Economic Analysis Techniques

KEY CONCEPTS
Time value of money, minimum attractive rate of return (MARR)
Methods: payback period, net present value ( NPV), net annual worth (NA), internal rate
of return ( IRR).
Tax and depreciation considerations.
Evaluation period (project lives)
READINGS
Relevant sections in Chapters 5, 6, 7, 8, 9,11, and 12 ( Chapters 3 and 4 as
additional reading for clarification).
TOPIC OUTLINE
1. Investment Aaisal Techniques
Investment appraisal techniques can be divided into three groups:

Economic analysis techniques (based solely on economic attribute)

Multi-attribute analysis techniques (based on several attributes, e.g. economic, reliability,
flexibility, etc)
Supplementary and risk analysis techniques that take risk and other factors into
consideration.
2. Time Value of Capital
2.1 Basic Concept

A sum of money today is worth more than the same amount at some time in the future
because of interest or rate of return, which can be earned.
For this reason, a cash flow must be identified in terms of timing as well as amount.

Two amounts of money are said to be equivalent if they are equal at a given point in time for
a given interest rate

Future worh (compounded): the equivalent sum of money at a point in the future for money
received today

Present worth: the equivalent sum of money at today's value for money received at a point
in the future.

Uniform annual worh: uniform annual series of money over a certain period of time which is
equivalent in amount to a particular schedule of receipts under consideration.
2.2 Determining Minimum Attractive Rate of Return
The future worth or the present worth of a sum of money depends on two factors

The time period, eg. number of years, and

The required rate of retur, eg. 15% per year
The value of an acceptable minimum rate of return, i, depends on many factors, including:

Current cost of capital.

Current opportunity cost.

Current rate of return on investments

Management attitude towards investments and risks.
As i depends on many factors including management attitude towards
investments and risks, the value of i may differ from company to company.
2.3 Four Basic Equations
1. F = P ( 1 + i) n
2. A = [P * i ( 1 + i) " ] / [( 1 + i)" -1]
P ;
3. A =[ F*i ]/[(1+i)
"
-1]
4. P = [ A1/ (1+i)] + [ A2/ (1+i)
2
] + ..... +[ An /(1+i )"J
The four equations above can be used to calculate the equivalent worth of a sum of money
F: future worth
P: present worth
A: uniform annual worth
i: rate of return, eg. 15% per year
n: time period, eg. 4 years.
For example, equation 2 can be used to calculate the uniform annual worth, A, over a period of n
years of a sum of money received at the present time (present worth P), given a rate of return, i.
Alteratively, the same equation can be used to calculate the present worth P if the uniform
annual worth A is known.
Equation 4 is used to calculate the present worth if the annual sum of money received over a
period of years varies from year to year, i.e. A 1, A, ..... , An.
2.4 Notations
In calculating equivalent worths, it is useful to use notations to represent the various parameters
involved. Below are some examples:

$ X(AJP, i% p.a., n years): What uniform annual payment each year for the next n years is
equivalent to a present lump sum of $X, given a rate of return of i% per year? Note that in the
notation AJP, the denominator P indicates $X is the known present lump sum, and the
numerator A indicates the uniform annual payment that you want to calculate

$ X(PJA, i% p.a., n years): What present amount of money is equivalent to n annual amounts
of $X , given a rate of return of i% per year?

$ X (PIF, i% p.a., n years): What present amount of money is equivalent to $ X that will be
received at the end of n years, given a rate of return of i% per year?
Examples
$ 3,155 (PIA. 10% p.a., 4 years) = $ 10,000
$ 10,000 ( AlP, 10% p.a., 4 years)=$ 3,155
$ 14,641 (PIF. 10% p.a., 4 years)= $ 10,000
3. Economic Methods for Measuring Investment Worth
Terminology
Independent alternatives: the choice of 1 project does not preclude the others.

Mutually exclusive alternatives: the choice of 1 project precludes the others.

MARR: minimum attractive rate of return
Economic Methods
The economic worth of an investment can be measured in a number of ways. Some of which are
discussed below:

Payback period (PBP) method: determines how long it will take to recover the initial
investment. Equivalent worth methods:

Net present value ( NPV) method: converts all cash flows to a single net sum equivalent at
today 's value using i = MARR.

Net annual worth ( N AW) method: converts all cash flows to an equivalent uniform annual
series of cash flows over the life of the investment project, using i = MARR.

Internal rate of return ( IRR) method: determines the interest rate that yields a net present
worh of zero.
Comments

Payback period method does not take into account interest and project life, i.e. it assumes a
zero interest rate.

NPV and NAW methods are equivalent

NPV assumes that return on investment can be re-invested at the MARR while IRR assumes
that return on investment can be re-invested at the IRR.

Independent projects : ranking of independent projects using NPV and IRR may differ but
both lead to tte same accept/reject decision.

