IBEHS 4P04 Study Guide (2nd Half) PDF

IBEHS 4P04 - Lecture 7 3P04 Review Lecture Pt. 2 Key Concepts 1. Minimum Acceptable Rate of Return (MARR): o MARR serves as the threshold interest rate to determine if a project is financially viable. o Projects with a return greater than MARR are prof...

IBEHS 4P04 - Lecture 7 3P04 Review Lecture Pt. 2 Key Concepts 1. Minimum Acceptable Rate of Return (MARR): o MARR serves as the threshold interest rate to determine if a project is financially viable. o Projects with a return greater than MARR are profitable, while those below it are not. o Reducing MARR can make a previously unviable project acceptable by increasing the present worth (PW). 2. Internal Rate of Return (IRR): o IRR is the interest rate at which the net present value (NPV) equals zero (break- even point). o Decision Rules: ▪ IRR > MARR: Project is profitable. ▪ IRR = MARR: Marginally acceptable. ▪ IRR < MARR: Project is not viable. o Understanding the relationship between IRR and MARR helps determine project acceptability. 3. Comparing Projects with Unequal Lives: o Repeated Lives Method: Adjust projects to the same analysis period by repeating their lifespans to the least common multiple (e.g., a 4-year project and a 6-year project are compared over 12 years). o Study Period Method: Use a fixed timeframe for analysis, calculating salvage values for projects exceeding the study period. 4. Calculating IRR: o Excel IRR() Function: ▪ Create a cash flow table with at least one positive and one negative value. ▪ Use the formula =IRR(range) to find IRR directly. Page 1 of 13  o Interest Factor Tables: ▪ Calculate equivalent present amounts for cash inflows (receipts) and outflows (disbursements). ▪ Set PW receipts equal to PW disbursements and solve for the compound interest factor (CIF). ▪ Use linear interpolation with interest factor tables to determine IRR. 5. Incremental Investments: o When comparing projects with different initial investments, evaluate using incremental cost: 1) Rank projects by increasing initial cost. 2) Compare the current best option with the next alternative using incremental IRR. 3) If incremental IRR exceeds MARR, the challenger becomes the new best option. 4) Repeat for all alternatives. 6. Depreciation: o Straight-Line Depreciation: ▪ Assets lose value uniformly over their lifespan. ▪ Formula for annual depreciation charge: ▪ Book value after nnn periods: o Declining-Balance Depreciation: ▪ Depreciation diminishes at a fixed percentage rate each period: ▪ Salvage value is approached but not reached. Key Examples 1. IRR Calculation: 2. Incremental Investment Comparison: o Wedge Island ($1.2M cost, $300k annual savings) vs. Ridgerock Lake ($2.3M cost, $500k annual savings): ▪ Incremental IRR for additional investment is 17%, indicating Wedge Island remains the better option as it exceeds the MARR. Page 2 of 13  3. Depreciation Example: o A laser machine purchased for $380,000 with a salvage value of $30,000 over 6 years has a book value of $146,667 after 4 years using straight-line depreciation. Study Guide for IBEHS 4P04 - Lectures 8 and 9: Public Decision-Making Key Concepts and Topics 1. Social Aspects of Engineering Decision-Making: o Engineering projects must consider societal costs and benefits beyond immediate economic impacts. o Example: A new pulp mill might increase profitability for a company but could also harm local water quality, fisheries, and wildlife. 2. What to Consider for Social Costs and Benefits: o Social benefits: Increased safety, reduced travel time. o Social costs: Loss of land, noise pollution, environmental impact. o Projects like highway construction need holistic analysis to weigh societal impacts. 3. Market Failure: o Defined as a situation where market prices fail to reflect all social costs and benefits, leading to inefficient resource allocation. o Example: Acid rain caused by burning high-sulfur coal. Lack of incentives for power plants to switch to cleaner fuels results in continued environmental harm. o Remedies include government regulations, litigation, and direct provision of goods and services. 4. Public Provision of Goods and Services: o Public goods have no direct market (e.g., police services) or face no competition due to economies of scale (e.g., postal services). o Governments often regulate or provide these services to ensure efficiency and affordability. Page 3 of 13 5. Public-Private Partnerships (P3s): o Collaboration between the government and private organizations for public projects, where private companies invest and recoup costs through tolls or fees. o Examples: Confederation Bridge, Highway 407 ETR. o Potential downsides include higher private-sector interest rates and insufficient focus on social benefits. 6. Benefit-Cost Analysis (BCA): o A systematic framework for evaluating public projects by assessing gains and losses. Steps: 1. Define project alternatives. 2. Identify and quantify benefits (e.g., increased safety, reduced travel time). 