Engineering Economic Analysis 9th Edition Chapters 6 & 7 ANNUAL CASH FLOW ANALYSIS RATE OF RETURN ANALYSIS

TOPICS
Other Topics: 13 Replacement Analysis (or other) Post-tax Analyses: Depreciation and Taxes
11-12 Chapters

Comparing Alternatives: Incremental and Other Analysis Techniques 8-9

Applications: 5-7 Present Worth, Cash Flow, Rate of Return Analyses Money-Time Relationships: Interest Rates and Compounding
3-4 2 1
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Present Economy Studies: Engineering Costs and Cost Estimating Introduction:

Making Economic Decisions

Still Dont Understands

Rate of Return analysis (8) Analysis periods including infinite (5) Calculating Rate of Return (3) Increments of investment and borrowing (2) {next week} Modified Internal Rate of Return (2) Some Present Worth analysis problems Some Rate of Return Analysis problems More explanation of EUAC and EUAB, MARR NPW plot Annual Cash Flow analysis Resolving present cost to annual cost When to go with trial and error
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Net Present Value (NPV)

Also called Net Present Worth (NPW) Net Present Value is the Present Worth of Benefits minus the Present Worth of Costs
B B2 B6 B8 |______|______|______|______|______|______|______|______| 0 C 1 2 C 3 4 5 6 7 8 2 C8

B = B2*(P/F, i, 2) + B6*(P/F, i, 6) + B8*(P/F, i, 8) C = C2*(P/F, i, 2) + C8*(P/F, i, 8) NPV = B - C This is identical to the Present Worth of [Benefits minus Costs] for each year, which is usually easier to calculate: NPV = (B2-C2)*(P/F, i, 2) + B6*(P/F, i, 6) + (B8-C8)*(P/F, i, 8)
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Calculating Equivalent Values

We will usually calculate NPV by finding the: Present Worth of Future Amounts (P/F, i%, n), and/or Present Worth of Annuities (P/A, i%, n) Occasionally, well find it easier to use: Present Worth of Gradients (P/G, i%, n)

We can apply these because of the principle of Equivalency we claim that Future Amounts, and/or Annuities, and/or Gradients can be transformed into a single Present Worth number that represents their value. We could just as easily transform Future Amounts, and/or Gradients, and or Present Worths into an equivalent Annuity (uniform annual cash flow amount) that represents their value. We would use A/F, A/G, and A/P . . .
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Equivalent Uniform Annual Worth

An Annuity (Uniform Series) that is equivalent to the Present Worth EUAW = PW(A/P,i,n) Will yield same decision result as Net Present Worth EUAW = Equivalent Uniform Annual Benefits (EUAB) Equivalent Uniform Annual Costs (EUAC) Easier for novices (your boss) to understand than Present Worth Can automatically handle replication of alternatives to balance out unequal lives (to be demonstrated) 6

Example 6-1

Example 6-1

Question: How much did your furniture cost? Answer A: It cost me $1000, but it will last for 10 years. Answer B: Its costing me $142.40 every year for 10 years. Both answers are equivalent
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Example 6-2

Example 6-2

Answer A: My furniture cost me $1000, but it will last for 10 years, and at that time I can sell it for $200; the Present Worth of its cost is $898. Answer B: Its costing me $127.92 every year for 10 years. Both answers are equivalent Which is easier to understand?
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Example 6-2 (again)

Shortcut calculation:

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Derivation of Shortcut
EUAC = P(A/P, i, n) S(A/F, i, n) P*i(1+i)n (1+i)n 1 P*i(1+i)n (1+i)n 1 P*i(1+i)n (1+i)n 1 S*i (1+i)n 1 S*i (1+i)n 1 S*i(1+i)n (1+i)n 1 S*i(1+i)n (1+i)n 1 S*i(1+i)n (1+i)n 1 S*i(1+i)n (1+i)n 1 S*i (1+i)n 1

