Lecture Engineering economics - Chapter 7: Analyzing, selecting, monitoring, and evaluating projects and investments

After completing this chapter, students will be able to: Application of basic analytical methods to compare alternatives; application of internal rate of return and incremental analysis to compare alternative; project analysis, selection, monitoring and performance measurement using project management techniques.

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Chapter 7 – Unit 1

Analyzing, Selecting, Monitoring, and

Evaluating Projects and Investments

IET 350 Engineering Economics

Learning Objectives – Chapter 7

Upon completion of this chapter you should understand:

Application of basic analytical methods to compare

alternatives

Application of internal rate of return and incremental

analysis to compare alternatives

Project analysis, selection, monitoring and performance

measurement using project management techniques

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Learning Objectives – Unit 1

Upon completion of this unit you should understand:

alternatives

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Allocation of capital one of the most important functions for

managers

Allocation of capital includes:

Analysis application of various techniques including

Analysis – application of various techniques including

time value of money

Selection – using the analysis to chose or not chose

among funding requests

Monitoring – periodic re‐analysis over life of investment.

Evaluating – identification of successes, failures or errors

in the original analysis to improve future analysis

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Investment Alternatives

Characteristics:

Life of alternatives may be equal, unequal or perpetual.

Mutually Exclusive – selection of one investment from a

group of alternatives

Independent – decision whether to invest or not invest in

alternatives. Possible decisions → all, some, one or none

Repetition – one‐time events or periodic (ongoing).

Necessity – investments may be optional or required.

Required investments must be made even though they

don’t meet target ROI

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General Techniques

Basic analytical techniques for alternatives comparison include :

Annual Amount –costs and revenues annualized using time

value of money. Typically the preferred method since

alternative’s lives do not need to be equal

Present Worth (Discounted Cash Flow) – costs and revenues

brought to present values using time value of money. Can be

used only when lives of alternatives are equal.

Future Worth –costs and revenues adjusted to future values

using time value of money. Alternatives must have equal lives.

ROI or IRR (Internal Rate of Return) –costs and revenues used

to determine the unknown return interest rate

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Steps:

1 Use only alternatives with identical service lives

2 Identify the required return on investment (ROI)

3 Bring all costs and revenues to present worth using P/A, P/F

or other time value of money method (e.g. gradients)

4 Compare resulting present worth of the alternatives

5 Select the best alternative:

¾Highest present worth of positive (revenue) cash flow

¾Lowest present worth of negative (cost) cash flow

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Future Worth Method

Steps:

1 Use only alternatives with identical service lives

3 Determine the future worth of all costs and revenues using

F/A, F/P or other time value of money method

4 Compare resulting future worth of the alternatives

¾Highest future worth of positive (revenue) cash flow

¾Lowest future worth of negative (cost) cash flow

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Annual Amount Method

Steps:

2 Determine the annual amount of all costs and revenues

using A/F A/P or other time value of money method

using A/F, A/P or other time value of money method

3 Compare resulting annual amounts of the alternatives

¾Highest annual positive (revenue) cash flow

¾Lowest annual negative (cost) cash flow

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Internal Rate of Return is calculated by finding the interest

rate at which revenues equal costs at the same point in time:

Pcosts=Prevenues–or – Fcosts=Frevenues–or – Acosts=Arevenues

When only costs are involved (e g buy or lease alternatives)

When only costs are involved (e.g. buy or lease alternatives)

IRR can be determined by equating initial cost with annual

costs for projects with equal lives

Rank alternatives from lowest to highest initial cost

IRR interest rate is determined using Pinitial cost = Acostand

solving for the interest rate (i)

If IRR > desired ROI → select higher initial cost option

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Example Problem 7.1

11 Example Problem 7.1 Solution

Unequal Service Lives

When analyzing alternatives with unequal service lives, the

following methods can be utilized:

Annual Amount – as previously discussed, all costs and

revenues annualized using time value of money.g y

Common Denominator Method – each alternative is

repeated the requisite number of times until the lives of

the alternatives are equal (common denominator)

Life Reduction – alternative with the longer‐life is reduced

to equal the life of the shorter‐life alternative. Assumption

that the longer‐life project will be ‘retired’ early.

