Engr 222 Notes

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• Syllabus
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3
CourseIntroduction
• WhyisEngineeringEconomyimportant?
– Methodstocomparedesignalternatives.
– Methodstoquantifycostsandbenefitsovera
periodoftime.
ABETͲ Engineering
• “theprofessioninwhichaknowledgeofthe
mathematicalandnaturalsciencesgainedby
study,experience,andpracticeisappliedwith
judgmenttodevelopwaystoutilize,
economically,thematerialsandforcesof
natureforthebenefitofmankind.“
LectureͲLearningFormat
• Lecture
– PowerPoint
– BoardExamples
• InClassExercise(ICE)onrelatedtopics
– Completedwithintheclasstime
– Combinationofhandcalcs andExcelwork
– Maybecompletedindividuallyoringroups
– Typically1Ͳ2problems
• Homework
– Coverssametopicsaslectures&ICE,ofteninmore
depth
– Completedindividually
6
Interest:PaidvsEarned
“Interestrate” “Rateofreturn”
(paidbyborrower) (paidtoinvestor)
© 2012 by McGraw-Hill, New York, N.Y All Rights Reserved
InterestandInterestRate
• Interest– themanifestationofthetimevalueof
money
• Feethatonepaystousesomeoneelse’s
money
• Differencebetweenanendingamountof
moneyandabeginningamountofmoney
¾ Interest=amountowedaftertime– principal
• Interestrate– Interestpaidoveratimeperiod
expressedasapercentageofprincipal
RateofReturn
• Interestearnedoveraperiodoftime isexpressedasa
percentageoftheoriginalamount(principal)
interest accrued per time unit

Rate of return (%) = x 100%
original amount
Borrower’sperspective– interestratepaid
Lender’sorinvestor’sperspective– rateofreturnearned
Amountatyear1=InitialAmount+InitialAmount(InterestRate)
9
BorrowingandLoaningMoney
Terminology
• Checkingaccount(currentaccount)– usedforfrequent
withdrawals(debitcard,ATM,check,transfer)anddeposits.
Typicallylittleornointerestispaidonbalance.
• Savingsaccount– interestbearingaccount,moneycanbe
withdrawnatanytime.Usuallycannotwritechecksdirectly
againstthisaccount.Interestratecanchangeanytime.
• Moneymarketaccount– interestbearingaccount,typically
havehigherbalancerequirementsand(slightly)higher
interestrates.Interestratecanchange,andmoneycanbe
withdrawnanytime.
• CertificateofDeposit (timedeposit)– fixedinterestrateover
acertaintimeperiod.Moneywithdrawnearlysubjectto
penalty.
10
BorrowingandLoaningMoney
Terminology
• Debitcard– paymentcardlinkedtoachecking
account.Purchasesimmediatelydeductedfrom
accountbalance.
• Creditcard– paymentcardlinkedtoapersonallineof
credit.Usuallyunsecured,veryhighinterestrates.
• Mortgageloan– usedtopurchaseahome(orland).
Secured,withrelativelylongrepaymentdurations.
• Homeequityloan– borrowerusesthevalueoftheir
homeassecurityforaloan.Oftenusedforlarge
purchases(e.g.,homeimprovements,medicalbills,
collegetuition).
11
BorrowingFunds
12
BrieflyDiscussCashͲFlowDiagram
• Whatisthevalueofgraphicallyrepresentingmoney
flows?
Youborrow$10,000at6%(compoundedannually)to
bepaidbackafter5years.Howmuchmustberepaid?
Abovetheline:MoneycomingINtoyou
0 1 2 3 4 5 6
Belowtheline:MoneygoingOUTfromyou
13
BrieflyDiscussCashͲFlowDiagram
• Whatisthevalueofgraphicallyrepresentingmoney
flows?
Youborrow$10,000at6%(compoundedannually)to
bepaidbackafter5years.Howmuchmustberepaid?
P=$10,000
i =6%
0 1 2 3 4 5 6
F=???
14
CashFlowDiagrams
Whatatypicalcashflowdiagrammightlooklike
Draw a time line Unless otherwise instructed, assume end-of-period cash flows
Time
0 1 2 … … … n-1 n
One time period (end of previous year
until beginning of next year)
F = $100
Show the cash flows (to approximate scale)
0 1 2 … … … n-1 n
Cash flows are shown as directed arrows: + (up) for inflow
P = $80
- (down) for outflow
15
TimeͲValueofMoney:Symbols
Youborrow$10,000at6%(compoundedannually)
tobepaidbackafter5years.Howmuchmustbe
repaid?
• i – interestrate
• N– numberofperiods(e.g.,years,months,etc.)
• P– theamountofmoneyatthepresent
• F– theamountofmoneyinthefuture
P=$10,000 i =6%peryear N=5years F=?
16
TimeValueofMoney:Terminology
• Presentworth(PW).Valueofmoneynow.Also
calledPresentValue(PV),NetPresentValue
(NPV),andDiscountedCashFlow(DCF).
• FutureWorth(FW).Valueofmoneyinthefuture.
AlsocalledFutureValue(FV).
• AnnualWorth(AW).Aseriesofconsecutive,
equal,endͲofͲperiodamountsofmoney.Also
knownasauniformseries.
17
CommonlyusedSymbols
t =time,usuallyinperiodssuchasyearsormonths
P =valueoramountofmoneyatatime t
designatedaspresentortime0
F =valueoramountofmoneyatsomefuture
time,suchasatt=nperiodsinthefuture
A =seriesofconsecutive,equal,endͲofͲperiod
amountsofmoney
n =numberofinterestperiods;years,months
i =interestrateorrateofreturnpertimeperiod;
percentperyearormonth
18
CashFlows:Terms
• CashInflows– Revenues(R),receipts,incomes,
savingsgenerated byprojectsandactivitiesthat
flowin.Plussignused.
• CashOutflows– Disbursements(D),costs,
expenses,taxescausedbyprojectsandactivities
thatflowout.Minussignused.
• NetCashFlow(NCF)foreachtimeperiod:
NCF=cashinflows– cashoutflows=R– D
• EndͲofͲperiodassumption:
Fundsflowattheendofagiveninterestperiod
19
CashFlows:Estimating
9 Pointestimate– AsingleͲvalueestimateofacashflowelement
ofanalternative
A=$150,000
0 1 2 3 4 5 6
9 Rangeestimate– Minandmaxvaluesthatestimatethecashflow
(andapproximatethedegreeofuncertainty)
A=$135,000Ͳ $150,000
(ICE3,pt1)
0 1 2 3 4 5 6 © 2012 by McGraw-Hill, New York, N.Y All Rights Reserved
20
21
EconomicEquivalence
Definition:Combinationofinterestrate(rateof
return)andtimevalueofmoneytodetermine
differentamountsofmoneyatdifferentpoints
intimethatareeconomicallyequivalent
Howitworks:Userate i andtimet inupcoming

