Syed Babar Ali

School of Science and Engineering

EE 556 Power System Planning – Fall 2019

Instructor: Fiaz A. Chaudhry, Ph.D., P.Eng.

Lecture 05 – Economic Concepts
Outline
 What is economics?
 Review of Economics Terms
 Time Value of Money
 Interest Formulas
 Escalation & Inflation
 Depreciation Methods
 Criteria for Evaluation of Projects
What is “economics”?
“The social science concerned with the efficient use
of limited or scare resources to achieve maximum
satisfaction of human material wants”.

It is the study of how men and society end up

choosing, with or without the use of money, to
employ scarce productive resources that could have
alternative uses to produce various commodities and
distribute them for consumption, now or in future,
among various people and groups in society.
What is the difference between
Finance and Economics?
Finance Economics
A fund management science. Study of A social science. It studies the
prices, interest rates, money flows production, consumption and
and financial markets distribution of goods and services, as
well as larger topics such as inflation,
Focus on entirely maximizing wealth recession, and supply and demand.

Main factor is measured by interest Focus on optimization of valued goals

rates
Includes other factors other than just
interest rates such as inflation,
and recession
In case you have limited resources
what you would like to do?
The limited / scarce resources requires that
they should be used optimally to gain
maximum advantage under the given
circumstances and given options.

The science of doing this evaluation is called

project appraisal.
Engineering Economics
The application of economic principles to
engineering problems, for example in
comparing the comparative costs of two
alternative capital projects or in determining
the optimum engineering course from the
cost aspect.

 It is important to know about Engineering

Economics because it determines:
I. Optimal cost-effectiveness
II. Alternative possibilities
Review of Economics Terms
The subject of economics is quite vast. We are not,
here, to investigate its principles. We want to, shortly,
review the definitions of some basic terms which will
be used in power system planning.
―Revenue
The money that a company earns by providing
services in a given period such as a year.
―Cost
The expense incurred in providing the services
during a period.
Review of Economics Terms
―Profit
The excess of revenue over the cost.
―Investment cost
The cost incurred in investing on machinery
equipment and buildings used in providing the
services.
―Operational cost
The cost incurred on running a system to
provide the services. Wages, resources (fuel, water,
etc.), taxes are such typical costs.
Review of Economics Terms
―Depreciation
The loss in value resulting from the use of
machinery and equipment during the specific period.
The rate of such a loss is called depreciation rate.
―Nominal interest rate
Nominal interest rate is the annual percentage
increase in the nominal value of a financial asset. If a
lender makes a loan to a borrower, at the outset, the
borrower agrees to pay the initial sum (the principal)
with interest (at a determined interest rate) at some
future date.
Review of Economics Terms
―Inflation rate
The percentage increase per a specific period
(typically a year) in the average price of goods and
services.
―Real interest rate
The rate of interest an investor, saver or lender
receives (or expects to receive) after allowing for
inflation. It is defined as:
“The nominal interest rate minus the inflation rate”.
―Salvation value
Salvation value is the real value of an
asset/equipment, remaining, at a specific time and
after considering the depreciation rate.
Review of Economics Terms
―Present Value or Present Worth Analysis
The mathematical process by which different
monetary amounts are moved either forward or
backward in time to a common point in time is
called present value or present worth analysis.
Other Equivalent Terms:
―Compounding
The process of moving money forward in time.
―Discounting
The process of moving money backward in time.
Review of Economics Terms
―Book Value
The book value of an asset is equal to the original
investment to be recovered minus all
depreciation charges accumulated to date.
Time Value of Money
Any one easily understands that money makes
money. In other words, if we invest an amount of X,
we expect some percent to be added at the end of
the year. In other words, X at present worth more
in the future. This concept is used if some one
invests or borrows money.
―For example:
If someone invests $ 100 on a project with a
5% predicted return, the person would gain $105 at
the end of the year. In other words, $100 at present
would worth $105 in one-year time.
Interest
 Money paid (earned) for the use of money.
 Interest can be Simple or Compound