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Unknown Service Lives

Analyzing alternatives with unknown service lives, a trial type of

solution method using annual amounts (Atotal) can be utilized:

Atotalcalculated for each alternative at some life (n)

Atotal totalvalue for each alternative compared:p

If equal, the service life = n

If not equal, the Atotalvalues for each alternative re‐

calculated using a different life (n)

Process repeated until life determined or can be estimated

as falling between two life (n) values.

Alternative selected based on lower annual costs for

estimated life of the project

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Go to Unit 2 IRR and Incremental Analysis

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IRR and Incremental Analysis

alternatives

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Using Internal Rate of Return (IRR) or Rate of Return (ROR)

analysis methods have the advantage of reducing all

revenues and costs into a single interest percentage

The single IRR or ROR percentage can then be compared to:g p g p

the firm’s required ROI to determine whether the

investment should be made

IRR or ROR rates from alternative investments to select

the best alternative for investment

interest rates outside the organization to determine

where to invest available capital

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Rate of Return Analysis

Special situations and limitations include:

Stand‐alone projects – project IRR compared to target or

desired ROI. If IRR > ROI the project is selected

Independent projects can be ranked by IRR Projects are

Independent projects can be ranked by IRR. Projects are

funded in order within the limits of the available capital

Mutually exclusive projects require the use of the

incremental analysis technique.

When a proposed project’s alternatives have IRR < ROI,

typically the project would not be funded (do nothing)

Exception – required investments for mandatory

projects such as safety or environmental. 20

Individual Projects

Stand‐alone or individual projects don’t have alternative. The

decision to be made is whether or not the fund the project

All costs, revenues, savings and profits are adjusted to the

same point in time using time value of money techniques.p g y q

An interest rate (IRR) is determined by setting the costs equal

to the revenues:

Pcosts=Prevenues–or – Fcosts=Frevenues–or – Acosts=Arevenues

Project’s IRR compared to target or desired ROI of the

organization. If IRR > ROI the project is funded

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Multiple projects which are independent require a decision

whether to invest or not invest in each alternative

independently. Possible decisions for independent projects

are to fund all, some, one or none

Each alternative’s IRR is determined by setting the costs equal

to the revenues on the same time basis

The Independent projects can be ranked by the calculated

IRR. Projects are funded in order from highest to lowest IRR:

if the IRR exceeds the firm’s ROI target and

within the limits of the available capital

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Incremental Analysis

Mutually exclusive situations require the selection of one

investment from a group of alternatives and require the use

of the incremental analysis technique.

Incremental analysis method includes:y

Determining the IRR for each alternative

Determining the IRR of the incremental difference

between the alternatives

Incremental difference IRR indicates if the additional

investment in the higher initial cost alternative is best given

the revenue or savings generated

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Mutually Exclusive Projects

Incremental analysis for two mutually exclusive alternatives:

1 Rank the projects from lowest to highest initial investment

2 Calculate the IRR for each project

3 Compare the IRR of each project to the target ROI

4 If one alternative’s IRR < ROI, eliminate and select the other

alternative. If both alternative’s IRR < ROI, no nothing

5 If both alternative’s IRR ≥ target ROI, determine the incremental

return on the difference in initial investment and the benefits of

increased revenue or savings

6 If the incremental IRR < target, select the lower initial‐cost

project. If the incremental IRR ≥ target ROI, select the higher‐

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Mutually Exclusive Projects

Incremental analysis for > two mutually exclusive alternatives:

