Lecture No.

15
Chapter 5
Contemporary Engineering Economics
Copyright © 2010

Contemporary Engineering Economics, 5th edition, © 2010

Chapter Opening
Story – GE’s
Healthymagination
Project
GE Unveils $6 Billion
Health-Unit Plan:
• Goal: Increase the
market share in the
healthcare sector.
• Strategies: Develop
products that will lower
costs, increase access
and improve health-care
quality.
• Investment required:
$6 billion over six years
• Desired project
outcome: Would help
GE’s health-care unit
grow at least twice as
fast as the broader
economy.
Contemporary Engineering Economics, 5th edition, © 2010
Ultimate Questions
GE’ s Point of View:
Would there be enough demand for their
products to justify the investment required in new
facilities and marketing?
What would be the potential financial risk if the
actual demand is far less than its forecast or
adoption of technology is too slow?
If everything goes as planned, how long does it
take to recover the initial investment?
Contemporary Engineering Economics, 5th edition, © 2010
Bank Loan vs. Project Cash Flows

Contemporary Engineering Economics, 5th edition, © 2010

Example 5.1 Describing Project Cash Flows –
A Computer-Process Control Project
XL Chemicals is thinking of installing a computer
process control system in one of its process plants.
The plant is used about 40% of the time, or 3,500
operating hours per year, to produce a proprietary
demulsification chemical.
During the remaining 60% of the time, it is used to
produce other specialty chemicals.
Annual production of the demulsification chemical
amounts to 30,000 kilograms, and it sells for $15 per
kilogram.

Contemporary Engineering Economics, 5th edition, © 2010

Example 5.1 Describing Project Cash Flows –
A Computer-Process Control Project
The proposed computer process control system will
cost $650,000 and is expected to provide the
following specific benefits in the production of the
demulsification chemical:
First, the selling price of the product could be
increased by $2 per kilogram because the product will
be of higher purity,
Second, production volumes will increase by 4,000
kilograms per year as a result of higher reaction yields,

Contemporary Engineering Economics, 5th edition, © 2010

Example 5.1 Describing Project Cash Flows –
A Computer-Process Control Project
Third, the number of process operators can be reduced
by one per shift, which represents a savings of $25 per
hour,
Finally, the new control system would result in
additional maintenance costs of $53,000 per year and
has an expected useful life of eight years.

Given: The preceding cost and benefit information.

Find: Net cash flow in each year over the life of the
new system.

Contemporary Engineering Economics, 5th edition, © 2010

Example 5.1 Describing Project Cash Flows –
A Computer-Process Control Project
Revenues from the price increases are
30,000 kg/year × $2/kg = $60,000/year.
The added production volume at the new pricing
adds revenues
4,000 kg/year × $17/kg = $68,000/year
The elimination of one operator results in an annual
savings of
3,500 hrs./year × $25/hr = $87,500/year

Contemporary Engineering Economics, 5th edition, © 2010

Example 5.1 Describing Project Cash Flows –
A Computer-Process Control Project
The net benefits in each of the eight years that make
up the useful lifetime of the new system are the gross
benefits less the maintenance costs:
$60,000 +$68,000+ $87,500-$53,000 =$162,500/year

Contemporary Engineering Economics, 5th edition, © 2010

Example 5.1 Describing Project Cash Flows –
A Computer-Process Control Project
Year Cash Inflows Cash Outflows Net
(n) (Benefits) (Costs) Cash Flows

