UNIVERSITY OF WOLLONGONG IN DUBAI

Engineering Economy
Group Project
Laila Obeid El Shehhi Rehab Al Kaabi Mohamed Ismail 7/10/2011 3486825 4108589 4030722

Engineering economy is a study of the time value of money in an engineering environment. Thus the subject is from an economic standpoint, for example, the investment differences of different types of energy supplies, the relative cost of two different types of machines, and in this case we will discuss whether a proposed project should be refurbished and continue to operate, or disposed at the time of evaluation.

TABLE OF CONTENTS
Introduction ...................................................................................................................................................................................... 2 Capital Expenditure Policies ........................................................................................................................................................... 3 Evaluating investments .................................................................................................................................................................. 3 Payback Time ............................................................................................................................................................................. 4 Return on Investment................................................................................................................................................................. 4 Net Present Worth ..................................................................................................................................................................... 4 Internal Rate of Return ............................................................................................................................................................... 5 Case description ................................................................................................................................................................................ 5 Study questions ................................................................................................................................................................................. 5 Solution Assumptions ........................................................................................................................................................................ 5 Scenario Analysis ............................................................................................................................................................................... 6 Results Discussion.............................................................................................................................................................................. 7 Conclusion and recommendation....................................................................................................................................................... 8 Bibliography ...................................................................................................................................................................................... 9 Appendix A ...................................................................................................................................................................................... 10 Appendix B ...................................................................................................................................................................................... 11 Appendix C ...................................................................................................................................................................................... 12

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INTRODUCTION
Facility investment decisions represent major commitments of corporate resources and have serious consequences on the profitability and financial stability of a corporation. The objective of this economic analysis is to identify and evaluate the probable economic outcome of a proposed project so that available funds assigned to it may be used to optimum advantage. The analysis is always made from the viewpoint of the owner of the project and usually involves a comparison of alternatives on a monetary basis. It should be recognized that an action always involves at least two possible courses: refurbishing the business or disposing of it. An economic analysis revolves around three processes: preparation, analysis, and evaluation. The process of preparation can be broken down into three steps: understanding the project, defining the objective, and collecting data. Similarly, analysis involves analysis of data, interpretation of results. Finally, there are two steps to evaluation: evaluation of the alternatives and identification of the best alternative. We could also say that Decision making is the fourth step. 1. Understanding the project: One cannot and should not attempt to perform aneconomic analysis without clearly understanding the project. This is often a substantialdifference between what one thinks the project is and what the project reallyis. 2. Defining the objectives: Failure to clarify the objectives of a project will oftencreate dissatisfaction. The objectives must be clearly stated and compatible witheach other. Some examples are Meet or exceed a specified minimum rate of return on an investment Return the investment (breakeven) within a specified time period Obtain a specific share of a market The firm s objectives and criteria must be specified and defined quantitatively. 3. Collecting data: This begins with a complete review of published literature,if available, or of historical data in the firm s files. Often, the wheel gets reinventedonly because someone did not bother to search out existing information. If nototherwise available, data can be obtained through private sources or roughly estimated through assumptions. 4. Analysis of data: This is the process of converting developed data into somethingmeaningful and useful. The use of a computer is highly beneficial. Often thecomputer can generate maximum amounts of information at a minimum cost. 5. Interpretation of results: Interpretation of the results usually occurs uponcompletion of the analysis. The results must be well organized, stored properly, andthen carefully adapted and utilized in the evaluation phase. 6. Evaluation of alternatives: In evaluating the alternatives, it is important touse uniform criteria for all, not different ones for each alternative. If the returnon-investment concept is to be used on one alternative, then each alternative is tobe evaluated by the return-on-investment concept. Furthermore, the method of calculationof the return on investment (ROI) must be uniform as well. 7. Identification of the best alternative(s): the analyst must narrow the choice down to thetwo or three best possibilities. Top management can then identify the one that comesclosest to meeting the objectives. As soon as the analysis, evaluation, selection, and approval of the best alternativehave been completed, the implementation process begins.

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CAPITAL EXPENDITURE POLICIES

Wear and tear of productive facilities, or new trends in the service industry, necessitatestheir eventual replacement. Industrial and consumer demands for more goodsand services necessitate an increase in supply and hence an increase in productivefacilities. Firms respond to these pressures through capital expenditures by investingnew plants, equipment, outlets and products. Often, capital spending can be minimized bysacrificing some output capabilities or through productivity improvement or costreduction opportunities. For whichever purpose the expenditure is made, the final criterion is the profit or savings to be realized through the modification. Working capital is money tied up in raw materials, intermediate- and finishedgoodsinventories, and accounts receivable, as well as cash needed to operate agiven project. Depreciation d consists of a fixed annual charge on the facility or equipmentinvestment which will result in recovery of the initial investment at the end ofthe useful life of the item. If the actual life of the facility or equipment is known,an exact rate of depreciation can be established where the sum of the rates willjust equal the investment.

