Stage 2: Basic Analysis Tools

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Evaluating Alternatives

o Formulating alternatives
 There are two types of alternatives
 Independent set
 Mutually exclusive set
 Mutually Exclusive set is where a candidate set of alternatives exist (more
than one)
 Objective: Pick one and only one from the set.
 Once selected, the remaining alternatives are excluded.

o Selection Criteria
 Payback period (Chapter 5)
 Conventional
 Discounted
 PW analysis (Chapter 5)
 Single project
 Project life (equal vs. different lives)
 Future value analysis
 Capitalized cost
 AW analysis (Chapter 6)
 Capital recovery
 Perpetual investment
 Rate of return analysis (Chapter 7-8)
 Single project
 Incremental ROR

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  Initial Project Screening Method - Payback Period

 Simple Payback Period

o Principle:
o How fast can I recover my initial investment?
o Method:
o Based on the cumulative cash flow (or accounting profit)
o Screening Guideline:
o If the payback period is less than or equal to some specified benchmark
period, the project would be considered for further analysis.
o Weakness:
o Does not consider the time value of money

N Cash Flow Cum. Flow

0 -$105,000+$20,000 -$85,000
1 $15,000 -$70,000
2 $25,000 -$45,000
3 $35,000 -$10,000
4 $45,000 $35,000
5 $45,000 $80,000
6 $35,000 $115,000

 Payback period should occurs somewhere between N = 3 and N = 4.

 Discounted Payback Period

o Principle:
o How fast can I recover my initial investment?
o Method:
o Based on the cumulative discounted cash flow
o Screening Guideline:

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 o If the discounted payback period (DPP) is less than or equal to
some specified benchmark period, the project could be
considered for further analysis.
Period Cash Flow Cost of Funds Ending Cash
(n) (An) (15%)* Balance
0 -$85,000 0 -$85,000

1 15,000 -$85,000(0.15) = -$12,750 -82,750

2 25,000 -$82,750(0.15) = -12,413 -70,163

3 35,000 -$70,163(0.15) = -10,524 -45,687

4 45,000 -$45,687(0.15) =-6,853 -7,540

5 45,000 -$7,540(0.15) = -1,131 36,329

6 35,000 $36,329(0.15) = 5,449 76,778

* Cost of funds = (Unrecovered beginning balance) X (interest rate)

 Equation to determine payback periods:

 Payback periods can be used as a screening tool for liquidity, but we

need a measure of investment worth for profitability
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 Net Present Worth Measure (PW Analysis)
o The future cost and revenue estimates are transformed into
equivalence dollars now at an interest rate usually equal to or greater
than the organization’s established MARR.
o The present worth is purely a function of the MARR (the discount rate
one uses).
o If one changes the discount rate, a different present worth will result.
o The cash flow may contain the mixture of positive (cash inflow) and
negative (cash outflow) cash flows. Sometime present worth is called
net present value (NPV).

 PW(i%) or NPV = PW + cash flows - PW- cash flows

o Decision rules
 Single alternative analysis:-

 If PW(MARR) >= 0, the requested MARR is met or

exceeded and the alternative is financially viable.

 Two or more alternatives analysis:-

 Revenue-based: Choose an alternative that gives the

largest PW(MARR)

 Cost-based: Choose an alternative that gives the

smallest PW(MARR)

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 Example: Determine NPV for MARR = 12%/year.

A B C
1 Period Cash Flow
2 0 ($76,000)
3 1 $35,560
4 2 $37,360
5 3 $31,850
6 4 $34,400
7 PW(12%) $30,065
=NPV(12%,B3:B6)+B2

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 Example: Two methods can be used for production expansion anchors.
Method A cost $80,000 initially and will have a $15,000 salvage value
after 3 years. The operation cost with this method will be $30,000 per
year. Method B will have a first cost of $120,000, an operating cost of
$8,000 per year, and a $40,000 salvage value after its 3-year life. At an
interest rate of 12% per year, which method should be used on the basis
of a present worth analysis?

