By Amrit Nakarmi Lecture #8 EE BME 29 July 2011

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Net Future Value (NFV)

y The NPV measures the surplus in an investment

project at time '0'. Sometimes we might need to find the equivalent worth or value of a project at the end of the investment period. Hence, the Net Future Value (NFV) measures the surplus at the end of the investment period.

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Net Future Value (NFV)

NFV Criterion NFV = A0(1+i)n + A1(1+i)n-1 + A2/(1+i) n-2 + .. +An NFV =sum of An(F/A, i,N-n)

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Net Future Value (NFV)

y If NFV >0, accept the project y If NFV = 0, remain indifferent y If NFV<0, reject the project

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Capitalized Equivalent Method

lim N Cg ( P / A, i, N ) ! lim N Cg [((1  i ) N  1) / i (1  i ) N ] ! 1 / i PV (i ) ! A( P / A, i, N C g ) ! A / i

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Capitalized Equivalent Method

Another method of PV criterion is useful when the life of project is perpetual or planning horizon is very long. Perpetual Service life PV = A/i

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Capitalized Equivalent Method

y The process of calculating PV cost for infinite period is

called capitalization of project cost. The cost is known as the Capitalized cost i.e. the amount of money to be invested now to get a certain return 'A' at the end of each and every year forever.

A PV ! i
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Capitalized Equivalent Method

y A hydropower project is of 50 years life. An

entrepreneur spent $800,000 (not considering time value of money) during the last 10 years. We have to compute the project value (worth) using different interest rates. y (a) If the entrepreneur s MARR is 8% compute NPV with 50 year service life and infinity. y (b) Repeat the same at 12% MARR and see the difference.

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Types of Projects
y Mutually Exclusive Projects
y Mutually exclusive means that any one of several

alternatives will fulfill the same need and that selecting one alternative means that others will be excluded.

y Revenue Projects and Service Projects

y Revenue projects are those projects hose revenues

depend on the choice of the alternative. y Service projects are those projects whose revenues do not depend on the choice of the project.

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Types of Projects
y For service projects, we use the NPV of costs and

choose the project which has the least negative NPV. y For revenue projects, we use NPV of revenues and choose the project which ahs the highest NPV.

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Annual Equivalent Value Analysis

The annual equivalent value (AE) criterion is a basis for measuring investment value by determining equal payments on an annual basis. First, we have to find the NPV of the project and then convert it to equal annual payments.

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Annual Equivalent Value (AEV)

AE(i) =PV(i)(A/P,i,n) If AE>0, accept the project If AE =0, remain indifferent If AE <0, reject the project

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Benefits of AE analysis
y 1. Consistency of report format. Financial and

engineering managers may prefer to work on yearly costs rather than overall costs. y 2. Need for unit costs. In many situations, project must be broken down into unit costs for comparison and ease. y 3. Unequal project lives. Comparing projects with unequal service lives is complicated in calculations, but using AE analysis, this problem can be easily solved.
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Operating Costs and Capital Costs

plant or factory. y Capital costs are incurred only one time in the project life, where operating costs incur annually. The annual equivalent of the capital cost is capital recovery cost 'CR'. CR = P(A/P,i,n) - S(A/F,i,n)
y Operating costs are incurred by the operations of the

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Operating Costs and Capital Costs

y (A/F, i, n)=(A/P, i, N) I y CR(i) =(i-S)(A/P,i, N) +iS

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Life Cycle Cost (LCC)

y If a project investment cost is P with the service life of

n period. y The annual operating cost is Ai . y The life cycle cost (LCC) is

LCC = Capital cost + operating cost

n

LCC ! P  Ai ( P / A, r , n)
n !1

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Annualized Life Cycle Cost (ALCC)

y Sometime in the big investment project, we have to

spread the capital cost for the entire service period, in order to minimize the the lumpy financial burden, then we have to calculate ALCC. ALCC = annual capital cost + annual operating cost

ALCC = annual capital cost + annual operating cost

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Annualized Life Cycle Cost (ALCC)

ALCC =LCC (A/P, I,n)

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Internal Rate of Return (IRR)

IRR is the interest rate earned on the unrecovered project balance of investment such that, when the project terminates, the unrecovered project balance will be zero. NPV = A0/(1+i*)0 + A1/(1+i*)1 + A2/(1+i*)2 =0 .+ An/(1+i*)n

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Internal Rate of Return (IRR)

Simple Investments
A simple investment is defined as that investment, when the sign change in the project cash flow occurs only once. A non-simple investment is that investment where the sign change occurs more than once.

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Investment Classification
Investm 0 period ent type Simple Simple Nonsimple Nonsimple
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_ _ _ 0 0 _

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Internal Rate of Return (IRR)

Methods of project Evaluation by IRR
y If IRR>MARR, accept the project y If IRR = MARR, remain indifferent y If IRR < MARR, reject the project

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Internal Rate of Return (IRR)

Multiple IRR When there are multiple values of IRR, we can predict unique value of IRR by examining its cash flows. 1. Net cash flow rule of sign 2. Accumulated net cash flow rule of sign

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Cash Flow Rule of Signs

Net Cash flow rule of sign
y The number of real i* that are greater than -100% for a

project with 'n' periods is never greater than the number of sign changes in the sequence of the An values. y Accumulated Cash flow rule of sign y If the net cash flow sign test shows multiple values of i*, then we should proceed to this sign test. y If the series of cumulative cash flows start negatively and changes the sign only once, then there exists a unique positive i*.

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Methods for determining IRR

y 1. The direct-solution method y 2. The trial-and-error method, and y 3. The graphic method

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Direct Solution Method

n 1 2 3 4 5
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Project 1 -$1,000 0 0 0 1,500

Project 2 _$2,000 1,300 1,500

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Direct Solution Method

Project 1
* *

FV (i ) ! $1, 000( F / P, i , 4)  $1,500 ! 0 $1,500 ! $1, 000( F / P , i* , 4) ! $1, 000(1  i* )4 1.5 ! (1  i* ) 4 i* ! 1.5  1 i* ! 0.1067or10.67%
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1 4

Direct Solution Method

Project 2
NPV ! $2, 000  Let x! 1 (1  i ) 1, 300 s $1, 300 $1, 500  !0 2 (1  i ) (1  i )

NPV ! $2, 000  $1, 300 x  $1, 500x 2 ! 0 1, 3002  4(1, 500)(2, 000) x! 2(1, 500) 1, 300 s 3, 700 x! 3, 000 x ! 0.8or  1.667 1 0.8 ! 1 i i ! 25%
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Incremental investment Analysis

y Under NPV and AEV analysis, the mutually

exclusive project with the highest value is selected and this method is known as Total Investment Approach . NPV, NFV, and AEV methods of project evaluation are absolute measures, whereas the IRR method is a relative (percentage) measure, and it ignores the scale of investment. But for comparison of mutually exclusive projects by IRR method, we have to do Incremental Investment Analysis.
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Incremental investment Analysis If

IRRB  A " MARR, SelectB IRRB  A IRRB  A MARR, Beindifferent MARR, SelectA

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Assignment
Please read and study carefully the design economics 8.4 sub-chapter Page 383 8.1, 8.2, 8.4, 8.6, 8.8, 8.9, 8.10, 8.13, 8.14, 8.15, 8.19, 8.20 8.22, 8.24, 8.30, 8.34, 8.36, 8.38, and 8.41 Page 436 9.4, 9.5,9.7,9.10,9.13,9.16,9.18,9.21,9.22,9.25, 9.30,9.33 and 9.34 Page 848 A.1 to A.5, A.8, A.10

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