3. Identify and quantify costs (e.g., construction costs, social costs like pollution). o Example: A highway improvement project analyzed for its impacts on travel efficiency and safety. 7. MARR in the Public Sector: o Public sector MARR (social discount rate) is lower than the private sector’s, as the goal shifts from profit maximization to maximizing societal benefits. o Factors influencing the rate include government borrowing costs (lower bound) and taxpayer opportunity costs (upper bound). 8. Quantifying Intangible Costs and Benefits: o Intangible factors, such as health, safety, and environmental impact, can be approximated using methods like: ▪ Contingent Valuation: Surveys to estimate public willingness to pay. ▪ Hedonic Pricing: Analyzing behavior in related markets to infer values (e.g., time savings based on hourly wages). 9. Benefit-Cost Ratios (BCRs): o Calculated as the ratio of the present worth (PW) of benefits to costs. o A project is viable if BCR > 1 and unviable if BCR < 1. Page 4 of 13  o Modified BCR includes operating costs for more nuanced evaluation. o Example: A fire department upgrading its dispatch system calculated a BCR > 1, making the project viable. 10. Comparison of Mutually Exclusive Projects: o When selecting between projects, calculate incremental BCR to compare the additional costs and benefits. o Example: Expanding an airport versus building a new one, with incremental BCR calculations used to determine the optimal choice. Key Examples 1. Highway Construction: o Benefits include reduced travel time and improved safety. o Costs include construction expenses, land acquisition, and environmental disruption. 2. Fire Department Dispatch System: o Benefits: Reduced response times, fewer equipment needs. o Costs: Initial capital investment and ongoing operating expenses. 3. Airport Expansion vs. New Construction: o Calculating present worth of costs and benefits for mutually exclusive alternatives shows the advantage of incremental BCR analysis Page 5 of 13 IBEHS 4P04 - Lectures 10 and 11: Production, Function, & Isoquants 1. Production Function in Healthcare Definition: Describes the relationship between health inputs (e.g., medical care, exercise, diet) and outputs (health status). o Inputs: Medical care, lifestyle, environment, human biology. o Outputs: Measured as health status (HS), represented as: Importance: o Helps analyze resource allocation and policy interventions in healthcare. o Focuses on the effectiveness of intermediate healthcare outputs in achieving better health outcomes. 2. Total Product (TP) and Marginal Product (MP) Total Product (TP): o Maximum output attainable with a given amount of input. o Typically experiences diminishing returns, meaning additional inputs result in smaller increases in output. Marginal Product (MP): o The additional output produced by increasing an input by one unit. o MP is the derivative of TP and shows incremental efficiency. o Important for decision-making as policies often target marginal gains rather than total contributions. Graphical Representation: o TP curve demonstrates total output over input changes. o MP curve shows how incremental output changes with each unit of input. 3. Interpreting Changes in Total Product Shifts in TP Curve: Page 6 of 13  o Occur due to external factors affecting output at all input levels. o Example: A pandemic reduces overall population health, shifting the TP curve downward. Moving Along the TP Curve: o Represents increased or decreased input use. o Example: Increasing breast cancer screenings shifts population health along the curve. 4. Marginal Productivity and Real-World Examples Example: Students Studying: o Marginal productivity of time spent studying varies: ▪ Student A improves grades significantly with additional study hours. ▪ Student B, already performing well, sees minimal improvements. ▪ Decisions should consider marginal rather than total contributions. Example: Healthcare Provider Services: o Placing interventions like hospital construction, pacemakers, and heart transplants along TP curves reflects their impact on healthy and diseased populations. 5. Isoquants and the Marginal Rate of Technical Substitution (MRTS) Isoquants: o Graphical representations of all possible input combinations yielding the same output. o Points on the same curve represent different input allocations but identical output levels. o A shift in the curve represents external changes affecting all input combinations. Marginal Rate of Technical Substitution (MRTS): o Measures the rate at which one input can be substituted for another while maintaining the same output. o Example: For a biopharmaceutical company producing drugs with labor (L) and bioreactors (K), MRTS quantifies the tradeoff between labor and capital. Page 7 of 13 Example Problems 1. Marginal Productivity of Students: o Student A improves grades by 30% with 5 additional hours of study (MP = 0.06). o Student B improves by only 1% in the same time (MP = 0.002). o Policy recommendation: Focus on Student A for higher marginal gains. 