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Lecture 6 Application of Money Time Relation

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13 views9 pages

Lecture 6 Application of Money Time Relation

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nouman215988
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© © All Rights Reserved
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APPLICATION OF MONEY-TIME

RELATIONSHIP IN ENGINEERING
ECONOMY STUDIES

By
Engr. Hiba Arshad
METHODS FOR ECONOMIC
ANALYSIS
• All engineering economy studies of capital projects
should consider the return that a given
infrastructure or development project will or
should produce. A basic question will be addressed
in this chapter; whether a proposed capital
investment and its associated expenditures
can be recovered by revenue (or savings) over
time in addition to a return on the capital that
is sufficiently attractive in view of the risks involved
and the potential alternative uses.
• Because patterns of capital investment, revenue
(or savings) cash flows, and disbursement cash flows
can quite different in various projects, there is no
single method for performing engineering economics
analysis that is ideal for all cases. Consequently,
METHODS FOR ECONOMIC
ANALYSIS
1. Present Worth Method
2. Future Worth Method
3. Annual Worth Method
4. Internal Rate of Return
Method
5. External Rate of Return
Method
6. Payback Period Method
METHODS FOR ECONOMIC
ANALYSIS
•The first three methods convert cash flows
resulting from a proposed solution into their
equivalent worth at some point (or points) in time by
using an internal rate known as the Minimum
Attractive Rate of Return (MARR).
•The IRR and ERR methods produce annual rates
of profit, or returns, resulting from an investment,
and then compared against the MARR.
•A sixth method, the payback period is a
measure of the speed with which an investment
is recovered by the cash inflows it produces. This
measure, in its common form, ignores time value of
money principles. For this reason, the payback
method is often used to supplement information
MINIMUM ATTRACTIVE RATE OF RETURN

The Minimum Attractive Rate of Return (MARR) is


usually a policy issue resolved by the top management of
an organization in view of numerous considerations.
Among these considerations are the following:
1.The amount of money available for investment, and the
source and cost of these funds (i.e. equity funds or
borrowed funds).
2.The number of good projects available for investment
and their propose (i.e. whether they sustain present
operations and are essential, or expand on present
operations and are elective).
3.The amount of perceived risk associated with
investment opportunities available to the firm and the
estimated cost of administering project over shot planning
horizons versus long planning horizons.
4.The type of organization`n involved (i.e, government,
MINIMUM ATTRACTIVE RATE OF RETURN
In theory the MARR, which is sometimes called the
Hurdle Rate, should be chosen to maximize the
economic well-being of an organization, subject to
the types of consideration just listed.

One popular approach to establishing a MARR involves


the opportunity cost viewpoint, and it result from the
phenomenon of “. Capital Rationing exists when
management decides to limit the total amount of capital
invested. This situation may arise when the amount of
available capital is insufficient to sponsor all worthy
investment opportunities.
1. ANALYZING PROJECTS WITH PRESENT WORTH METHOD
(NET PRESENT WORTH, NPV)

The Present Worth (PW) method is based on the


concept of equivalent worth of all cash flows
relative to some base or beginning point in time called
the present. That is, all cash inflows and outflows are
discounted to the present point in time at an interest
rate that is generally the MARR. Net present value
(NPV) is a technique that is used to assess the viability
of projects based on the projected receipts and
disbursements over the projects' planning horizons. It
can, however, become difficult to arrive at credible
single point estimates for some of these cash flows.
Increases in project complexity, increases in planning
horizons, and the need to engage multiple
subcontractors are all factors that increase the risk in
developing an accurate NPV. One possible approach to
address this problem is to incorporate the risks
Example-1 [PW (NPV)
Method]
A piece of new equipment has been proposed by engineers to
increase the productivity of a certain manual welding operation.
The investment cost is $25,000, and equipment will be a market
value of $5,000 at the end of a study period of five years.
Increased productivity attributable to the equipment will amount
to $8,000 per year after extra operating costs have been
subtracted from the revenue generated by the additional
production. A cash flow diagram for this investment opportunity
is given below. If the firm’s MARR (before income taxes) is 20%
per year, is this proposal a sound one? Use the PW method.
Solution:
PW = PW of cash flow - PW of cash flow
or
PW(20%) = $8,000(P/A, 20%,5) + $5,000(P/F,20%,5) - $25,000
= $934.29
Because PW(20%) > 0, this equipment is economically justified.

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