Lecture 07

Engineering Economics

Methods of Evaluating a
Single Project
Practice Numerical
Example 4.

Find NPV at 8% if the costs and benefits are given below

 PAYBACK PERIOD
According to these criteria, that project which recovers its
costs in the shortest period of time is considered best. For
example, look at the following example
Project C0 B 1 – C1 B2 – C2
A 100 110 1
B 100 0 1000

Both Project A and B involve an initial cost of Rs. 100 and both lasts two years.
A returns 110 while B returns nothing after one year. Project A is judged, superior
to Project B., However, considering the 2nd year's returns, the payback period
judgment seems faulty.
 Benefit Cost Ratio
The benefit-cost ratio (BCR) is a profitability indicator used in cost-benefit
analysis to determine the viability of cash flows generated from an asset or project.
The benefit-cost ratio (BCR) is an indicator showing the relationship between the
relative costs and benefits of a proposed project, expressed in monetary or
qualitative terms.
The BCR compares the present value of all benefits generated from a project/asset
to the present value of all costs.
If a project has a BCR greater than 1.0, the project is expected to deliver a positive
net present value to a firm and its investors.
If a project's BCR is less than 1.0, the project's costs outweigh the benefits, and it
should not be considered.
The primary limitation of the BCR is that it reduces a project to a simple number
when the success or failure of an investment or expansion relies on many factors
and can be undermined by unforeseen events.
Simply following a rule that above 1.0 means success and below 1.0 spells failure
is misleading and can provide a false sense of comfort with a project. The BCR
must be used as a tool in conjunction with other types of analysis to make a well-
informed decision.
BCR=
BCR=
year Project cost Gross DF at PW of benefits Present
s Benefit 12 % worth of
costs

Capital Operating Producti Gross

items cost on cost cost

0 6000 0 0 6000 - 1 0 6000

1 7500 0 0 7500 5000 0.873 4465
2 6000 0 0 6000 5000 0.797
3 600 700 1300 6000 0.712
4 600 700 1300 6000
5 600 700 1300 6000
6 600 700 1300 6000
7 600 700 1300 6000
Salv 25844 21857
age
valu
e
BCR= 1.22
Find BCR at 8% interest rate
 Internal Rate of Return (IRR)

 The IRR method is the most widely used rate-of-return method for performing

engineering economic analyses.

 It is sometimes called by several other names, such as the investor’s method, the
discounted cash-flow method, and the profitability index.
 This method solves for the interest rate that equates the equivalent worth of an
alternative’s cash inflows (receipts or savings) to the equivalent worth of cash
outflows (expenditures, including investment costs).
 Equivalent worth may be computed using any of the three methods discussed
earlier.
 The resultant interest rate is termed the Internal Rate of Return (IRR).
 The IRR is sometimes referred to as the breakeven interest rate.
 The discount rate which equates NPV equal to zero is called IRR
 Now how the decision is made about accepting or rejecting a project?
 A project is worth to accept if the IRR is greater than the social discout rate or
opportunity cost of capital
 Example:
 If the opportunity cost of capital ‘r’ is 12% then any rate which is greater than
this and equte theNPV to zero is IRR
 IRR= Lower Discount Rate+ Difference between two []
 Compute IRR at if OCC is 9%

year Gross Gross Net Df 8% NPV DF 6% NPV DF 7% NPV

costs ben- benfits 8% 6% 7%
efits

0 7000 - -7000

1 9500 11000 1500

2 9500 11000 1500

3 8000 9500 1500

4 5500 7500 2000

5 4500 6600 2100

6 -234.4 177.2 -40.7

If r increases NPV falls
R falls NPV increases
IRR is 6.8%