B2.
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Economics
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IRR on Increment Investment:
Three Alternatives
n D1 D2 D3
0 -$2,000 -$1,000 -$3,000
1 1,500 800 1,500
2 1,000 500 2,000
3 800 500 1,000
IRR 34.37% 40.76% 24.81%
Step 1: Examine the IRR for each
project to eliminate any project
that fails to meet the MARR.

Step 2: Compare D1 and D2 in pairs.
IRR
D1-D2
=27.61% > 15%,
so select D1.

Step 3: Compare D1 and D3.
IRR
D3-D1
= 8.8% < 15%,
so select D1.

Here, we conclude that D1 is the best
Alternative.
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Economics
39
Incremental Borrowing Analysis
Decision Rule:


If BRR
B-A
< MARR,
select B.
If BRR
B-A
= MARR,
select either one.
If BRR
B-A
> MARR,
select A.

Principle:
If the difference in flow
(B-A) represents an
increment of investment,
then (A-B) is an increment
of borrowing.
When considering an
increment of borrowing,
the rate i
*
A-B
is the rate we
paid to borrow money
from the increment.

i
*
A B
A B
BRR

=
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Economics
40
Borrowing Rate of Return
n B1 B2 B1-B2
0 -$3,000 -$12,000 +$9,000
1 1,350 4,200 -2,850
2 1,800 6,225 -4,425
3 1,500 6,330 -4,830
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Economics
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Incremental Analysis for Cost-Only Projects
Items CMS Option FMS Option
Annual O&M costs:
Annual labor cost $1,169,600 $707,200
Annual material cost 832,320 598,400
Annual overhead cost 3,150,000 1,950,000
Annual tooling cost 470,000 300,000
Annual inventory cost 141,000 31,500
Annual income taxes 1,650,000 1,917,000
Total annual costs $7,412,920 $5,504,100
Investment $4,500,000 $12,500,000
Net salvage value $500,000 $1,000,000
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Economics
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Incremental Cash Flow (FMS CMS)

n

CMS Option

FMS Option
Incremental
(FMS-CMS)
0 -$4,500,000 -$12,500,000 -$8,000,000
1 -7,412,920 -5,504,100 1,908,820
2 -7,412,920 -5,504,100 1,908,820
3 -7,412,920 -5,504,100 1,908,820
4 -7,412,920 -5,504,100 1,908,820
5 -7,412,920 -5,504,100 1,908,820
6 -7,412,920 -5,504,100
$2,408,820
Salvage + $500,000 + $1,000,000
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Economics
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Solution:
PW i
P A i
P F i
IRR
FMS CMS
FMS CMS
( ) $8, ,
$1,908, ( / , , )
$2, , ( / , , )
.43%

=
+
+
=
= <
000 000
820 5
408 820 6
0
12 15%,
select CMS.
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Economics
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Ultimate Decision Rule:
If IRR > MARR, Accept
This rule works for any investment situations.

In many situations,
IRR = ROR
but this relationship does not hold for an investment
with multiple RORs.
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Economics
45
Predicting Multiple RORs
- 100% < i
*
< infinity
Net Cash Flow Rule of Signs
No. of real RORs (i*s)

<

No. of sign changes in the project
cash flows
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Economics
46
Example
n Net Cash flow Sign Change
0
1
2
3
4
5
6
-$100
-$20
$50
0
$60
-$30
$100


1


1
1
No. of real i*s 3
This implies that the project could have
(0, 1, 2, or 3) i*s but NOT more than 3.
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Economics
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Accumulated Cash Flow Sign Test
Find the accounting sum of net cash flows at
the end of each period over the life of the
project
Period Cash Flow Sum
(n) (A
n
) S
n
If the series S starts negatively and changes sign
ONLY ONCE, there exists a unique positive i*.
S A
S S A
S S A
S S A
N N N
0 0
1 0 1
2 1 2
1
=
= +
= +
= +

A
A
A
A
N
0
1
2

0
1
2

N
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Economics
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Example
n A
n
S
n
Sign change
0
1
2
3
4
5
6
-$100
-$20
$50
0
$60
-$30
$100
-$100
-$120
-$70
-$70
-$10
-$40
$60
1
No of sign change = 1, indicating a unique i*.
i* = 10.46%
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Economics
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Example A.2
$2,145
$3,900
$5,030
$1,000
0
1
2
3
Is this a simple investment?
How many RORs (i*s) can you expect from
examining the cash flows?
Can you tell if this investment has a unique rate of
return?
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Economics
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Summary
Rate of return (ROR) is the interest rate earned on
unrecovered project balances such that an investments
cash receipts make the terminal project balance equal to
zero.
Rate of return is an intuitively familiar and understandable
measure of project profitability that many managers prefer
to NPW or other equivalence measures.
Mathematically we can determine the rate of return for a
given project cash flow series by locating an interest rate
that equates the net present worth of its cash flows to zero.
This break-even interest rate is denoted by the symbol i*.
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Internal rate of return (IRR) is another term for ROR that
stresses the fact that we are concerned with the interest
earned on the portion of the project that is internally
invested, not those portions that are released by (borrowed
from) the project.
To apply rate of return analysis correctly, we need to
classify an investment into either a simple or a nonsimple
investment.
A simple investment is defined as one in which the initial
cash flows are negative and only one sign change in the net
cash flow occurs, whereas a nonsimple investment is one
for which more than one sign change in the cash flow
series occurs.
Multiple i*s occur only in nonsimple investments.
However, not all nonsimple investments will have multiple
i*s,
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For a simple investment, the solving rate of return (i*) is
the rate of return internal to the project; so the decision rule
is:
If IRR > MARR, accept the project.
If IRR = MARR, remain indifferent.
If IRR < MARR, reject the project.
IRR analysis yields results consistent with NPW and other
equivalence methods.
For a nonsimple investment, because of the possibility of
having multiple rates of return, it is recommended the IRR
analysis be abandoned and either the NPW or AE analysis
be used to make an accept/reject decision.
When properly selecting among alternative projects by
IRR analysis, incremental investment must be used.