―Simple
The amount of simple interest is a function of
three variables:
 Original amount borrowed (lent) or principal.
 Interest rate per time period.
 Number of time periods for which principal is
borrowed (lent).
Simple Interest
SI =
where
SI = Simple Interest
= Principal or original amount
borrowed
i = Interest Rate per time period
N = number of time periods
Example: Simple Interest
• Assume that you deposit $ 100 in a savings
account paying 8 % S.I and keep it there for 10
years. At the end of 10 years, the amount of
interest accumulated is determined as follows:
SI =
= $ 100 (.08) (10)
= $ 80
• For any simple interest rate , the future value ‘F’
of an original amount at the end of ‘N’ periods is
determined as:
Example: Simple Interest
• Using Eq. (ii), future value of $ 100 after 10 years
with 8 % Simple interest rate will be:
F = 100 (1+(0.08*10)) = $ 180
• Sometimes we need to proceed in the opposite
direction. That is we know the future value ‘F’ of
a deposit at ‘i %’ for ‘N’ years but we don’t know
the principal or original amount ‘ ’
Compound Interest
Interest paid (earned) on any previous
interest earned, as well as, on the principal
borrowed (lent).

Generally, compound interest rate is used in the

real world
Interest Formulas
• Six basic time/money relationships, or interest formulas,
that are useful in determining equivalent values for sums
of money occurring at different times.
• Notation to be familiar with:
―i is an interest or discount rate per interest or
discounting period.
―N is the number of interest or discounting periods.
―P is a present sum of money.
―F is a future sum of money at the end of N periods.
―A is an end-of-period payment (or receipt) in a uniform
series of payments (or receipts) over N periods at i
interest or discount rate.
I. Single Payment compound amount formula
• If ‘P’ dollars are deposited in an account in which
interest is accumulated at a specific rate ‘i’ for a
given number of periods ‘N’, then the account
will grow to P(1 +i) by the end of the first period
and to P(1 +i)(1 +i) by the end of the second
period. In general, at the end of N periods

• The expression , denoted is

called the single payment compound amount
factor.
I. Single Payment compound amount formula

Fig. 1 : Cash flow diagram for present and

future sums.
Example: Single Payment compound amount
formula
• Suppose that $1,000 is invested for six years at
an interest rate of 10% per year, compounded
annually. How much will be in the account at the
end of six years?
Solution
―Using Eq.(1)
F=$1000(1+0.10)^6= $1772

At the end of 6th year, $1000 will amount to $1772

with 10% compound interest
II. Single present worth formula
 The present worth ‘P’ of a sum, ‘N’ periods in the future, ‘F’, can
be determined by rearranging Eq.(1), the single compound amount
formula, to express ‘P’ in terms of ‘F’:

𝟏 𝒊
 The expression , denoted 𝑵, is called the single
(𝟏 𝒊)𝑵
payment present worth factor.
 In this case, ‘i’ is usually called the discount rate as monetary
amount is moved backward in time, i.e. it is used to determine the
present value of money ‘N’ periods in the past.
Example: Single present worth
formula
 Suppose that an investor wishes to deposit an
amount now so that in 30 years $1,000,000 will
be in an account that pays 10% interest per
year, compounded annually. What amount must
be deposited now?
Solution
― Using Eq.(2)

Solve for P using F value of the previous example.

III. Uniform sinking fund formula
• A fund established to accumulate a desired future
amount of money at the end of a given length of
time through the collection of a uniform series of
payments is called a sinking fund.
• Each payment has a constant value ‘A’, which is
called an annuity, and is made at the end of each of
N interest periods.
• For example, the money invested at the end of the
first period will earn interest for (N — 1) periods, &
its amount will be at the end of ‘N’
periods.
• Similarly, the payment at the end of the second
period, will amount to .
III. Uniform sinking fund formula

Fig. 2 : Cash flow diagram for a uniform series of payments

III. Uniform sinking fund formula
• The last payment, made at the end of the last
period, will earn no interest. Therefore, by
summing all the contributions and simplifying:

• The expression , denoted is

called the sinking fund factor.
Example: Uniform sinking fund
formula
• Suppose You are thinking about retirement and you are
considering investing money each month so you will
have $100,000 in thirty years. If the nominal annual
interest rate is 8% and the interest is compounded
monthly, calculate the monthly investment amount.
Solution
• Using Eq. (3)

• you must invest $67.10/month in order to have $100,000

in thirty years.
IV. Uniform series compound
amount formula
• A future sum ‘F’ equivalent to a uniform series of
end-of-period sums ‘A’ can be determined by
rearranging Eq.(3):