relationstomovemoney(valuesofP,F,andA)
betweentimepointst =0,1,…,ntomakethem
equivalent (notequal)attheratei
22
ExampleofEquivalence
Differentsumsofmoneyatdifferenttimesmaybe
equalineconomicvalueatagivenrate
$110
Rate of return, i = 10% per year
Year
0 1
$100 now
The amount of $100 now is economically equivalent to the

amount of $110 one year from now, if the $100 is invested at a
rate of 10% per year.
Note:Adepositisnotequivalenttoawithdrawal! © 2012 by McGraw-Hill, New York, N.Y All Rights Reserved
23
Youcanreceive$100in1yearoracertainamount
today.Fori =10%,howmuchistheamountyou
shouldreceivetoday?
$100
P = ??
i = 10%
Year
0 1
F=P(1+i)N
P=F/(1+i)N =$100/(1.10)1 =$90.91
24
FindingtheUnknownParameter
CashͲFlowDiagramsasaProblemStatement
F=??? F=4,500 A=??? A=12,500
0 1 2 3 4 0 1 2 3 4 0 1 2 3 4 0 1 2 3 4
P=11,000 P=??? P=7,500 P=???
FindFgivenP. FindPgivenF. FindAgivenP. FindPgivenA.
F/P P/F A/P P/A
25
i= 0.05
TotalAmount Cumulative
Amount Previous Subjectto5% InterestDueAt Amount
Year Taken Balance Interest ENDofperiod Owed
0
1 12500 0 12500 625 13125
2 12500 13125 25625 1281 26906
3 12500 26906 39406 1970 41377
4 12500 41377 53877
26
SimpleandCompoundInterest
• SimpleInterest
Interestamountiscalculatedusingprincipalonly
Interest=(principal)(numberofperiods)(interestrate)
I= Pͼnͼi
Example:$100,000lentfor3yearsatsimplei=
10%peryear.Whatisrepaymentafter3years?
Interestamount=100,000(3)(0.10)=$30,000
Totaldue=100,000+30,000=$130,000
27
SimpleandCompoundInterest
• CompoundInterest
Interestamountisbasedonprincipalplusall
accruedinterest
• Interest“compounds”overtime
Interest=(principal+allaccruedinterest)(interestrate)
Interestfortimeperiod t(It)is:
P =principal
§ j t 1
·
¦
IJ =thecumulativeinterestamount
It ¨P I J ¸¸ i
¨ forthetimebefore timeperiodt
© j 1 ¹ i =interestrate
28
CompoundInterestExample
Example:$100,000lentfor3yearsati=10%peryear
compoundedannually.
Whatistherepaymentdueafter3years?
Interest,year1: I1 =100,000(0.10)=$10,000
Totaldue,year1: T1 =100,000+10,000=$110,000
Interest,year2: I2 =110,000(0.10)=$11,000
Totaldue,year2: T2 =110,000+11,000=$121,000
Interest,year3: I3 =121,000(0.10)=$12,100
Totaldue,year3: T3 =121,000+12,100=$133,100
§ j t 1
·
It ¨P
¨ ¦I J
¸ i ‫ܫ‬ଷ ൌ 100,000 ൅ 10,000 ൅ 11,000 · 0.10 =$12,100
¸
© j 1 ¹
29
NominalandEffectivei
• Nominalinterest(r)=interestcompounded
morethanoneinterestperiodperyearbut
quoted onanannualbasis.
– Example:16%peryear,compoundedquarterly
• The4%perperiodinterestrateisnominally16%peryear
• Effectiveinterest(i)=actualinterestrateearned
orchargedforaspecifictimeperiod.
– Example:4%interestperperiod,willhavean
effectiveannualinterestrategreaterthan16%...
30
NominalandEffectivei
• Relationbetweennominalinterestand
effectiveinterest:
M
§ r ·
i ¨1 ¸ 1
© M¹
i =effectiveannual interestrate
r=nominalinterestrateperyear
M=numberofcompoundingperiodsperyear
r/M=interestrateperinterestperiod
Example:16%nominalannualinterest,compoundedquarterlyis
whateffectiveinterestrate?
31
ICE:Compounding
• Ratio
– “TheratioofFutureamount/Presentamount:
(F/P,i%,N)=(1+i)N
32
ȴ =0.18%ȴ =3.11%
1) HigherinterestratesїbiggerdiīerencebetweennominalandeīecƟveinterest
2) Increasingthefrequencyofcompoundinghasadecreasingeffect(e.g.,ȴ =1.44%for24%
goingfromannualtosemiannual,butgoingfromsemiannualtoquarterlyȴ =0.81)
33
BorrowingFunds
34
Projectsyourcompanycoulddo…
A. Upgradecomputernetwork
B. Newdeliverytrucks
C. Remodelloadingdocks
D. HireinͲhousedataentry
E. Purchaseaccountingsoftware
F. Providenewlaptopstosalespeople
G. Installsecuritycamerasinwarehouse
Howmuchdoesitcost?
Whatisthereturnoninvestment?
35
MARRIllustration
36
TheMinimumAttractiveRateofReturn(MARRorhurdlerate)is
generallyapolicy emanatingfromthetopͲlevelmanagementofan
organization.Factors usedindeterminingtheMARRcaninclude:
1. Theamountofmoneyavailableforinvestment,andthesourceand
costofthesefunds(i.e.,cashreserves,equityorborrowedfunds).
• WeightedAverageCostofCapital(WACC)
2. Thenumberofgoodprojectsavailableandtheirpurpose.
• OpportunityCost
3. Theamountofperceivedrisk associatedwithinvestment
opportunitiesavailabletotheorganizationandthecostof
administeringprojects.
4. Thetypeoforganization– government,publicutility,privateindustry,
hospital,etc.
37
TypesofFinancing
• EquityFinancing –Fundsfromretainedearnings,
newstockissues,orowner’sinfusionofmoney.
• DebtFinancing –Borrowedfundsfromoutside
sources– loans,bonds,mortgages,venture
capitalpools,etc.Interestispaidtothelenderon
thesefunds
Foraneconomicallyjustifiedproject:
RORшMARR>WeightedAverageCostofCapital
38
39
40
OpportunityCost
Definition:
ThevalueofthesecondͲbestoption.
Largestrateofreturnofallprojectsnotaccepted(forgone)duetoa
lackofcapitalfunds
Example:AssumeMARR=10%.ProjectA,not
fundedduetolackoffunds,isprojectedtohave
RORA =13%.ProjectBhasRORB =15%andis
fundedbecauseitcostslessthanA.
Opportunitycostis13%,i.e.,theopportunityto
makeanadditional13%isforgonebynotfunding
projectA
41
WeightedAverageCostofCapital
WeightedAvg=[A]*(%ofA)+[B]*(%ofB)+[C]*(%ofC)
(%ofA)+(%ofB)+(%ofC)
[A]Thevalueofcategory“A”(e.g.,theinterestrateforacertainalternative)
[B]Thevalueofcategory“B”
[C}Thevalueofcategory“C”
Note:the“%ofA”(andB&C)canalsobereplacedby“AmountofA”(andB&C)
42
InterestFactors
43
44
Example1:FindingFutureValue
Apersondeposits$5000intoanaccountwhichpaysinterestatarate
of8%peryear.Theamountintheaccountafter10yearsisclosestto:
(A) $2,792 (B) $9,000 (C) $10,795 (D) $12,165
The cash flow diagram is:

Solution:
F = P(F/P,i,n )
= 5000(F/P,8%,10 )
= 5000(2.1589)
= $10,794.50
Answeris(C)
45
Example2:FindingPresentValue
Asmallcompanywantstomakeasingledepositnowsoitwillhaveenough
moneytopurchaseabackhoecosting$50,000fiveyearsfromnow.Ifthe
accountwillearninterestof10%peryear,theamountthatmustbe
depositednowisnearestto:
(A) $10,000 (B) $ 31,050 (C) $ 33,250 (D) $319,160
The cash flow diagram is: Solution:

P = F(P/F,i,n )
= 50,000(P/F,10%,5 )
= 50,000(0.6209)
= $31,045
Answeris(B)
46
UniformSeriesInvolvingP/AandA/P
The uniform series factors that involve P and A are derived as follows:
(1) Cash flow occurs in consecutive interest periods
(2) Cash flow amount is same in each interest period
The cash flow diagrams are:
A=Given A=?
0 1 2 3 4 5 0 1 2 3 4 5
P=? P=Given
P = A(P/A,i,n) Standard Factor Notation A = P(A/P,i,n)

Note: P is one period Before the first A value
47
48
Example3:UniformSeriesInvolvingP/A
A chemical engineer believes that by modifying the structure of a certain water
treatment polymer, his company would earn an extra $5000 per year. At an interest
rate of 10% per year, how much could the company afford to spend now to just
break even over a 5 year project period?
(A) $11,170 (B) 13,640 (C) $15,300 (D) $18,950
The cash flow diagram is as follows: Solution:

A=$5000 P = 5000(P/A,10%,5)
= 5000(3.7908)
0 1 2 3 4 5 = $18,954
P=?
i=10% Answer is (D)
49
UniformSeriesInvolvingF/AandA/F
The uniform series factors that involve F and A are derived as follows:
(1) Cash flow occurs in consecutive interest periods
(2) Last cash flow occurs in same period as F
Cash flow diagrams are:
A=Given
A=?
0 1 2 3 4 5 0 1 2 3 4 5
F=? F=Given
F = A(F/A,i,n) Standard Factor Notation A = F(A/F,i,n)