2. MRTS in Biopharmaceutical Production: IBEHS 4P04 - Lecture 12: Uncertainty & Risk Assessment Introduction to Risk and Uncertainty All projects carry inherent uncertainties related to key parameters such as prices, interest rates, cash flow magnitude, and timing. Sensitivity Analysis 1. Definition: o A tool to assess how variations in one parameter, while holding others constant, affect a project’s performance. o Helps prioritize which parameters contribute most to uncertainty. 2. Steps to Perform Sensitivity Analysis: o Identify baseline or "base case" values for parameters. o Modify a single parameter (e.g., +5%, -5%, +10%, -10%) and recalculate project performance (e.g., NPV or PW). o Visualize results on a sensitivity graph. 3. Example: Power Plant Investment: o Scenario: A healthcare facility evaluates replacing its power source with the following: ▪ Initial cost: $3M Page 8 of 13  ▪ Life: 20 years ▪ MARR: 12% ▪ Annual savings: $1M, annual costs: $65K, fuel: $375K. ▪ Overhaul costs: $35K every 4 years, $17K at year 10. o Sensitivity graph shows electricity savings has the largest effect, demonstrating project viability heavily depends on these savings. 4. Shortcomings of Sensitivity Analysis: o Valid only within the analyzed range. o Ignores interaction effects between parameters (e.g., cost and savings variations together). Break-Even Analysis (BEA) 1. Definition: o Determines the value of a parameter (e.g., cost, interest rate) where the project becomes viable or unviable. o Unlike sensitivity analysis, BEA focuses on thresholds where key parameters reach a critical value. 2. Application: o Single Project: ▪ Find the break-even point for parameters like electricity savings, MARR, or initial costs. ▪ Example: A project is viable as long as annual savings exceed $849,207, and the MARR remains below 17.73% (equivalent to IRR). o Multiple Projects: ▪ Compare projects to identify ranges of parameter values favoring one over the other. ▪ Example: A dental company choosing between two wax warmers finds the break-even sales volume for each. 3. Steps in BEA: o For each parameter, calculate the threshold value (e.g., max cost, min savings). Page 9 of 13  o Compare values across alternatives to choose the optimal project based on specific criteria. Case Study: Multiple Projects Scenario: A dental company evaluates two wax warmers (Finedetail and Simplicity). o Costs vary with production volume; parameters include sales estimates, unit costs, and tax impacts. o Analysis identifies the sales threshold where Finedetail becomes less viable compared to Simplicity Page 10 of 13 IBEHS 4P04 - Lectures 13 & 14: Taxes Key Concepts 1. Types of Taxes 1. Personal Income Taxes: o Calculated progressively: Higher income levels are taxed at higher percentages. o Tax filing involves reporting income, taxes paid, and deductions. o Resources: McMaster University provides free tax filing support. 2. Corporate Income Taxes: o Typically proportional ("flat") rather than progressive. o Small businesses benefit from reduced tax rates (e.g., Canada's Small Business Deduction allows effective tax rates below 20%). o Taxes are calculated on net income (revenues - expenses). 2. Project Evaluation with Taxes 1. Before- and After-Tax Minimum Acceptable Rate of Return (MARR): o Before-tax MARR: Taxes are not explicitly included, so the rate is set higher. o After-tax MARR: Explicitly incorporates taxes, resulting in a lower rate. o Conversion formula: 2. Internal Rate of Return (IRR): o IRR reflects the interest rate at which NPV = 0. o After-tax IRR approximates: 3. Tax-Adjusted Present Worth and Annual Worth 1. Present Worth (PW): o Adjust first costs, annual savings/expenses, and salvage values for tax effects: ▪ Savings/expenses: Multiply by (1−t). ▪ Depreciation: Account for tax savings from allowable depreciation. o Example: Page 11 of 13  ▪ Initial cost = $45,000, annual savings = $23,000, tax rate = 42%. ▪ Tax-adjusted PW = $3,097. 2. Annual Worth (AW): o Convert all cash flows into equivalent annual values considering taxes. o Example: ▪ Annual savings = $15,700 (adjusted for tax). ▪ AW = $859 per year. 4. Depreciation and Tax Rules 1. Depreciation: o Capital purchases are depreciated over time to reduce taxable income. o Permitted Methods in Canada: ▪ Declining-balance method is the most common. ▪ Half-Year Rule: Only half of the purchase cost is depreciated in the first year. 2. Capital Cost Allowance (CCA): o Canada’s tax depreciation system groups assets into CCA classes, each with a specific depreciation rate. o Undepreciated Capital Cost (UCC): Tracks remaining book value for depreciation purposes. 3. UCC Example: o Initial asset cost = $10,000, CCA rate = 20%. o First-year depreciation 5. Tax Benefits from Capital Investments 1. Capital Tax Factor (CTF): o Captures present worth of tax savings due to depreciation: Page 12 of 13 2. Capital Salvage Factor (CSF): o Adjusts salvage values for tax effects o Page 13 of 13