(P-S)*i(1+i)n (1+i)n 1 EUAC = (P-S)*(A/P, i, n) S*i

S*i [(1+i)n -1] (1+i)n 1

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Annual Cash Flow Essential Points

1. EUAW = PW(A/P,i,n) 2. EUAW = Equivalent Uniform Annual Benefits (EUAB) Equivalent Uniform Annual Costs (EUAC) 3. For an irregular cash flow over the analysis period, first determine the PW then convert to EUAW
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Example 6-3

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In-class Exercise

Page 195 6-11

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Analysis Period & Alternative Lives

1. Analysis period is equal to the useful life of all alternatives 2. Analysis period is a common multiple of alternative lives 3. Analysis period is some other finite period, such as project life 4. Analysis period is infinite, i.e., n =

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Analysis Period is Common Multiple of Lives (1)

Which of these two investments is better?
$1000 |______|______|______|______| 0 1 2 3 4 $200 PW= -$200 + $1000(P/F,5%,4) PW= $622.70 $1400 |______|______|______|______|______|______|______|______| 0 1 2 3 4 5 6 7 8 $200 PW= -$200 + $2000(P/F,5%,8) PW=$747.52

i=5%

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Analysis Period is Common Multiple of Lives (2)

Which of these two investments is better?
$1000 $1000

i=5%

|______|______|______|______|______|______|______|______| 0 1 2 3 4 5 6 7 8 $200 $200 PW= -$200 + $1000(P/F,5%,4) - $200(P/F,5%,4) + $1000(P/F,5%,8) PW= $622.70 - $164.54 + $676.80 PW=$1134.96 $1400 |______|______|______|______|______|______|______|______| 0 1 2 3 4 5 6 7 8 $200 PW= -$200 + $2000(P/F,5%,8) PW=$747.52

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Analysis Period is Common Multiple of Lives (3)

Which of these two investments is better?
$1000 $1000

i=5%

|______|______|______|______|______|______|______|______| 0 1 2 3 4 5 6 7 8 $200 $200 PW= -$200 + $1000(P/F,5%,4) - $200(P/F,5%,4) + $1000(P/F,5%,8) PW= $622.70 - $164.54 + $676.80 PW=$1134.96 EUAW = PW(A/P,5%,8) = $1134.96(0.1547) = $175.60 $1400 |______|______|______|______|______|______|______|______| 0 1 2 3 4 5 6 7 8 $200 PW= -$200 + $2000(P/F,5%,8) PW=$747.52 EUAW = PW(A/P,5%,8) = $747.52(0.1547) = $115.64

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Analysis Period is Common Multiple of Lives (4)

Which of these two investments is better?
$1000 |______|______|______|______| 0 1 2 3 4 $200 PW= -$200 + $1000(P/F,5%,4) PW= $622.70 EUAW = PW(A/P,5%,4) = $622.70(0.2820) = $175.60 $1400 |______|______|______|______|______|______|______|______| 0 1 2 3 4 5 6 7 8 $200 PW= -$200 + $2000(P/F,5%,8) PW=$747.52 EUAW = PW(A/P,5%,8) = $747.52(0.1547) = $115.64

i=5%

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Example 6-7

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Example 6-7 (cont.)

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Analysis Period & Alternative Lives

1. Analysis period is equal to the useful life of all alternatives 2. Analysis period is a common multiple of alternative lives 3. Analysis period is some other finite period, such as project life 4. Analysis period is infinite, i.e., n =

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Example 6-8

Implicit assumption is that both pumps will be repeatedly replaced at the end of their lives with identical pumps, at original costs and salvage values
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Analysis Period & Alternative Lives

1. Analysis period is equal to the useful life of all alternatives 2. Analysis period is a common multiple of alternative lives 3. Analysis period is some other finite period, such as project life 4. Analysis period is infinite, i.e., n =

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Example 6-9

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Equivalent Uniform Annual Worth

