WHAT IS ECONOMICS ?
1. Problem recognition
2. Development of the feasible alternatives.
3. Development of the cash flows for each alternative.
4. Selection of a criterion ( or criteria).
5. Analysis and comparison of the alternatives.
6. Selection of the preferred alternative.
7. Performance monitoring and post-evaluation results.
Interest and Investment Costs
Or
PRINCIPLES OF MONEY-TIME
RELATIONSHIPS
MONEY
• Medium of Exchange
Means of payment for goods or services;
What sellers accept and buyers pay ;
• Store of Value
A way to transport buying power from one time
period to another;
• Unit of Account
A precise measurement of value or worth;
Allows for tabulating debits and credits
CAPITAL
Exchange money
• Equity • Sell partial • Stock • Exchange
financing ownership of for shares
shares of of stock
company; as proof
stock forof partial
ownership
ownershipofof
company;
INTEREST:
• Classical definition: Interest is the money returned to the
owners of capital for use of their capital.
• Modern economics: Su stitute the te etu o apital o
etu o i est e t fo i te est .
• Engineers define interest as : The o pe satio paid fo
the use of borrowed capital
INTEREST RATE:
• The percentage of money being borrowed that is paid to the
lender on some time basis.
PRINCIPAL:
• The amount of capital on which the interest is paid is known
as Principal
SIMPLE INTEREST
• The total interest earned or charged is linearly
proportional to the initial amount of the loan (principal),
the interest rate and the number of interest periods for
which the principal is committed.
• Whe applied, total i te est I ay e fou d y
I = ( P ) ( N ) ( i ), where
– P = principal amount lent or borrowed
– N = number of interest periods ( e.g., years )
– i = interest rate per interest period
F = P (1+i)n …………………………….
Nominal & Effective Interest Rate
• Interest rate is often expressed on an annual basis
• Interest period may not be one year
NOMINAL INTEREST RATE
Statement-1:
% pe pe iod a d the i te est is o pou ded at half-yea pe iod
Statement-2:
% o pou ded se ia ually
Statement-3:
No i al i te est ate % o pou ded se i-a ually
• Nominal interest rate should always include a qualifying
statement indicating the compounding period
EFFECTIVE INTEREST RATE
• Exact interest rate based on original principal and of convenient
time unit of 1 year
Effective Interest Rate from Nominal Interest Rate
• If nominal interest rate is quoted, then effective interest rate
can be calculated from eqn (1)
• Fafter 1 year = P(1 + r/m)m …………………………… eqn (2)
m = number of interest/year
r = nominal interest rate
n=1
(a) The total amount of principal plus simple interest due after 2
years if no intermediate payments are made.
(b) The total amount of principal plus compounded interest due
after 2 years if no intermediate payments are made.
(c) The nominal interest rate when the interest is compounded
monthly.
(d) The effective interest rate when the interest is compounded
monthly.
Continuous Interest Rate
Eqn (2), (3) & (4) represent the basic expressions from which
continuous interest relationships can be developed.
r = nominal interest rate
m = numbers of interest periods/year
If compounded continuously, m infinity
• Fafter n year = Plim m infinity [1+r/m]mn
[{1+r/m} (m/r)]
lim m infinity
= e =2.71828
• F after n years = Pern = P(1+ieff)n …………………eq (5)
• ern = (1+ieff)n
• ieff = er - ………………….eq (6)
Example
− −
Typical cash flow diagram
Typical cash flow diagram
Present Worth (PW) and Discount
BOND: Some types of capital are in the form of bonds having an indicated
value at a future date. In business terminology, the difference between the
indicated future value and the present worth (or present value) is known as
the discount
Example: PW and Discount
−
Annuities
F=
• To simplify Eq. (19), multiply each side by (1 + i) and subtract Eq. (19)
from the result. This gives
Ordinary annuity
Fi = R(1+i)n – R
F = R[(1+i)n-1]/i
F = P(1+i)n
R[(1+i)n-1]/i= P(1+i)n
P = R[(1+i)n-1]/i[(1+i)n]
Special Types of Annuities
Mathematical example:
Original cost of an Equipment: $ 12000
Useful life: 10 years
Salvage value: $ 2000
The engineer wants to replace the equipment after 10 years for an indefinitely
long period of time, and it will be necessary to supply $10,000 every 10 years in
order to replace the equipment.
The engineer therefore wishes to provide a fund of sufficient size so that it will
earn enough interest to pay for the periodic replacement.
If the discrete annual interest rate is 6 percent, this fund would need to be
$12,650.
F = P (1+i)n (P+10000) = P (1+0.06)10
PERPETUITIES AND CAPITALIZED COSTS
• Thus, at the end of 10 years, the equipment can be replaced for $10,000
and $12,650 will remain in the fund.
