Podcast
Questions and Answers
What type of projects can only be selected one at a time?
What type of projects can only be selected one at a time?
The payback period method considers the time value of money.
The payback period method considers the time value of money.
False
What is the primary advantage of the discounted payback period (DPBP) method?
What is the primary advantage of the discounted payback period (DPBP) method?
It considers the time value of money.
The formula for calculating the present sum needed to provide service indefinitely is P = A/___, where A is the annual payment.
The formula for calculating the present sum needed to provide service indefinitely is P = A/___, where A is the annual payment.
Signup and view all the answers
Which project evaluation method focuses on cash flows occurring at period ends?
Which project evaluation method focuses on cash flows occurring at period ends?
Signup and view all the answers
Match the project evaluation methods with their key characteristics:
Match the project evaluation methods with their key characteristics:
Signup and view all the answers
Sunk costs are included in engineering economics project evaluations.
Sunk costs are included in engineering economics project evaluations.
Signup and view all the answers
What is the preferred condition for NPV when evaluating a project?
What is the preferred condition for NPV when evaluating a project?
Signup and view all the answers
What is a primary criterion for selecting a project using Net Present Value (NPV)?
What is a primary criterion for selecting a project using Net Present Value (NPV)?
Signup and view all the answers
A negative NPV indicates that a project will provide a return on investment without any cost to the investor.
A negative NPV indicates that a project will provide a return on investment without any cost to the investor.
Signup and view all the answers
What does MARR stand for in project evaluation?
What does MARR stand for in project evaluation?
Signup and view all the answers
The formula for calculating Net Present Value is NPV = Present Value (Benefits) - Present Value (________).
The formula for calculating Net Present Value is NPV = Present Value (Benefits) - Present Value (________).
Signup and view all the answers
Which of the following could be a reason for a firm to choose a project with a lower dollar value?
Which of the following could be a reason for a firm to choose a project with a lower dollar value?
Signup and view all the answers
Match the following terms with their descriptions:
Match the following terms with their descriptions:
Signup and view all the answers
In an NPV analysis, under what conditions should the cash flows be considered?
In an NPV analysis, under what conditions should the cash flows be considered?
Signup and view all the answers
MARR must always be lower than WACC to favor more investment options.
MARR must always be lower than WACC to favor more investment options.
Signup and view all the answers
What is the future cost of constructing a new plant, according to the calculations provided?
What is the future cost of constructing a new plant, according to the calculations provided?
Signup and view all the answers
The remodel option has a smaller future cost than the new plant option.
The remodel option has a smaller future cost than the new plant option.
Signup and view all the answers
What is the primary reason for selecting the new plant over remodel in future value analysis?
What is the primary reason for selecting the new plant over remodel in future value analysis?
Signup and view all the answers
The formula for calculating the net present cost (NPC) for the new plant involves the use of ______.
The formula for calculating the net present cost (NPC) for the new plant involves the use of ______.
Signup and view all the answers
Match the project options with their net present cost (NPC):
Match the project options with their net present cost (NPC):
Signup and view all the answers
If interest rates rise, what impact does that have on the net present value (NPV) of future cash flows?
If interest rates rise, what impact does that have on the net present value (NPV) of future cash flows?
Signup and view all the answers
Net future value (NFV) and net present value (NPV) can be used to evaluate mutually exclusive projects.
Net future value (NFV) and net present value (NPV) can be used to evaluate mutually exclusive projects.
Signup and view all the answers
What should be the same when evaluating different projects using future value analysis?
What should be the same when evaluating different projects using future value analysis?
Signup and view all the answers
Which of the following describes Net Present Value (NPV)?
Which of the following describes Net Present Value (NPV)?
Signup and view all the answers
Future cash flows should be discounted to determine their present value when evaluating an investment.
Future cash flows should be discounted to determine their present value when evaluating an investment.
Signup and view all the answers
What does the term 'cumulative cash flow' refer to?
What does the term 'cumulative cash flow' refer to?
Signup and view all the answers
The difference between the initial investment and the sum of all discounted future cash flows is known as ______.
The difference between the initial investment and the sum of all discounted future cash flows is known as ______.
Signup and view all the answers
Match the following cash flow components with their descriptions:
Match the following cash flow components with their descriptions:
Signup and view all the answers
What type of cash flows are often labeled in parentheses?
What type of cash flows are often labeled in parentheses?
Signup and view all the answers
In cash flow analysis, all cash flows are considered equally in value, regardless of when they occur.
In cash flow analysis, all cash flows are considered equally in value, regardless of when they occur.
Signup and view all the answers
What does a positive Net Present Value (NPV) indicate for a project?
What does a positive Net Present Value (NPV) indicate for a project?
Signup and view all the answers
To evaluate investments accurately, future cash flows should be adjusted using a ______.
To evaluate investments accurately, future cash flows should be adjusted using a ______.
Signup and view all the answers
Which project had a cumulative cash flow of zero by year 3?
Which project had a cumulative cash flow of zero by year 3?
Signup and view all the answers
Study Notes
Core Concepts and Assumptions
- Engineering economics uses the end-of-period convention where cash flows are calculated at the end of each period.
- Sunk costs (past expenses) are not relevant for decision-making; only current and future situations are considered.
- There are two perspectives in engineering economics: investor and borrower.