An Annuity (Uniform Series) that is equivalent to the Present Worth EUAW = PW(A/P,i,n) Will yield same decision result as Net Present Worth EUAW = Equivalent Uniform Annual Benefits (EUAB) Equivalent Uniform Annual Costs (EUAC) Easier for novices (your boss) to understand than Present Worth Can automatically handle replication of alternatives to balance out unequal lives 27

In-class Exercise

Pages 195 6-10

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Three Major Methods of Economic Analysis

PW - Present Worth (EU)AW - Annual Worth IRR - Internal Rate of Return
The IRR is the interest rate at which the benefits equal the costs: PW Benefit = PW Cost PW Benefit - PW Cost = 0 NPW = 0 EUAB - EUAC = 0 PW Benefit/PW Cost = 1
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Solving for IRR

Often requires page-flipping of Compound Interest tables and interpolation Can use IRR function in Excel Can use IRR/ROR function, or Compute i (CPT-i) on financial calculators If compounding is more frequent than annually, IRR is formally defined as an effective annual rate
ia = (1+i)m 1 IRR = (1+IRRm)m - 1
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Example 7-1

Same as setting NPW = 0

Engineering Economic Analysis - Ninth Edition Newnan/Eschenbach/Lavelle Copyright 2004 by Oxford University Press, Inc.

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Example 7-3

Engineering Economic Analysis - Ninth Edition Newnan/Eschenbach/Lavelle Copyright 2004 by Oxford University Press, Inc.

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Example 7-3 (Continued)

10% x% 15%

10.16 0.0 -4.02

a/b=c/d (10% - x)/(10% - 15%)=(10.16 - 0)/(10.16 - (-4.02)) 10% - x = (10% - 15%) (10.16/(10.16+4.02)) x = 10% + (15% - 10%) (10.16/14.18) 33

Year

Cash flow ($100.00) $20.00 $30.00 $20.00 $40.00 $40.00 13.47%

Unrecovered investment at beginning of year $100.00 $93.47 $76.07 $66.32 $35.25 Total

Return on unrecovered investment $13.47 $12.59 $10.25 $8.93 $4.75 $50.00

Investment Unrecovered repayment at investment at end of year end of year $6.53 $17.41 $9.75 $31.07 $35.25 $100.00 $93.47 $76.07 $66.32 $35.25 ($0.00)

Example 7-3
The iterations may be graphed and the true IRR will be indicated at the point where the NPW curve = 0.

0 1 2 3 4 5 IRR

Trial interest rates 0 5 10 15 20 25 30 35 40 45 50

NPW $50.00 $26.46 $9.24 ($3.49) ($12.97) ($20.06) ($25.37) ($29.36) ($32.34) ($34.54) ($36.16)

$60.00 $50.00 $40.00 Net Present Value $30.00 $20.00 $10.00 $0.00 ($10.00) 0 ($20.00) ($30.00) ($40.00) ($50.00) 5 10 15 20 25 30 35 40 45 50

In-class Exercise

Page 223
7-9

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Example 7-4
Coupon rate = 4% semiannually, or 8% annually

Was it a good idea for the original buyer to sell this bond? (8% vs. 3%)

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Example 7-4 (cont.)

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The nominal interest rate above is called the Yield to Maturity

Yield to Maturity is often called Yield of a bond (this is typically NOT the coupon rate!) As interest rates rise (like now), investors seek higher yield from bonds Requiring higher yields results in lower prices for bonds that are resold (like Example 7-4) Lower prices for bonds is bad news for the original buyers of the bonds, unless they hold the bonds until their maturity (they will always receive their original coupon rate and their principal back at maturity) In times of declining interest rates (2000 2003), original buyers of (safe) bonds were 38 happy campers, because they could sell their bonds at a premium

Calculating Bond Price, Given Yield (YTM)

In Example 7-4b, suppose I insisted on a 10% yield (nominal annual interest rate). How much should I pay for the bond?