EVALUATING INVESTMENTS
This section concerns itself with some of the different methods being employed toevaluate venture decisions. Years ago, intuition was an adequate tool for makingsuch decisions. Today, however, owing to pressures of competition, quantitativetechniques have replaced intuition, reducing the risk of failure. A decision to undertakea venture involves careful analysis of capital requirements and other resourcesfor profit maximization within the framework of social responsibilities. Because of these life cycles, investments and costs must be carefully controlled. Among factors to be evaluated in an investment analysis are the uncertainties ofthe state of the economy, the possibility of operating failures, and technologicalchanges. With quantitative evaluations, making an investment decision is a matterof weighing anticipated profits against the minimum profitability standard set by afirm. The company must make profitable investments and refrain from making unprofitableones. Investment evaluation must be objective, realistic, appropriate to the situation,and easily understood by management. This responsibility lies in the hands of theevaluating engineer or technologist. There are many methods in use for evaluating investments. Some incorporatethe time value of money; that is, they consider the fact that profits to be realizedfrom a given project decrease in value in the future as a result of inflation. Or,stated differently, the dollar will have a lower purchasing power next year and evenlower the year after, and so on. Other methods neglect the time value of money,which makes them inefficient if a project has a long useful life. The basic and mostimportant methods involving the time value of money are 1. Payback time (PT) 2. Return on investment (ROI) 3. Present Worth 4. Internal Rate of Return The most widely used is payback time; however, return on investment is the mostlogical and theoretically acceptable means of determining investment feasibility. Since no single method is best for all cases, the engineer or technologist shouldunderstand the basic concepts involved in each method and be able to choose thebest one suited to the situation. Page 3 of 13

PAYBACK TIME
For studies involving the design of components (equipment)for processing plants, it is often convenient to evaluate capital expenditures in termsof payback time (other equivalent terms are payback period, payout time, payoffperiod, and payoff time). It is the number of years over which capital expenditure(not including working capital) will be recovered, or paid back, from profits madepossible by the investment; that is, the project or piece of equipment will pay foritself in this number of years. It is a quick and convenient but crude method ofidentifying projects that are apt to be either highly profitable or unprofitable duringtheir early years. If the payback time is equal to or only slightly less than theestimated life of the project or piece of equipment, then the proposal is obviouslya poor one. If, on the other hand, the payback time is considerably less than theestimated life, then the proposal begins to look attractive. Another attractive feature of payback time is its usefulness in selecting acceptableproposals out of several investment alternatives having similar characteristics. The major disadvantage of payback time is its failure to consider profits afterthe investment has been recovered. There are several ways to determine payback time. The three most widely usedare payback time based on average yearly gross profit, payback time based onaverage yearly net profit, and payback time based on average yearly cash flow. Cash flow, which is the total amount of money generated by an investment, is foundby adding the annual depreciation charge to net profit.

RETURN ON INVESTMENT
The return-on-investment approach relates the project santicipated net profit to the total amount of capital invested. The total capitalinvested consists of that actually expended for facilities or equipment as well asworking capital. To obtain reliable estimates of investment returns, it is necessary to make accuratecalculations of net profits at the required capital expenditure. To computenet profit, estimates must be made of direct production costs, fixed expenses suchas interest, depreciation, and overhead, and general expenses. The main disadvantage of the return-on-investment approach is its complexityas compared with payback time, but this disadvantage allows increased precisionand thoroughness. The two most widely used approaches in determining return on investment arereturn on original investment and return on average investment. Return on Original Investment. This is the percentage relationship of the averageannual net profit to the original investment (which includes non-depreciable itemssuch as working capital).

NET PRESENT WORTH

The difference between the present value of cash inflows and the present value of cash outflows. NPV is used in capital budgeting to analyze the profitability of an investment or project. NPV analysis is sensitive to the reliability of future cash inflows that an investment or project will yield. NPV compares the monetary value today to the value in the future, taking inflation and returns into account. If the NPV of a prospective project is positive, it should be accepted. However, if NPV is negative, the project should probably be rejected because cash flows will also be negative.

