Chapter 3

ECONOMIC ANALYSIS
Time Value of Money
Interest Rates
Equivalent Worth Methods
Analysis of Alternatives
Benefit Cost Analysis

ECONOMIC ANALYSIS
Analysis of a projects economics,
considering its feasibility and
potential for success.
Why?
To justify the need for the project
Project evaluation: Feasible and Financially
sustainable
Evaluation of alternatives: Different
methods/projects to satisfy the need
Planning future
developments/improvements/ expansion

TIME VALUE OF MONEY

Change in the value of money over time:
Increase in cost of items [Inflation]
Interest on borrowed money

Cash Flow
Input & output (revenue & expense) of cash over time
Regular input/output at fix intervals becomes a series
Uniform series is for equal amount of input/output at
the same frequency (e.g. monthly, yearly)
Gradient Series is for constant increase or decrease of
input/output at a specific rate and at the same
frequency over time.

INTEREST RATES
The rate at which the value increases over
time.
Types:
(1) Discounted Rate (Federal rate of loaning money to
financial institutions)
(2) Minimum Acceptable Rate of Return (MARR) (Rate at
which the project or system need to derive to be
worthwhile)
(3) Nominal Interest Rate (r) (quoted interest rate
without compounding)
(4) Effective Interest Rate (ieff) (compounded over more
that one period, p) (ieff=(1+r/p)p-1)

COMPOUND INTEREST SERIES

i = Interest Rate
n = Number of periods (e.g., years)
P = Present Sum
F = Future Sum
A = Annuity; Equivalent Uniform Annual
Cost
G = Gradient Amount increase
arithmetically
g = Gradient Amount increase geometrically

COMPOUND INTEREST SERIES

Single payment compound amount
factor
(F/P,i,n) = (1+i)n

Single payment present worth factor

(P/F,i,n) = 1/(1+i)n

Uniform series compound amount factor

(F/A,i,n) = [(1+i)n-1]/i

Uniform series sinking fund factor

(A/F,i,n) = i/[(1+i)n-1]

COMPOUND INTEREST SERIES

Uniform series present worth factor
(P/A,i,n) = [(1+i)n-1]/i(1+i)n

Uniform series capital recovery factor

(A/P,i,n) = i(1+i)n/[(1+i)n-1]

Arithmetic gradient present worth factor

(P/G,i,n) = [(1+i)n-in-1]/i2(1+i)n

Arithmetic gradient uniform series factor

(A/G,i,n) = [(1+i)n-in-1]/i(1+i)n-i

COMPARISON OF ALTERNATIVES
Steps:
(1)Define alternatives
(2)Determine study period (common time frame)
(3)Estimate cash flow for each alternative
(4)Specify interest rate (MARR)
(5)Criteria for effectiveness
(6)Compare the alternatives
(7)Perform sensitivity analysis
(8)Select the preferred alternative

COMPARISON OF ALTERNATIVES
If alternatives have different lives,
study period is one of the following:
(1)Organizations traditional planning
period
(2)Life of the shortest-lived alternative
(3)Life of the longest-lived alternative
(4)Lowest common multiple of the
lives of all alternatives

EQUIVALENT WORTH METHODS

(1)Present Worth Method

(P/F,i,n) = 1/(1+i)n
(P/A,i,n) = [(1+i)n-1]/i(1+i)n
(P/G,i,n) = [(1+i)n-in-1]/i2(1+i)n

(2) Annual Worth Method

(P/A,i,n) = [(1+i)n-1]/i(1+i)n
(A/F,i,n) = i/[(1+i)n-1]
(A/G,i,n) = [(1+i)n-in-1]/i(1+i)n-I

(3) Future Worth Method

(F/P,i,n) = (1+i)n
(F/A,i,n) = [(1+i)n-1]/i

PAYBACK PERIOD
Number of periods it takes for the net
benefits to equal the cost of the
investment
Payback Period = Initial Investment
Net undiscounted
benefits

RATE OF RETURN ANALYSIS

Marginally Attractive Rate of Return
(MARR)
Knowing investment amount and
either annual amount or desired
future sum, then determine the rate
of interest to match.

SENSITIVITY & BREAKEVEN

ANALYSIS
Sensitivity Analysis
Impact of small changes in any parameter on
the outcome of the alternative

Breakeven Analysis

Conditions under which two alternatives are

equivalent
Considering the variation in one or more
parameters

DECISION ANALYSIS
(1)Capital Expansion
(2) Replacement Decision
(3) Make-or-Buy Decision
(4) Lease-or-Buy Decision

QUESTIONS
Time Value of Money
Interest Rates
Equivalent Worth Methods
Analysis of Alternatives
Benefit Cost Analysis