1 Rank the projects from lowest to highest initial investment

2 Calculate the IRR for each project

3 Compare the IRR of each project to the ROItarget

4 Eliminate any alternative where the IRR < ROItarget. If all

alternative’s IRR < ROItarget, no nothing

5 Calculate the incremental return on the difference in initial

investment and the benefits of increased revenue or savings

between each alternative

6 Eliminate any incremental alternative where IRRincremental<ROItarget

7 Select the alternative with the highest initial investment 26

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Benefit/Cost Analysis – sum of the present worth of benefits

such as revenues, profits or savings are divided by the sum of

the present worth of cost and expenses. Benefit/cost ratio ≥

1.0 indicates benefits exceed costs

Payback – number of years required to payback the initial

cost of the investment. Sometimes used to rank projects

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∑

=

Costs

of Worth Present

Benefits

of Worth Present Costs

Benefits

years Savings Annual Investment

Other Analysis Methods

Discounted Cash Flow – present worth of the costs are

subtracted from the present worth of the revenues. The

greater the difference, the better the investment:

Pdifference difference= Prevenues revenues– Pcosts costs

Life Cycle Cost Analysis – includes the initial costs, operating

costs, residual value, revenues and profits. In other words all

revenues and costs over the life of the project.

May or may not use time value of money techniques

Life cycle costs is the term used by the government.

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Other Analysis Methods

MAPI – popular method at one time which used a handbook

with forms, tables and graphs for analyzing equipment

purchase or replacement. The handbook was published by

the Machinery and Allied Products Institute

Proprietary Techniques – many organizations have developed

analysis techniques. Most of these techniques are

adaptations of the four basic analysis techniques with

organization specific language

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Go to Unit 3 Project Management

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Project Management

alternatives

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Good project management is important for the success of the

organization. Project management key for:

New product development

Process improvements

Advertising and promotion activities

Construction and rehabilitation of facilities

Creation of software

Custom‐designed and built systems

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Project Management

Time value of money techniques are vital to project analysis,

selection, monitoring and measurement

Time value of money techniques can be integrated with

management of a project’s quality, schedule and costs.g p j q y,

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Project Management

Financial planning and budgeting for ongoing activities is

different from analysis, selection and planning for one‐time

investments

Operating Budget – estimate of the next period’s income p g g p

and costs. Costs are typically divided into material, labor

and overhead

Capital Budget – decision to fund projects, equipment

and investments or expand firm’s fixed asset base.

Includes investment in development, new products,

research and related projects.

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Project Analysis is primarily based on the four methods

previously discussed → present worth, future worth, annual

amount and internal rate of return

Project Selection can involve ranking projects by the results of j g p j y

the analysis. Example:

Highest net present worth

Lowest annual costs

Highest internal rate of return

Cautions regarding project analysis and selection:

Estimates of cost and revenues can be overly optimistic

Equipment lives may be overestimated 37

Project Analysis and Selection

Project Selection methods include:

Internal rate of return/incremental analysis

Initial cost of the project

Risk of the project

Present worth (assuming equal lives)

Non‐financial factors

Combination of above

W. Edward Deming (quality expert and management

consultant) strongly recommends using facts (data) whenever

available rather than intuition or ‘gut feelings’.

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Project Analysis and Selection

Examples of ranking and risk vs. reward graphs from the text.

Note that return is not consistent with risk:

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Most organizations have more projects that available funds

Project selection includes allocating and rationing available

funds among possible projects

Allocation of funds includes not only the quantitative

analysis, but also includes non‐financial factors such as:

Customer needs

Quality of products and/or services

Safety, morale and/or training of employees

Environmental requirements

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Sources of Funds

Sources of funds are not constant over time. During some

time periods:

Profits are high and available for

reinvestment

Interest rates are low and

borrowed funds are available

Securities market good for sale

of stocks and bonds

Project selection also involves

matching projects to funding sources.

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Optimizing Project Selection

It is important not to optimize one project at the expense of

the total organization → suboptimization

Mix of projects, risks and estimates of how they will interact

with existing systems must be taken into consideration when g y

selecting projects

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Suboptimization occurs when you optimize the performance of a department

or area which adversely affects other areas and results in a cost to the total

organization. The optimization of a single metric in every department or area

will result in a suboptimal organization. An optimized organization will have

some areas that operate less than optimally in certain measures.

http://www.roi‐ally.com/definitions.htm#suboptimization

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