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Engineering Economics - EIT Review

Cash Flow Evaluation

Hugh Miller
Colorado School of Mines
Mining Engineering Department
Fall 2013

Introduction
As we have addressed the fundamental concepts associated with
engineering economics and cash flows, is now time to convert these
estimates into measures of desirability as a tool for investment decisions.
We will use the following criteria:

Present & Future Value


Annual Value
Benefit / Cost Ratio
Payback period
Internal Rate of Return
Variations of IRR

Present Value
The Present Value or Present Worth method of evaluating
projects is a widely used technique. The Present Value
represents an amount of money at time zero representing
the discounted cash flows for the project.

PV
T=0

+/- Cash Flows

Net Present Value (NPV)


The Net Present Value of an investment it is simply the difference between cash
outflows and cash inflows on a present value basis.
In this context, the discount rate equals the minimum rate of return for the
investment
Where:
NPV = Present Value (Cash Benefits) - Present Value (Cash Costs)

Present Value Example

Initial Investment:$100,000
Project Life:
10 years
Salvage Value: $ 20,000
Annual Receipts: $ 40,000
Annual Disbursements: $ 22,000
Annual Discount Rate: 12%
What is the net present value for this project?
Is the project an acceptable investment?

Present Value Example Solution

Annual Receipts

$ 226,000

Salvage Value

$40,000(P/A, 12%, 10)


$20,000(P/F, 12%, 10)

6,440

Annual Disbursements

$22,000(P/A, 12%, 10)

-$124,000

Initial Investment (t=0) -$100,000

Net Present Value

$ 8,140

Greater than zero, therefore acceptable project

Future Value
The future value method evaluates a project based
upon the basis of how much money will be
accumulated at some future point in time. This is
just the reverse of the present value concept.

FV
T=0

+/- Cash Flows

Future Value Example

Initial Investment:$100,000
Project Life:
10 years
Salvage Value: $ 20,000
Annual Receipts: $ 40,000
Annual Disbursements: $ 22,000
Annual Discount Rate: 12%
What is the net future value for this project?
Is the project an acceptable investment?

Future Value Example Solution

Annual Receipts

$ 20,000

$22,000(F/A, 12%, 10)

-$ 386,078

Initial Investment

$20,000(year 10)

Annual Disbursements

$ 701,960

Salvage Value

$40,000(F/A, 12%, 10)

$100,000(F/P, 12%, 10)

Net Future Value

-$ 310,600

$ 25,280

Positive value, therefore acceptable project


Can be used to compare with future value of other projects

PV/FV Example
No theoretical difference if project is evaluated in
present or future value
PV of $ 25,282
$25,282(P/F, 12%, 10)

$ 8,140

FV of $8,140
$8,140(F/P, 12%, 10)

$ 25,280

Non-Uniform Cash Flows


Future or present value methods are ideally suited
for cash flows that are non-uniform over the life of
the investment (as most are). Simply treat each
year separately.

T=0

+/- Cash Flows

Annual Value

Sometimes it is more convenient to evaluate a


project in terms of its annual value or cost. For
example, it may be easier to evaluate specific
components of an investment or individual
pieces of equipment based upon their annual
costs as the data may be more readily available
for analysis.

Annual Analysis Example

A new piece of equipment is being evaluated for


purchase which will generate annual benefits in
the amount of $10,000 for a 10 year period, with
annual costs of $5,000. The initial cost of the
machine is $40,000 and the expected salvage is
$2,000 at the end of 10 years. What is the net
annual worth if interest on invested capital is
10%?

Annual Example Solution

Benefits:

125

$5,000 per year

-$ 5,000

Investment:

$2,000(P/F, 10%, 10)(A/P, 10%,10)

Costs:

$10,000

Salvage

$10,000 per year

$40,000(A/P, 10%, 10)

Net Annual Value

-$ 6,508

-$1,383

Since this is less than zero, the project is expected to


earn less than the acceptable rate of 10%, therefore
the project should be rejected.

Benefit/Cost Ratio

The benefit/cost ratio is also called the


profitability index and is defined as the ratio of
the sum of the present value of future benefits to
the sum of the present value of the future capital
expenditures and costs.

