ENGINEERING ECONOMY

Instructor: Lai Van Tai

 Chapter 4
PROJECT EVALUATION
BENEFIT – COST RATIO (B/C)
 Chapter 4: PROJECT EVALUATION
BENEFIT – COST RATIO (B/C)
o Methods in evaluation
o Principles in evaluation
o MARR (Minimum attractive rate of return)
Evaluation methods
o Equivalent value (NPV, FV, AV)
o Internal rate of return (IRR)
o B/C ratio
o Payback Period
o Break even point
Benefits and costs ratio
o Private vs Public projects
o Benefits
n Financial benefits - revenue
n Social benefits
n Environmental benefits….
o Costs
n Investing cost
n Operating costs
Benefits costs ratio
o Principles
n Apply equivalent value on Benefits and costs
n Given MARR
n A single Project is acceptable if (B/C)>1
n In comparison:
o apply incremental comparison method (∆B/∆C)
(If additional capital alternative is accepted è bigger project
will be selected)
o replacement rule for different lives of alternatives
ratio (SIR) by some governmental agencies.
ratio (SIR) by some governmental agencies.
Several different formulations of the B–C ratio have been developed. Two of the
Several different formulations of the B–C ratio have been developed. Two of the
more commonly used formulations are presented in this section, illustrating the use of
more commonly used formulations are presented in this section, illustrating the use of
both present worth and annual worth.
both present worth and annual worth.
Benefits costs ratio
Conventional B–C ratio with PW:
Conventional B–C ratio with PW:
PW(benefits of the proposed project)
B–C = PW(benefits of the proposed project)
B–C = PW(total costs of the proposed project)
PW(total costs of the proposed project)
PW(B)
= PW(B) (10-1)
= I − PW(MV) + PW(O&M) (10-1)
I − PW(MV) + PW(O&M)
where PW(·) = present worth of (·);
where PW(·) B= present worth
= benefits of the of (·);
proposed project;
BI = benefits
= initial of the proposed
investment project; project;
in the proposed
MVI = initial investment
= market value at theinend
the of
proposed project;
useful life;
MV =
O&M market value
= operating andatmaintenance
the end of useful life;
costs of the proposed project.
O&M = operating and maintenance costs of the proposed project.
Modified B–C ratio with PW:
Modified B–C ratio with PW: PW(B) − PW(O&M)
B–C =
PW(B)I −− PW(O&M).
PW(MV)
(10-2)
B–C = . (10-2)
I − PW(MV)
A project
A project is
is acceptable
acceptable when
when the
the B–C
B–C ratio,
ratio, as
as defined
defined inin either
either Equation
Equation (10-1)
(10-1) or
or
(10-2), is greater than or equal to 1.0.
(10-2), is greater than or equal to 1.0.
Equations (10-1)
Equations (10-1) and
and (10-2)
(10-2) can
can be
be rewritten
rewritten in
in terms
terms of
of equivalent
equivalentannual
annualworth,
worth,
as follows:
as follows:
Benefits costs ratio
Conventional B–C ratio with AW:
Conventional B–C ratio with AW:
AW(benefits of the proposed project)
B–C = AW(benefits of the proposed project)
B–C = AW(total costs of the proposed project)
AW(total costs of the proposed project)
AW(B)
= AW(B) , (10-3)
= CR + AW(O&M) , (10-3)
CR + AW(O&M)
where AW(·) = annual worth of (·);
where AW(·) = annual worth of (·);
B = benefits of the proposed project;
B = benefits of the proposed project;
CR = capital-recovery amount (i.e., the equivalent annual
CR = capital-recovery amount (i.e., the equivalent annual
cost of the initial investment, I, including an allowance
cost of the initial investment, I, including an allowance
for market, or salvage value, if any);
for market, or salvage value, if any);
O&M = operating and maintenance costs of the proposed project.
O&M = operating and maintenance costs of the proposed project.
Modified B–C ratio with AW:
Modified B–C ratio with AW:
AW(B) − AW(O&M)
B–C = AW(B) − AW(O&M). (10-4)
B–C = CR . (10-4)
CR
Benefits costs ratio - Comparison