0 0 $650,000 -$650,000

1 215,500 53,000 162,500

2 215,500 53,000 162,500

… … … …

8 215,500 53,000 162,500

Contemporary Engineering Economics, 5th edition, © 2010

Cash Flow Diagram for the Computer Process
Control Project

Contemporary Engineering Economics, 5th edition, © 2010

 Principle:
How fast can I recover my initial investment?
 Method:
Based on the cumulative cash flow (or accounting
profit)
 Screening Guideline:
If the payback period is less than or equal to some
specified bench-mark period, the project would be
considered for further analysis.
 Weakness:
Does not consider the time value of money
Contemporary Engineering Economics, 5th edition, © 2010
Example 5.3 Payback Period
Autonumerics Company has just bought a new
spindle machine at a cost of $105,000 to replace one
that had a salvage value of $20,000.
The projected annual after-tax savings via improved
efficiency, which will exceed the investment cost, are
as follow:

Contemporary Engineering Economics, 5th edition, © 2010

Example 5.3 Payback Period

Given: Cash flow series as shown in previous figure

Find: Conventional payback period

Contemporary Engineering Economics, 5th edition, © 2010

N Cash Flow Cum. Flow

0 -$105,000+$20,000 -$85,000
1 $15,000 -$70,000
2 $25,000 -$45,000
3 $35,000 -$10,000
4 $45,000 $35,000
5 $45,000 $80,000
6 $35,000 $115,000

Contemporary Engineering Economics, 5th edition, © 2010

N Cash Flow Cum. Flow

0 -$105,000+$20,000 -$85,000
1 $15,000 -$70,000
2 $25,000 -$45,000
3 $35,000 -$10,000
4 $45,000 $35,000
5 $45,000 $80,000
6 $35,000 $115,000

Payback period should occurs somewhere

between N = 3 and N = 4.

Contemporary Engineering Economics, 5th edition, © 2010

 $45,000 $45,000
Annual cash flow
$35,000 $35,000
$25,000
$15,000
0
1 2 3 4 5 6
Years
$85,000
150,000
Cumulative cash flow ($)

100,000 3.2 years

Payback period
50,000
Assumption:
0 cash flows occur
continuously
-50,000 throughout the
-100,000 year

0 1 2 3 4 5 6
Years (n)
Contemporary Engineering Economics, 5th edition, © 2010
Practice Problem
How long does it take to recover the initial
investment for the computer process control system
project in Example 5.1?

Contemporary Engineering Economics, 5 th edition, © 2010

 Discounted Payback Period
 Principle:
How fast can I recover my initial investment plus
interest?
 Method:
Based on the cumulative discounted cash flow
 Screening Guideline:
If the discounted payback period (DPP) is less than
or equal to some specified bench-mark period, the
project could be considered for further analysis.
 Weakness:
Cash flows occurring after DPP are ignored
Contemporary Engineering Economics, 5th edition, © 2010
Discounted Payback Period Calculation
Period Cash Flow Cost of Funds Ending Cash
(n) (An) (15%)* Balance
0 -$85,000 0 -$85,000

1 15,000 -$85,000(0.15) = -$12,750 -82,750

2 25,000 -$82,750(0.15) = -12,413 -70,163

3 35,000 -$70,163(0.15) = -10,524 -45,687

4 45,000 -$45,687(0.15) =-6,853 -7,540

5 45,000 -$7,540(0.15) = -1,131 36,329

6 35,000 $36,329(0.15) = 5,449 76,778

* Cost of funds = (Unrecovered beginning balance) X (interest rate)

Contemporary Engineering Economics, 5th edition, © 2010

Discounted Payback Period Calculation
Period Cash Flow Cost of Funds Ending Cash
(n) (An) (15%)* Balance
0 -$85,000 0 -$85,000

1 15,000 -$85,000(0.15) = -$12,750

2 25,000

3 35,000 -$70,163(0.15) = -10,524 -45,687

4 45,000 -$45,687(0.15) =-6,853 -7,540

5 45,000 -$7,540(0.15) = -1,131 36,329

6 35,000 $36,329(0.15) = 5,449 76,778

* Cost of funds = (Unrecovered beginning balance) X (interest rate)

Contemporary Engineering Economics, 5th edition, © 2010

Discounted Payback Period Calculation
Period Cash Flow Cost of Funds Ending Cash
(n) (An) (15%)* Balance
0 -$85,000 0 -$85,000

