Decision Rule: Economically Profitable Project; How to select?

1. Internal Rate of Return:

The rate of discount that makes the Net Present Value of the return from investment
(return from all cash inflows) zero. At this rate of return, benefit from the business is just
equal to its cost of the production.

NPV is used in capital budgeting to analyze the profitability of a projected investment or

project

. where

Ct = net cash inflow during the period t

Co = total initial investment costs

r = discount rate and

t = number of time periods

A positive net present value indicates that the projected earnings generated by a project or
investment (in present dollars) exceed the anticipated costs (also in present dollars).
Generally, an investment with a positive NPV will be a profitable one and one with a
negative NPV will result in a net loss.

The higher a project's internal rate of return, the more desirable it is to undertake the
project. IRR can be used to rank multiple prospective projects a firm is considering on a
relatively even basis. Assuming the costs of investment are equal among the various
projects, the project with the highest IRR would probably be considered the best and
undertaken first.

Calculation of IRR

Calculation of IRR of an investment project is done by trial and error. In general discount
rate and present worth are inversely related. A higher discount rate results in a smaller
sum of present worth and a lower discount rate results in a bigger total. It is required to
select two rates, one resulting in a positive present worth and the other is a negative
present worth.
IRR = Lower discount rate + (Positive worth)/(sum of positive PW and negative PW)*
. (Higher discount rate Lower discount rate)

Ex. 1. A company ABC is considering of opening a store for selling automobile products,
with an initial outlay of Rs. 5000000 and the estimated annual profit income of

Rs. 800000. The planning horizon is 10 years. There would be no salvage value(Resale
value) at the end of this period. What is the IRR of this proposal?

In this problem, every values should be changed to present worth.

Given:

Initial cost = Rs. 5000000( it is in terms of present value only)

Annual income or annual worth = 800000

Time = 10 years

We have to use trial error process to determine IRR

IRR will be in between positive NPV and negative NPV

NPV( 10%) = Cash inflows in terms of present value cash outflows in terms of present
value

= 800000 (P/A, 10%, 10) 5000000

= 800000 * [(1 + 0.10)10 1]/ 0.10(1 + 0.10)10] 5000000 ( if discount factor is not
given)

= 800000 * 6.1446 5000000

= Rs. - 84, 320

NPV ( 9%) = 800000(P/A, 9%, 10) 5000000

= 800000* 6.4177 5000000

= 5134160 5000000

= Rs.134160

Therefore required IRR = 10% + (134160)/ (134160+84320) (10 9)%

 How to select the discount rate?

Common methods for determining the discount rate include using the expected of other
investment choices with a similar level of risk (rates of return investors will expect), or
the costs associated with borrowing money needed to finance the project.

Decision rule depends on the following factors.

a. IRR

b. Benefit cost ratio

c. NPV

Replacement

Defender: It is the existing asset which is under consideration for apossible replacement

Challenger: It is the best available asset for acquisition

Sunk Cost: It is the cost as Original Investment cost less depreciation plus repairing expenses

= Market Value of the asset + Repairing Expenses

Operating Cost : Expenses of keeping an asset in active service.

Obsolescence = Replacement of the existing machine is required due to technological up

gradation.

Economic Life of an asset = Economic life is the expected period of time during which an asset
is useful to the average owner. The economic life of an asset could be different than its actual
physical life. Estimating the economic life of an asset is important for business so that they can
determine when it is worthwhile to invest in new equipment and they can allocate appropriate
funds to purchase replacements once the equipment has exceeded its useful life.

Physical life of an asset = Time period between original acquisition and final disposal of an
asset over its successive owner.