• The expression , denoted , is

called the uniform series compound amount
factor.
Example: Uniform series compound
amount formula
• Assume you save $4,000/year and deposit it at
the end of the year in an imaginary saving
account (or some other investment) that gives
you 6% interest rate (per year compounded
annually), for 20 years. How much money will
you have at the end of the 20th year?
Solution
―Using Eq. (4)
•

• So, you will have 147,142.4 dollars at 20th year

V. Uniform capital recovery
formula
• A uniform end-of-period payment ‘A’ that is required to
accumulate to a given present investment ‘P’, when the
interest rate and number of periods are known, can be
calculated by substituting Eq.(1) for ‘F’ in Eq.(4):

𝒊(𝟏 𝒊)𝑵 𝒊
• The expression (𝟏 𝒊)𝑵 𝟏
, denoted 𝑵, is called the
capital recovery factor.

• This factor may also be expressed as the sum

𝒊
of the𝒊 sinking
fund factor and the interest rate, i.e. 𝑵= 𝑵 .
V. Uniform capital recovery
formula

Fig.3 : Cash flow diagram for a uniform capital recovery formula

Example: Uniform capital recovery
formula
• Assume you want to buy a car today for $25,000
and you can finance the car for 5 years with 4%
of interest rate per year compound annually,
how much you have to pay each year?
Solution
― Using Eq.(5)

In order to finance the car, $5,616/year should be

paid.
Calculate monthly installment?
VI. Uniform series present worth
formula
• The present worth of a series of uniform end-of-
period payments can be calculated by
rearranging Eq.(5):

• The expression , denoted , is

called the uniform series present worth factor.
VI. Uniform series present worth
formula

Fig.4 : Cash flow diagram for Uniform series present worth

formula
Example: Uniform series present
worth formula
• Calculate the present value of 10 uniform
investments of $ 2,000 to be invested at the end
of each year for interest rate 12% per year,
compound annually.
Solution
―Using Eq.(6)

• The present worth of these equal investments

annually would be $ 11,300.45.
Escalation and Inflation
―Inflation
It is a sustained increase in the general price
level of goods and services in an economy over a
period of time. When the price level rises, each unit of
currency buys fewer goods and services;
consequently, inflation reflects a reduction in the
purchasing power per unit of money.
For example
If the inflation rate is 5% per year, then goods
that cost $1.00 a year ago typically cost $1.05 this
year. The increase in the general level of prices
means that the purchasing power of money has
eroded.
Escalation and Inflation
―Escalation
Escalation refers to a persistent rise in the
price of specific commodities, goods, or services
due to a combination of inflation, supply/demand,
and other effects such as environmental and
engineering changes."
it is usually classified as
I. Real
II. Apparent.
Escalation and Inflation
I. Real Escalation
An escalation due to resource depletion,
new regulations and increased demand with
limited supply.
 Real escalation is independent and
exclusive of inflation.
II. Apparent Escalation
It includes the effects of both inflation and
real escalation.
Escalation and Inflation
• The relationship between inflation, real
escalation and apparent escalation is as follows:

where
e is the apparent escalation rate,
e' is the real escalation rate
f is the inflation rate
Escalation and Inflation
• Assuming constant rates of inflation and
escalation, the total annual increase in a cost
over ‘N’ time periods can be determined by
multiplying the cost by the expression:

Where
is the cost in a reference year.
is the cost N years later.
Example: Escalation and Inflation
• Suppose that the price of coal (in US $) in 1990 is
1.00/10^9 $/J, and that the annual inflation rate
over this period is 6%. Furthermore, assume that the
price of coal will escalate over the 1990 -2000 period
at an average annual rate of 1.5% as a result of
resource depletion (i.e. this escalation is
independent of inflationary effects). The price of
coal in the year 2000, expressed in 1990 dollars, can
then be determined as follows:
Solution
Coal price in year 2000 = (coal price in 1990 dollars) x

= 1.015
.
Coal price in year 2000 =
Example: Escalation and Inflation
―If the effects of inflation are included, then the
coal price in the year 2000 are calculated as:

Coal price in year 2000 = (coal price in 1990 dollars) x

= (coal price in 1990 dollars) x

= 1.015
.
=
Depreciation
Four commonly used depreciation methods are
I. Straight line
II. Sum-of-the-years digits
III. Double Declining balance
IV. Sinking fund.
Depreciation
• The following notation is used in the development of
depreciation formulas:
―I is the purchase price (present worth at time zero)
of asset,
―V is the net salvage value (i.e. a future value) at end
of asset's useful life
― is the depreciation charge at end of year t.
― is the book value of asset at the end of year t.
―N is the useful life of asset in years, and
―t is the number of years of depreciation from time
of purchase.
Depreciation methods
I. Straight line depreciation
• The simplest and the most widely used of all
depreciation methods in which the depreciation
charged each year is constant over the useful life
of the asset.

• When t = N, the book value is equal to the

salvage value.
• Book Value decreases linearly with ‘t’.
Example: Straight line depreciation
• Suppose a company is purchasing a piece of equipment
at a cost of $25 000. For an expected five year operating
life and an estimated net salvage value (at the end of the
fifth year) of $ 10 000, Calculate the annual depreciation
charges and end-of-year book value using Straight line
depreciation Method.
Solution

Similarly,
Depreciation methods
II. Sum-of-the-years digits depreciation
• This depreciation method provides a larger
depreciation charge in the early years of plant
life (called accelerated depreciation), which may
correspond more closely to the way an asset
(e.g. a power plant) actually depreciates.
Example: Sum-of-the-years digits
depreciation
• Suppose a company is purchasing a piece of
equipment at a cost of $25 000. For an expected five
year operating life and an estimated net salvage
value (at the end of the fifth year) of $ 10 000,
Calculate the annual depreciation charges and end-
of-year book value using Sum-of-the-years digits
depreciation method.
Example: Sum-of-the-years digits
depreciation
Depreciation methods
III. Double Declining balance
• The declining balance method is another
accelerated depreciation option for amortizing
an asset at an accelerated rate early in its life,
with corresponding lower annual charges near
the end of service.
• it is called the double declining balance method
because a rate equal to twice the straight-line
rate is used (i.e. 2/N).
Example: Double Declining
balance
• Suppose a company is purchasing a piece of
equipment at a cost of $25 000. For an expected
five year operating life and an estimated net
salvage value (at the end of the fifth year) of $
10 000, Calculate the annual depreciation
charges and end-of-year book value using
Double Declining balance Method.

0
Example: Double Declining balance
• The depreciation allocation shown at the end of
the second year for the double declining balance
method reflects the fact that accrued
depreciation, which by calculation would be $25
000 (2/5) (3/5), or $6000, must never exceed the
depreciable base (I—V). Therefore, because $
10, 000 was charged the first year, only $5000 is
permitted in the second year.
• The book value is calculated as:
Example: Double Declining balance

• The book value cannot be lower than the salvage

value. So after the second year the book value
remains constant.
Depreciation methods
IV. Sinking fund depreciation
 In this method a fund is created with the amount of annual
depreciation. An amount equal to annual depreciation is invested
each year outside the business. The income earned from
investment is deposited into the fund and immediately reinvested.
This process is carried out throughout the life of the asset and at
the end of its life a sum equal to the cost of the asset is
accumulated in the fund. Then the whole investment is sold and a
new asset is acquired with the sale proceeds.
 The special feature of this method is that the sum required to buy
the new asset is available from depreciation or sinking fund.
Depreciation methods
IV. Sinking fund depreciation
Example: Sinking fund depreciation
 Suppose a company is purchasing a piece of equipment at a
cost of $25 000. For an expected five year operating life and
an estimated net salvage value (at the end of the fifth year) of
$ 10 000, Calculate the annual depreciation charges and
end-of-year book value using Sinking fund depreciation
Method. Assume 10 % of annual rate of interest.
Example: Sinking fund depreciation
Summary of All Four Methods

Fig.4 : Summary of the results of the example solved

Lecture 06 – Criteria for Evaluation of Projects
Outline
 What is economics?
 Review of Economics Terms
 Time Value of Money
 Interest Formulas
 Escalation & Inflation
 Depreciation Methods
 Criteria for Evaluation of Projects
 Criteria for Evaluation of
Projects