Note: F takes place in the same period as last A
50
51
Example4:UniformSeriesInvolvingF/A
Anindustrialengineermadeamodificationtoachipmanufacturing
processthatwillsavehercompany$10,000peryear.Ataninterest
rateof8%peryear,howmuchwillthesavingsamounttoin7years?
(A) $45,300 (B) $68,500 (C) $89,228 (D) $151,500
The cash flow diagram is:

F=? Solution:
A = $10,000 F = 10,000(F/A,8%,7)
= 10,000(8.9228)
0 1 2 3 4 5 6 7
= $89,228
i = 8%
52
ArithmeticGradients
Arithmetic gradients change by the same amount each period
The cash flow diagram for the PG

of an arithmetic gradient is: Gstartsattheendofyear2
(notattheendofyear1)
PG=?
This is because cash flow in year 1 is
1 2 3 4 n usually not equal to G and is handled
separately as a base amount
0
(shown on next slide)
G
2G
3G
(nͲ1)G
NotethatPG is locatedTwo Periods

Ahead ofthefirstchangethatis
Standard factor notation is
equaltoG
PG = G(P/G,i,n)
53
InterestFactors
54
Balance
PresentValueoftheInflows=PresentValueoftheOutflows
іIsthiscashŇow
diagraminbalance?
i =??
Itdependsontheinterestrate.
55
FindingtheUnknownInterestRate
• Givenacashflowdiagram,discountallthe
futurevaluestothepresent
• Combinewiththeamountalreadyatthe
present(oftenanoutflow)
• Keepchangingtheinterestratei untilthe
presentvalueofinflows=presentvalueof
outflows
56
MSExcel,assumes… Soifit’sactuallyTHIS…
F=12,500
P=??? F=12,500
0 1 2 3 4
0 1 2 3 4
P=???
WhenusingbuiltͲin formulas Thenanegativesignmustbe

toconvertbetweenFandP. putintothebuiltͲinformula.
‘Whatdeposittodayis ‘Whatisthepresentvalueof
requiredforacertainwithdrawal somefutureamount?’
inthefuture?’
57
P/FforSpreadsheets
PresentvaluePiscalculatedusingPVfunction:
=PV(0.i,n,,ͲFV)
• Interestrateasadecimal
• n=thenumberofyearsfromwhateverfutureyearisgoing
intothefunctionuntilthepresent.
• Doublecommastoskipover“pmt”
• Whenyouapplythisfunctionmultipletimes,rowͲafterͲrow,you
aretreatingeachyearlikeasingleindividualamount
• Excelassumesthatasignchangeoccurs
58
ICE(PresentValue)
59
FindingtheNetPresentValue
Thepresentvalueofacashflow,discountedati
=NPV(0.i,rangeofvaluesinfuture)
*Range of values: highlight cells containing future amounts.

*Note: interest rate as a decimal
*Note: only include FUTURE VALUES in this function!!!!!

60
F/PforSpreadsheets
FuturevalueFiscalculatedusingFVfunction:
=FV(0.i,n,,ͲPV)
• Interestrateasadecimal
• nisthenumberofyearsuntilthefuturedateinquestion
• Doublecommastoskipover“pmt”
• Excelassumesthatasignchangeoccurs
61
ICE(FutureValue)
i=8.5%
Usethefollowingcolumns:Year,YearsUntilYear16,Amount,FV
62
Findingtheinterestrate
TheinterestratethatbalancesaPVandpayments:
=RATE(n,pmt,PV)
The interest rate that balances a FV and payments:

= RATE(n, pmt,, FV)
*Note: the two amounts in each function must have opposite sign
63
AnnotationExampleonMUOnline
64
ShiftedUniformSeries
Whatstepsarerequiredto
findthepresentvalueof
thiscashflowdiagram?
P=??
65
Scratchpad
Whatstepsarerequiredto
findthepresentvalueof
thiscashflowdiagram?
P=??
66
Step1:TakeA=1100from
9Ͳ11toyear8,using
(P/A,i=?,N=3)
P=??
67
Step2:Taketheamountat
year8toyear0with
(P/F,i=?,N=8)
P=??
68
Step3:TakeA=500from
4Ͳ7toyear3with
(P/A,i=?,N=4)
P=??
69
Step4:TakeG=100from
4Ͳ7toyear3with
(P/G,i=?,N=4)
P=??
70
Step5:Taketheamountat
year3toyear0with
(P/F,i=?,N=3)
P=??
Finally:combine
theamountsat
year0tofindthe
netpresentvalue.
71
ICE,Part1
72
ICEPart2
a)
b)DeterminewhatinterestratewouldmaketheFutureValue=100,000.
c)Explain:whymusttheinterestrateincrease inorderfor thefuturevaluetoincrease?
73
Part3 (InterestRate)
74
Proposalsand
DecisionMaking
Analysis
75
ImportantTerminology
• Mutuallyexclusivealternatives– onlyone
proposalcanbeselected.
• Independentprojects– morethanonecanbe
selected
• Donothing– currentapproachismaintained,
nothingnewinitiated.Costsarenotaltered.
• RevenueͲbasedproject– alternativesgenerate
differingcashinflowsandoutflows.
• CostͲbasedproject– onlyhascashoutflow(i.e.,
costs)allalternativeshavethesamerevenue
76
PresentWorthAnalysis
DecisionCriteria
• Discounteachalternative’scashflowtothe
presentusingtheMARR
– Ifprojectsaremutuallyexclusive,selecttheproject
withthehighestpositivePW
– Ifprojectsareindependent,selectallthathavePW
ш0attheMARR
77
Sometimesalternativeshaveadifferentusefullife…
PWA =?
OptionA
A=5,000
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18
i=4%
P=11,500
PWB =? OptionB
A=4,100
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18
i=4%
Howcanwecomparethem?
P=16,200
78
TheLeastCommonMultiple(LCM)Approach
OptionA
PWA =?
Cycle1 Cycle2 Cycle3
A=5,000
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18
i=4%
P=11,500 F=11,500 F=11,500
PWB =? OptionB
A=4,100
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18
i=4%
P=16,200 F=16,200
79
LCMAssumesRepeatability
• Cantheitembepurchasedinthefuturefor
thesamecostastoday?
– Ifnot,whatshouldyoudo?
• Willtherevenuesandcostsbethesameinthe
secondcycleastheywereinthefirstcycle?
80
81
PWA =?
OptionA
A=5,000
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18
i=4%
P=11,500
PWB =? OptionB
A=4,100
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18
i=4%
Howcanwecomparethem?
P=16,200
82
PWA =?
OptionA
A=5,000
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18
P=11,500
PWB =? OptionB
A=4,100
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18
P=16,200
83
The“ContractServices”Approach
PWA =?
OptionA
A=5,000
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18
i=4%
A=4,000
Asimilaritemisbeingleased
P=11,500
fortheremainingyearsofthe
studyperiod
PWB =? OptionB
A=4,100
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18
i=4%
Therefore,thetwooptionsnow
havethesameusefullife.
P=16,200
84
The“EarlyTermination”Approach
PWA =?
OptionA
A=5,000
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18
i=4%
A=4,000
P=11,500
OptionB
PWB =?
A=4,100
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18
i=4%
Insteadofcontinuingthelongeralternative,
terminateitearly.Selltheequipment,and
foregothefuturerevenues.
P=16,200
85
86
87
ExamPrep:ConceptQuestions
• WhatisthepurposeofPresentWorthanalysis?
• WhatassumptionisbuiltͲintotheLCM
approach?
• WhatfactorsinfluenceMARR?
• Whyistheresometimesadifferencebetweena
nominalinterestrateandaneffectiveinterest
rate?
88
DifferentUsefulLife
1) LeastCommonMultiple
(LCM)approach
– Reliesonthe“Repeatability
Assumption”
2) Contractservices
approach
– Considerifthealternative
withtheshorterusefullife
canbeleased
3) Earlyterminationofthe
longeralternative
– Selltheitemwiththe
longerusefullife
89
FutureWorthAnalysis
FW exactly like PW analysis, except calculate FW
Must compare alternatives for equal service

(i.e. alternatives must end at the same time)
Common applications:
Projectswhererevenueonlybeginsafterseveral
yearsofinvestments(e.g.,airport,tollroads,etc.)
Projectswhereanassetisexpectedtobesold
beforetheendofitsusefullife
© 2012 by McGraw-Hill All Rights Reserved
90
ICE14,Part1
91
ICEPart2
92
AnnualWorthAnalysisͲ Visualized
Canbeusedtocomparealternativeswithdifferentusefullife.
Noneedtomakeanyfixes(e.g.,LCM)tocompare.
93
AdvantageofAWAnalysis
AWcalculatedforonlyonelifecycle:
Youcan compareitemswithadifferentuseful
lifewithAWanalysis.
Assumptions:
Services needed for at least the LCM of lives of alternatives
Selected alternative will be repeated in succeeding life cycles
in same manner as for the first life cycle
All cash flows will be same in every life cycle (i.e., will change
by only inflation or deflation rate)
94
CapitalizedCost(CC)Analysis
Whatifyouhaveaninvestment(orliability)that
paysoutforever?Howmuchisthatworthtoday?
A=50,000
…
0 1 2 3 4 5 6 7
ь
P=??
Basic equation is: CC = P = A

i
“A” essentially represents the interest on a perpetual investment
Example:Youwanttowithdraw$50,000eachyear(forever)fromanaccount
thatearns10%interest.Howmuchshouldyoudepositintheaccounttoday?
95
AnnualValueofaPermanentInvestment
• ManypublicͲsectorprojects
haveassetsthathavesuch
longlivesthattheyare
consideredpermanent
– Dams,canals,bridges,etc.
• Theannualworth(and“CapitalRecovery”
amount)oftheinitialinvestmentis:
A=Pͼi A=annualworth
P=presentworth(initialcost)
i=interestrate
96
CapitalRecovery
• Theannualamountrequiredtobalancethe
initialinvestmentandfinalsalvagevalue.
Anyoperation&maintenancecosts
fortheitemwillbeadded tothe
CapitalRecoverycost.CRonly
accountsforthedifferencebetween
theinitialpurchase,finalsale,and
timeͲvalueofmoney.
97
CapitalRecoveryandAW
Capital recovery (CR) is the equivalent annual amount
that an asset, process, or system must earn each year to
just recover the first cost and a stated rate of return over
its expected life. Salvage value is considered when
calculating CR.
CR=ͲP(A/P,i%,n)+S(A/F,i%,n)
98
99
100
CashFlow
CumulativeSavingsBalance
Income RegularExpenses
ExtraordinaryExpenses
Investmentsmake
balancegrow.
101
StudentReportExample
102
Approximateaveragefoodtruckcost:$85,000
• Howlongisitgoingtotaketopayoffthefood
truck?
• Attheendofeachyear,whatisthe
“UnrecoveredInvestmentBalance”?
103
R:revenue E:Expense(R– E)=profit