B/C Ratio Example

Present value cash inflows


Project A
$500,000

Project B
$100,000

Present value cash outflows (costs)


$300,000

$ 50,000

Net Present Value


$200,000

$ 50,000

Benefit/Cost Ratio
1.67

2.0

Payback Period
This is one of the most common evaluation criteria used by engineering
and resource companies.
The Payback Period is simply the number of years required for the cash
income from a project to return the initial cash investment in the project.
The investment decision criteria for this technique suggests that if the
calculated payback is less than some maximum value acceptable to the
company, the proposal is accepted.
The following example illustrates five investment proposals having
identical capital investment requirements but differing expected annual
cash flows and lives.

Payback Period

Example
Calculation of the payback period for a given investment proposal.
a) Prepare End of Year Cumulative Net Cash Flows
b) Find the First Non-Negative Year
c) Calculate How Much of that year is required to cover the previous period
negative balance
d) Add up Previous Negative Cash Flow Years

Initial
Investment

Alternative A
(45,000) 10,500

11,500

10

12,500 13,500 13,500 13,500 13,500 13,500 13,500 13,500

End of Year Cummulative Net Cash Flow


(45,000) (34,500) (23,000) (10,500)
Pay Back Period
Fraction of First Positive Year
Pay Back Period

Annual Net Cash Flows


4
5
6
7

3,000 16,500 30,000 43,500 57,000 70,500 84,000


b
0.78
3.78

c)

0.78 = 10,500/13,500

d)

3 + 0.78

Example:
Calculate the payback period for the following investment proposal

Initial
Investment
Alternative A
(120)

10

10

50

Annual Net Cash Flows


4
5
6
7

10

50

50

50

50

50

50

End of Year Cummulative Net Cash Flow


(120) (110) (100) (50)
0
50

100

150

200

250

300

Pay Back Period


Fraction of First Positive Year
Pay Back Period

50

1.00
4.00

Example:
Calculate the payback period for the following investment proposal

Initial
Investment
Alternative A
(120)

10

10

50

Annual Net Cash Flows


4
5
6
7

10

50

50

50

50

50

50

End of Year Cummulative Net Cash Flow


(120) (110) (100) (50)
0
50

100

150

200

250

300

Pay Back Period


Fraction of First Positive Year
Pay Back Period

50

1.00
4.00

Example:
Calculate the payback period for the following investment proposal

Initial
Investment
Alternative A
(120)

10

10

50

Annual Net Cash Flows


4
5
6
7

10

50

50

50

50

50

50

End of Year Cummulative Net Cash Flow


(120) (110) (100) (50)
0
50

100

150

200

250

300

Pay Back Period


Fraction of First Positive Year
Pay Back Period

50

1.00
4.00

Example:
Calculate the payback period for the following investment proposal

Initial
Investment
Alternative A
(250)

86

50

77

Annual Net Cash Flows


4
5
6
7

10

41

70

127

24

40

End of Year Cummulative Net Cash Flow


(250) (164) (115) (38) 14
55

124

252

276

282

322

Pay Back Period


Fraction of First Positive Year
Pay Back Period

52

0.73
3.73

Example:
Calculate the payback period for the following investment proposal

Initial
Investment
Alternative A
(250)

86

50

77

Annual Net Cash Flows


4
5
6
7

10

41

70

127

24

40

End of Year Cummulative Net Cash Flow


(250) (164) (115) (38) 14
55

124

252

276

282

322

Pay Back Period


Fraction of First Positive Year
Pay Back Period

52

0.73
3.73

Example:
Calculate the payback period for the following investment proposal

Initial
Investment

Alternative A
(250)

86

50

77

Annual Net Cash Flows


4
5
6
7

10

41

70

127

24

40

End of Year Cummulative Net Cash Flow


(250) (164) (115) (38) 14
55

124

252

276

282

322

Pay Back Period


Fraction of First Positive Year
Pay Back Period

52

0.73
3.73

Effect of Pre-production Period


When calculating the payback period for a new project we typically
have several years of negative cash flows (investment) prior to positive
cash flows.
Two Approaches: Total Payback and Payback After 1st Production

Effect of Pre-production Period


The total payback period is calculated from the start of the project and
represents the commitment of the investor throughout the pre-production
period, particularly the opportunity cost associated with the investment
during this period.
Disadvantages:
A)
B)

This criterion fails to consider cash flows after the payback period,
therefore, it cant be regarded as a suitable measure of profitability.
It doesnt consider the magnitude or timing of the of cash flows during the
payback interval.