Conventional/ Traditional Modern

Pay
Annual Rate Of Net Present Internal Rate of Discounted
Back
Return (ARR) Value (NPV) Return (IRR) PayBack Period
Period

Benefit to Cost Return on

Ratio Analysis Investment

Criteria for Evaluation of Projects

Key Takeaway: Traditional methods are not all encompassing and are used as
checking methods, Modern methods are more robust and have a more
wholistic approach
Criteria for Evaluation of Projects
Conventional Criteria
Payback Period
Payback period is the period of time
required for the profit or other benefits of an
investment to equal the cost of the investment.
Example: Payback Period
 The cash flow for two alternatives is given
below.
Year Alternative A ($) Alternative B ($)
0 -1000 -2783
1 200 1200
2 200 1200
3 1200 1200
4 1200 1200
5 1200 1200

 Based on Payback period which alternative

should be selected?
Key Takeaway: Used to determine when (timewise) your
investment will be recovered
Example: Payback Period
 Alternative A
̶ In the first 2 years, only $400 of the $1000 cost is recovered.
̶ The remaining $600 cost is recovered in the first half of 3rd
Year. Thus the payback period for Alt. A is 2.5 years.
 Alternative B
̶ Since the annual benefits are uniform, the payback period is
simply
$2783/$1200 per year =2.3 years

To minimize the payback period, choose Alt. B.

Example: Payback Period
 A firm is trying to decide which of two weighing
scales it should install to check a package-filling
operation in the plant. If both scales have a 6-
year life, which one should be selected?
Assume an 8% interest rate.
Alternative Cost ($) Uniform Annual Salvage Value
benefit ($) ($)

Atlas Scale 2000 450 100

Tom Thumb Scale 3000 600 700
Example: Payback Period
Solution
 Atlas Scale

=4.4 years

 Tom Thumb Scale

=5 years
Payback Period - Characteristics
There are four important points to be understood about payback
period calculations:
 This is an approximate, rather than an exact, economic analysis
calculation.
 All costs and all profits, or savings of the investment, prior to
payback are included without considering differences in their
timing.
 All the economic consequences beyond the payback period are
completely ignored.
 Being an approximate calculation, payback period may or may not
select the correct alternative.
Payback Period – Analytical View
 The Atlas scale appears to be the more attractive alternative in the
previous example. Is this really the case?
 Present worth method choses Tom Thumb scale as the best
alternative.
 Two different approaches reveal different conclusions.
 The $700 salvage value at the end of 6 years for the Tom Thumb
scale is a significant benefit.
 The salvage value occurs after the payback period, so it was
ignored in the payback calculation.
 Present worth analysis concludes that the Tom Thumb scale is more
desirable due to consideration of ignored salvage value.
Example: Payback Period
With Unequal Cash Flows
Company C is planning to take another project requiring initial investment of
$ 50 million & is expected to generate $ 10 million in 1st year, $ 13 million in
2nd year, $16 million in 3rd year, $19 million in 4th year and $ 22 million in 5th
year. Calculate the payback period of the project.

Calculate the cumulative cash flow.

Payback period = 3 + (11/19) = 3.58 Years

Year Cash Flow Cumulative Cash

Flow
0 (50) (50)
1 10 (40)
2 13 (27)
3 16 (11)
4 19 8
5 22 30
Criteria for Evaluation of Projects
Conventional Criteria
Annual rate of Return
Annual rate of return (ARR) is the ratio of estimated
annual profit of a project to the average investment made in the
project.

 The project with ARR equal to or greater than the required

accounting rate of return should be accepted.
 In case of mutually exclusive projects, accept the one with
highest ARR.
Example: Annual Rate of Return
• An initial investment of $130,000 is expected to generate annual
profit of $32,000 for 6 years. Depreciation is allowed on the straight
line basis. It is estimated that the project will generate scrap
(Salvage) value of $10,500 at the end of 6th year. Calculate its
annual rate of return assuming that there are no other expenses on
the project.
Solution
Initial Investment−Scrap Value
Annual Depreciation =

