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.
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 Application of internal rate of return and incremental analysis to compare alternatives Project analysis, selection, monitoring and performance measurement using project management techniques Learning Objectives – Unit 1 Upon completion of this unit you should understand: Application of basic analytical methods to compare alternatives Application of internal rate of return and incremental Application of internal rate of return and incremental analysis to compare alternatives Project analysis, selection, monitoring and performance measurement using project management techniques Capital Allocation Allocation of capital one of the most important functions for managers Allocation of capital includes: Analysis – application of various techniques including 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 Investment Alternatives Characteristics: Life of alternatives may be equal, unequal or perpetual Mutually Exclusive – selection of one investment from a group of alternatives 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 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 Present Worth Method Steps: Use only alternatives with identical service lives Identify the required return on investment (ROI) Bring all costs and revenues to present worth using P/A, P/F or other time value of money method (e.g. gradients) Compare resulting present worth of the alternatives Select the best alternative: ¾ Highest present worth of positive (revenue) cash flow ¾ Lowest present worth of negative (cost) cash flow Future Worth Method Steps: Use only alternatives with identical service lives Identify the required return on investment (ROI) Determine the future worth of all costs and revenues using F/A, F/P or other time value of money method Compare resulting future worth of the alternatives Select the best alternative: ¾ Highest future worth of positive (revenue) cash flow ¾ Lowest future worth of negative (cost) cash flow Annual Amount Method Steps: Identify the required return on investment (ROI) 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 Compare resulting annual amounts of the alternatives Select the best alternative: ¾ Highest annual positive (revenue) cash flow ¾ Lowest annual negative (cost) cash flow ROI or IRR Method Internal Rate of Return is calculated by finding the interest rate at which revenues equal costs at the same point in time: 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 Pcosts=Prevenues –or – Fcosts=Frevenues –or – Acosts=Arevenues Rank alternatives from lowest to highest initial cost IRR interest rate is determined using Pinitial cost = Acost and solving for the interest rate (i) If IRR > desired ROI → select higher initial cost option 10 Example Problem 7.1 Example Problem 7.1 Solution 11 Unequal Service Lives When analyzing alternatives with unequal service lives, the following methods can be utilized: Annual Amount – as previously discussed, all costs and g y revenues annualized using time value of money 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. 12 Example Problem 7.2 Example Problem 7.2 Solution 13 Unknown Service Lives Analyzing alternatives with unknown service lives, a trial type of solution method using annual amounts (Atotal) can be utilized: Atotal calculated for each alternative at some life (n) Atotal value for each alternative compared: p If equal, the service life = n If not equal, the Atotal values 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 14 Example Problem 7.3 Example Problem 7.3 Solution 15 End Unit 1 Material Go to Unit 2 IRR and Incremental Analysis 16 Chapter 7 – Unit 2 IRR and Incremental Analysis IET 350 Engineering Economics Learning Objectives – Unit 2 Upon completion of this unit you should understand: Application of basic analytical methods to compare alternatives Application of internal rate of return and incremental Application of internal rate of return and incremental analysis to compare alternatives Project analysis, selection, monitoring and performance measurement using project management techniques 18 Rate of Return Analysis 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 19 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 the project is funded 21 Independent Projects 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 22 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 23 Mutually Exclusive Projects Incremental analysis for two mutually exclusive alternatives: Rank the projects from lowest to highest initial investment Calculate the IRR for each project Compare the IRR of each project to the target ROI Compare the IRR of each project to the target ROI If one alternative’s IRR