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ENGG 938

Engineering Economics Project


Summer 2013
Hamdeh Buhumaid 4469331
Kawthar Aljasmi 4433415
Outline
Introduction 3

Project Question 4

Part a 4-5

Part b 6-8

Part c 9

Part d 10

Part e 10-12

Appendices 13

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Introduction:

The objectives of this project is to use what we learnt about in


Engineering economics and to apply the concepts to give our
recommendations about the project and whether it should be
undertaken based on the NPV , IRR and MIRR. Another objective is to
perform a sensitivity analysis on the most important factors to see how
the project will change with these factors. The last part of the project is
to run a risk analysis and adjust the project according to the findings.

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Capital Budgeting: Cash Flow Estimation and Risk Analysis

You have been asked by Target to evaluate the proposed expansion of its facilities to introduce
a new product line. The expansion will require the company to purchase new equipment. The
invoice price would be approximately $200,000; another $10,000 in shipping charges would be
required; and it would cost an additional $30,000 to install the equipment. The new equipment
would be set up in unused space in Targets main plant. The firm had spent $100,000 last year
to rehabilitate the site. The plant space could be leased out to another firm at $20,000 a year.
The machinery has an economic life of 4 years and falls into the 3-year MACRS class. It is
expected to be sold after 4 years for $25,000. The new product line would generate sales of
1,250 units per year for four years at a cost of $100 per unit in the first year, excluding
depreciation. Each unit can be sold for $200 in the first year. The sales price and cost are
expected to increase by 3% per year due to inflation. To handle the new equipment, the firms
net working capital would have to increase by an amount equal to 12% of the next years sales
and would be recovered by the end of the year. The firms marginal tax rate is 30%, and its cost
of capital is 10%.

a. Calculate the net cash flows for each year? Based on these cash flows, what are the
projects NPV, IRR and MIRR? Do these values suggest that the project should be
undertaken?

First step is to arrange the information given in the question. For our project we decided to
approach it using the balance sheet method.

1. Initial Cash Outlay

Year
0 1 2 3 4
Cost of Project -240,000
Change in NWC -30,000 -30900 -31827 -32781.81 0

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2. Operating Cash flows

Year
Operating Cash Flows
OCF1 OCF2 OCF3 OCF4
(OCFs)
Revenues 250,000 257,500 265,225 $273,181.75
cost of rent -20,000 -20,000 -20,000 -20,000
Costs -125,000 -128,750 -132,613 ($136,590.88)
Net Revenues 105,000 108,750 112,613 116,591
Depreciation (79,200) (108,000) (36,000) (16,800)
EBT 25800 750 76,613 99,791
Taxes (30%) -7740 (225) (22,984) (29,937)
NOPAT 18060 525 53,629 69,854
Depreciation 79,200 108,000 36,000 16,800
OCF 97,260 108,525 89,629 86,654

3. Terminal Cash flows

Year
0 1 2 3 4
Salvage Value 25,000
Book Value 0
Gain from Sale 25,000
Taxes (30%) (7,500)
Recovery of NWC 30000 30900 31827 32781.81
Terminal CF3 50,282

4. Net Cash flows

Year
NCF0 NCF1 NCF2 NCF3 NCF4
-270,000 96,360 107,598 88,674 136,935

NPV @ 10% $66,675


IRR 20.44%
MIRR 16.24%
cost of capital $66,675
Looking at the NPV, IRR and MIRR the decision is to undertake the project.

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b. Perform a sensitivity analysis on the unit sales, salvage value, and cost of capital for the
project. Assume that each of these variables can vary from its base case, or expected,
value by plus and minus 10, 20, and 30%. Include a sensitivity diagram, and discuss the
results.

Using excel we can calculate the NPV for the 3 variables:

b.1 Cost of Capital


Percentage Cost of capital NPV
0% (Base) 0.1 $66,675
+10% 0.11 59181.0
-10% 0.09 74447.8
+20% 0.12 51953.5
-20% 0.08 82514.0
+30% 0.13 44979.9
-30% 0.07 90888.1

NPV VS Cost of Capital


$100,000
$90,000
$80,000
$70,000
$60,000
y = -764687x + 143703
$50,000
$40,000
$30,000
$20,000
$10,000
$0
0 0.02 0.04 0.06 0.08 0.1 0.12 0.14

The results show that the NPV is very sensitive to the change in cost of capital percentage. The
slope is -764687, it is negative because the less the cost of capital the higher the NPV and
vice versa.

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b.2 Salvage Value
Percentage SV NPV
0% (Base) 25000 66890.7
+10% 27500 68086.0
-10% 22500 65695.5
+20% 30000 69281.3
-20% 20000 64500.2
+30% 32500 70476.6
-30% 17500 63304.9

NPV VS Salvage Value


71000
70000
y = 0.4781x + 54938
69000
68000
67000
NPV
66000
65000
64000
63000
62000
0 5000 10000 15000 20000 25000 30000 35000
Salvage Value

The results show that the NPV is not as sensitive to the change in Salvage Value as it is to the
change in cost of capital. The slope is 0.4781, it is positive because the more salvage value
the higher the NPV and vice versa.

