GCB 3173

Engineering Economics and Entrepreneurship

ASSIGNMENT

Group Members

Lecturer
Date of Submission

:
:

Chong Li Feng
Choo Ee Huey
Choo Tze Chyuan
Goh Aik Wei
Phua Yun Hock
Dr. Maran Marimuthu
23 November 2015

18038
18510
18270
18165
18295

Chemical Engineering
Chemical Engineering
Chemical Engineering
Chemical Engineering
Chemical Engineering

Question 1 [20 marks)

An International O&G company based in Malaysia, is currently facing a series of challenges for
attaining greater efficiency in its upstream operations. The current scenario requires the company to
redesign its existing process flow that will incur additional costs to the company. In addition, the
company is also expected to spend on the installation of new devices as part of its reengineering
programme in order to strengthen its process control system. The first proposal (Proposal 1) will
have a start-up cost of RM85,000 with an annual maintenance cost estimated at RM49,500. This
project will have to be replicated after 3 years.
Second Proposal (Proposal 2) involves installation of a recently designed process flow and this is
regarded as a more sophisticated design. It seems that there will be greater flexibility in the
operations using special devices that can be installed in the process flow. This will help the company
achieve greater efficiency in the upstream operations. The start-up cost of this plan is RM272,000,
but because the system is made with greater accuracy, it will not have to be replaced for at least 4
years. Its maintenance cost is estimated to be RM4,500 per year plus RM8,200 in year 3 for
replacement of signal processing software. Neither proposals will have a salvage value. At an interest
rate of 11 % per year, which one should be recommended?
Show your answers in both mathematical and graphical expression (using excel).You may use
assumptions.

Solution:
Present Worth is used as the measure of worth.
Given interest rate is 11% per year.
Assumption: Use Lowest Common Factor of 12 years.

a) Mathematical Expression:
The cash flow for Proposal 1 is as shown below:

Present Worth of Proposal 1:

PW1
= 85 000 49 500 (P/A, 11%, 12) 85 000 (P/F, 11%, 3) 85 000 (P/F, 11%, 6)
85 000 (P/F, 11%, 9)
= 85 000 49 500 (6.4924) 85 000 (0.7312) 85 000 (0.5346) 85 000 (0.3090)
= RM 547 193

The cash flow for Proposal 2 is as shown below:

Present Worth of Proposal 2:

PW2
= 272 000 4 500 (P/A, 11%, 12) 8 200 (P/F, 11%, 3) 8 200 (P/F, 11%, 7) 8 200 (P/F, 11%,
11) 272 000 (P/F, 11%, 4) 272 000 (P/F, 11%, 8)
= 272 000 4 500 (6.4924) 8 200 (0.7312) 8 200 (0.4817) 8 200 (0.3173) 272 000 (0.6587)
272 000 (0.4339)
= RM 610 951

Conclusion:
Proposal 1 is chosen because it has higher present worth (least negative value).

b) Graphical Expression:
Year
0
1
2
3
4
5
6
7
8
9
10
11
12

Start-up Cost
(RM)
-85000
0
0
-85000
0
0
-85000
0
0
-85000
0
0
0

Annual Maintenance Cost

(RM)

Annual Total

(RM)
0
-85000
-49500
-49500
-49500
-49500
-49500
-134500
-49500
-49500
-49500
-49500
-49500
-134500
-49500
-49500
-49500
-49500
-49500
-134500
-49500
-49500
-49500
-49500
-49500
-49500
PRESENT WORTH AT YEAR 0

Present Worth
(RM)
-85,000.00
-44,594.59
-40,175.31
-98,345.24
-32,607.18
-29,375.84
-71,909.19
-23,842.09
-21,479.36
-52,579.38
-17,433.13
-15,705.52
-14,149.12
-547,195.97

Graphical Expression of Cash Flow for Proposal 1

Start-up cost (RM)

Year
0
1
2
3
4
5
6
7
8
9
10
11
12

Annual maintenance cost (RM)

Start-up Cost

Annual Maintenance

Replacing Cost

(RM)

Cost (RM)

(RM)

