Cost Analysis and Estimating for Engineering and Management Chapter 10 Engineering Economy © 2004 Pearson Education, Inc Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ 07458 Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Ch 10-1 Overview Methods to Determine Project Returns ● Impact of Time Value of Money (Interest) −Simple and Compound Interest Calculations −Methods to Evaluate Projects ● Various Rates of Return ● Evaluation of Replacement Alternatives ● Tax Effects on Decisions ● © 2004 Pearson Education, Inc Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ 07458 Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Ch 10-2 Money All Projects Require Money ● All Should Return Money (Payback) ● When Large Sums of Money or Longer Times Are Involved – Interest Becomes Important ● Decisions Are Based on Money ● © 2004 Pearson Education, Inc Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ 07458 Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Ch 10-3 Capital Monetary Assets ● Should Be Employed to Earn a Return ● Invested −In Ordinary Financial Transactions −In Some Endeavor (Production/Service) ● Need to Evaluate Investments ● © 2004 Pearson Education, Inc Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ 07458 Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Ch 10-4 Monitoring Return Ways to Express Return −Total Dollars −Ratio with Sales −Return on Investment ● Calculation of Return −Average Annual Rate of Return −Payback Period −Engineering-Economy Rate of Return ● © 2004 Pearson Education, Inc Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ 07458 Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Ch 10-5 Average Annual Rate of Return Yearly After Tax Profit from Activity ● Total Investment in the Activity ● earnings per year return = × 100, % investment value ● Alternately Eq 10.1 Eq 10.2 average earnings - ( total investment ÷ economic life ) return = ì 100, % average investment â 2004 Pearson Education, Inc Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ 07458 Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Ch 10-6 Payback Period ● How Many Years to Earn Back the Investment net investment payback = , years annual after tax earnings ● Eq 10.3 Capital Liquidity Importance © 2004 Pearson Education, Inc Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ 07458 Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Ch 10-7 Payback Caveats Assumes Equal Annual Earnings ● Does Not Account for −Interest −Depreciation / Obsolescence −Earnings After Payback ● © 2004 Pearson Education, Inc Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ 07458 Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Ch 10-8 Interest Choice of Investments −Traditional (Bank, Stock Market, etc.) −Capital into Endeavor (Equipment, etc.) ● Time Value of Money ● Interest Calculations −Simple −Compound ● © 2004 Pearson Education, Inc Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ 07458 Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Ch 10-9 Simple Interest ● Interest I = Pni ● Total Including Principal F = P + I = P(1+ni) ● Payments Are at the End of the Periods © 2004 Pearson Education, Inc Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ 07458 Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Ch 10-10 Comparison for Example Automatic Semiautomatic Annual capital recovery cost, P(A/P, 10%,5) $329,750 $211,040 Annual cost 1,002,500 1,478,000 $1,332,250 $1,689,040 Comparative annual cost © 2004 Pearson Education, Inc Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ 07458 Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Ch 10-36 Unequal Life Comparison Must Be for Equal Output −Extra Cost Involved with Extra Output ● Different Useful Lives for Alternatives −Analysis Period Common Multiple of Useful Lives ● Example I1 – Years, I2 – Years −Common Multiple = 12 Years ● © 2004 Pearson Education, Inc Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ 07458 Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Ch 10-37 Unequal Life Example I1 Investments Initial cost I2 $230,000 $320,000 25,000 Salvage value 40,000 Economic life, year 12 12 10% 10% Annual operating cost Multiple of lives Repeated investments MARR before taxes © 2004 Pearson Education, Inc Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ 07458 Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Ch 10-38 12 Year Cash Flow © 2004 Pearson Education, Inc Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ 07458 Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Ch 10-39 