• The total capital determined in this manner is called the capitalized cost.
• Let P be the amount of present principal (i.e., the present worth) which
can accumulate to an amount of F during n interest periods at periodic
interest rate i. So, F = P(1+i)n …………………………
• If perpetuation is to occur, the amount F accumulated after n periods
minus the cost for the replacement (CR) must equal the present worth P.
• Therefore, F - CR = P ……………….. [F= 22650; P = 12650; CR = 10000]
• E uatio s a d gi e ………..
• Capitalized cost (K) = original cost of the equipment (CV) + the present
value of the renewable perpetuity
PERPETUITIES AND CAPITALIZED COSTS
PERPETUITIES AND CAPITALIZED COSTS
PERPETUITIES AND CAPITALIZED COSTS
PERPETUITIES AND CAPITALIZED COSTS
Decision
1. The amount of money available for investment, and the source and cost
of these funds (i.e., equity funds or borrowed funds)
2. The number of good projects available for investment and their purpose
(i.e., whether they sustain present operations and are essential, or
whether they expand on present operations and are elective)
3. The amount of perceived risk associated with investment opportunities
available to the firm and the estimated cost of administering projects
over short planning horizons versus long planning horizons
4. The type of organization involved (i.e., government, public utility, or
private industry)
MARR Determination
The Present Worth Method (PW)
• The FW is based on the equivalent worth of all cash inflows and outflows
at the end of the planning horizon (study period) at an interest rate that is
generally the MARR. Also, the FW of a project is equivalent to its PW; that
is, FW = PW(F/P, i%, N).
The Annual Worth Method (AW)
AW
The Internal Rate of Return Method
• The IRR method is the most widely used rate-of-return method for
performing engineering economic analyses. It is also called as:
I estor’s method, Discounted cash-flow method, Profitability index
and Breakeven interest rate
• IRR method solves for the interest rate at which the equivalent
worth of an alte ati e s cash inflows (receipts or savings) is equal
to the equivalent worth of cash outflows (expenditures, including
investment costs).
• Equivalent worth may be computed using PW/FW/AW method.
• Fo a si gle alte ati e, f o the le de s ie poi t, the IRR is not
positive unless (1) both receipts and expenses are present in the
cash-flow pattern, and (2) the sum of receipts exceeds the sum of
all cash outflows.
• Be sure to check both of these conditions in order to avoid the
unnecessary work involved in finding that the IRR is negative.
(Visual inspection of the total net cash flow will determine whether
the IRR is zero or less.)
IRR Formulation: Using a PW formulation, we see that the IRR is
the i′% at hi h
Advantages
• The key advantage of the method is its widespread acceptance by
industry, where various types of rates of return and ratios are routinely
used in making project selections. The difference between a p oje t s IRR
and the required return (i.e., MARR) is viewed by management as a
measure of investment safety. A large difference signals a wider margin of
safety (or less relative risk).
The External Rate of Return Method
• The reinvestment assumption of the IRR method may not be valid in an
engineering economy study. For instance, if a fi s MARR is 20% per year
and the IRR for a project is 42.4%, it may not be possible for the firm to
reinvest net cash proceeds from the project at much more than 20%. This
situation, coupled with the computational demands and possible multiple
interest rates associated with the IRR method, has given rise to other rate
of return methods that can remedy some of these weaknesses.
• One such method is the ERR method. It directly takes into account the
interest rate (∈) external to a project at which net cash flows generated
(or required) by the project over its life can be reinvested (or borrowed). If
this external reinvestment rate, which is usually the fi s MARR, happens
to equal the p oje t s IRR, then the ERR method produces results identical
to those of the IRR method.
• In general, three steps are used in the calculation procedure. First, all net
cash outflows are discounted to time zero (the present) at ∈% per
compounding period. Second, all net cash inflows are compounded to
period N at ∈%. Third, the ERR, which is the interest rate that establishes
equivalence between the two quantities, is determined. The absolute
value of the present equivalent worth of the net cash outflows at ∈% (first
step) is used in this last step. In equation form, the ERR is the i′% at which
Example on ERR
• The payback method, which is often called the simple payout method,
mainly indicates a proje t’s liquidity rather than its profitability.
• Historically, the payback method has been used as a measure of a
p oje t s riskiness, since liquidity deals with how fast an investment can be
recovered.
• A low valued payback period is considered desirable. The payback method
calculates the number of years required for cash inflows to just equal cash
outflows. Hence, the simple payback period is the smallest value of θ θ ≤
N) for which this relationship is satisfied under normal EOY cash-flow
convention.
• For a project where all capital investment occurs at time 0, Simple pay
back period is:
• Five of the basic methods [present worth (PW), annual worth (AW), future
worth (FW), internal rate of return (IRR), and external rate of return (ERR)]
methods provide a basis for economic comparison of alternatives for an
engineering project.