Advantages
1.

Simple and easy to calculate, providing a simple number which can be used
as an index of proposal profitability.

2.

Prevents management from exposure to excessive risk


The shorter the payback the less risk associated with the investment

3. Measure of lost opportunity risk


Projects with short payback will minimize opportunity risk since early
cash flows will be returned to the firm within a short span of time. (Liquidity)
4.

Payback period represents a break even point.


Projects with life greater than the payback period will contribute profit to
the firm

Engineering Economics
EIT Review
IRR & Discount Rates

Investment Rate of Return


In project evaluation, any reference to rate of return normally refers to
the discounted cash flow return on investment (DCF-ROI) or the
discounted cash flow rate of return (DCF-ROR)
These terms are special versions of the more generic term, Internal
Rate of Return (IRR) or sometimes called marginal efficiency of capital
Besides NPV, is probably the most common evaluation technique used
in the minerals industry

Internal Rate of Return

Internal Rate of Return refers to the interest rate that the investor
will receive on the investment principal

IRR is defined as that interest rate (r) which equates the sum of
the present value of cash inflows with the sum of the present value
of cash outflows for a project. This is the same as defining the IRR
as that rate which satisfies each of the following expressions:
PV cash inflows - PV cash outflows = 0
NPV = 0 for r
PV cash inflows = PV cash outflows

In general, the calculation procedure involves a trial-and-error solution


unless the annual cash flows subsequent to the investment take the form of
an
annuity. The following examples illustrate the calculation procedures for determining
the internal rate of return.

Example
Given an investment project having the following annual cash flows; find the IRR.
Year
Cash Flow

0
(30.0)

1
(1.0)

2
5.0

3
5.5

4
4.0

17.0

20.0

20.0

(2.0)

10.0

Solution:
Step 1. Pick an interest rate and solve for the NPV. Try r =15%
NPV

= -30(1.0) -1(P/F,1,15%) + 5(P/F,2,15) + 5.5(P/F,3,15) + 4(P/F,4,15)


+ 17(P/F,5,15) + 20(P/F,6,15) + 20(P/F,7,15) - 2(P/F,8,15) + 10(P/F,9,15)
= + $5.62

Since the NPV>0, 15% is not the IRR. It now becomes necessary to select a
higher interest rate in order to reduce the NPV value.
Step 2. If r =20% is used, the NPV = - $ 1.66 and therefore this rate is too high.
Step 3. By interpolation the correct value for the IRR is determined to be r =18.7%

IRR using Excel


Using Excel you should insert the following function in the
targeted cell C6:

Analysis
The acceptance or rejection of a project based on the IRR
criterion is made by comparing the calculated rate with the required rate
of return, or cutoff rate established by the firm. If the IRR exceeds the
required rate the project should be accepted; if not, it should be rejected.
If the required rate of return is the return investors expect the
organization to earn on new projects, then accepting a project with an
IRR greater than the required rate should result in an increase of the
firms value.

Analysis
There are several reasons for the widespread popularity of the IRR
as an evaluation criterion:

Perhaps the primary advantage offered by the technique is


that it provides a single figure which can be used as a
measure of project value.

Furthermore, IRR is expressed as a percentage value.


Most managers and engineers prefer to think of economic
decisions in terms of percentages as compared with
absolute values provided by present, future, and annual
value calculations.

Analysis
Another advantage offered by the IRR method is related to the
calculation procedure itself:
As its name suggests, the IRR is determined internally for
each project and is a function of the
magnitude and timing of
the cash flows.
Some evaluators find this superior to selecting a
rate
prior to calculation of the criterion, such as in the profitability
index and the present, future, and
annual value
determinations. In other words, the
IRR eliminates the need to
have an external interest rate supplied for calculation purposes.

Multiple Roots Case


One of the disconcerting aspects associated with the internal rate of return is
that more than one interest rate may satisfy the calculation. The solution
procedure for IRR is essentially the solution for an nth degree polynomial of the
form:
NPV = 0 = A0 + A1X + A2X2 + A3X3 + .... + AnXn
where X = 1/(1 + r)

For a polynomial of this type there may be n different real roots, or values of
r, which satisfy the equation. Multiple positive rates of return may occur when
the annual cash flows have more than one change in sign.

