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Lecture 1Lecture 1INTRODUCTION TO INTRODUCTION TO
MODULE 2MODULE 2
Module 2Module 2 Principles of evaluationPrinciples of evaluation DepreciationDepreciation Income taxIncome tax Breakeven analysisBreakeven analysis Choosing amongst alternative investmentsChoosing amongst alternative investments
Brief introduction to meBrief introduction to me Introduction to Lecture 1Introduction to Lecture 1
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INTRODUCTIONINTRODUCTION
Engineering ManagementEngineering Management Chartered EngineerChartered Engineer 18 years - Industrial Experience18 years - Industrial Experience
Systems Design, Programme and Technical ManagementSystems Design, Programme and Technical Management 13 years - Department of Electronics13 years - Department of Electronics
Deputy Head of DepartmentDeputy Head of Department Chair, Faculty Curriculum Development BoardChair, Faculty Curriculum Development Board Chair, Local Branch of Institution of Electrical Engineers Chair, Local Branch of Institution of Electrical Engineers
(IEE)(IEE) Vice President, European Association for Education in Vice President, European Association for Education in
Electrical and Information Engineering (EAEEIE)Electrical and Information Engineering (EAEEIE) Engineering Management Course DirectorEngineering Management Course Director
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LECTURE 1LECTURE 1
Principles of evaluation of alternativesPrinciples of evaluation of alternatives Basic concepts for comparing alternativesBasic concepts for comparing alternatives Introduction to methods for evaluating and comparingIntroduction to methods for evaluating and comparing Benefits - Cost ratio analysisBenefits - Cost ratio analysis
Rules:Rules: If you have a question - please ask - anytime!If you have a question - please ask - anytime! If you do not understand something - stop meIf you do not understand something - stop me When I ask for interaction please contributeWhen I ask for interaction please contribute If nobody speaks up I will pick on somebodyIf nobody speaks up I will pick on somebody
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BASIS FOR COMPARISONBASIS FOR COMPARISON
What does ‘the same’ mean?What does ‘the same’ mean?
Recall (Module 1) - ‘Equivalence’Recall (Module 1) - ‘Equivalence’
““A basis for comparison is an A basis for comparison is an indexindex containing particular containing particular information about a series of receipts and disbursements information about a series of receipts and disbursements representing an investment opportunity.”representing an investment opportunity.”
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COMPARISON IN REALITYCOMPARISON IN REALITY
Reduction to a single Reduction to a single ‘index’‘index’ or or ‘value’‘value’
120,000 m.u. > 115,000 m.u.120,000 m.u. > 115,000 m.u.
Time value of moneyTime value of money
120,000 m.u. now ? 125,000 m.u. in 1 years time120,000 m.u. now ? 125,000 m.u. in 1 years time
State and understand all assumptionsState and understand all assumptions
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BASES FOR COMPARISONBASES FOR COMPARISON
Present worthPresent worth
Annual equivalentAnnual equivalent
Future worthFuture worth
Internal rate of returnInternal rate of return
Payback periodPayback period
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PRESENT WORTHPRESENT WORTH
The The present worthpresent worth is the net equivalent amount at the is the net equivalent amount at the present that represents the difference between the present that represents the difference between the equivalent disbursements and the equivalent receipts of an equivalent disbursements and the equivalent receipts of an investment’s cash flow for a defined interest rate.investment’s cash flow for a defined interest rate.
Also called the Also called the Net Present Value’Net Present Value’ or NPV of a future net or NPV of a future net cash streamcash stream
The future net cash flows are discounted back to present The future net cash flows are discounted back to present worth, or preset value, using the discount factorworth, or preset value, using the discount factor
The present worth of all the future net cash flows are The present worth of all the future net cash flows are summed to give the net summed to give the net present worthpresent worth..