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b.3 Unit Sales
Percentage Unit sales NPV
0% (Base) 1250 $66,675
+10% 1125 38758.1
-10% 1375 94591.4
+20% 1500 122508.1
-20% 1000 10841.4
+30% 1625 150424.8
-30% 875 -17075.3

$160,000
NPV VS Unit sales
$140,000
y = 223.33x - 212492
$120,000
$100,000
$80,000
$60,000
$40,000
$20,000
$0
($20,000) 0 500 1000 1500 2000

($40,000)

The results show that the NPV is sensitive to the change in Unit Sales as it is to the change in
cost of capital. The slope is 223.33, it is positive because the more Unit sales the higher the
NPV and vice versa.

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c. Assume that you are confident of the estimates of all the variables that affect the projects
cash flows except unit sales and sales price: if product acceptance is poor, unit sales would
be only 900 units a year and the unit price would only be $160; a strong consumer
response would produce sales of 1,600 units and a unit price of $240. You believe that
there is a 25% chance of poor acceptance, a 25% chance of excellent acceptance, and a
50% chance of average acceptance (the base case). Use the worst-, most likely, and best-
case NPVs and probabilities of occurrence to find the projects expected NPV, standard
deviation, and coefficient of variation.

Best Case Base case Worst Case


Unit 1600 1250 900
Price 240 200 160
NPV 290528.036 66890.7466 -93103.14676

Standard Deviation 136564.14


Expected value 82801.5955
CV 1.64929364

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d. Assume that Targets average project has a coefficient of variation in the range of 0.2 - 0.4.
Would the new product line be classified as high risk, average risk, or low risk? Target
typically adds or subtracts 3 percentage points to the cost of capital to adjust for risk.
Should the new product line be accepted after adjusting for risk?

WACC
High risk CV>.4 0.13 13%
average risk .2<CV<.4 0.1 10%
Low risk CV<.2 0.1 7%

Form part C the CV = 1.6 >.4 so we adjust the Cost of capital to 13% to get the new value of the
NPV and it is > 0 so we take the project, but we should keep in mind the risk factors and
adjust our project accordingly:

NPV @ 10% $44,980


IRR 20.44%
MIRR 17.44%
Cost of capital 13%

e. Discuss the results, and make a recommendation in your report. Are there any subjective
risk factors that should be considered before the final decision is made? In preparing your
report, you should refer to relevant economic and financial factors that might impact the
project.

Some other topics that may be addressed in engineering economics


are inflation, uncertainty, replacements, depreciation, resource depletion, taxes, tax
credits, accounting, cost estimations, or capital financing. All these topics are primary skills and
knowledge areas in the field of cost engineering.

No two infrastructure projects will cost the same amount of money no matter how similar
they are. Apart from basic technical factors, the wide range of economic and institutional
conditions in different Member States will itself always lead to variations. Nevertheless, the
fundamental project costs are based on the actual cost of the land, materials, equipment and

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labour in the region where the project is being procured. These basic costs will vary depending
upon a number of factors which are discussed below:

A. Location
Location affects project costing via institutional factors and through geographical realities.
Institutional factors can affect initial project cost estimates in a number of ways. Consents
procedures in particular may be more arduous in some countries, affecting the time it will take
to successfully implement a project. Allowance for the costs involved in sustaining a long public
consultation exercise is an example. Where major projects are likely to be strongly opposed on
environmental grounds, more cost may have to be allowed for environmental mitigation
measures. In geographical terms, construction and material costs, land costs and design
standards vary widely across the EU because of the varying distances from suppliers, climate
and weather conditions, and general market conditions. Even within a country, variations will
exist depending on whether a project is being implemented in a peripheral or central area, or in
an urban or rural context. Generally, the more remote a project is, the more expensive it will
be because of the cost of transporting construction materials and equipment to the site. In an
urban location, land costs are usually much higher.

B. Site Characteristics
A site can be affected by soil and drainage conditions and access restrictions which can
affect the original cost estimates. The amount of excavation, piling and foundation activities
required are particularly affected by poor ground conditions. Where there is uncertainty about
ground conditions, accurate project costing cannot be achieved unless a soil survey is
undertaken. This may require the sinking of boreholes to obtain soil samples at different levels
beneath the surface.

C. New Build or Improvements


Generally, the construction of new infrastructure is more expensive than improvements to
existing infrastructure, or the refurbishment of buildings. This is primarily because the non-
building costs such as land purchase, foundations, services provision etc. Do not have to be
included when simply upgrading existing structures.

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D. Tax Liabilities
An organisation will be liable to pay tax on its purchases. Some organisations and types of
project are not liable to pay taxes, or else these can be reclaimed. Local government projects
and infrastructure for public use are examples. Some public or quasi-public sector companies,
voluntary and private sector organisations can be liable and these tax costs can have a
significant impact on gross construction costs.

E. Timescale
Generally, the longer a project takes, the greater the project costs will be. Project
timescales are dependent on the specification of a project. Usually, the larger a project is the
longer it will take to implement. This is not always the case; if substantial additional resources
are used, project implementation can often be accelerated. In some cases, work on a project
may take a lot longer than expected because its phasing is dependent upon other, linking
projects or public finance programmes. A project which involves non-continuous phases is
usually more expensive than one undertaken without interruption because of the additional
costs involved in re-mobilising plant and contractors.

A. . Inflation
The longer the expected construction period, the more account will need to be taken of
expected inflationary price increases over time. This is particularly important where a public
authoritys expenditure programme is involved. Initial cost estimates will need to allow for the
value that will need to be paid at the time the project actually goes ahead.

For this project we should monitor inflation rates which we have already calculated for
it since the beginning of the project formulation. Another factor

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Appendix:

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