ECLT 5930/SEEM 5740: Engineering Economics

2016–16 First Term

Master of Science in ECLT & SEEM

Instructors: Dr. Keith Wong

Department of Systems Engineering & Engineering Management
The Chinese University of Hong Kong

October 20, 2016

 Recap: Comparison and Selection among Alternatives

1. We focused on settings in which

• alternatives are mutually exclusive;
• durations of the alternatives are the same;
• there is no budget concern.

2. Use incremental analysis to determine which project is most preferred.

Pick the alternative that requires the minimum investment of

capital and produces satisfactory functional results, unless the
incremental capital associated with an alternative having a larger
investment can be justified with respect to its incremental benefits.

3. The use of PW is more reliable in evaluating the feasibility/profitability of

projects, although IRR is appealing to many finance managers due to its ease of
comparison.

ECLT 5930/SEEM 5740 (2016–17 First Term) October 20, 2016 1

 Recap: Equivalence of Selection Rules

• If we use the PW Selection Rule to choose the best investment project, then it
suffices to pick the one with the highest non–negative PW evaluated at MARR.

• However, if we use the IRR Selection Rule, then we must apply the incremental
analysis procedure and select the one whose incremental IRR over every other
project is no less than MARR.

• In general, the PW and IRR Selection Rules may give different conclusions.
However, if the cash flows of ∆(A − B) are given by

−I, R1, . . . , RN , (*)

where I, R1, . . . , RN ≥ 0, then

PW∆(A−B)(MARR) ≥ 0 ⇐⇒ IRR∆(A−B) ≥ MARR.

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 Algorithms for Solving Capital Budgeting

• Recall that we have the following integer programming problem for capital
budgeting:
∑n
maximize wixi
i=1
∑n
subject to cixi ≤ C,
i=1
xi = 0 or 1 for i = 1, . . . , n.

Here, ci and wi are the capital investment and PW of alternative i, respectively.

• If we solve this problem by brute force, we need to check 2n possibilities.

ECLT 5930/SEEM 5740 (2016–17 First Term) October 20, 2016 3

 Algorithms for Solving Capital Budgeting (Cont’d)

• In general, there are many heuristics to find a feasible solution to the problem.
– Greedy strategy: Order the “cost–effectiveness” wi/ci in decreasing order,
and choose the alternatives in this order until the budget is filled.
– Linear Relaxation: Solve the linear program

∑
n
maximize wixi
i=1
∑n
subject to cixi ≤ C,
i=1
0 ≤ xi ≤ 1 for i = 1, . . . , n.

Question: What to do with the optimal solution, which could have fractional
entries?

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 Algorithms for Solving Capital Budgeting (Cont’d)

• Let {x∗i } be an optimal solution to the linear program.

• Idea: Treat x∗i as probability. Specifically, generate a random binary solution

{X̂i} by
x∗i = Pr(X̂i = 1) = 1 − Pr(X̂i = 0).

• Question: Is the solution feasible? Clearly, each X̂i = 0 or 1. Now,

[ ]
∑
n ∑
n ∑
n
E ciX̂i = ciE[X̂i] = cix∗i ≤ C.
i=1 i=1 i=1

Also, [ ]
∑
n ∑
n
E wiX̂i = wix∗i = OPT(LP) ≥ OPT(IP),
i=1 i=1

where OPT(LP) and OPT(IP) are the optimal values of the linear program and
integer program, respectively.

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 Algorithms for Solving Capital Budgeting (Cont’d)

• In fact, one can say more.

– (Probability of Infeasibility) For all ϵ > 0,
( n ) ( )
∑ ϵ C 2
Pr ciX̂i ≥ (1 + ϵ)C ≤ exp − ∑n 2 .
i=1
2 i=1 ci

– (Probability of Sub–Optimality) For all 0 < η < 1,

( n ) ( )
∑ 2
η OPT(LP)
Pr wiX̂i ≤ (1 − η)OPT(LP) ≤ exp − ∑n 2 .
i=1
2 i=1 wi

• We shall not discuss the proof here.

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 Algorithms for Solving Capital Budgeting (Cont’d)

• The solution returned by the greedy strategy or the linear relaxation method is
generally not optimal.

• To compute the optimal solution without resorting to exhaustive search, one can
use dynamic programming.