Annual Deprecia on = ($130,000 − $10,500) ÷ 6 ≈ $19,917

Annual Profit = $32,000 − $19,917 = $12,083

Annual Rate of Return = $12,083 ÷ $130,000 ≈ 9.3%

Example : Annual rate of Return
Compare the following two mutually exclusive
projects on the basis of ARR. Cash flows and salvage
values are in thousands of dollars. Use the straight
line depreciation method.
Year Cash Outflow Cash Inflow Salvage Value
($) ($) ($)
0 -220
Project A
1 91
2 130
3 105 10

Year Cash Outflow Cash Inflow Salvage Value

($) ($) ($)
0 -198
Project B
1 87
2 110
3 84 18
 Example : Annual rate of Return

Step : 1 Annual Depreciation = ( 220 − 10 ) / 3 = 70

Step : 2 Annual Income
Year Cash Cash Salvage Annual Annual
Outflow Inflow Value ($) Depreciation Income
($) ($) ($) ($)
0 -220
Project A
1 91 70 21
2 130 70 60
3 105 10 70 45

Step : 3 Average Annual Income = ( 21 + 60 + 45 ) / 3 = $ 42

Step : 4 Annual Rate of Return = 42 / 220 = 19.1%
 Example : Annual rate of Return

Step : 1 Annual Depreciation = ( 198− 18 ) / 3 = 60

Step : 2 Annual Income

Year Cash Cash Salvage Annual Annual

Outflow Inflow Value ($) Depreciation Income
($) ($) ($) ($)
0 -198
Project B
1 87 60 27
2 110 60 50
3 84 18 60 42

Step : 3 Average Annual Income = ( 27 + 50 + 42 ) / 3 = $ 39.66

Step : 4 Annual Rate of Return = 39.66 / 198 = 20 %
Example : Annual rate of Return
 Since the ARR of the project B is higher, it is more
favorable than the project A.
 This method is easy to calculate but It ignores time
value of money.
 Suppose, if we use ARR to compare two projects having
equal initial investments. The project which has higher
annual income in the latter years of its useful life may
rank equal to the one having higher annual income in
the beginning years – because they had equal average
income.
Criteria for Evaluation of Projects
Modern Criteria
Benefit to Cost Ratio Analysis
It is the ratio of Present value of benefits over
present value of costs taken into consideration the
time value of money.

A B/C ratio greater than 1 reflects an acceptable

project

Key Takeaway: To determine financial feasibility of

project to see if benefits outweigh the costs
Example: Benefit to Cost Ratio Analysis
 Consider 4 mutually exclusive alternatives.

A B C D
Initial cost ($) 400 100 200 500
Uniform Annual 100.9 27.7 46.2 125.2
Benefit ($)

 Each alternative has 5 years of useful life and no

salvage value. Based on 6% interest rate, which
alternative should be selected?
B/C Criterion for two or more Alternatives
 Compute the incremental B/C ratio for the cash
flow representing the increment of investment
between the higher initial cost alternative and the
lower initial cost alternative.
 If this incremental B/C ratio is 1, choose the
higher cost alternative; otherwise, choose the
lower cost alternative
Example: Benefit to Cost Ratio Analysis
Step 1 Compute B/C Ratio for the Alternatives
Example: Benefit to Cost Ratio Analysis
Step 2 : Rank the remaining alternatives in order of increasing initial cost &
examine the increment of investment between the lowest alternatives
Example: Benefit to Cost Ratio Analysis
Step 3 : Do the next two alternative comparison

The B/C ratio exceeds 1.0 hence alternative D is selected.

Criteria for Evaluation of Projects
Modern Criteria
Net Present Value
It is the present value of all cash flows associated with
an investment. It may be expressed as the difference between the
present value of the future returns and the capital cost.
― An analysis of net present value of various investment
alternatives helps in decision making for maximum returns.
― Only projects with a positive net present value are acceptable.
Because the return from these projects exceeds the cost of
capital (the return available by investing the capital).