1 15,000 -$85,000(0.15) = -$12,750 -82,750

2 25,000 -$82,750(0.15) = -12,413 -70,163

3 35,000 -$70,163(0.15) = -10,524 -45,687

4 45,000 -$45,687(0.15) =-6,853 -7,540

5 45,000 -$7,540(0.15) = -1,131 36,329

6 35,000 $36,329(0.15) = 5,449 76,778

* Cost of funds = (Unrecovered beginning balance) X (interest rate)

Contemporary Engineering Economics, 5th edition, © 2010

Discounted Payback Period Calculation
Period Cash Flow Cost of Funds Ending Cash
(n) (An) (15%)* Balance
0 -$85,000 0 -$85,000

1 15,000 -$85,000(0.15) = -$12,750 -82,750

2 25,000 -$82,750(0.15) = -12,413 -70,163

3 35,000 -$70,163(0.15) = -10,524 -45,687

4 45,000 -$45,687(0.15) =-6,853 -7,540

5 45,000 -$7,540(0.15) = -1,131 36,329

6 35,000 $36,329(0.15) = 5,449 76,778

* Cost of funds = (Unrecovered beginning balance) X (interest rate)

Contemporary Engineering Economics, 5th edition, © 2010

Discounted Payback Period Calculation
Period Cash Flow Cost of Funds Ending Cash
(n) (An) (15%)* Balance
0 -$85,000 0 -$85,000

1 15,000 -$85,000(0.15) = -$12,750 -82,750

2 25,000 -$82,750(0.15) = -12,413 -70,163

3 35,000 -$70,163(0.15) = -10,524 -45,687

4 45,000 -$45,687(0.15) =-6,853 -7,540

5 45,000 -$7,540(0.15) = -1,131 36,329

6 35,000 $36,329(0.15) = 5,449 76,778

* Cost of funds = (Unrecovered beginning balance) X (interest rate)

Contemporary Engineering Economics, 5th edition, © 2010

Discounted Payback Period Calculation
Period Cash Flow Cost of Funds Ending Cash
(n) (An) (15%)* Balance
0 -$85,000 0 -$85,000

1 15,000 -$85,000(0.15) = -$12,750 -82,750

2 25,000 -$82,750(0.15) = -12,413 -70,163

3 35,000 -$70,163(0.15) = -10,524 -45,687

4 45,000 -$45,687(0.15) =-6,853 -7,540

5 45,000 -$7,540(0.15) = -1,131 36,329

6 35,000 $36,329(0.15) = 5,449 76,778

* Cost of funds = (Unrecovered beginning balance) X (interest rate)

Contemporary Engineering Economics, 5th edition, © 2010

Discounted Payback Period Calculation
Period Cash Flow Cost of Funds Ending Cash
(n) (An) (15%)* Balance
0 -$85,000 0 -$85,000

1 15,000 -$85,000(0.15) = -$12,750 -82,750

2 25,000 -$82,750(0.15) = -12,413 -70,163

3 35,000 -$70,163(0.15) = -10,524 -45,687

4 45,000 -$45,687(0.15) =-6,853 -7,540

5 45,000 -$7,540(0.15) = -1,131 36,329

6 35,000 $36,329(0.15) = 5,449 76,778

* Cost of funds = (Unrecovered beginning balance) X (interest rate)

Contemporary Engineering Economics, 5th edition, © 2010

Illustration of Discounted Payback Period

Contemporary Engineering Economics, 5th edition, © 2010

Depending on which cash flow assumption adopted,
the project must remain in use about 4.2 years
(continuous cash flows),
or 5 years (year-end cash flows)

Contemporary Engineering Economics, 5th edition, © 2010

 Payback periods can be used as a screening tool for
liquidity, but we need a measure of investment worth for
profitability.

Contemporary Engineering Economics, 5 th

edition, © 2010