• Setup
– Assume that the capital investments c1, . . . , cn, the PWs w1, . . . , wn, and the
budget C are all integers.
– Let d(i, j) denote the maximum possible PW if the alternatives are A1, . . . , Ai
and the budget is j, where i = 1, . . . , n and j = 1, . . . , C.
– We are interested in computing d(n, C).

• Idea: Use recursion.

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 Algorithms for Solving Capital Budgeting (Cont’d)

• Key observation: To determine d(i, j), let us focus on alternative Ai.

– If we do not choose Ai, then our maximum possible PW is d(i − 1, j).
– Otherwise, we gain a PW of wi, but the budget is reduced by ci. Hence, our
maximum possible PW is wi + d(i − 1, j − ci).
– Naturally, we will pursue the better of these two options. Hence,

d(i, j) = max{d(i − 1, j), wi + d(i − 1, j − ci)}.

– We define d(i, 0) = 0 for all i and d(i, j) = −∞ for all j < 0.

• The above reasoning suggests that we can compute d(n, C) using a table of size
n × C.

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 Algorithms for Solving Capital Budgeting (Cont’d)
• Suppose that C = 7 and

w1 = 3, c1 = 2 ∥ w2 = 4, c2 = 3 ∥ w3 = 5, c3 = 4 ∥ w4 = 2, c4 = 2.

• We keep track of d(i, j) = max{d(i − 1, j), wi + d(i − 1, j − ci)} using

i/j 1 2 3 4 5 6 7
1 0 3 3 3 3 3 3
2 0
3 0
4 0
• We also keep track of our choices using

i/j 1 2 3 4 5 6 7
1 0 1 1 1 1 1 1
2 0, 0
3 0, 0, 0
4 0, 0, 0, 0

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 Algorithms for Solving Capital Budgeting (Cont’d)
• Suppose that C = 7 and

w1 = 3, c1 = 2 ∥ w2 = 4, c2 = 3 ∥ w3 = 5, c3 = 4 ∥ w4 = 2, c4 = 2.

• We keep track of d(i, j) = max{d(i − 1, j), wi + d(i − 1, j − ci)} using

i/j 1 2 3 4 5 6 7
1 0 3 3 3 3 3 3
2 0 3 4 4 7 7 7
3 0
4 0
• We also keep track of our choices using

i/j 1 2 3 4 5 6 7
1 0 1 1 1 1 1 1
2 0, 0 1, 0 0, 1 0, 1 1, 1 1, 1 1, 1
3 0, 0, 0
4 0, 0, 0, 0

ECLT 5930/SEEM 5740 (2016–17 First Term) October 20, 2016 10

 Algorithms for Solving Capital Budgeting (Cont’d)
• Suppose that C = 7 and

w1 = 3, c1 = 2 ∥ w2 = 4, c2 = 3 ∥ w3 = 5, c3 = 4 ∥ w4 = 2, c4 = 2.

• We keep track of d(i, j) = max{d(i − 1, j), wi + d(i − 1, j − ci)} using

i/j 1 2 3 4 5 6 7
1 0 3 3 3 3 3 3
2 0 3 4 4 7 7 7
3 0 3 4 5 7 8 9
4 0
• We also keep track of our choices using

i/j 1 2 3 4 5 6 7
1 0 1 1 1 1 1 1
2 0, 0 1, 0 0, 1 0, 1 1, 1 1, 1 1, 1
3 0, 0, 0 1, 0, 0 0, 1, 0 0, 0, 1 1, 1, 0 1, 0, 1 0, 1, 1
4 0, 0, 0, 0

ECLT 5930/SEEM 5740 (2016–17 First Term) October 20, 2016 11

 Algorithms for Solving Capital Budgeting (Cont’d)
• Suppose that C = 7 and

w1 = 3, c1 = 2 ∥ w2 = 4, c2 = 3 ∥ w3 = 5, c3 = 4 ∥ w4 = 2, c4 = 2.