Mutually exclusive projects : both NPV and IRR do not necessari ly lead to the same
accept/reject decision since the ranking depends on the method used.
4. Payback Period Method
The payback peri od of a project is the period when the total net revenues are equal to the initial
investment.
If the net annual revenues are uniform, then the payback period is given by:
Payback period (in years)= (initial investment) I (net annual revenue)
Example 1, consider the two investment options below.
Initial cost
Life
Salvage value
Annual receipts
Annual expenditure
Option A
$20000
5 years
$4000
$10000
$4400
Minimum attractive rate of return= 15% p.a.
Option B
$30000
10 years
$0
$14000
$8600
The PBP for option A is ($20,000) I ($10,000- $4,400) = 3.57 years
.. .. " '" . . . c - .: , ;
Note that the PBP method takes into consideration neither MARR nor project life.
Example 2. A firm is trying to select between two weighing scales; Atlas scale and Tom Thumb
scale. Both have a 6-year life. Assume an 8% interest rate. Given:
Alternative
Atlas scale
Tom Thumb scale
Solution:
Atlas scale:
Payback
Tom Thumb scale:
Payback
$3000
co,l
1000
2
Figre 3. 1
Cost($)
2000
00
Uniform Annual
Benefit ($)
450
600
ost
Period
Uniform annual benefit
2000
= -= 4.4years
450
Cost
Period
benefit
(a)
Uniform annual
6000
= -= 5years
600
3
4 I s
4.4
End of Useful Life
Salvage Value ($)
100
700
(h)
Payback period plot for (a) Atlas scale and (b) Tom Thumb scale
Therefore, to minimise the payback period select Atlas scale.
5. Net Present Worth Method
Procedure
Step 1: Draw a cash flow diagram showi ng all incomes and expenditures
Step 2: Wri te down the NPV by bringing all future values to present values, using the notations
descri bed above
Step 3: Calculations using appropriate equations
Step 4: Conclusion and comments.
As an example, consider investment option A described above.
Worksheet
Step 1
This investment has an initial cost (expenditure) of $20,000 at year 0, i.e. at today 's value.
The investment has a net annual income of $5600 ( $10,000- $4,400) for 5 years.
In addition at the end of year 5, the investment will be sold for $4000 (salvage value)
Draw the cash flow diagram
Step 2
NPV = $ 5600 (PIA. 15% p.a., 5 years)+$ 4000 (PIF, 15% p.a., 5 years) - $ 20000
= $5600 (3.3522) + $4000(0.4972) - $20000
Step 3
NPV = $18,772 (eqn. 2) + $1,988 (eqn. 1)- $2,000
= $760
Step4
Note that if

I f the NPV of a project is greater than zero, it means that the rate of return of the project is
higher than the required MARR.

If the NPV of a project is equal to zero, it means that the rate of return of the project is equal
to the required MARR.

I f the NPV of aproject is less than zero, it means that the rate of return of the project is less
than the required MARR.
The NPV of option A is $760. Therefore this project is acceptable as its rate of return is higher
than the required MARR of 15%
6. Net Annual Worth Method
Procedure
The procedure for the NAW method is similar to that of NPV method except in step 2, you convert
all cash flows to an equivalent uniform annual series of cash flows over the life of the investment
project, using i = MARR.
As an example, consider investment option A described above.
Worksheet
Step 1
This investment has an initial cost (expenditure) of $20,000 at year 0, i.e. at today 's value.
The investment has a net annual income of $5600 ( $10,000-$4,400) for 5 years.
In addition at the end of year 5, the investment will be sold for $4000 (salvage value)
Draw the cash flow diagram
Step 2
NAW = $ 5600 + $ 4000 ( AIF. 15% p.a., 5 years) - $ 20000 (AlP, 15% p.a., 5 years)
= $5600 + $4000(0.1482) -$20000(0.2983)
Step 3
NAW = $5600 + $593 (eqn. 3)- $5,966 (eqn. 2)
= $227
Step4
Note that if

If the NAW of a project is greater than zero, it means that the rate of return of the project is
higher than the required MARR.
If the NAW of a project is equal to zero, it means that the rate of return of the project is equal
to the required MARR.

If the NAW of a project is less than zero, it means that the rate of return of the project is less
than the required MARR.
The NAW of option A is $227. Therefore this project is acceptable as its rate of return is higher
than the required MARR of 15%.
Comments on the equivalence of NPV and NAW methods
As previously discussed, the NPV and NAW methods are equivalent. The NAW of option A is
$227 per year for 5 years. The NPV of $227 per year for 5 years is $760, i.e.
$ 227 (PIA, 15% p.a., 5 years) =$ 760
7. Internal Rate of Return Method
Procedure
The procedure for the IRR method is similar to that of NPV method except in step 2, you bring all
future values to present values using the notations described above where the value of the rate of
return is unknown.
The value of the rate of return is then determined (usually by trial and error method) by equating
the present values of all net revenues to the project 's initial cost.
As an example, consider investment option A described above.
Step 1
This investment has an initial cost (expenditure) of $20,000 at year 0, i.e. at today 's value.
The investment has a net annual income of $5600 ( $10,000 - $4,400) for 5 years.
In addition at the end of year 5, the investment will be sold for $4000 (salvage value)
Draw the cash flow diagram
Step 2
$ 5600 (PIA. i % p.a., 5 years)+$ 4000 (PIF. i % p.a., 5 years) =$ 20000
Step 3
Solving the equation in Step 2 for the unknown variable i using trial and error method:
i = 16.5 %
Step4
In this case, the proposed project is acceptable because the IRR of 16.5 % is higher than the
MARR of 15 %.
Comments on NPV vs IRR

NPV assumes that return on investment can be re-invested at the MARR while IRR assumes
that return on investment can be re-invested at the IRR.

