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After Completing This Chapter...

The student should be able to: . . Use future worth, benefit-cost ratio, payback
period, and sensitivity analysis methods.
to solve engineering economy problems. . . Link the use of thefuture worth analy
sisto the present worth and annual worth methods
developedearlier. . . Mathematically develop the benefit-cost ratio, and use thi
stnodel to select alternatives
and make economic choices. . Understandthe concept of thepaybackperiod of an inv
estment,andbe able t~ calculate
. this quantity for prospectiveprojects. Demonstrate a basic level understanding
of sensitivity and breakevenanalyses and the
use of these tools in an engineeringeconomic analysis. . Use a spreadsheet to pe
rform sensitivity and breakeven analyses.
QUESTIONS TO CONSIDER )
1. Officeleases frequently require building owners,rather than tenants, to pay h
eating and
cooling costs. What effect might this have on the decision making of potential t
enants
for green buildings?'
2. The green building movement has had more success among developers who hold on
to
their buildings for years and rent them out, rather than selling them as soon as
they are
constructed. What factors might influence their views?
3. Manyenvironmentallyfriendlybuildingsare architecturallydistinctiveandfeatureb
etter
quality materials and workmanshipthan traditionalcommercialstructures.Environmen
tal
advocateshopethese characteristicswillhelp greenbuiJ,.dings attracta rent "premi
um."
How might these features make the buildings more attractive to tenants?
..
Other Analysis
Techniques
Clean, Green, and.Far Between
Designers and engineers have made great progress in developingenvironmentallyfri
endly
construction materials and building techniques. And "green" office buildings off
er numerous . i .
advantages. They use energy more efficiently, provide a more natural environment
for.
workers, and can even reduce indoor air pollution.
The only problem is, no one wantsto build them. In the commercial sector,
barely 1%of officeconstructionprojectshavebotheredto applyfor certification
as green buildings.
Commercial developershave found th~t environmentallyfriendly features
addto the expenseof construction.Eventhoughadditionalcostsmayincrease I..
overall construction expenses by only 1 or 2%, they can make it harder for:the
builder to recoup its investment and break even on the project.
Moreover, the extra expenditures apparently do little to attract potential
tenants. Renters may like the idea of being cleaner and greener-but they don't
want to pay extra for it.
= .....
=-- ---.1'
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i'j
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1
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--. -. .. - . - . - ... ... .. .....
272 OTHER ANALYSISTECHNIQUES
Chapter 9 examines four topics:
Future worth analysis
Benefit-cost ratio analysis Payback period Sensitivity and breakeven analysis
Future worth analysis is very much like present worth analysis, dealing with the
n (future
worth) rather than with now (present worth) situations.
Previously,we have written economic analysis relationships based on either:
PW of cost = PW of benefit or EUAC = EUAB
Instead of writing it in this form, we could define these relationships as
PW of benefit
=1
PWof cost
or
EUAB
=1
EUAC
When economic analysis is based on these ratios, the calculations are called ben
efit-cost
ratio analysis.
Payback period is an approximate analysis technique, generally defined as the ti
me
required for cumulativebenefits to equal cumulativecosts. Sensitivitydescribes t
he relative
magnitude of a particular variation in one or more elements of a problem that is
sufficient
to change a particular decision. Closely related is breakeven analysis, which de
termines
the conditionswhere two alternatives are equivalent.Thus, breakeven analysis is
a form of
sensitivity analysis.
FUTUREWORTH ANALYSIS
Wehaveseenhoweconomicanalysistechniquesresolvedalternativesinto comparableunits.
In present worth analysis, the comparison was made in terms of the present conse
quences
of taking the feasible courses of action. In annual cash flow analysis, the comp
arison was
in terms of equivalent uniform annual costs (or benefits). We saw that we could
easily
convertfrom present worth to annualcash flow,and vice versa.But the concept of r
esolving
alternatives into comparable units is not restricted to a present or annual comp
arison.The
comparison may be made at any point in time. In many situations we would like to
know
what thefuture situation will be, if we take some particular course of action no
w. This is
called future worth analysis.
Ron Jamison, a 20-year-old college student, consumes about a carton of cigarette
s a week. He
wonders how much money h~ could accumulate by age 65 if he quit smoking now and
put his
cigarett~moneyinto~asavings account. Cig"aretiescost $35 per carton. Ron expects
:that a savings
account would earn 5% interest, compounded semiannually. Compute Ron's future wo
rth at
age 65. ;,."..'::1: -.