• We keep track of d(i, j) = max{d(i − 1, j), wi + d(i − 1, j − ci)} using

i/j 1 2 3 4 5 6 7
1 0 3 3 3 3 3 3
2 0 3 4 4 7 7 7
3 0 3 4 5 7 8 9
4 0 3 4 5 7 8 9
• We also keep track of our choices using

i/j 1 2 3 4 5 6 7
1 0 1 1 1 1 1 1
2 0, 0 1, 0 0, 1 0, 1 1, 1 1, 1 1, 1
3 0, 0, 0 1, 0, 0 0, 1, 0 0, 0, 1 1, 1, 0 1, 0, 1 0, 1, 1
4 0, 0, 0, 0 1, 0, 0, 0 0, 1, 0, 0 1, 0, 0, 1 1, 1, 0, 0 1, 0, 1, 0 1, 1, 0, 1

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 This Lecture: Incremental Analysis When Durations of the
Alternatives are Different

• When the mutually exclusive alternatives under study have different durations,
we cannot just “add” or “subtract” their cash flow diagrams.

R0A R1A R2A R0B R1B R2B R3B R4B

????

0 1 2 3 4 0 1 2 3 4

E0A E1A E2A E0B E1B E2B E3B E4B

Alternative A Alternative B

Figure 1: Alternatives with different durations

• One way to compare these alternatives is to convert them into ones that have
the same duration.

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 Alternatives with the Same Duration: Repeatability

• Repeatability Assumption
– Focus on a period that is either indefinitely long or equal to a common
multiple of the individual durations of the alternative.
– The economic consequences that are estimated to happen in an alternative’s
initial useful life span will also happen in all succeeding life spans.

R1 R2 R1 R2 R1 R2

=⇒
0 1 2 3 4 0 1 2 3 4

C C C

Figure 2: The repeatability assumption

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 Alternatives with the Same Duration: Cotermination

• Coterminated Assumption
– Use a finite and identical study period for all alternatives.
– This period puts the alternatives on a common and comparable basis by
adjusting their estimated cash flows.
– The actual adjustment will depend on context (more on this later).

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 Comparing Alternatives Using the Repeatability Assumption

• Consider two projects A and B. Let NA and NB be the durations of projects A

and B, respectively.

• Let N be the least common multiple of NA and NB .

– For example, if NA = 4 and NB = 6, then N = 12.

• Fill up the study period N by “repeating” the projects.

• We can then compare projects A and B by comparing

PWA,N (MARR) vs. PWB,N (MARR).

• Of course, we can also compare

AWA,N (MARR) vs. AWB,N (MARR),

and the conclusion will be the same.

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 Using the Repeatability Assumption: Example
• Consider two projects A and B with MARR=10% and future cash flows given
by
A B
Capital Investment −$3, 500 −$5, 000
Annual Revenue $1, 900 $2, 500
Annual Expenses −$645 −$1, 020
Useful life 4 years 6 years

The value at the end of useful life is assumed to be zero.

• Under the repeatability assumption, we compute their AW as follows:

AWA,12(10%) = −$3, 500 × (A/P, 10%, 4) + $1, 900 − $645 = $151,

AWB,12(10%) = −$5, 000 × (A/P, 10%, 6) + $2, 500 − $1, 020 = $332.

Hence, we prefer project B.

– Note that the least common multiple N = 12 does not come into the
calculation when we use the AW method.

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 Comparing Alternatives Using the Coterminated Assumption

• Note that the repeatability assumption is quite restrictive, as not all alternatives
can be repeated.

• In this case, we can pick a study period N and adjust the cash flows of the
alternatives so that they are comparable over the chosen study period.

• Specifically, let N be the chosen study period. Consider a project P whose

duration is NP .

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 Comparing Alternatives Using the Coterminated Assumption

Suppose first that NP < N . We consider two cases:

• If P is a cost alternative (i.e., one that involves all negative cash flows, except
perhaps at the end when the disposal of assets gives rise to a positive cash flow),
then either
– repeat the cost portion of P until period N (e.g., contracting for service or
leasing needed equipment); or
– repeat part of the useful life of the original alternative and use an estimated
market value to truncate it at the end of period N (more on this later).

• If P is an investment alternative (i.e., one that involves an initial capital

investment, followed by positive cash flows), then either
– reinvest the cash flow at MARR until the end of period N ; or
– replace the initial investment with another asset having possibly different cash
flows over the remaining life.