Capital Recovery Cost = It is the earning back of the initial funds put into an investment

Annual Capital Recovery = P( A/P, i%, n) Sn ( A/F, i%, n)

Sn = Salvage value at the end of n years

 Ex. 2. With interest at 8% and given the following data, calculate whether the defender
should be replaced or not. ( All amounts are in rupees)

Defender Challenger
Initial Cost 60000 150000
Annual Operating Cost 20000 10000
Salvage Value 8000 0
Number of years 6 6

For defender:

Annual Expenditure (AE)(8%) = 60000( A/P, 8%, 6) + 20000 8000( A/F, 8%, 6)

= 60000* 0.2163 +20000 8000* 0.1363

= Rs. 31887.60

For Challenger:

Annual Expenditure (AE) (8%) = 150000( A/P, 8%, 6) + 10000

= Rs. 42445

As the annual exp of challenger > the annual exp of defender, therefore defender should not be
replaced.
 Inflation

Sustained rise in general price level

Value of money falls
Excess supply of money
 Stages of Inflation

Initial Stage - Creeping and Crawling Inflation ( 2% to

3%)

Intermediate stage I Walking and Trotting Inflation (3%

to 7%)

Intermediate Stage II Running or Galloping Inflation(

10% to 20%)

Final Stage Hyperinflation(20% to 100%)

Causes of Inflation

Demand Pull Inflation

Cost Push Inflation

The demand pull inflation

Excess demand inflation

Increase in money supply

Black money

Population

Export promotion
Demand Pull Inflation
Cost Push inflation
Wages

Raw material cost

Increase in profit margin

Other factors
Cost Push Inflation
Effect of inflation
Investment and production increases in a less than full
employment economy.

Real income declines.

Employment generation

Inequality of income distribution

 Effect of Inflation

Growth Stimulant in its initial stage

Adverse effect on external sector

Shift in asset preferences

Fiscal Impact
Effect of inflation

Increase in farmers income

Adverse impact on fixed income group

Debtor gained due to the reduction of the burden of

debt

Creditor loosened due to the decline in purchasing

power of money
 Price Index and Quantity Index
Quantity index is a numerical estimate of the average change of
quantity over time (between the base period and current period).
Quantity Index = [Quantity ( current period)/ Quantity ( Base period)] * 100

Price Index is a numerical estimate of the average changes of price over

time (between the base period and current period).
It may be further classified on the basis of the level of prices, such as
. wholesale and retail and on the basis of areas and localities.
Price index of a single variable is known as Price Relative.
 Fixed Base and Chain base index

Each of the entire series of index numbers has the same

base period. According to this index, values can be
directly comparable with each other.

In chain base method, the base period of each index

number is the preceding period.
 Weighted and Unweighted Index numbers

When all commodities are not of equal importance. We

assign weight to each commodity relative to its
importance and index number computed from these
weights is called weighted index numbers.
Unweighted index is just arithmetic average.
As an example of how to calculate an arithmetic average,
suppose that there are three stocks in an index with
returns of 10%, 11% and 15%. The arithmetic return would be
calculated as follows:
(0.10+0.11+0.15)/3 = 0.1200 =12%
Simple/ Commodity Index Number

Unweighted index number

Index number for a single variable is Price

Relative or Quantity Relative.
 Composite Index Number

Wholesale Price Index (manufactured, consumers goods etc)

Consumer Price Index (Food, Fuel and Light, Housing, Clothing,

Footwear, Medical, education etc)

Sensex of the Bombay Stock Exchange is a free-float market-weighted

stock market index of 30 well-established and financially sound
companies, which are listed in BSE
 Wholesale Price Index

The Wholesale Price Index (WPI) is the price of a

representative basket of wholesale goods. Some
countries use WPI changes as a central measure
of inflation. But now India has adopted new CPI to
measure inflation. However, United States now report
a producer price index instead.
 Relevance of inflation in Engineering
Economics
Engineering economics, previously known as
engineering economy, is a subset of economics
concerned with the use and application of economic
principles in the analysis of engineering decisions.

Engineering economist should pay attention to the price

behaviour of inputs which affect the financial
performance of the business concern.

In respect of price trend engineers can derive the

projected cash flows of the business entity.