Chapter

p 28

Applied Engineering Economics

 INTRODUCTION
• In the p
previous session,, the basic tools for economic
analysis were developed.
• These tools allow us to manipulate cash flows in many
ways and d give
i us the
th power to t compare and d evaluate
l t
cash flow against specified criteria.
• Application of these tools is the subject of this chapter.
• In general, economic selection criterion will be either
maximization of benefits, minimization of costs, or
maximization of the net profits .
• Techniques will be presented for evaluation of single as
well as multiple alternative type problems.
problems
 LEARNING OBJECTIVES
• Evaluate and select the best alternative using
present value, future value, equivalent
uniform annual value,
value and discounted rate of
return; and
• Compare alternatives using the benefit
benefit‐cost
cost
ratio.
 CASH FLOW ANALYSIS
There are two fundamental approaches to the analysis of
a given cash flow, equivalent worth, and rate‐of‐return.
• Equivalent Worth‐
 The equivalent worth method simply converts to one
of the basic forms, i.e., the equivalent present worth,
or annual worth, using previously‐developed
techniques and the required MARR.
MARR
 A negative result means the proposed cash flow is
unacceptable because it does not provide the required
return‐on‐investment.
i
 Positive results are desirable and indicate an
investment that will meet the p prescribed criteria.
• Rate‐of‐Return
Rate of Return
 The fundamental concept behind rate‐of‐return
(ROR) analysis is that the ROR is the interest rate
at which benefits are equivalent to costs.
 Thus the cash flow is solved for the unknown
value, i.e. This technique is also known as internal
rate of return and can be used with either present
worth or annual worth equivalents.
 Example 28.1
• A $10,000 investment returned $2,342 per year over a 5‐year period. What was
the rate of return on this investment?
Solution‐ Set the present worth of benefits equal to the present worth of costs, then
algebraically isolate the discount factor and treat it as an unknown.
$2,342 (P/A, i, 5) = $10,000
(P/A i,i 5) = $10,000/$2,342
(P/A, $10 000/$2 342 = 4
4.27
27
Now look at the compound interest factors in the tables 27.2 and 27.3 for the value of
i where (P/A, i, 5) = 4.270; since no tabulated value is given, find the values on
either side of the desired value and interpolate to find the rate of return i.
F
From the
h tables
bl find
fi d
i (P/A, i, 5)
5.0% 4.379
? 4.270
6.0% 4.212

In this example, the rate of return for the investment was found to be 5.5 percent.
 MULTIPLE ALTERNATIVES
• Manyy pprojects
j will require
q a selection from amongg
several mutually‐exclusive alternatives.
• The selection of one alternative will preclude the
selection
l ti off any other
th alternative.
lt ti
• Two simple rules will help identify the preferred
alternative:
 Compute the net present worth (annual worth or
future worth) of each alternative at a the required
minimum attractive rate of return (MARR); and
 Select the alternative having the highest net present
worth (annual worth or future worth)
worth).
 Example 28.2
• Given the following mutually
mutually‐exclusive
exclusive
alternatives and a minimum attractive rate of
return (MARR)of 5 percent,
percent which one would
be
YEAR
chosen?
A B C
0 ($2,500) ($2,700) ($3,000)
1 0 650 0
2 0 650 350
3 0 650 700
4 0 650 1
1,050
050
5 3,100 650 1,400
Total $600 $550 $500
 Example 28.2
• Solution‐ Compute the net present worth for each
alternative and select the highest value. Notice the
values on the total line would suggest that alternative
B would be favored. Remember, this does not consider
the time value of money.
PWₐ=‐$2,500+$3,100(P/F,5%,5)=‐$2,500+$3,100
( 7835) = ‐$71
(.7835) $71
PWB =‐$2,700+$650(P/A,5%,5)=‐$2,700+$650
((4.329)=
) ‐$114
$
PWC =‐$3,000+$350(P/G,5%,5)=‐$3,000+$350
(8.237)= ‐$117
 Analysis Period
• When comparing alternatives using present worth
methods, it is necessary to analyze over a common
planning horizon.
• In the event that alternatives do not have equal lives,
consideration must be given to the difference.
• A common technique is to select an analysis period equal
to the least common multiple of the alternative lives.
• Another approach is to select an analysis period and
determine the salvage value for each alternative at that
point in time.
p
• When using annual worth methods there is no need to
establish equal lives.
 Capitalized Cost
• Problems occasionally arise involving extremely long
analysis periods.
• For example, in governmental analysis of permanent
structures such as roads dams, and pipelines, the required
maintenance can be spread over an infinite period (n=∞).
• In these cases the analysis is called capitalized cost or more.
• Simply stated, capitalized cost is the present sum of money
that would have to be set aside now, at a given interest
rate, to provide a perpetual uniform cash flow.
• In equation form,
P= A/i
 INCREMENTAL ANALYSIS
• Assume that the rate‐of return on two alternatives is known.
• Investment A yields 100 percent, and investment B yields 20
percent.
• Do we select A as the preferred alternative:
• Given further
f h information
f we find
f d that
h investment A was $1 $
returning $2 at the end of year 1, and investment B was $10,000
returning $12,000 at the end of year 1.
• The profit for A is $1 and B is $2
$2,000.
000
• The lower rate of return (ROR) alternative in this case is probably
the better investment if the minimum attractive rate of return
((MARR)) is 20 p percent or less
• This illustrates the need for a procedure to evaluate the return on
the increment of initial investment if one alternative requires a
higher initial investment than the other.
 Rate of Return
• This technique is based on the paired comparison of alternatives.
• The following steps should be followed in an incremental rate‐of‐
return analysis:
1. Identify all alternatives. Be sure to consider the option of
maintaining the status or quo or what is often called “dodo nothing;
nothing;”
2. Compute the rate‐of‐return for each alternative and discard any
alternative with ROR<MARR;
3. Arrange remaining alternatives in ascending order of initial cost;
4. Calculate the rate‐of return on the difference between the first two
(lowest initial cost) alternatives. If this ΔROR≥MARR, retain the
lower cost alternative;
5
5. Take the retained alternative from the previous step and compare it
to the next higher alternative; and
6. Repeat this process until all alternatives have been evaluated.
 Benefit‐Cost
Benefit Cost Ratio
• This analysis technique is based on the ratio of benefits to costs.
• An alternative is considered acceptable if the following criteria are
met:
PW of benefits–PW of costs≥0 or EUAB–EUAC ≥0

Another way of stating this in terms of ratios is:

B ‗ PW of benefits ‗ EUAB ≥1
C PW of costs EUAC

The incremental approach for the analysis of two or more alternatives

will
ill follow
f ll the
h same procedure
d as that
h for
f rate‐off –return analysis.
l i
 TAX CONSIDERATIONS
• The effect of taxes on investments are a significant part of all real
problems and should be considered.
considered
• Because taxes have been ignored in our analysis, the results are
considered a before‐tax cash flow.
q
• If the consequences of income tax and other tax effects are incorporated
p
into the economic analysis we will have an after‐tax analysis.
• The following relationships are involved:
 Before‐tax cash flow;
 Depreciation;
 Taxable income: (before‐tax cash flow)‐ (depreciation)
 Income taxes = (taxable income) X (incremental tax rate); and
 After‐tax
After tax cash flow = (before –taxtax cash flow) – (income taxes)
taxes).
Tax laws are complex and changing. It is not our purpose to explain then in
this text. All of the principles and techniques that have been developed
can be applied to an after‐tax analysis.