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Economic Evaluation of Facility Investments

6.1 Project Life Cycle and Economic Feasibility


Facility investment decisions represent major commitments of corporate resources
and have serious consequences on the profitability and financial stability of a
corporation. In the public sector, such decisions also affect the viability of facility
investment programs and the credibility of the agency in charge of the programs. It is
important to evaluate facilities rationally with regard to both the economic feasibility
of individual projects and the relative net benefits of alternative and mutually
exclusive projects.

This chapter will present an overview of the decision process for economic evaluation
of facilities with regard to the project life cycle. The cycle begins with the initial
conception of the project and continues though planning, design, procurement,
construction, start-up, operation and maintenance. It ends with the disposal of a
facility when it is no longer productive or useful. Four major aspects of economic
evaluation will be examined:

1. The basic concepts of facility investment evaluation, including time preference


for consumption, opportunity cost, minimum attractive rate of return, cash
flows over the planning horizon and profit measures.

2. Methods of economic evaluation, including the net present value method, the
equivalent uniform annual value method, the benefit-cost ratio method, and the
internal rate of return method.

3. Factors affecting cash flows, including depreciation and tax effects, price level
changes, and treatment of risk and uncertainty.

4. Effects of different methods of financing on the selection of projects, including


types of financing and risk, public policies on regulation and subsidies, the
effects of project financial planning, and the interaction between operational
and financial planning.

In setting out the engineering economic analysis methods for facility investments, it is
important to emphasize that not all facility impacts can be easily estimated in dollar
amounts. For example, firms may choose to minimize environmental impacts of
construction or facilities in pursuit of a "triple bottom line:" economic, environmental
and social. By reducing environmental impacts, the firm may reap benefits from an
improved reputation and a more satisfied workforce. Nevertheless, a rigorous
economic evaluation can aid in making decisions for both quantifiable and qualitative
facility impacts.

It is important to distinguish between the economic evaluation of alternative physical


facilities and the evaluation of alternative financing plans for a project. The former
refers to the evaluation of the cash flow representing the benefits and costs associated
with the acquisition and operation of the facility, and this cash flow over the planning
horizon is referred to as the economic cash flow or the operating cash flow. The latter
refers to the evaluation of the cash flow representing the incomes and expenditures as
a result of adopting a specific financing plan for funding the project, and this cash
flow over the planning horizon is referred to as the financial cash flow. In general,
economic evaluation and financial evaluation are carried out by different groups in an
organization since economic evaluation is related to design, construction, operations
and maintenance of the facility while financial evaluations require knowledge of
financial assets such as equities, bonds, notes and mortgages. The separation of
economic evaluation and financial evaluation does not necessarily mean one should
ignore the interaction of different designs and financing requirements over time
which may influence the relative desirability of specific design/financing
combinations. All such combinations can be duly considered. In practice, however, the
division of labor among two groups of specialists generally leads to sequential
decisions without adequate communication for analyzing the interaction of various
design/financing combinations because of the timing of separate analyses.

As long as the significance of the interaction of design/financing combinations is


understood, it is convenient first to consider the economic evaluation and financial
evaluation separately, and then combine the results of both evaluations to reach a final
conclusion. Consequently, this chapter is devoted primarily to the economic
evaluation of alternative physical facilities while the effects of a variety of financing
mechanisms will be treated in the next chapter. Since the methods of analyzing
economic cash flows are equally applicable to the analysis of financial cash flows,
the techniques for evaluating financing plans and the combined effects of economic
and financial cash flows for project selection are also included in this chapter.

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6.2 Basic Concepts of Economic Evaluation


A systematic approach for economic evaluation of facilities consists of the following
major steps:

1. Generate a set of projects or purchases for investment consideration.


2. Establish the planning horizon for economic analysis.

3. Estimate the cash flow profile for each project.

4. Specify the minimum attractive rate of return (MARR).

5. Establish the criterion for accepting or rejecting a proposal, or for selecting the
best among a group of mutually exclusive proposals, on the basis of the
objective of the investment.

6. Perform sensitivity or uncertainty analysis.

7. Accept or reject a proposal on the basis of the established criterion.

It is important to emphasize that many assumptions and policies, some implicit and
some explicit, are introduced in economic evaluation by the decision maker. The
decision making process will be influenced by the subjective judgment of the
management as much as by the result of systematic analysis.

The period of time to which the management of a firm or agency wishes to look ahead
is referred to as the planning horizon. Since the future is uncertain, the period of time
selected is limited by the ability to forecast with some degree of accuracy. For capital
investment, the selection of the planning horizon is often influenced by the useful life
of facilities, since the disposal of usable assets, once acquired, generally involves
suffering financial losses.

In economic evaluations, project alternatives are represented by their cash flow


profiles over the n years or periods in the planning horizon. Thus, the interest periods
are normally assumed to be in years t = 0,1,2, ...,n with t = 0 representing the present
time. Let Bt,x be the annual benefit at the end of year t for a investment project x where
x = 1, 2, ... refer to projects No. 1, No. 2, etc., respectively. Let C t,x be the annual cost
at the end of year t for the same investment project x. The net annual cash flow is
defined as the annual benefit in excess of the annual cost, and is denoted by At,x at the
end of year t for an investment project x. Then, for t = 0,1, . . . ,n:

(6.1)

where At,x is positive, negative or zero depends on the values of B t,x and Ct,x, both of
which are defined as positive quantities.
Once the management has committed funds to a specific project, it must forego other
investment opportunities which might have been undertaken by using the same funds.
The opportunity cost reflects the return that can be earned from the best alternative
investment opportunity foregone. The foregone opportunities may include not only
capital projects but also financial investments or other socially desirable programs.
Management should invest in a proposed project only if it will yield a return at least
equal to the minimum attractive rate of return (MARR) from foregone opportunities
as envisioned by the organization.

In general, the MARR specified by the top management in a private firm reflects
the opportunity cost of capital of the firm, the market interest rates for lending and
borrowing, and the risks associated with investment opportunities. For public projects,
the MARR is specified by a government agency, such as the Office of Management
and Budget or the Congress of the United States. The public MARR thus specified
reflects social and economic welfare considerations, and is referred to as the social
rate of discount.

Regardless of how the MARR is determined by an organization, the MARR specified


for the economic evaluation of investment proposals is critically important in
determining whether any investment proposal is worthwhile from the standpoint of
the organization. Since the MARR of an organization often cannot be determined
accurately, it is advisable to use several values of the MARR to assess the sensitivity
of the potential of the project to variations of the MARR value.