Rule
• The alternative that requires the minimum investment of capital and
produces satisfactory functional results will be chosen unless the
incremental capital associated with an alternative having a larger
investment can be justified with respect to its incremental benefits.
Investment Alternatives
MARR: 10%
Rule 1: When revenues and other economic benefits are present and vary
among the alternatives, choose the alternative that maximizes overall
profitability. That is, select the alternative that has the greatest positive
equivalent worth at i = MARR and satisfies all project requirements.
Rule 2: When revenues and other economic benefits are not present or are
constant among the alternatives, consider only the costs and select the
alternative that minimizes total cost. That is, select the alternative that has
the least negative equivalent worth at i = MARR and satisfies all project
requirements.
The Study (Analysis) Period
• The study (analysis) period, sometimes called the planning horizon, is the
selected time period over which mutually exclusive alternatives are
compared. The determination of the study period for a decision situation
may be influenced by several factors—
the service period required,
the useful life of the shorter-lived alternative,
the useful life of the longer-lived alternative, and
company policy.
MARR: 10%
Analyzing Cost-Only Alternatives, Using Equivalent Worth
MARR: 10%
The preference ranking (P4 ≻ P2 ≻ P1 ≻ P3) resulting from the
analysis is the same for all three methods.
Rate-of-Return Methods
MARR = 10%
Factor
Capital Investment ($) 408,000 519,000
Annual Expenses ($) 43,200 28950
Useful life (years) 9 14
Market value ($) 37,500 60,000
MARR = 15%
MARR = 6%
Setting EUACH(3%) = EUACG(3%) and solving for X, we find the breakeven cost of gasoline
to be X = $3.64/gal.
Figure 11-2 shows the breakeven chart for these vehicles as a function of the
cost of gasoline. If our best estimate of the average cost of gasoline over the
next five years is less than $3.64 per gallon, then purchasing a traditional
gasoline-only vehicle is more economical. The hybrid would be the vehicle of
choice if the cost of gasoline is projected to be higher than $3.64 per gallon.
Three Alternative Breakeven Analysis: Hours of Operation
• Example
• Consider a proposal to enhance the vision system used by a postal service
to sort mail. The new system is estimated to cost $1.1 million and will
incur an additional $200,000 per year in maintenance costs. The system
will produce annual savings of $500,000 each year (primarily by
decreasing the percentage of misdirected mail and reducing the amount
of mail that must be sorted manually). The MARR is 10% per year, and the
study period is five years at which time the system will be technologically
obsolete (worthless). The PW of this proposal is
PW % = −$ , , + $ , −$ , P/A, 10%, 5) = $37,236.
Determine how sensitive the decision to invest in the system is to the
estimates of investment cost and annual savings.
Sensitivity Graph (Spiderplot)
Sensitivity is specifically defined to mean the percent change in one or
more factors that will reverse a decision among project alternatives or
reverse a decision about the economic acceptability of a single project.
Example
The best (most likely) cash flow estimates are given below for a new piece
of equipment being considered for immediate installation. Because of new
technology, it is need to investigate its PW over a range of ±40% changes
in the estimates (with a 10% incremental basis) for a. capital investment,
b. annual net cash flow, c. market value, d. useful life. Based on these best
estimates, plot a diagram that summarizes the sensitivity of present worth
to percent deviation changes in each separate factor estimate when MARR
is 10%. I = -$11500; A = $ 3000; MV = $1000; N = 6 years
PW of best estimate:
PW(10%) = -$11500 + $3000 (P/A,10%,6) +$1000(P/F,10%,6) =$2130
Therefore
Risk adjusted MARR fo P : %
Risk adjusted MARR fo Q : %
At Risk f ee MARR, oth P a d Q ha e the sa e PW of $ 9, 9. All else
ei g e ual, Q is o e desi a le tha P .
0 -$160000 -$160000
1 120,000 20827
2 60000 60000
3 0 120000
4 60000 60000
230 MW
Jamuna Multipurpose Bridge
Difficulties in Evaluating Public-Sector Projects
What Interest Rate Should Be Used for Public Projects?
• In the public sector, projects are not usually intended as profit-making
ventures. Instead, the goal is the maximization of social benefits,
The first element shows that after all direct and secondary effects have been taken into
account a $1 change in final demand for manufactured goods will cause a $2.30 change in
total demand in the manufacturing sector. The second element of the first column
estimates that change in total demand in agriculture resulting from a $1 change
in final demand for manufactured goods.
Forecasting with an Input/output Model
Example
Suppose that an increase in exports causes a $5 billion increase in final demand in
the agricultural sector-After taking into account all the direct and secondary effects,
what impact would this change have on total demand for manufactured and
agricultural goods?