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 PW Analysis of Different-life Alternatives
o The PW of the alternatives must be compared over the same number
of years.
o The equal-service requirement can be satisfied by either of two
approaches:
o Compare alternatives over a period of time equal to the least
common multiple (LCM) of their lives.
o Compare alternatives using a study period of length n years, which
does not necessarily take into consideration the useful lives of the
alternatives.
 Example:
Machine A Machine B
 First Cost $11,000 $18,000
 Annual Operating Cost 3,500 3,100
 Salvage Value 1,000 2,000
 Life 6 years 9 years
i = 12% per year

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 6 years 6 years 6 years

Cycle 1 for A Cycle 2 for A Cycle 3 for A

9 years 9 years
Cycle 1 for B Cycle 2 for B
18 years

Exercise: The estimates for each method are shown. Determine which has
the least cost on the basis of a present worth comparison at 10% per year for
the following scenarios:

(a) The estimates as shown

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(b) The contract award cost increases by 20% every 2-year renewal

 Conclusion:
o Present worth is an equivalence method of analysis in which a
project’s cash flows are discounted to a lump sum amount at
present time.
o The MARR or minimum attractive rate of return is the interest rate
at which a firm can always earn or borrow money.
o MARR is generally dictated by management and is the rate at which
NPV analysis should be conducted.

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 AW Analysis
o Principle: Measure an investment worth on annual basis
o Benefits: By knowing the annual equivalent worth, we can:
o Seek consistency of report format
o Determine the unit cost (or unit profit)
o Facilitate the unequal project life comparison

o The results are reported in $/time period

AW = PW(A/P,i%,n)

AW = FW(A/F,i%,n)

o AW analysis is commonly considered the more desirable because

o The AW value is easy to calculate.
o The measure of worth is understood by most individuals.
o The assumptions are essentially identical to those of the PW
method

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 Example: A chemical engineer is considering two styles of pipes for
moving distillate from a refinery to the tank farm. A small pipeline will
cost less to purchase (including values and other appurtenances) but will
have a high head loss and, therefore, a higher pumping cost. The small
pipeline will cost $1.7 million installed and will have an operating cost of
$12,000 per month. A larger-diameter pipeline will cost $2.1 million
installed, but its operating cost will be only $8,000 per month. Which
pipe size is more economical at an interest rate of 1% per month on the
basis of an annual worth analysis? Assume the salvage value is 10% of the
first cost for each pipeline as the end of the 10-year project period.

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 o Cost of Owning & Operating => Capital Recovery

o The management is concerned about the equivalent annual cost of

owing a productive asset.
o Capital Recovery (CR) is the annualized equivalent of capital cost
(the initial investment P0 and the future salvage value Fn or S)
o This cost is termed “Capital Recovery Cost” which is the ownership
cost.

𝐶𝑅 (𝑖%) = 𝑃(𝐴⁄𝑃 , 𝑖, 𝑛) − 𝑆(𝐴⁄𝐹 , 𝑖, 𝑛)

Example: Given P0 = $20,000, S = $4,000, N = 5 years, i = 10%

Find: See if annual revenue of $5,000 is large enough to cover both

the capital and operating costs.
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 o Referred to CHEng example, determine CR of the two pipeline
system.

 Capitalized Cost (CC) and Perpetual Investment (PI)

o CC- the present worth of a project that lasts forever.
o PI - the annual worth of a project that lasts forever or an investment
without a finite cycle
o If “P” is the present worth of the cost of that investment, then EAC is
P times i, the interest P would have earned each year.
o Infinite analysis period
o Government Projects e.g. roads, dams, bridges (projects that possess
perpetual life)

( ) ( )
𝑃=𝐴 ( )
=> 𝑃 = 𝐴

When 𝑛 → ∞
1
1−
(1 + 𝑖 )
lim 𝑃 = lim 𝐴
→ → 𝑖

𝑃= or 𝐴 = 𝑃𝑖

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 Example: For the cash flows shown, use an annual worth comparison
and an interest rate of 10% per year. Determine the alternative that is
economically best.
X Y Z
First cost, $ 90,000 400,000 650,000
Annual cost, $ 40,000 20,000 13,000
per year
Overhaul every - - 80,000
10 years, $
Salvage value, $ 7,000 25,000 -
Life, years 3 10 ∞

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