-272000
0
0
0
-272000
0
0
0
-272000
0
0
0
0

Annual

Present

Total

Worth

(RM)
0
0
-272000
-4500
0
-4500
-4500
0
-4500
-4500
-8200
-12700
-4500
0
-276500
-4500
0
-4500
-4500
0
-4500
-4500
-8200
-12700
-4500
0
-276500
-4500
0
-4500
-4500
0
-4500
-4500
-8200
-12700
-4500
0
-4500
PRESENT WORTH AT YEAR 0

(RM)
-272,000.00
-4,054.05
-3,652.30
-9,286.13
-182,139.11
-2,670.53
-2,405.88
-6,117.06
-119,980.68
-1,759.16
-1,584.83
-4,029.50
-1,286.28
-610,965.53

Graphical Expression of Cash Flow for Proposal 2

Start-up cost

Annual maintenance cost

Replacing Cost

Conclusion:
Proposal 1 is chosen because it has higher present worth (least negative value).

Question 2 [20 marks]

A few days ago. Bachan was convinced of the fact that the overall project ROR values for two
options P and Q were quite reliable and the details are given below. Bachan found out that i*P=25.2%
and i*Q=21.3% and as such, he proposed to select Project P as it exceeded the required rate of return
by 5.2%. A few days ago, the market showed a major deterioration in its performance. As a result,
Bachans company has revised its capital investment plan, which results in a massive drop in the
required rate of return. Bachan expects the rate will be slashed by 7% per annum. The following
questions have been raised to assist Bachan to deal with issues involving rate of return and required
rate of return.
First cost, $
Annual operating cost, $ per year
Annual revenue, $ per year
Salvage value, $
Life, years
i*, %

Project P
-50,000
-6,500
27,000
0
7
25.2

Project Q
-105,000
-15,000
45,000
20,000
7
21.3

(a) What is meant by required rate of return?

(b) Determine the required rate of return. What is the difference between MARR and required
rate of return?
(c) Perform a correct analysis using the above cash flows of Project P and Q. What is your
recommendation? Justify.

Solution:
(a) Required rate of return (RROR) is the minimum annual percentage earned by an investment that
will induce individuals or companies to put money into a particular security or project. It is the
minimum acceptable rate of return on an investment proposal that is comparable with the rate of
return obtained effortlessly and at a low level of risk in the financial markets.

(b) Initial required rate of return = 25.2% - 5.2% = 20%

The required rate of return is expected to be slashed by 7% per annum, therefore:
Final required rate of return = 20%(0.93)7 = 12.03%

The minimum attractive rate of return (MARR) is the minimum rate of return that a company is
willing to accept before starting a project, given its risk and the opportunity cost of forgoing
other projects. Basically, there is no difference between MARR and RROR. Both carry the
similar meaning and have the same function. They are often set to be a benchmark rate or cut-off
rate. An investment is justified economically if it is expected to return at least the MARR or
RROR.

(c) Initial observation:

Mutually exclusive, cost alternatives with equal life estimates and no multiple ROR values
indicated.

The incremental cash flow is calculated:

First cost, $
Annual operating cost, $ per year
Annual revenue, $ per year
Salvage value, $
Life, years
i*, %

Project P
-50 000
-6 500
27 000
0
7
25.2

Project Q
-105 000
-15 000
45 000
20 000
7
21.3

The incremental cash flow diagram is represented as follows:

Project Q-Project P
-55 000
-8 500
18 000
20 000

ROR equation in term of Present Worh (PW) on incremental cash flow:

0 = 55 000 + (18 000 8 500)(P/A, i*, 7) + 20 000(P/F, i%, 7)
0 = 55 000 + 9 500(P/A, i*, 7) + 20 000(P/F, i%, 7)

Trial 1: i = 12%
PW = 55 000 + 9 500(4.564) + 20 000(0.4523) = -2 590

Trial 2: i = 10%
PW = 55 000 + 9 500(4.868) + 20 000(0.5132) = 1 510

Using interpolation:
i* 10
0 1510

12 10 2590 1510
i* 10.74%

Conclusion:
Compared to RROR (12.04%),
Since i* < RROR, Project P is chosen.