Interest Rate 12%Year 2000 2001 2002 2003 2004 2005Net Cash Flow -100,000 25,000 27,000 35,000 30,000 35,000Present Worth -100,000 22,321 21,524 24,912 19,066 19,860Net Present Worth7,683
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ANNUAL EQUIVALENTANNUAL EQUIVALENT
The annual equivalent amount is the amount of money that The annual equivalent amount is the amount of money that would be disbursed annually over the life of the project would be disbursed annually over the life of the project that is equivalent, in present worth terms, to the overall that is equivalent, in present worth terms, to the overall project cost.project cost.
Calculate the NPV as shown in the Calculate the NPV as shown in the present worthpresent worth method. method. Calculate the amount that, if paid each year over the life of Calculate the amount that, if paid each year over the life of
the project, results in the same present worth. This the project, results in the same present worth. This amount is the amount is the annual equivalentannual equivalent..
Interest Rate 12%Year 2000 2001 2002 2003 2004 2005Net Cash Flow -100,000 25,000 27,000 35,000 30,000 35,000Present Worth -100,000 22,321 21,524 24,912 19,066 19,860Net Present Worth7,683Annual Equivalent 2,131 2,131 2,131 2,131 2,131
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FUTURE WORTHFUTURE WORTH
Because we can move the value of money forwards or Because we can move the value of money forwards or backwards in time using the compound interest equation, backwards in time using the compound interest equation, we can, as we have seen, calculate the we can, as we have seen, calculate the present worth present worth of a of a future net cash flow.future net cash flow.
Equally we can project forwards the present worth of a Equally we can project forwards the present worth of a present net cash flow into the future. The result is the present net cash flow into the future. The result is the future worthfuture worth..
Interest Rate 12%Year 2000.06 28918.33 2000 2000 2000 2000Net Cash Flow 0 19,952 0 0 0 0Present Worth 0 13,560 0 0 0 0Net Present Worth13,560Future Worth 15,187 17,010 19,051 21,337 23,898
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INTERNAL RATE OF RETURNINTERNAL RATE OF RETURN
The The present worthpresent worth or or Net Present ValueNet Present Value of a future net of a future net cash stream is determined for a particular interest rate.cash stream is determined for a particular interest rate.
Generally the Generally the Present worthPresent worth decreases with increasing decreases with increasing interest rate.interest rate.
There exists, in There exists, in general, a value for general, a value for the interest rate at the interest rate at which the which the Present Present worthworth equals zero. equals zero.
This value of This value of interest rate is interest rate is called the called the Internal Internal rate of Returnrate of Return or or IRRIRR
IRR=15%
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PAYBACK PERIODPAYBACK PERIOD
The payback period without interest is commonly defined The payback period without interest is commonly defined as the length of time required to recover the first cost of as the length of time required to recover the first cost of an investment from the net cash flow produced by that an investment from the net cash flow produced by that investment.investment.Year 2000 2001 2002 2003 2004 2005
Net Cash Flow -100,000 25,000 27,000 35,000 30,000 35,000Cumulative NCF-100,000 -75,000 -48,000 -13,000 17,000 52,000
2003/4
• Interest Rate is ignored• Cumulative Net Cash Flow is zero between 2003 and 2004.
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CAPITALIZED EQUIVALENT CAPITALIZED EQUIVALENT AMOUNTAMOUNT
The Capitalized Equivalent Amount is the amount at The Capitalized Equivalent Amount is the amount at Present Worth which, at a given interest rate, is equivalent Present Worth which, at a given interest rate, is equivalent to an repetitive Net Cash Flow amount that continues in to an repetitive Net Cash Flow amount that continues in perpetuity. perpetuity.
Capitalized Equivalent 83,333Interest Rate 12%Year 0 1 2 3 4 5 …Annual Amount 10,000 10,000 10,000 10,000 10,000 10,000
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PRIVATE VERSUS PUBLICPRIVATE VERSUS PUBLIC
Private organisationsPrivate organisations ProfitProfit
Public organisations / activitiesPublic organisations / activities General welfareGeneral welfare Value to beneficiariesValue to beneficiaries Beneficiaries are unique individualsBeneficiaries are unique individuals
Value = Value = ff(personal values, beliefs, etc.)(personal values, beliefs, etc.)