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INTERNAL RATE OF RETURN

The discount rate often used in capital budgeting that makes the net present value of all cash flows from a particular project equal to zero. Generally speaking, the higher a project's internal rate of return, the more desirable it is to undertake the project. As such, IRR can be used to rank several prospective projects a firm is considering. Assuming all other factors are equal among the various projects, the project with the highest IRR would probably be considered the best and undertaken first. You can think of IRR as the rate of growth a project is expected to generate. While the actual rate of return that a given project ends up generating will often differ from its estimated IRR rate, a project with a substantially higher IRR value than other available options would still provide a much better chance of strong growth. IRRs can also be compared against prevailing rates of return in the securities market. If a firm can't find any projects with IRRs greater than the returns that can be generated in the financial markets, it may simply choose to invest its retained earnings into the market.

CASE DESCRIPTION
Emmar is considering the following investment proposal, you are required to analyze the proposal and make a recommendation. Emmar could open an eco-tourist resort. This would require an initial investment of AED1,000,000. This includes assets which may be depreciated for tax purposes over 10 years. Assets prime cost is AED660,000. Revenues will come from three areas, accommodation, food, and retail sales of environmentally friendly items. Accommodation costs will average 75% of accommodation revenues, food costs will average 85% of food revenues and retail sales costs are expected to average 50% of their revenues. After 8 years, the project will need major refurbishment, so a decision will be made then as to whether to continue or not. If they don t continue, they expect to be able to recoup from salvageable items an amount equal to AED100,000 from the depreciable assets. Net Working capital requirements are estimated to be 5% of accommodation revenues, 10% of food costs, and 7% of retail sales revenues. The working capital will need to be in place the year before the revenues are received. Working Capital is not returned at the end of the project. The tax rate is 30% (paid in the year of income) and the required return is 10.5%.

STUDY QUESTIONS
A decision will be made then as to whether to continue or not. If they don t continue a) Using any spreadsheet package, estimate the net cash flows and calculate the NPV and the IRR of the project. b) The tourism industry is extremely variable, with the threat of terrorism, war, and airline failures all possible. Suppose all revenues are 30% less than forecast. Recalculate with this change. c) Redo the spreadsheet under the assumption that domestic travel increases due to the above factors, and revenues are 25% above that forecast. How does this change your answers? d) Suppose costs are 10% higher than expected. Redo the spreadsheet, keeping revenues at the original levels. How does the result of this impact on your decision?

SOLUTION ASSUMPTIONS
In order to reach a valid analysis, we will assume that the assets is purchased and placed in service at the beginning of year 1(or the end of year 0, and the first year's depreciation will be claimed at the end of year 1. We will also neglect the effect of the gains tax from assets disposal on income tax calculations.No working capital will be recovered at the end of the project. Another major assumption is that the depreciation that the assets will undergo is assumed to be straight line depreciation.

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SCENARIO ANALYSIS
In order to benchmark the scenarios, we will have to evaluate each scenario based on the given information. In each scenario, we will have to first calculate the Income Statement. The income statement is calculated by adding all the revenues that come from all different sources, in our case, revenues come from sales in accommodation, food sales, and retail sales of environmental products. Summed together we get the total revenue. All expenses are then added togetherand added with the depreciation of assets, and all together are subtracted from the total revenue. This would produce a complete income statement. The depreciation is deducted in order to calculate the taxable income, and then the taxes are calculated and subtracted from the income, which would give the net income. The depreciation is then added again as it was just an adjustment used in order to calculate the tax properly. The reason is that asset decrease in value and taxes are calculated on the value of assets at that time. The assets are AED 660,000.00 which is part of the total investment of AED 1,000,000.00. The assets will recover AED 100,000.00 as its salvage value at the end of year 8. Therefore the salvage value is subtracted from the assets value and then divided by the number of years.  The net income and depreciation is equal to the operating activities. It is added with the investing activities and financing activities to give us the net cash flow.

FIGURE 1 NET CASH FLOW CALCULATION

Then we can evaluate the net present value (NPV) of the project and calculate its initial rate of rate of return (IRR) which will help us finally to evaluate the project. The investing activities are comprised of negative cash flows, such as the capital investments, any investments in the working capital and gains taxes. On the positive side we have salvage proceeds and any working capital recovered. All borrowed funds and added capital is added in the financial activities section and all repayments are deducted. After calculating the net income, net cash flow, we could then use different methods to evaluate the project. We will then calculate the payback period by putting the initial investments negative and then add the net revenue for each year till the cash flow surpasses the zero point. We can also calculate the present worth by converting all the cash flow values to the present value in order to calculate the profit or loss from the present value of money.

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The third method of evaluation is the internal rate of return, and comparing it with the required rate of return or the Minimum Attractive Rate of Return (MARR) which is 10.5%. In each scenario the IRR will be compared with the MARR and if the IRR<MARR then the project should be accepted. The fourth method used is the Return on investment (ROI):    

This would calculate the percent of capital recovered from the investment, and if the scenario provides 100% or more, it would be accepted.