For independent projects: rankings using NPV and IRR may differ but both lead to the same
accept/reject decision.

For mutually exclusive projects : both NPV and IRR do not necessari ly lead to the same
accept/reject decision since the ranking depends on the method used.
8. Tax and Depreciation

It is often necessary to take into consideration depreciation and income taxes in investment
appraisal.
Depreciation refers to the decrease in value of a property with use and time.

Depreciation is usually used for taxation purposes.

There are a number of techniques, which can be used to determine the amount that can be
deducted from the value of a property due to depreciation, eg. Straight-line method,
returning balance method.

One of the most common techniques is the straight-line method where the value of the
property is decreased linearly to zero at the end of the life of the property.
The procedure for taking into account depreciation and income taxes is as follows:

Establish net annual cash flow over project life, taking into account depreciation and
taxation.

Use appropriate economic technique such as NPV to evaluate the project.
Example
Consider the following project:
Initial cost
Life
Salvage
Net income
$100,000
5 years
$10,000
$60,000 p.a.
Min. rate of return = 15%
Tax rate= 40%
Depreciation = linear over 5 years with no salvage value (straight line method)

Establish net annual cash flow over project life, taking into account depreciation and
taxation.
Year Cash in Cash out Depreciation Tax. income Tax Net cash flow
0
1
2
3
4
5
5
100000 -100000
60000 20000 40000 16000 44000
60000 20000 40000 16000 44000
60000 20000 40000 16000 44000
60000 20000 40000 16000 44000
60000 20000 40000 16000 44000
10000 10000 4000 6000
Once the above table has been completed correctly, any evaluation techniques such as
NPV technique can be used to evaluate the project using the net cash flow for each year
(last column)
NPV = -$10000 + $44000(P/A, 15 %, 5 years)+ $6000(P/F, 15%, 5 years)
9. Comparing Alternatives and Selecting Study
Period
A systematic procedure for comparing investment alternatives (mutually exclusive projects) can
be outlined as follows:
Define the alternatives

Determine the study period
Provide estimates of the cash flow for each alternative

Specify the return rate (MARR)

Select the criteria for judging the success. Eg. Economic and other attributes (multi-
attribute will be covered in this course)
Compare the alternatives
Perform sensitivity analyses

Select the alternatives
When comparing two projects with different lives, either NPV or NAW technique can be used,
assuming repeatability.
Example
Consider the following projects:
Option A Option B
Initial cost
Life
Salvage value
Annual receipts
Annual expenditure
$20000
5 years
$4000
$10000
$4400
Minimum rate of return = 15% p.a.
Study period = 1 0 years
$30000
10 years
$0
$14000
$8600
Assume repeatability, i.e. Project A can be repeated for a further 5-years period.
NPV technique
The cash flow for option A over 10 years is as follows (assuming repeatability):
Initial cost at year 0
Net cash flow for years 1 to 5
Replacement cost at end of year 5
Net cash flow for years 6 to 10 =
Salvage value at end of year 1 0 =
= $20,000
= ($10000 - $4400) per year = $5600
=
$20000 (cost of new investment)- $4000 (salvage
value of old investment) = $16000
($10000 - $4400) per year = $6600
$4000
NPV for option A= -$20000 + $5600 (P/A, 15%, 10 years)- $16000 (P/F, 15%, 5 years)+
$4000 (P/F, 15%, 10 years)
= -20000 + 5600(5.0188) + 4000 (0.4972) - $20000(0.4972) + 4000 (0.2472)
= $ 1139
NPV for option B (using usual procedure)=- $2899
Thus project A is a better choice.
NAW technique
NAW (option A)= -$20000(AP, 15%, 5 years)+ $6600 + $4000 ( AI F, 15%, 5 years)= $227
NAW (option B)= -$30000(AP, 15%, 10 years)+ $5400 =- $578
Again option A is a better choice, assuming repeatability
Some comments

Both NPV and NAW techniques are the same, noting that the NPV of an annual worth of
$227 (obtined from NAW technique) is $1139 (the same result as obtained from NPV
technique}, i.e. for option A, $227 (PIA, 15%, 10 years) = $1139
If the study period for the above example is 7 years (instead of 10 years), we still
use the same technique, assuming repeatability for option A with an estmate of the
salvage value of option A at the end of the 7
th
year.