Note:Theprofitiswhatshouldjustifytheinitialinvestment.
InternalRateofReturnisthevalueofi’ thatcausestheunrecoveredinvestment
balancetoexactlyequalzero attheendofthestudyperiod(yearN).
i’ istheinterestratetobedeterminedinmanyrelatedproblems.
104
105
Bonds
Abondisaninterestbearingcertificatethatprovides
futurenetcashflowsataspecifiedinterestrateandhasa
cashvaluethatcanberedeemedatsomefuturedate.
ThePWmethodisonewaytofindthevalueofabond.
106
BondValue
Theownerofabondispaidtwo typesofpayments:
1. aseriesofperiodicinterestpayments(rͼZ)untilthebondisretired.
2. asinglepayment(C)whenthebondisretired.
VN =C(P/F,i%,N)+rͼZ(P/A,i%,N)
Presentvalueofthe Presentvalueofallthe
redemption price interestpayments
Terminology:
• Z =face,orpar,value
• C =redemptionordisposalprice(usuallythesameasZ)
• r=bondrate(nominalinterest)perinterestperiod
• N =numberofperiodsbeforeredemption
• i =bondyieldrateperperiod
• VN =value(price)ofthebondatNinterestperiodspriortoredemption
107
ICE– Bond VN =C(P/F,i%,N)+rͼZ(P/A,i%,N)

Anew10Ͳyearbondisbeingissued,anditpaysarate
of6%peryear(payablesemiͲannually),andis
redeemableatitsfacevalueof$1000.Howmuch
shouldsomeonepaytopurchasethebondtoreceivea
yieldof8%peryear?
N=________(numberofperiodsbeforeredemption)
r=_________(bondrateperperiod)
i =_________(yieldrateperperiod)
C=________(redemptionprice)
Z=________(facevalue)
108
Whatisthepointofthisfigure?
109
HunƟngtonBankї
IRRDemoExampleSpreadsheet
110
Illustration:InterestRatesMatter
Ifyoubuyanewworktruck,youestimatethatyoucanearnanadditional$900per
month innewrevenue(afterthecostoffuelandinsurance).Shouldyoudoit?
111
TheInternalRateofReturnforDecisionMaking
Interest rate that equates the
equivalent worth of cash inflows
to the equivalent worth of cash
--IRR--
outflows.
IRRshouldbeusedwhenrevenuesare
presentandexceedcosts(IRRshouldn’t
benegative).
MosteasilysolvedusingExcelfunctionor
Graphically. CashIN CashOUT
Analysiscriteria:
i*шMARR,acceptproject
i*<MARR,rejectproject
112
RateofReturn
• Fullname:Internalrateofreturn,i*
– Therateearnedontheunrecoveredbalanceofan
investment
– TheratepaidontheyetͲunpaidbalanceofborrowed
money
– Theinterestratethatbringsallcashinflowsandoutflowsto
azerobalancewiththefinalamount.
DiscountallvaluestoP.
i*istheinterestratewhereєPW=0
113
TheIRRMethod
• Findtheinterestrate(i’)wherethePresentWorth
ofRevenue=thePresentWorthofExpenses
N N
PW ¦ R ( P / F , i'%, k ) ¦ E ( P / F , i'%, k )
k 0
k
k 0
k 0
GraphicalIllustrationofthe
effectofinterestrate.
114
IRRWarnings
• Yes:compareIRRforoneprojecttoMARR
– Acceptorrejectthatoneproject
• NO:compareIRRofdifferentalternatives
– IRRalonecannotidentifythemostprofitableproject
(otherfactors,suchastheamounts,alsodetermine
whichprojectismostprofitable)
• IRRassumesthatthecashflowgeneratedbythe
projectisreinvestedattheIRR
115
116
Gauguin:“WhenWill
YouMarry”
SoldinFebruary2015
for$300million
(originalsalespricein
1893wasapproximately
$750– equivalenttoabout
$20,000intoday’sterms)
117
RateofReturn
IRRFunctionality:
Yes:compareaproject’sIRRagainstMARR
NO:compareIRRofdifferentprojectstoeachother
InternalRoR – (IRR)Assumescashinflowsarereinvested
intotheproject(oranotherinvestmentwithidenticalreturn)
Ͳ Example)Savingsaccount:earningscan bereinvestedin
thesameaccount.
ExternalRoR – (ERR)Usewhenrevenuecannotbe
reinvestedbackintotheprojectͲ isinvestedelsewhere.
ͲExample)Buyingararepaintingasaninvestment,andthen
sellingit.Youmustbuysomethingelsewiththeprofits;
earningscannot bereinvestedinthesamepainting.
118
ExternalRateofReturn
TheERRmethodallowsforanexternal reinvestmentinterestrateii
tobeconsidered.
ii istheratethatcashflowsgeneratedbytheprojectcanbe
reinvested.(Itiswhereyouputthecashthatisgenerated.)
Method:
1) Net cashoutflows arediscounted totimezeroatii (i.e.,
findthePVofoutflows)
2) Netcashinflows arecompounded toN(endofthecash
flowdiagramtimeline)atii (i.e.,findtheFVofinflows)
3) ERRistheinterestratei’%thatestablishesequivalence
betweenthesetwoquantities
Ͳ UseabsolutevalueofthePW
119
Step1 – DiscountOutflowstoPresentusinggivenii Note:ifbothinflowandoutflow