- Projects are categorized into three types:
- Independent projects: Evaluated separately, any project can be chosen.
- Mutually exclusive projects: Only one can be chosen.
- Related but not mutually exclusive projects: Decisions regarding one project impact another.
Payback Period Method
- Measures the time required to recover the initial investment.
-
Advantages:
- Easy to understand and use.
- Focuses on liquidity.
- Conservative approach to uncertain future cash flows.
-
Disadvantages:
- Ignores the time value of money.
- Arbitrary cutoff points may be used.
- Disregards cash flows after the payback period.
- Biased towards short-term projects, leading to potential loss of long-term benefits.
Discounted Payback Period (DPBP)
- Considers the time value of money by discounting future cash flows.
- Requires a specified interest or discount rate.
- Provides a more accurate measure than the simple payback period.
- Shorter DPBP is generally preferred.
Net Present Value (NPV)
- Calculates the difference between the initial cost and the sum of discounted future cash flows.
-
Key Assumptions:
- Cash flows occur at the end of each period.
- The timing and magnitude of cash flows are known.
- The interest rate (MARR) is known.
-
Decision Criteria:
- Higher NPV is preferred.
- Positive NPV indicates a desirable project.
- The MARR must exceed the Weighted Average Cost of Capital (WACC).
Capitalized Equivalent Method
- Used for permanent/infinite period projects like infrastructure.
- Calculates the present sum needed to provide the service indefinitely.
- Formula: P = A/i (where A is the annual payment and i is the interest rate).
- Commonly used in government and institutional analysis.
Future Value Analysis
- Evaluates alternatives at future points in time.
- Similar to NPV, but focused on future value.
- Requires the same time period for comparison.
- Useful for long-term planning, e.g., retirement savings.
Practical Examples
-
Equipment Selection Example:
- Model I: Costs 15,000andgenerates15,000 and generates 15,000andgenerates5,000 annual profit.
- Model II: Costs 20,000andgenerates20,000 and generates 20,000andgenerates6,500 annual profit.
- At a 10% MARR, Model II is preferred because it has a higher NPV.
-
Perpetual Scholarship Example:
- A $5,000 annual scholarship is given forever.
- With a 4% interest rate, the required endowment is $125,000.
Net Present Value (NPV)
- For choosing between projects with the same time period: select the one with a higher NPV
- NPV calculation: Present Value (Benefits) - Present Value (Costs)
- A positive NPV makes a project desirable
- A negative NPV implies the project requires out-of-pocket payments
Discount Rate
- Often called MARR (Minimum Acceptable/Attractive Rate of Return)
- MARR should exceed the weighted average cost of capital (WACC) and the rate of return of the opportunity cost (options for investing)
Key Assumptions
- Cash flows occur at time 0 and at the end of each period from 1 to N
- Cash flows are known, the project horizon (N), is known, and there is no uncertainty
- The interest rate, i*, for the time value of money is known
MARR
- The minimal acceptable rate of return (MARR), is also known as the hurdle rate
- MARR should cover at least the firm's cost of capital, often measured by WACC
- Often includes a risk premium: MARR= WACC + Risk Premium
- May favor projects with higher rates of return, even if they have smaller dollar values
Example 2 - NPV
- New company needing equipment for a 5-year period
- Two models considered:
- Model I: Costing 15,000withprofitsof15,000 with profits of 15,000withprofitsof5,000/year
- Model II: Costing 20,000withprofitsof20,000 with profits of 20,000withprofitsof6,500/year
- A MARR of 10% is used to determine the best model
Example 1 – Solution Payback Period
- Payback Period: estimates how long it takes for an investment's income to cover its initial cost
- Analyzed for two projects, Project A and Project B
- Data includes time period (N), cash flow for each project, and cumulative cash flow
Example 1 – Solution DPBP
- Discounted Payback Period (DPBP): similar to payback period, but uses discounted cash flows
- Analyzes Project A and Project B
- Data includes N, discounted cash flow, and cumulative discounted cash flow
Net Present Value (NPV)
- NPV: Difference between an investment's initial cost and the sum of all discounted future cash flows
- Requires same time period for evaluation
- Uses the same criteria and process as present value analysis
Example 4 – Future Value Analysis
- A firm decides to establish a second plant
- Two options:
- Buy an existing factory and remodel it
- Buy land and build a new plant
- Data includes the cost of each option, broken down by year and component (land, design, construction, equipment)
- An interest rate of 8% is applied to determine which option is better
Example 4 – Solution
- Future Cost calculated for both options (new plant and remodel) using the future value formula (F/P, 8%, 3)
Example 4 – Solution (NPV)
- Net Present Cost (NPC) calculated for both options using the present value formula (P/A, 8%, 3) and (P/F, 8%, 2)
Summary
- Understand how to calculate the payback period and how it can be used to assess a project's desirability
- Differentiate between independent and mutually exclusive projects
- Calculate which independent or mutually exclusive projects should be approved using NPV or NFV
- Calculate present value for a project with infinite analysis period using the Capitalized Cost method
Studying That Suits You
Use AI to generate personalized quizzes and flashcards to suit your learning preferences.
Related Documents
Description
Test your understanding of key principles in engineering economics, including the end-of-period convention, sunk costs, and the classification of projects. Evaluate the advantages and disadvantages of the payback period method and learn how it impacts investment decisions.