RESULTS DISCUSSION
Using four types of evaluation methods gives the decision maker a deeper insight of the possible outcome of the project. The results are as following: Net Cash Flow: 0 -1,047,175.00 -1,033,022.50 -1,058,968.75 -1,049,342.50 1 57,150.00 46,305.00 66,187.50 16,515.00 2 145,875.00 108,412.50 177,093.75 66,262.50 3 274,500.00 198,450.00 337,875.00 160,500.00 4 274,500.00 198,450.00 337,875.00 160,500.00 5 274,500.00 198,450.00 337,875.00 160,500.00 6 293,625.00 211,837.50 361,781.25 180,262.50 7 260,025.00 188,317.50 319,781.25 163,027.50 8 384,550.00 305,485.00 450,437.50 312,205.00

A B C D

Payback Period: Payback Period 5 6 4 6 Discounted Payback Period 5 7 4 6

A B C D Internal Rate of Return:

A B C D Present Worth:

IRR 13.48707% 6.91778% 18.15082% 2.76605%

A B C D Return on Investment

Present Worth AED 141,763.20 AED (154,262.32) AED 388,451.13 AED (335,572.74)

A B C D

ROI 113.42% 85.56% 131.17% 75.04% Page 7 of 13

After obtaining the following results from the evaluation we can confidently conclude the following: 1) Scenario C has the best Net Cash flow and Scenario D has the worst. 2) Scenario C has the shortest payback period, and Scenario B has the longest payback period, which is almost equivalent to scenario A and D, 3) Scenario A and C have acceptable IRR which is above 10.5% and B and D does not satisfy this criteria. 4) Scenario C and A has positive Present worth and B and D has a negative Present worth. 5) The Return of Scenario C and A is more than the amount invested. In almost all evaluation methods scenario C was the best and D was the worst performing. Overall, we can assume that the project has a 50% chance of success. We have also proposed a fifth scenario, where the revenues are 30% lower than forecasted as in the 2 scenario, however, we calculated the reduction in costs using interpolation which would give a hundred percent return on investment. A 2% reduction in cost gives a 91.9% ROI, and a 10% reduction in costs returns 117.7% ROI, therefore using the following equation we can calculate the percent where the reduction in cost will return a 100% ROI in case the revenues is lower by 30%. 
nd

CONCLUSION AND RECOMMENDATION

Using different types of evaluation provides a strong perspective to decision makers, using different evaluation has certain advantages and disadvantages, and together they may complete each other for a global decision. If the project operates as forecasted, then it would be accepted. Through analysis, it is apparent that a slight increase in costs (10%) than the calculated, would cause substantial losses, whereas a decrease in revenue for external reason could cause a loss, but not as substantial as of over running costs, therefore the cost controlling and management of the project should be strict. On the other hand, if the project costs and revenue is as it is forecasted, then the project is profitable, and it will also return significant profit if the revenue was greater than forecasted. By calculation, we found that cost control is a very important factor in the profitability of this project, as we have assumed just a 4.55% reduction in cost even if the revenues were 30% than forecasted and the project was still profitable. The final recommendation is to continue with the project, after verifying the cost analysis of the project, and create a strict cost management for the project, and the probability of success could grow from 50% to 75%.

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BIBLIOGRAPHY
1. Baker, S. L. (n.d.). Internal Rate of Return. Retrieved July 8, 2011, from University of South Carolina: http://hspm.sph.sc.edu/COURSES/ECON/irr/irr.html Economic Evaluation of Facility Investments. (n.d.). Retrieved July 8, 2011, from Central Michigan University: http://pmbook.ce.cmu.edu/06_Economic_Evaluation_of_Facility_Investments.html Ganic, E. N., & Hicks, T. G. (2003). McGraw Hill's Engineering Companion. McGraw Hill. Internal Rate of Return. (n.d.). Retrieved July 8, 2011, from Investopedia: http://www.investopedia.com/terms/i/irr.asp Park, C. S. (2011). Contemporary Engineering Economics. New Jersey: Pearson. Vlez-Pareja, I. (2010). Ranking Investments with Internal Rate of Return and Benefit - Cost Ratio. Columbia.

2.

3. 4. 5. 6.

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APPENDIX A
This appendix contains the calculation spreadsheets for the four scenarios

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APPENDIX B
This Appendix contains the net cash flow diagram for the four scenarios.

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APPENDIX C
This appendix contains a spreadsheet containing all the calculations and equations used on excel.

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