occurinthesameyear,move
Step2 – CompoundInflowstoFutureusinggivenii
onlytheNETamount.
Convertatii%
(Externalreinvestmentrate)
Step3 – DiscountInflowsfromFuturetoPresentusingguessofERR,i’
ExternalRateofReturn,i’% atERRi’
TheinterestratethatmakesthePWofthe
futurerevenues=Ͳ thePWoftheexpenses
Step4 – KeepchangingERRi’untilPWinflow =ͲPWoutflow
120
ERRContinued
N N
¦ E ( P / F , i %, k )( F / P, i'%, N ) ¦ R ( F / P, i %, N k )
k 0
k i
k 0
k i
CashOutflows (expenses) CashInflows (revenue)
Discountedtotimezero Compoundedtothefuture (endofproject)
i’%Ͳ externalrateofreturnperperiod
ii =externalreinvestmentrateperperiod
E=expenses(outflow)
R=revenues(inflow)
121
ICEERR
Youhaveaprojectwiththe Net Cash
cashflowsummarizedhere. Year Flow
0 Ͳ25,000
Theprojectisnotsuitablefor
1 5,500
directreinvestment;
2 6,500
incomingrevenuewillbe
3 Ͳ1,000
placedintoanaccountthat
4 4,500
yields2.5%.
5 5,500
WhatistheExternalRateof 6 7,000
Returnforthisproject? 7 5,500
(ICETemplate)
122
Bonds
Abondisaninterestbearing certificatethatprovides
futurenetcashflowsataspecifiedinterestrateandhasa
cashvaluethatcanberedeemedatsomefuturedate.
ThePWmethodisonewaytofindthevalueofabond.
123
BondValue
Theownerofabondispaidtwo typesofpayments:
1. aseriesofperiodicinterestpayments(rͼZ)untilthebondisretired.
2. asinglepayment(C)whenthebondisretired.
VN =C(P/F,i%,N)+rͼZ(P/A,i%,N)
Presentvalueofthe Presentvalueofallthe
redemption price interestpayments
Terminology:
• Z =face,orpar,value
• C =redemptionordisposalprice(usuallythesameasZ)
• r=bondrate(nominalinterest)perinterestperiod
• N =numberofperiodsbeforeredemption
• i =bondyieldrateperperiod
• VN =value(price)ofthebondatNinterestperiodspriortoredemption
124
ICE– Bond VN =C(P/F,i%,N)+rͼZ(P/A,i%,N)

Anew10Ͳyearbondisbeingissued,anditpaysarate
of6%peryear(payablesemiͲannually),andis
redeemableatitsfacevalueof$1000.Howmuch
shouldsomeonepaytopurchasethebondtoreceivea
yieldof8%peryear?
N=________(numberofperiodsbeforeredemption)
r=_________(bondrateperperiod)
i =_________(yieldrateperperiod)
C=________(redemptionprice)
Z=________(facevalue)
125
Interpretingbondvalueamount
Facevaluevs.PurchasePrice
126
Step1 – DiscountOutflowstoPresentusinggivenii Note:ifbothinflowandoutflow
occurinthesameyear,move
Step2 – CompoundInflowstoFutureusinggivenii
onlytheNETamount.
Convertatii%
(Externalreinvestmentrate)
Step3 – DiscountInflowsfromFuturetoPresentusingguessofERR,i’
ExternalRateofReturn,i’% atERRi’
TheinterestratethatmakesthePWofthe
futurerevenues=Ͳ thePWoftheexpenses
Step4 – KeepchangingERRi’untilPWinflow =ͲPWoutflow
127
IRRAnalysisisn’tforcomparingalternatives
• Thebestprojectistheonethat
yieldsthemostprofit
• Sometimestheprojectwiththe
highestIRRyieldsthemost
profit
• Butsometimes….itdoesn’t.
ICE
Youcan’tcompareprojectsbytheirIRRandalwaysknowwhichoneisbest(unless
theybothrequirethesameoriginalinvestmentamountattimezero.)
128
MARR=4% ComparingIRRs– Whyyoushouldn’tdoit.

Year ProjectA ProjectB a) CalculatetheIRRforeachproject.
0 Ͳ50,000 Ͳ85,000 Whichoneishigher?
1 9,000 14,000
2 9,000 14,000 b) CalculatethePresentWorthofeach
3 9,000 14,000 project.Whichoneishigher?
4 9,000 14,000
5 9,000 14,000
c) Whichprojectshouldbeselected?
6 9,000 14,000
d) Ifyoumustborrowmoneyatthe
7 9,000 14,000
MARR,explainwhatdoesthePresent
8 9,000 14,000 Worthrepresent?
9 9,000 14,000
10 9,000 14,000
129
Project
• Costoflivingadjustment(income)andprice
inflationrate(expenses)
• Howspecifictogetwithexpenses
Notokay: Okay:
– Rent:$500 Weeklyfoodbudget
– Utilities:$100 Ͳ Meat$20
– Food:$300 Ͳ Milk$3
Ͳ Bread$5
– Insurance:$150 Ͳ Vegetables$25
Ͳ Fruit$18
Ͳ Booze$55
Ͳ Cereal$24
130
CalculationofIncrementalCF
Incremental cash flow = cash flowB – cash flowA
where larger initial investment is Alternative B
Example: Either of the cost alternatives shown below can be used in