Multiple Roots Case


The following example illustrates the possibility of multiple rates which satisfy the definition of IRR:

Suppose a mining operation has a remaining life of eight years, but an investment is considered to increase the production rate. This will result in depleting the
deposit in six years. Assuming the following cash flows, is the investment justified?

Because there are two sign reversals in the cash flows, Descartes Rule of Signs indicates there are a
maximum of two real roots to the IRR polynomial.
Solving for these roots by trial and error yields the following:

Multiple Roots Case


Graphically this appears as shown in the following figure:

The rates at which NPV = 0 are, by definition, the internal rates of return. By interpolation, the two solving rates of return for this example are approximately 4.5 and 12.3%

Multiple Roots Case


Should the firm invest in the project or not?
If both rates were above the firm's required rate of return there would be no
problem and the firm would accept the project.
However, what if the required rate of return is 10%? Which of the calculated
IRR values is correct? The answers to these questions are that they are both
mathematically correct, but they are meaningless from an economic standpoint.
Neither of these rates can be considered an adequate measure of the project's
rate of return because a project can not earn more than one rate of return over its
life. Therefore, the calculation of an IRR value(s) does not always enable the
decision-maker to make accept/reject decisions on investment proposals.

Multiple Roots Case


How often this problem of multiple rates actually occurs?
The possibility of multiple-rate occurrences is perhaps more prevalent in
the case of new mining ventures than in most other industries. The negative
cash flows are typically the result of anticipated periods of reduced market
prices, major capital expenditures for equipment replacement, expansion
programs, and/or major environmental expenditures, particularly at the end of
project life.
Because of the possibility of multiple rates and the reinvestment
assumption when using-the IRR to rank projects, the evaluator must carefully
consider the exclusive use of this technique for decision-making.

Selecting a Discount Rate


There is nothing so disastrous as a rational investment
policy in an irrational world John Maynard Keynes
We have discussed the time value of money and illustrated
several examples of its use. In all cases an interest rate or
discount rate is used to bring the future cash flows to the
present (NPV - Net Present Value)
The selection of the appropriate discount rate has been the
source of considerable debate and much disagreement. In
most companies, the selection of the discount rate is
determined by the accounting department or the board of
directors and the engineer just uses the number provided to
him, but short of just being provided with a rate, what is the
correct or appropriate rate to use?

Example
What is the impact of the discount rate on the investment?

Cash
Flow Yr 0

Cash
Flow Yr 1

Cash
Flow Yr 2

Cash
Flow Yr 3

Cash
Flow Yr 4

Cash
Flow Yr 5

-500

-500

+750

+600

+800

+1000

IRR

ROR

NPV

2%

1,941

6%

1,581

10%

1,283

15%

981

20%

739

47.82%

What is in the Discount Rate?


According to practice, the discount rate has to cover the following
items:
Opportunity Costs
Transaction Costs
Compensate for Risk
Cover anticipated Inflation
Some of these items can be accounted for in other financial analysis
methods and do not have to be address in the discount rate itself.

Financial Cost of Capital


The financial cost of capital is based on the assumption
that financing is unlimited and the company can always
pay off loans or buy stock back, so the financial cost of
capital rate of return is the average cost of debt after tax
(remember interest is tax deductible) and the cost of
equity (what the share holders desired return is using the
capital asset pricing model CAPM)

Marginal Weighted Average Cost of Capital


The cost of capital is the minimum rate of return that a
firm needs to earn on new investments to maintain the
existing value of its shares of common stock. To
determine the cost of capital a weighted average of all
sources of capital must be evaluated. The weighted
average should include a mix of debt and equity on an
after tax basis.

Hurdle Rate
The hurdle rate is a common term used by companies
as an expression of their rate of return used for financial
analysis.
This is generally a higher number than the FCC rate as
they add an imposed economic hurdle for the project to
overcome. This helps companies express that a project
that just achieves a FCC rate of return does not add real
value to the company.

Opportunity Cost of Capital


The opportunity cost of capital is the most
common method of establishing the
investors minimum rate of return.
This is based upon the expected returns that
the company will generate in the next 1 to
15 years. It is the average return that
investors expect to make over the next few
years expressed as a compound interest.