ECLT 5930/SEEM 5740 (2016–17 First Term) October 20, 2016 19

 Cost vs. Investment Alternatives Under the Coterminated
Assumption, with NP < N
S S MV

0 1 2 3 4 0 1 2 3

E0 E1 E2 E3 E4 E0 E1 E2 E1
E0
NP = 3, N = 4 NP = 2, N = 3

Figure 3: Cost alternatives

F
R1 R2 R1 R2 R3 R4

0 1 2 3 4 0 1 2 3 4

C C0 C2

NP = 2, N = 4

Figure 4: Investment alternatives

ECLT 5930/SEEM 5740 (2016–17 First Term) October 20, 2016 20

 Comparing Alternatives Using the Coterminated Assumption
Suppose now that NP > N .

• Truncate the alternative at the end of period N using an estimated market value
(e.g., assets can be disposed at the estimated value).

MV S

0 1 2 3 4

E0 E1 E2 E3 E4

NP = 4, N = 2

Figure 5: Alternatives with NP > N

Underlying principle
To compare the mutually exclusive alternatives over the
same study period.

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 Using the Coterminated Assumption: Example

• Consider again the earlier example, where MARR=10%:

A B
Capital Investment −$3, 500 −$5, 000
Annual Revenue $1, 900 $2, 500
Annual Expenses −$645 −$1, 020
Useful life 4 years 6 years

• Suppose that
– the study period is chosen to be 6 years; and
– the cash flow at the end of project A is reinvested at MARR until the end of
period 6.

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 Using the Coterminated Assumption: Example (Cont’d)

• To compare the two alternatives, we use the FW method.

• For project A, we have

[ ]
FWA(10%) = − $3, 500 × (F/P, 10%, 4) + ($1, 900 − $645) × (F/A, 10%, 4)

× (F/P, 10%, 2)
= $847.

• For project B, we have

FWB (10%) = −$5, 000 × (F/P, 10%, 6) + ($2, 500 − $1, 020) × (F/A, 10%, 6)
= $2, 561.

• Hence, we still prefer project B to project A.

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 Application: Truck Purchase

• A company needs to have four additional forklift trucks to support a warehouse,

which is anticipated to be shutdowned in 8 years. Two mutually exclusive
alternatives are identified as follows:

Truck A Truck B
Capital Investment −$184, 000 −$242, 000
Annual Expense −$30, 000 −$26, 700
Useful life 5 years 7 years
Salvage Value $17, 000 $21, 000

• Suppose that the three–year lease cost is $104,000 per year, and the one–year
lease cost is $134,000 per year.

• Furthermore, assume that the MARR of the firm is 15%.

• Question: Which type of the truck should the firm buy?

ECLT 5930/SEEM 5740 (2016–17 First Term) October 20, 2016 24

 Application: Truck Purchase (Cont’d)
• Since the warehouse is going to be shutdowned in 8 years, we can choose that
as our study period.

• Let us compare the cash flows. We assume that when the purchased truck has
reached the end of its useful life, we lease a truck for the remaining years at the
aforementioned price.
Truck A Truck B ∆(B − A)
Year 0 −$184, 000 −$242, 000 −$58, 000
Year 1 −$30, 000 −$26, 700 $3, 300
Year 2 −$30, 000 −$26, 700 $3, 300
Year 3 −$30, 000 −$26, 700 $3, 300
Year 4 −$30, 000 −$26, 700 $3, 300
Year 5 −$13, 000 −$26, 700 −$13, 700
Year 6 −$104, 000 −$26, 700 $77, 300
Year 7 −$104, 000 −$5, 700 $98, 300
Year 8 −$104, 000 −$134, 000 −$30, 000

• Since PW∆(B−A)(15%) = $5, 177, we conclude that Truck B is more preferred

to Truck A.

ECLT 5930/SEEM 5740 (2016–17 First Term) October 20, 2016 25

 The Imputed Market Value Technique

• Recall that when using the coterminated assumption, we may want to estimate
an asset’s market value before it reaches its useful life.

• The most convenient way for achieving this is to get the current estimate from
the marketplace.

• However, this may not always be possible.

– low turnover of the asset in the marketplace
– information about recent transactions unavailable

• Hence, we need to estimate the market value of an asset without current or

representative historical data.