∆B ∆C ∆ B/∆ C Conclusion

Positive Positive Positive If Ratio > 1 à the bigger better

Positive Negative Negative The bigger one is better

Negative Positive Negative The smaller one is better

Negative Negative Positive If ratio < 1 à the bigger better

Benefits costs ratio

Alternative A Alternative B (∆)

Initial investment 10 15 5
Annual revenue 5 7.0 2
Annual costs 2.2 4.3 2.1
Salvage value (SV) 2 0
useful life (n) 5 10
MARR 8% 8%

CR 2.165 2.2 0.037

B/C= [B-(O+M)] /CR 1.294 -2.703
Benefits costs ratio
ALTERNATIVES A B C D E F
Initial investment 1000 1500 2500 4000 5000 7000
Annual benefits 150 375 500 925 1125 1425
SV 1000 1500 2500 4000 5000 7000
MARR 18% 18% 18% 18% 18% 18%

CR = P.(A/P, i%, n) – SV(A/F, i%, n)

if P = SV, CR = P*i%

ADDITIONAL (∆) A B C-B D-B E-D F-E

Initial investment 1000 1500 1000 2500 1000 2000
∆ Annual benefits 150 375 125 550 200 300
∆CR 180 270 180 450 180 360
B/C 0.83 1.39 0.69 1.22 1.11 0.83
Conclusion No yes no yes yes no
OTHER METHODS OF ANALYSIS
o PAY BACK PERIOD
o BREAK EVEN POINT
 TH I GIAN BÙ V N C A D
a study period of N. The payback method, which is often calle
method, mainly indicates a project’s liquidity rather than its profi
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the simple payback
method has period, , ignores
been θused the timeofvalue
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A Perio
5-13,
is the number desirable.
sof years
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PAYBACK PERIOD considered
the years
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ng
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Only when θ = N (the
is the smallest valuelast time≤period
of θ(θ N) for in the planning
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hor
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o Necessary(salvage)
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o Simple payback (payout) period
information only in conjunction CF : Dòng
(R k −
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with one or more of
t k=1
) −
th
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i theanfive
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discussed. P! !
Sometimes, the discounted payback period, Tp θ (θ ≤ N), is ca
time value of money is considered. In this case,CF
“main_1” — 2019/2/6! CF: dòng ti—npage
— 12:07 t m247i th
— i#30an
!θ
(Rk − Ek )(P/F, i%, k) − I ≥ 0,
o Discounted payback period k=1

where i% is the MARR, I is the capital investment usually made

(k = 0), and
With: θ ! is the E:
R: Revenue; smallest value that
Expenditure; satisfies
I: Initial Equation (5-10). Ta
Investment
and 5) also illustrates the determination of θ ! for Example 5-13. N
first year in which the cumulative discounted cash inflows exceed
 investment. Payback periods of three years or less are often desired in U.S. industry,
so the project in Example 5-13 could be rejected, even though it is profitable. [IRR =
21.58%, PW(20%) = $934.29.] The simple and discounted payback periods are shown
graphically in Figure 5-9.
PAYBACK PERIOD
TABLE 5-2 Calculation of the Simple Payback Period (θ) and the
Discounted Payback Period (θ ! ) at MARR = 20% for
Example 5-13a
Column 3 Column 4 Column 5
Column 1 Column 2 Cumulative PW PW of Cumulative PW
End of Net Cash at i = 0%/yr Cash Flow at i = 20%/yr
Year k Flow through Year k at i = 20%/yr through Year k
0 −$25,000 −$25,000 −$25,000 −$25,000
1 8,000 −17,000 6,667 −18,333
2 8,000 −9,000 5,556 −12,777
3 8,000 −1,000 4,630 −8,147
4 8,000 +7,000 3,858 −4,289
5 13,000 5,223 +934
↑ ↑
θ = 4 years because the !
θ = 5 years because the
cumulative balance cumulative discounted
turns positive at balance turns positive
EOY 4. at EOY 5.
a Notice that θ ! ≥ θ for MARR ≥ 0%.
Break-even point
$ $
TR
TC
Break-even point TC

VC

TR
FC

Q
Q

Two Break-even point

Market demand and revenue

P Demand curve
D P = a – b.Q

TR Revenue curve
TR = p*Q = (a-bQ)Q
TR = aQ – bQ2