Key Takeaway: To determine if the project has positive cashflows today and the
value of the project today in $ terms
Criteria for Evaluation of Projects
Modern Criteria

NPV = PV of benefits – PV of cost

Where
is the initial cash flow or capital investment
Example: Net Present Value
 Smart Manufacturing Company is planning to reduce its labor costs by
automating a critical task that is currently performed manually.
 The automation requires the installation of a new machine. The cost to
purchase and install a new machine is $15,000.
 The installation of machine can reduce annual labor cost by $4,200.
 The life of the machine is 15 years.
 The salvage value of the machine after fifteen years will be zero.
 The required rate of return of Smart Manufacturing Company is 25%.
 Should Smart Manufacturing Company purchase the machine?
Example: Net Present Value
―Solution:
• Initial cost $ 15,000
• Life of the project 15 Years
• Annual Cost Saving $4,200
• Salvage Value 0
• Rate of return 25%

Smart Manufacturing Company should purchase and install

the machine - because the present value of the cost
savings is greater than the present value of the initial cost.
NPV of Projects
Present Value Index
Choosing among several alternative investment
proposals:
If there are certain proposals with
different amounts of initial investment, then
they are ranked through an index called
present value index.

The proposal with the highest present value index is

considered the best.
 Example: NPV of Projects
Present Value Index
Proposal X Proposal Y Proposal Z

Present Value of cash inflow $ 212,000 $171,800 $185,000

Investment required $200,000 $160,000 $180,000
NPV $12,000 $11,800 $5,200

Present Value Indices:

Proposal X: 212,000/200,000 = 1.06
Proposal Y: 171,800/160,000 = 1.07
Proposal Z: 185,200/180,000 = 1.03
 Proposal X has the highest net present value but is not the most desirable
investment.
 The present value indices show Proposal Y as the most desirable investment
because it promises to generate 1.07 present value for each dollar invested,
which is the highest among three alternatives.
Criteria for Evaluation of Projects
Modern Criteria
Useful Lives Different from the Analysis Period
 In NPV analysis, there must be an identified analysis period and in
many situations the alternatives will have useful lives different from
the analysis period.
 One way to evaluate alternatives with lives different from the study
period is described here.
Example: Net Present Value
with different useful lives of asset
 Renewable Energy, Inc. is considering investing in two projects:
Solar Park or Wind Farm.
 Solar park will cost $20 million and will generate $7.5 million
per annum for 5 years. Wind farm will cost $35 million and will
generate $8 million for 10 years. If the company’s cost of capital
is 10%, determine which project should the company invest in,
using the NPV method.

Note: Values are in million

Example: Net Present Value
with different useful lives of asset

 Direct comparison of the Solar Park and the Wind Farm projects
can’t be made because they have difference useful lives.
 We need to employ the annual net present value method and
then accept the project with higher annual NPV.
Note: Values are in million
Example: Net Present Value
with different useful lives of asset
Annual net present value is calculated as

Annual NPV (Solar) = $8.43 (0.2637)= $2.22 million

Annual NPV (Wind) = $14.16 (0.1627)= $2.304 million

• The company should accept the Wind Farm project

because it generates more value per year of project
as compared to the Solar Park project.
Criteria for Evaluation of Projects
Modern Criteria
Internal Rate of Return (IRR)
The IRR is defined as any discount rate that
results in a net present value of zero, and is
usually interpreted as the expected return
generated by the investment.

Key Takeaway: To determine in percentage terms if a

project is worth investing in today
Example: Internal Rate of Return
• Find the IRR of an investment having initial cash outflow
of $213,000. The cash inflows during the first, second,
third and fourth years are expected to be $65,200,
$96,000, $73,100 and $55,400 respectively.

Solution:
• Start with IRR of your choice ( Hit and Trial Based) and
calculate NPV.

NPV at 10% discount rate = $18,372

• Since NPV is greater than zero we have to increase

discount rate, thus
Example: Internal Rate of Return
• NPV at 13% discount rate = $4,521
• NPV at 14% discount rate = $204
• NPV at 15% discount rate = -$3,975