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BENEFIT - COST ANALYSISBENEFIT - COST ANALYSIS
General rule:General rule: Maximise the value gained from the use of available resourcesMaximise the value gained from the use of available resources The benefits may accrue to anyoneThe benefits may accrue to anyone Those who pay may or may not be the beneficiaries (generally Those who pay may or may not be the beneficiaries (generally
not)not)
BenefitsBenefits Those things that provide a gain to the userThose things that provide a gain to the user
DisbenefitsDisbenefits Those things that provide unfavorable benefits to the userThose things that provide unfavorable benefits to the user
Net benefitsNet benefits Benefits - DisbenefitsBenefits - Disbenefits
Net “good” that will be engendered by the projectNet “good” that will be engendered by the project
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BENEFIT - COST ANALYSISBENEFIT - COST ANALYSIS
Costs:Costs: Project cost less any savings gained from its Project cost less any savings gained from its
implementationimplementation
All benefits and costs are expressed in All benefits and costs are expressed in Present Worth Present Worth termsterms
summed over the different benefitssummed over the different benefits
Project us deemed desirable if:Project us deemed desirable if: The benefits exceed the costsThe benefits exceed the costs
Benefits
Costs1
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TYPES OF BENEFITSTYPES OF BENEFITS
How far should one go to identify all the consequences of a How far should one go to identify all the consequences of a project?project? This question is importantThis question is important All considered consequences should be fully understood All considered consequences should be fully understood
and quantifiedand quantified Poor choice can have a substantial impact on the cost of Poor choice can have a substantial impact on the cost of
undertaking the Benefit - Cost analysisundertaking the Benefit - Cost analysis Too many consequences - too expensiveToo many consequences - too expensive Too few - loss of key component and possible Too few - loss of key component and possible
political impactpolitical impact
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CLASSIFYING BENEFITSCLASSIFYING BENEFITS
Primary benefitsPrimary benefits Primary benefits are those that represent the value of Primary benefits are those that represent the value of
the direct products or services realized from the project the direct products or services realized from the project activities.activities.
Example: A new irrigation system increases crop yieldExample: A new irrigation system increases crop yield
Secondary benefitsSecondary benefits Secondary benefits are those that represent the value Secondary benefits are those that represent the value
of additional products or services stimulated by the of additional products or services stimulated by the project activities. project activities.
Beneficial by products of the projectBeneficial by products of the project Example: The new irrigation system increases the Example: The new irrigation system increases the
economic strength of the farming community.economic strength of the farming community.
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VALUING BENEFITSVALUING BENEFITS
Not always an easy taskNot always an easy task Should be measured in terms meaningful to the stakeholdersShould be measured in terms meaningful to the stakeholders
A good Benefits - Cost analysis should not only compare the A good Benefits - Cost analysis should not only compare the quantifiable consequences of a project but should also describe quantifiable consequences of a project but should also describe the non-quantifiable characteristics in whatever terms are the non-quantifiable characteristics in whatever terms are feasible.feasible.