ECLT 5930/SEEM 5740 (2016–17 First Term) October 20, 2016 26

 The Imputed Market Value Technique (Cont’d)
• Suppose that we want to estimate the market value of, say, a piece equipment
at the end of period T , where T is less than the equipment’s useful life N .

• Let
– C = initial capital investment on the equipment;
– S = salvage value of the equipment; and
– r = MARR.
Then, we can compute the market value (MV) of the equipment as follows:
[ ]
MVT = C × (A/P, r%, N ) − S × (A/F, r%, N ) × (P/A, r%, N − T )

+ S × (P/F, r%, N − T ).

• The first term represents the PW of the remaining capital recovery amount at
the end of period T .

• The second term represents the PW of the salvage value at the end of period T .

ECLT 5930/SEEM 5740 (2016–17 First Term) October 20, 2016 27

 Illustration of the Imputed Market Value Technique
S
A A A A A

0
1 2 3 4 5

MARR = r%
C

Figure 6: The imputed market value technique, with T = 3 and N = 5

• To understand the capital recovery term in the MV calculation, observe that if
the above project is feasible to begin with, we must have
AW(r%) = −C × (A/P, r%, 5) + A + S × (A/F, r%, 5) ≥ 0,

or equivalently, A ≥ C × (A/P, r%, 5) − S × (A/F, r%, 5).

• The right–hand side is the minimum amount we need to collect in periods 4 and
5 in order to recover our capital. Since periods 4 and 5 are beyond the study
period, we need to charge the aforementioned amount to period 3, thus yielding
the following capital recovery term in the MV calculation:
[C × (A/P, r%, 5) − S × (A/F, r%, 5)] × (P/A, r%, 2).

ECLT 5930/SEEM 5740 (2016–17 First Term) October 20, 2016 28

 The Imputed Market Value Technique: Example
• Suppose that we have a project with the following data:
– capital investment C = $47, 600;
– useful life N = 9 years;
– salvage value S = $5, 000; and
– MARR r = 20%.

• Then, the capital recovery amount is given by

CR = $47, 600 × (A/P, 20%, 9) − $5, 000 × (A/F, 20%, 9) = $11, 568.

• To obtain an estimate of the market value at the end of period 5, we compute

MV5 = PWCR,5(20%) + PWS,5(20%)

= CR × (P/A, 20%, 4) + $5, 000 × (P/F, 20%, 4)
= $29, 947 + $2, 411
= $32, 358.

ECLT 5930/SEEM 5740 (2016–17 First Term) October 20, 2016 29

 Comparing Alternatives with Different Durations: Exercise
• Suppose that MARR=10%, and consider the following two projects:

Project A Project B
Capital Investment −$40, 000 −$60, 000
Annual Benefit $12, 000 $10, 000
Useful life 4 years 8 years
Salvage Value $24, 000 $40, 000

• Suppose that both projects can be repeated.

• Question: Which project should we pursue?

– Hint:
i(1 + i)N
(A/P, i%, N ) = ,
(1 + i)N − 1
i
(A/F, i%, N ) = .
(1 + i) − 1
N

ECLT 5930/SEEM 5740 (2016–17 First Term) October 20, 2016 30

 Comparing Alternatives with Different Durations: Exercise

• Now, suppose that project A cannot be repeated. We assume that the cash flow
associated with project A at the end of year 4 can be reinvested at MARR.

• Question: Which project should we pursue?

– Hint:

(F/P, i%, N ) = (1 + i)N ,

(1 + i)N − 1
(F/A, i%, N ) = .
i

ECLT 5930/SEEM 5740 (2016–17 First Term) October 20, 2016 31

 Comparing Alternatives with Different Durations: Exercise

• Now, suppose that we fix our study period to be T = 4 years. We choose to

estimate the market value of project B at the end of year 4.

• Question: Which project should we pursue?

– Hint:

(1 + i)N − 1
(P/A, i%, N ) = ,
i(1 + i)N
1
(A/P, i%, N ) = ,
(P/A, i%, N )
i
(A/F, i%, N ) = ,
(1 + i)N − 1
1
(P/F, i%, N ) = N
.
(1 + i)

ECLT 5930/SEEM 5740 (2016–17 First Term) October 20, 2016 32

 What’s Next?

• Assignment: Read Chapter 6 of the course textbook.

• Next: Depreciation and income taxes (Chapter 7 of the course textbook)

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