....
Future Worth Analysis 273
SOUJTIONi
Semiannual saving $35lcarton x 26 weeks . . $910
Future worth (FW)- A(FjA,,2'l2%, 90) = 910(329.2) . . $299,57f
An east coast firm has decided to establish a second plant in Kansas City.There
is a factory for
sale for $850,000 that, with extensiveremodeling, could be used. As an alternati
ve,the company
could buy vacant land for $85,000 and have a new plant constructed there. Either
way, it will be
3 years before the company will be able to get a plant into production. The timi
ng and cost of the
various components for the factory are given in the following cash flowtable.
Year
o1
Construct New Plant
Buy land $ 85,000
Design and initial 200,000
construction costs
Balanceof . 1,200,000
construction costs
Setup of production 200,000
equipment
2
3
Remodel Available F~ctory
Purchase factory $850,000
Design and remodeling 250,000
costs
Additional remodeling 250,000
costs
Setup of production 250,000
equipment
If interest is 8%, which alternative results in the lower equivalent cost when t
h~,fiim begins .
production at the end of the third year?
New Plant
Future worth of cost (FW) - 85,000(Fj P,8%, 3) + 200,000(FjA, 8%,3)
+ 1,000,OOO(FjP, 8%,1)- $1,836,000
Remodel Available Factory
Future worth of cost (FW) . 850,OOO(Fj P, 8%, 3) + 250,000(FjA., 8%, 3)
iii
274 OTHER ANALYSISTECHNIQUES
The total cost of remodeling the available factory ($1,600,000) is smaller than
the total cost of a
new plant ($1,685,000). The timing of the expenditures, however, is less favorab
le than building
the new plant. The new plant is projected to have the smaller future worth of co
st and thus is the
preferred altefl1ative..
BENEFIT-COST RATIO ANALYSIS
At a given minimum attractive rate of return (MARR), we would consider an altern
ative
acceptable, provided
PW of benefits - PW of costs ~ 0 or EUAB - EUAC2: 0
These could also be stated as a ratio of benefits to costs, or
;
; ,
B PW of benefit _EUAB > 1

Benefit-cost ratio C = PW of costs - EUAC , '


Rather than using present worth or annual cash flow analysis to solve problems,
we can
base the calculations on the benefit-cost ratio, BIe. The criteria are presented
in Table9-1.
Wewill illustrate "B/C analysis" by solving the same example problems worked by
other
economic analysis methods. ' ' ,
, , TABLE9-1 Benefit-Cost Ratio Analysis
Situation Criterion
Fixed input Amount of money or other
input resources are fixed
Fixed task, benefit, or
other output to be
accomplished
Neither amount of money
or other inputs nor
amount of benefits or
other outputs are fixed
Fixed output
Neither input
nor output
fixed
Maximize BIC
Maximize BIC
Two alternatives: Compute
incremental benefit-cost ratio
(~BI ilC) on the increment
of investment between the
alternatives. If ilBI ilC ::::1,
choose higher-cost alternative;
otherwise, choose lower~cost
alternative. ,
Three or more alternatives:
Solve by benefit-cost ratio
incremental analysis
Benefit-Cost Ratio Analysis 275
A finn is trying to decide which of two devices to install to reduce costs in a
particular situation.
Both devices cost $1000 and have useful lives of 5 years and no salvage value. D
evice A can
be expected to result in $300 savings annually. Device B will provide cost savin
gs of $400
the first year, but savings will decline by $50 annually, making the second...ye
arsavings $350,
the third-year savings $300, and so forth. With interest at 7%, which device sho
uld the firm
purchase?
jSOtuTION
Wehave used three types of analysis thus far to solve this problem: present wort
hin Example 5-1,
annual cash flowin Example 6-5, and rate of return in Example 7-9.
Device A
PW of cost = $1000
PW of benefits =300(PjA, 7%,5)
- 300(4.100) =$J230
-B PWof benefit 1230 --;---= 1.23
C PWof costs 1000
Device B

rI
PW of cost -- $1000
PW of benefit = 400(P j A, 7%, 5) - 50(P fG-, 7%, 5)
=400(4.100).--' 50(7.647)= 1640 --'382= 1258
BPW of benefit 1258
---= . CPWof. .' c.o..sts., = -1-0-00--1.26
To ma)!:imizethe benefit-cost ratio, select Device B,.
Twomachines are being considered for purchase.Assuming 10%interest, which machin
e should
be bought?
r
1:
- --~
, ---- -..
Initial cost
Unifonn, annual benefit
End-of-useful-lifesalvage value
.,,, UsefuUife,.in years
Machine X
$200
95
50
6
::I;;;: ~ 1
-- .d
Machine Y
$700
120
150
=~ :=.ef2'i1''I: ~=
..
-- - - ( ,
276 OTHER ANALYSISTECHNIQUES
SOLUTION
Assuming a 12-yearanalysis period, the cash flowtable is:
Year
o
1-5
MachineX
-$200
+95
{
+95
-200
+50
+95
{
+95
+50
6
7-11
12
Wewill solve the problem using
Machine Y
-$700
+120
+120
+120
+120

+150
B EUAB
C EUAC
and considering the salvage value of the machines to be reductions in cost, rath
er than increases
in benefits. This choice affects the ratio value, but not the decision.
Machine X
EUAC = 200(Aj P, 10%,6) - 50(Aj F, 10%,6)
= 200(0.2296) - 50(0.1296) = 46 - 6 = $40
EUAB = $95
Note that this assumes the replacement for the last 6 years has identical costs.
Under these