Comparison Present Worth for 12 Years PW (I1) = – $800,520 PW (I2) = – $629,116 ● Select Investment 2, Lower Cost ● −Assuming Revenues Are Equal Study Period May Be Excessive ● Situation May Vary from Assumptions ● © 2004 Pearson Education, Inc Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ 07458 Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Ch 10-40 Restricted Life Project Limited to Years ● Assume Salvage Value = $0 PW(I1) = – $273,388 PW(I2) = – $320,000 ● Compare to Include Salvage Value (320,000-273,338)/(P/F,10%,2)=$56,400 ● Decision Depends on Salvage Cost of I2 ● © 2004 Pearson Education, Inc Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ 07458 Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Ch 10-41 Replacement Existing Alternative In Operation ● Economic Facts Are Different for Challenger ● Equipment Life – Period of Lower Cost ● Need Value for Existing Equipment −Don’t Use Book or Trade In Value −Need the Market Value ● © 2004 Pearson Education, Inc Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ 07458 Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Ch 10-42 Equivalent Annual Cost for Replacement ● Includes Resale Value (Fs) EAC = ( P − Fs )( A / P, i %, n) + Fs i Eq 10.13 Or EAC = P ( A / P, i %, n) − Fs ( A / Fs i %, n) © 2004 Pearson Education, Inc Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ 07458 Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Ch 10-43 Example ● i = 20%, Life = Years Year Defender (D) Operating cost Challenger (C) Salvage value $120,000 Operating cost Salvage value $350,000 $34,000 70,000 $3000 310,000 39,000 40,000 10,000 270,000 46,000 25,000 12,000 240,000 56,000 10,000 15,000 210,000 20,000 170,000 31,000 120,000 © 2004 Pearson Education, Inc Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ 07458 Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Ch 10-44 Results Existing (Defender) EAC(D) = – $86,618 ● Challenger EAC(C) = – $105,208 ● Challenger Has Higher Cost Don’t Replace ● © 2004 Pearson Education, Inc Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ 07458 Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Ch 10-45 Effects of Taxes ● Taxable Income −Before Tax Cash Flow Less Depreciation and Other Charges ● Rate of Return After Tax MARR ≅ (Before Tax MARR)(1-t) Before Tax MARR = 20%, t = 38% After Tax MARR = About 12.4% ● Timing of Cash Flow Has Impacts © 2004 Pearson Education, Inc Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ 07458 Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Ch 10-46 Considerations for After Tax Analysis Costs, Savings, Revenues ● Depreciation ● Taxable Income ● Cash Flow Effects ● Engineering Economy Analysis ● Decision Process ● −Consider Non-Economic Factors © 2004 Pearson Education, Inc Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ 07458 Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Ch 10-47 After Tax Example Yr End Before Tax Defender Dep Deductible Charges 35% Tax Savings After Tax Cash Flow -$3 -$3 -25 $3.3 -$28.3 -$9.9 -15.1 -14 3.3 -17.3 -6.1 -7.9 -14 3.4 -17.4 -6.1 -7.9 Challenger -$28 -$28 -7 9.2 -$16.2 -$5.7 -1.3 -7 12.6 -19.6 -6.9 -0.1 -7 6.2 -13.2 -4.6 -2.4 © 2004 Pearson Education, Inc Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ 07458 Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Ch 10-48 Outcome EAC(D) = – $11.1 Million EAC(C) = – $12.5 Million ● Different Depreciation Methods Used −Favor Challenger ● Costs Represent Disbursements −Thus Positive Costs ● Select Challenger © 2004 Pearson Education, Inc Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ 07458 Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Ch 10-49 Summary Methods of Project Alternative Evaluation ● How to Use and Apply Interest Calculations ● How to Evaluate Replacements ● What Is the Impact of Taxes for Economic Decisions ● © 2004 Pearson Education, Inc Pearson Prentice Hall, Pearson Education, Upper Saddle River, NJ 07458 Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Ch 10-50 ... 07458 Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Ch 10-12 Set Up for Discussions ● Example Situation −Investment $1025, for Years Year ● Cost $1025 0 Revenue... Education, Upper Saddle River, NJ 07458 Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Ch 10-22 Engineering Economy P, F, A, i, and n ● Functional Notation F=P(P/F, i%,... River, NJ 07458 Ostwald and McLaren / Cost Analysis and Estimating for Engineering and Management Ch 10-30 IRR Based Solely on Project’s Cash Flow −Before Taxes ● Find IRR for Present Worth of $0