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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 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
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?
Annual Receipts
$ 226,000
Salvage Value
6,440
Annual Disbursements
-$124,000
$ 8,140
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
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?
Annual Receipts
$ 20,000
-$ 386,078
Initial Investment
$20,000(year 10)
Annual Disbursements
$ 701,960
Salvage Value
-$ 310,600
$ 25,280
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
T=0
Annual Value
Benefits:
125
-$ 5,000
Investment:
Costs:
$10,000
Salvage
-$ 6,508
-$1,383
Benefit/Cost Ratio
Project B
$100,000
$ 50,000
$ 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
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
10
50
50
50
50
50
50
100
150
200
250
300
50
1.00
4.00
Example:
Calculate the payback period for the following investment proposal
Initial
Investment
Alternative A
(120)
10
10
50
10
50
50
50
50
50
50
100
150
200
250
300
50
1.00
4.00
Example:
Calculate the payback period for the following investment proposal
Initial
Investment
Alternative A
(120)
10
10
50
10
50
50
50
50
50
50
100
150
200
250
300
50
1.00
4.00
Example:
Calculate the payback period for the following investment proposal
Initial
Investment
Alternative A
(250)
86
50
77
10
41
70
127
24
40
124
252
276
282
322
52
0.73
3.73
Example:
Calculate the payback period for the following investment proposal
Initial
Investment
Alternative A
(250)
86
50
77
10
41
70
127
24
40
124
252
276
282
322
52
0.73
3.73
Example:
Calculate the payback period for the following investment proposal
Initial
Investment
Alternative A
(250)
86
50
77
10
41
70
127
24
40
124
252
276
282
322
52
0.73
3.73
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.
Engineering Economics
EIT Review
IRR & Discount Rates
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
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
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%
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:
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.
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.
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:
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%
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%
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.