Chapter 6

Investment Evaluation

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Introduction
• Engineering economic analysis focuses on costs,
revenues, and benefits that occur at different times.
• As an engineer gains experience and becomes
manager, he/she is expected to know the art of money.

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Why Engineering Economics
• Which engineering projects are worthwhile?
• Which engineering projects should have a higher priority?
• How should the engineering project be designed?
• How to achieve long-term financial goals:
• How to compare different ways to finance purchases:
• How to make short and long-term investment decisions:

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Engineering Economics:
• “Engineering economy involves formulating, estimating, and
evaluating the expected economic outcomes of alternatives
designed to accomplish a defined purpose. Mathematical
techniques simplify the economic evaluation of alternatives.”
• Because the formulas and techniques used in engineering
economics are applicable to all types of money matters, they
are equally useful in business and government, as well as for
individuals.

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 Performing an Engineering Economy Study: or
steps
1. Identify and understand the problem; identify the objective.
2. Collect relevant, available data and define viable solution
alternatives.
3. Make realistic cash flow estimates.
4. Identify an economic measure of worth criterion for decision making.
5. Evaluate each alternative; use sensitivity analysis as needed.
6. Select the best alternative.
7. Implement the solution and monitor the results.

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The nature of investment decisions:
• The essential feature of investment decisions is time and
money.
• Investment involves making an outlay of cash, at one point in
time, which is expected to yield economic benefits to the
investor at some other point in time.
• Large amounts of resources are often involved. Many
investments made by businesses involve laying out a
significant proportion of their total resources.
• It is often difficult and/or expensive to bail out of an
investment once it has been undertaken.
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Investment appraisal methods:
Research shows that there are basically four methods used by
businesses to evaluate investment opportunities. They are:
● Accounting rate of return (ARR)
● Payback period (PP)
● Net present value (NPV)
● Internal rate of return (IRR).
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Financial Evaluation
 Once we have done financial analysis, we have to decide whether
the project is acceptable or not
 To decided acceptability of the project there are many methods
developed over period of time
 Methods are categorized in two main groups
 non-discounting Methods
 discounting Methods

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Project appraisal
• A detail evaluation of the project to determine
economic, technical and financial viability
• Assessing of feasibility to proceed
• Analysis of cost and benefit of proposed project
• Assessing a project in different aspect to determine
the whole impact of project
Since risk is involved in all activities associated with the
project , project appraisal aims at improving the quality
of projects and their long term profitability, which
further focuses on minimizing the risk of lending
rectifying their weaknesses and improving their
effectiveness.
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Project appraisal
• The term ‘project appraisal’ embraces the
techniques applied to determine the financial
and/or economic viability of the creation of
capital assets, so that decision-makers can
identify and select those projects that offer the
highest probability of adding to profitability
and/or social welfare.

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Process of project appraisal
The process of project appraisal consists of five
steps
• Initial assessment,
• Defining problem and long-list,
• Consulting and short-list,
• Developing options, and
• Comparing and selecting project.

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• If the appraisal process starts from an early stage,
then the company will be in a better position to
decide how capital should be spend in the project and
also it will help them to make the decision of not
spending too much or stopping a project that is not
economically viable.

Non discounting Discounting

• Net present value
• Payback period
• Internal rate of return
• Accounting rate of return
• Profitability index

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 Project appraisal technique
1. Accounting rate of return (ARR)
• Accounting rate of return or 'ARR' compares the profits you
expect to make from an investment to the amount you need to
invest.
• It's normally calculated as the average annual profit you expect
over the life of an investment project, compared with the
average amount of capital invested.

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Project appraisal technique
2. Payback period
• Payback period is a simple technique for assessing an
investment by the length of time it would take to repay it. It's
usually the default technique for smaller businesses and
focuses on cashflow, not profit.
• The length of time required for an investment to recover its
initial outlay

Example: Calculate payback period of example: NPV. If

the cut-off period is 4 years, is a project is acceptable?

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 Project appraisal technique
Discounted cashflow
Discounted cashflow applies a discount rate to work out
the present-day equivalent of a future cashflow.
1. Net present value (NPV) is the difference between the
resent value of cash inflows and the present value of
cash outflows over a period of time. By contrast,
internal rate of return (IRR) is a calculation used to
estimate the profitability of potential investments.

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Net present value (NPV)
• Present value (PV) for ‘n’ number of years at a discount rate of
‘r’ is given by

Where, , Future money gain/ inflow

Criteria
NPV>0, accept project, the greater the NPV, the better the project
NPV<0, reject project
NPV=0,

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Example: NPV
• A sum of $400,000 invested today in a project may
give a series of below cash inflows in future.
$70,000 in year 1
$120,000 in year 2
$140,000 in year 3
$140,000 in year 4
$40,000 in year 5
If the opportunity cost of capital is 8% per annum, then
should we accept or reject the project?
Solution
Formula for calculating present value

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Solution Con,..
PV for year 1
PV for year 2
PV for year 3
PV for year 4
PV for year 5
Add all cash inflows of all PVs
Present value of cash outflow is 400,000
Net present value (NPV)

NPV is positive. Therefore, WE ACCEPT THE PROJECT

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 2. Internal rate of return (IRR)
• IRR is a discount rate at which NPV is zero.
IRR used
• Rank different projects
• Higher IRR, the more desirable
Accept project when IRRopportunity cost of capital/ discount rate
Accept project when IRRopportunity cost of capital/ discount rate
May project when IRRopportunity cost of capital/ discount rate
Relation between IRR, discount rate and NPV
If IRRopportunity cost of capital/ discount rateNPV is always +ve
If IRRopportunity cost of capital/ discount rateNPV is always –ve
If IRRopportunity cost of capital/ discount rateNPV is always 0

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Example: IRR
• The cost of project is $1000. it has a time horizon of 5 years
and the expected wise incremental cash flows are:
Year 1: 200
Year 2: 300
Year 3: 300
Year 4: 400
Year 5: 500
Compute IRR of the project. If the opportunity cost of the capital
is 12%, Would you accept the project?
Solution
Using excel

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Solution cont,…

• You know that, if IRRopportunity cost of capital/ discount

rateNPV is always +ve
• Therefore, the project is acceptable.

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3. Profitability index (PI)

Project acceptance criteria using profitability index

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Example: PI
• Recall the previous example given in (Example: NPV),
Calculate PI

Since PI > 1, project is acceptable.

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Project appraisal technique
3. Payback period
• Payback period is a simple technique for assessing an
investment by the length of time it would take to repay it. It's
usually the default technique for smaller businesses and
focuses on cashflow, not profit.
• The length of time required for an investment to recover its
initial outlay

Example: Calculate payback period of example:NPV. If

the cut-off period is 4 years, is a project is acceptable?

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Example (Use NPV)
Assume a company is reviewing two projects. Management must
decide whether to move forward with one, both, or neither. Its
cost of capital is 10%. The cash flow patterns for each are as
follows:

Project A
Initial Outlay = $5,000
Year one = $1,700
Year two = $1,900
Year three = $1,600
Year four = $1,500
Year five = $700
Project B
Initial Outlay = $2,000
Year one = $400
Year two = $700
Year three = $500
Year four = $400
Year five = $300

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Investment decision making in cases of
uncertainty
Solutions of investment-related problems under conditions
of uncertainty, especially evaluation of investment projects
in conditions of uncertainty and risk, are possible to perform
applying different methods and techniques. The best known
methods employed in investment decision making are:
• Break-even Analysis
• Sensitivity Analysis
• Scenario Method
• Theory of Games and Decision Making Theory, etc

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