Since NPV is fairly close to zero, w.r.t other NPVs,

at 14% so IRR ≈ 14%
Criteria for Evaluation of Projects
Modern Criteria
• When there are two alternatives, rate of return
analysis is performed by computing the incremental
rate of return IRR on the difference between the
alternatives.
• Since we want to look at increments of investment,
the cash flow for the difference between the
alternatives is computed by taking the higher initial-
cost alternative minus the lower initial cost
alternative.
• If IRR is the same or greater than the MARR
(minimum attractive rate of return), choose the
higher-cost alternative.
• If IRR is less than the MARR, choose the lower-cost
alternative.
Example: Incremental Rate of return
• If an electromagnet is installed on the input
conveyor of a coal-processing plant, it will pick
up scrap metal in the coal. The removal of this
metal will save an estimated $1200 per year in
costs associated with machinery damage due to
metal. The electromagnetic equipment has an
estimated useful life of 5 years and no salvage
value. Two suppliers have been contacted:
• Leaseco will provide the equipment in return for three
beginning-of-year annual payments of $1000 each;
• Saleco will provide the equipment for $2783.
• If the MARR is 10%, which supplier should be
selected?
 Example: Incremental Rate of Return
In Rate of Return analysis, the method of solution is to examine the
differences between the alternatives. By taking Saleco-Leaseco, we
obtain an increment of investment.
Year COF CIF NCF COF CIF NCF Saleco -
Leaseco ($) Leaseco ($) Leaseco ($) Saleco ($) Saleco ($) Saleco ($) Leaseco
C1 C2 L=C1+C2 C4 C5 S=C4+C5 ($) S-L

0 -1000 0 -1000 -2783 0 -2783 -1783

1 -1000 1200 200 0 1200 1200 1000

2 -1000 1200 200 0 1200 1200 1000

3 0 1200 1200 0 1200 1200 0

4 0 1200 1200 0 1200 1200 0

5 0 1200 1200 0 1200 1200 0

NCF = Net Cash Flow

COF = Cash Outflow
CIF = Cash Inflow
Example: Incremental Rate of Return
• Thus the incremental Rate of Return of selecting Saleco rather
than Leaseco is 8%.
• This rate is less than 10 % MARR. Select Leaseco

Year Cash Flow At 0 % At 8 % At 20 %

Saleco-Leaseco
($)
0 -1783 -1783 -1783 -1783
1 1000 1000 926 833
2 1000 1000 857 694
3 0 0 0 0
4 0 0 0 0
5 0 0 0 0
NPV ($) 217 0 -256
Criteria for Evaluation of Projects
Modern Criteria
Return on Investment
Return on Investment (ROI) is a performance
measure, used to evaluate the efficiency of an
investment or compare the efficiency of a number of
different investments. ROI measures the amount
of return on an investment, relative to the
investment’s cost.

Gain from Investment − Cost of Investment

Cost of Investment
Key Takeaway: Used to compare gain from investment vs. Its costs in
percentage terms for the upcoming term of the project.
Example: Return on Investment
• An investor buys $1,000 worth of stocks in 2010 and
sells the shares after one year for $1,200. Calculate
ROI.

Gain from Investment − Cost of Investment

Cost of Investment
1200−
1000

• Now the investor buys $2,000 worth of stocks in

2011 and sold his shares for a total of $2,800 in
2014. The ROI would be
Example: Return on Investment
−
000
―ROI doesn’t take into account the time value of
money.
―The investor got 40% on the investment over
the three years which yields 13.33% profit per
year.
―This shows that his first investment was actually
the more efficient choice that earned him 20 %
profit in one year.
Criteria for Evaluation of Projects
Modern Criteria
Discounted Payback Period
The discounted payback period (DPP) method is
based on the discounted cash flows technique and is
used in project valuation as a supplemental screening
criterion.
In simple words, it is the number of years needed to
recover initial cost (cash outflows) of a project from its
future cash inflows.
To calculate it, we need to add the discounted value of
each future cash inflow as long as the initial cost will
be recovered.
Example: Discounted Payback Period
An initial Investment of $ 2,324,000 is expected to generate $ 600,000
per year for 6 years. Calculate the discounted Payback Period of the
investment if the discount rate is 11 %.
Year Cash Flow Present Value Discounted Cumulative
‘CF’ Factor Cash Flow Discounted
‘PV’ Cash Flow
($) P= 1/(1+i)^n CF x PV ($)
0 -2,324,000 1 -2,324,000 -2,324,000
1 600,000 0.9009 540,541 -1,783,459
2 600,000 0.8116 486,973 -1,296,486
3 600,000 0.7312 438,715 -857,771
4 600,000 0.6587 395,239 -462,533
5 600,000 0.5935 356,071 -106,462
6 600,000 0.5346 320,785 214,323

PayBack Period = 5 + (106,462/320,785) =5.32 Years

 Thank you

Fiaz.Chaudhry@lums.edu.pk

+92 (321) 999-0780