P=?

i=5% (semiannual rate)

P = $40 (P/A,5%,18) + $1000 (P/F,5%,18) P = $40 (11.690) + $1000 (0.4155) = $883.10

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In-class Exercise

Page 224
7-17

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Engineering Economic Analysis 9th Edition

Chapter Appendix 7A Difficulties Solving for an Interest Rate

Engineering Economic Analysis - Ninth Edition Newnan/Eschenbach/Lavelle Copyright 2004 by Oxford University Press, Inc.

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Cash Flow Rule of Signs

There may be as many positive values of i as there are sign changes in the cash flow. Sign changes are counted when:

to to

A zero cash flow is ignored

Engineering Economic Analysis - Ninth Edition Newnan/Eschenbach/Lavelle Copyright 2004 by Oxford University Press, Inc.

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Multiple IRR
Example 7A-1
Year 0 1 2 3 4 5 IRR/period IRR/period Trial interest rates 0 5 10 15 20 25 30 35 40 45 50 Cash flow $19.00 $10.00 ($50.00) ($50.00) $20.00 $60.00 10.24% 47.30% NPW $9.00 $3.28 $0.11 ($1.50) ($2.14) ($2.20) ($1.91) ($1.44) ($0.88) ($0.28) $0.32 Guess 10.00% 50.00% Unrecovered investment at beginning of year ($19.00) ($30.95) $15.88 $67.51 $54.43 Total Return on unrecovered investment ($1.95) ($3.17) $1.63 $6.91 $5.57 $9.00 Investment repayment at end of year $11.95 ($46.83) ($51.63) $13.09 $54.43 ($19.00) Unrecovered investment at end of year ($30.95) $15.88 $67.51 $54.43 $0.00

Net Present Value

Occurs when a cash flow produces more than one point at which NPW = 0

$10.00 $8.00 $6.00 $4.00 $2.00 $0.00 ($2.00) ($4.00) 0 5 10 15 20 25 30 35 40 45 50

Engineering Economic Analysis - Ninth Edition Newnan/Eschenbach/Lavelle Copyright 2004 by Oxford University Press, Inc.

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Modified Internal Rate of Return (MIRR)

Determine a corporations external rate for borrowing money (financing rate) Determine a corporations typical rate for investing (presumably larger than its rate for borrowing) Combine cash flows in each period into a single net receipt (+) or a single net expense (-) Find the present worth of the expenses with the financing rate Find the future worth of the receipts with the investing rate Calculate the interest rate which makes the present and future worths equivalent. That interest rate is the MIRR. P = F (P/F, MIRR, n) 1 = (P/F, MIRR, n)
Real life cash flows often change signs, so MIRR is very often used
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Still Dont Understands

Rate of Return analysis (8) Analysis periods including infinite (5) Calculating Rate of Return (3) Increments of investment and borrowing (2) {next week} Modified Internal Rate of Return (2) Some Present Worth analysis problems Some Rate of Return Analysis problems More explanation of EUAC and EUAB, MARR NPW plot Annual Cash Flow analysis Resolving present cost to annual cost When to go with trial and error
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Homework
1. Do remainder of the in-class problems in this package, if we didnt finish them today, and do pages 197-200, problems: 6-29, 6-41, 648, and pages 223-228, problems: 7-16, 7-18, 7-38 2. Read-ahead Chapters 8 and 9 of textbook Give me exactly three items you learned from reading Chapters 8 & 9 (one phrase/sentence each) Give me up-to-three items you read in Chapters 8 & 9 that you still dont understand (one phrase/sentence each)

Homework is due via email by 6:00 p.m. on Tuesday, October 31 Send me answers only to the homework problems (Part 1) (no need to send all work, but you can, if you wish) Send me reading comprehension items, above (Part 2) Send to baseil@njit.edu (backup: rbaseil@comcast.net, or fax)
Homework graded on whether its done, not right/wrong homework credit for Part 1 and for Part 2 * * * NO CREDIT FOR LATE HOMEWORK * * *
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