Consideration of taxes:Consideration of taxes: Economic gains or losses in respect of taxes should be taken Economic gains or losses in respect of taxes should be taken
into account in the analysisinto account in the analysis Example: loss of company tax where a project displaces Example: loss of company tax where a project displaces
businesses to a different geographic location.businesses to a different geographic location. Example: increase in sales tax where a project leads to more Example: increase in sales tax where a project leads to more
salessales
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IDENTIFYING BENEFITSIDENTIFYING BENEFITS
Benefits to PublicBenefits to Public Reduced vehicle operating Reduced vehicle operating
costs (excluding Fuel tax)costs (excluding Fuel tax) Reduced commercial and Reduced commercial and
noncommercial travel timenoncommercial travel time Increased safetyIncreased safety Increased accessibility Increased accessibility
between communitiesbetween communities Ease of drivingEase of driving Appreciation of land valuesAppreciation of land values
Savings to StateSavings to State Toll revenuesToll revenues Increased taxes due to Increased taxes due to
appreciated land and appreciated land and increased business activityincreased business activity
Disbenefits to the PublicDisbenefits to the Public Land removed from Land removed from
agricultural productionagricultural production Damages resulting from Damages resulting from
changes to water flowchanges to water flow Decreased movement of Decreased movement of
livestock across highwaylivestock across highway Increased air pollution and Increased air pollution and
litterlitter
Costs to StateCosts to State Construction costsConstruction costs Maintenance costsMaintenance costs Administrative costsAdministrative costs
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COSTSCOSTS
Total project cost = Total project cost = Capital (Investment cost) ‘I’Capital (Investment cost) ‘I’
+ Annual recurrent cost ‘C’+ Annual recurrent cost ‘C’
So:So:
Alternative expression: (Benefit - Annual cost) / InvestmentAlternative expression: (Benefit - Annual cost) / Investment
Cost I C
BC B
I C
BC B CI
Net gain to beneficiary Net gain to beneficiary per unit of invested per unit of invested capitalcapital
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THE SOMETOWN STONE THE SOMETOWN STONE COMPANYCOMPANY
A toll road has been opened between two cities. Your business is in one of these cities. You need to travel between the two cities regularly as you have a customer to whom you deliver goods has their factory in the other city. The distance between you and your customer is 102 miles via the shortest free road and 95 miles via the new toll road. Determine the economic advantage of using the toll road, if any, given the following conditions:
Toll cost 5.50 m.u. Driver cost 12.50 m.u./hour Average driving speed is 60 mph via the toll road and 50 mph via the
free road
The estimated average cost of operating the truck per mile is 0.18 m.u./mile via the toll road and 0.20 m.u./mile via the free road
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EVALUATING PUBLIC PROJECTSEVALUATING PUBLIC PROJECTS
Select the Select the proper point of viewproper point of view Sociological - classes of people, organisations, Sociological - classes of people, organisations,
demographicdemographic Environmental - geographic regionEnvironmental - geographic region
Who receives the benefits?Who receives the benefits? Who pays?Who pays?
Point of view Project
National National highway, Major water-resource project, Mass-transit system
Regional Regionally funded air-quality control project, Regional highway
City City park, Local community projects
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EVALUATING IN PRACTICEEVALUATING IN PRACTICE
Great care needs to be takenGreat care needs to be taken Some projects benefit some at the expense of othersSome projects benefit some at the expense of others Decisions are politicalDecisions are political The impact on the environment ?????The impact on the environment ?????
Private Sector Public Sector
Organizational viewpoint Variable viewpoint
Benefits = Profit, Growth, Shareholder wealth
Benefits are larger than local for local projects (visitors, people in transit, etc.)
Source of funds = Debt or Equity Government funds are ‘free’ to local community
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BENEFIT - COST ANALYSISBENEFIT - COST ANALYSIS
Project impactProject impact With the project outcomesWith the project outcomes Without the project outcomesWithout the project outcomes (Not the same as before and after the project!)(Not the same as before and after the project!)
General welfare benefitsGeneral welfare benefits Enhancement of personal economic situationEnhancement of personal economic situation Desire for clean airDesire for clean air Desire for clean waterDesire for clean water Pleasant surroundingsPleasant surroundings Personal securityPersonal security Improvement of quality of lifeImprovement of quality of life
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BENEFIT - COST ANALYSISBENEFIT - COST ANALYSIS
What interest rate should we choose?What interest rate should we choose? At least the government’s cost of borrowing moneyAt least the government’s cost of borrowing money ““To maintain public and private expenditures on a comparative basis, it
seems logical that the interest rate selected should represent the opportunity forgone when taxes are paid. That is, the interest rate should reflect the rate that should have been earned if the funds had not been removed from the private sector.”
Rate is a matter of judgment
10 20 30Interest Rate
Government costof borrowing
Individuals’ investment opportunity
Organization's return on investment
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CASE STUDY - 2
State Highways Dept