a grinding process. Tabulate the incremental cash flows.
A B B-A
First cost, $ -40,000 - 60,000 -20,000
Annual cost, $/year -25,000 -19,000 +6000
Salvage value, $ 8,000 10,000 +2000
The incremental CF is shown in the (B-A) column
The ROR on the extra $20,000 investment in B determines which alternative
to select (as discussed later)
131
Review:Concept
frompreviousICE WhichalternativehasthehigherIRR?
ForMARR=10%,whichalternativeshouldbeselected?
DecisionMaking:
Thequestionisnot,“whichproject
hasthehighestIRR?”
Thequestionshouldbe,“isthe
additionalinvestmentamount
yieldingmorethantheMARR?”
Whencomparingprojects,future
revenuesshouldbediscountedatthe
MARR,notattheIRR.
132
IncrementalAnalysis
WhenusingIRRtocomparealternatives,examinethedifference inthe
investmentrequiredandanalyzeiftheadditionalbenefit(revenue)
resultingfromtheadditionalinvestmentisworthwhile.
Concept:
IftheIRRofthedifference >MARR,thentheadditional
investment isjustified.
133
TerminologyandVariables
• I (Interest)Amountearnedorpaidovertimebasedonan
initialamountandinterestrate.
• i (Interestrate)Interestexpressedasapercentageofthe
originalamountpertimeperiod.
• i* (Rateofreturn)Compoundinterestrateonunpaidor
unrecoveredbalancessuchthatthefinalpaymentresultsina
zerobalance.
– InternalRateofReturn(IRR)isi* whenyouassumetheearnings
canbereinvestedbackintotheproject.
• i’ (Externalrateofreturn,EROR)Theoverallrateofreturn
foraprojectwhereextrafundscannotbereinvested,and
wheretheyareinsteadinvestedinanexternalsource.
• ii (Externalreinvestmentrate)Therateatwhichextrafunds
areinvestedinsomesourceexternaltotheproject.
• ¨i* (RateofReturnontheExtraInvestment)Isdetermined
duringincrementalanalysis.
134
ѐIRRIllustration
<MARR
KeepC
Conclusion:OptionCisthebest
Principle:spendeveryextradollarthatwillbringareturngreaterthantheMARR.
135
136
RateofReturnEvaluationusingAnnualWorth
• Itissometimespreferredtocompare
alternativesonthebasisof theirannualworth.
• Tofindtherateofreturnontheadditional
investment requiredtopurchasethemore
expensivealternative,yousolvefortheinterest
ratewhere
AWA =AWB
*Whenusingthismethod,repeatabilityisimplied.
137
ICE:IncrementalAnnualWorthAnalysis
Whatistherateof
returnonthe
additionalamountfor
themoreexpensive
alternative?
OptionA OptionB
• InitialCost:$8000 • InitialCost:$13,000
• AnnualCost:$3500 • AnnualCost:$1600
• Lifespan:10years • Lifespan:5years
• Salvagevalue:$0 • Salvagevalue:$2000
138
139
DecisionMakingObjectiveSoFar:MaximizeProfit
140
It’snotalways
justaboutthe
money.
141
PublicSectorProjects
aproduct,service,orsystemused,financed,and
ownedbythecitizensofanygovernmentlevel.
• Highways • Garbagecollection
• Bridges • Schools(primary,
• Waterways secondary,university)
• Hospitals&clinics • Conventioncenters
• Parks&recreation • Sportsarenas
• Water • Airports
• Electricity • Economicdevelopment
• Gas projects
• Sewer • Housingprojects
Purpose:provideservicetothecitizenryforthepublicgoodatnoprofit.
142
Differences:Publicvs.PrivateProjects
Characteristic Public Private
Size of Investment Large Small, medium, large
Life Longer (30 – 50+ years) Shorter (2 – 25 years)
Annual CF No profit Profit-driven
Funding Taxes, fees, bonds, etc. Stocks, bonds, loans, etc.
Interest rate Lower Higher
Selection criteria Multiple criteria Primarily ROR
Environment of evaluation Politically inclined Economic
Note:forthegovernmenttospendmoney,ithastotakethatmoneyawayfrom
someoneelse(orfromanotherprojectthatmighthavebeenmoredeserving).
143
CashFlowClassificationsandB/CRelations
Mustmonetize eachprojecteffect,andclassifyaseitherbenefit,
disbenefit,orcost.
Benefit(B)-- Advantages to the public (time savings, improved reliability,

enhanced safety, environmental protection, leisure opportunities,
increased business revenue, etc.)
Disbenefit (D) -- Disadvantages to the public (delay, environmental damage,
decreased value of assets or revenue, reduction in quality of
life, etc.)
Cost(C)ͲͲ Expendituresbythegovernment
*Initialcost(Ci)
*AnnualM&Ocosts(CM&O)
Note 1: All terms must be expressed in same units, i.e., PW, AW, or FW
Note 2: Do not use minus sign ahead of costs
Note 3: Savings to the government are subtracted from costs. © 2012 by McGraw-Hill All Rights Reserved
144
B/CAnalysis– SingleProject
B-D
Conventional B/C ratio =
Ci + CM&O
If B/C 1.0, accept project;
otherwise, reject
B – D – CM&O
Modified B/C ratio =
Ci
Fromtheperspectiveofaprivatepartner(whodoesn’tincurdisbenefit expenses,but
doescapturethebenefits),theProfitabilityIndexis:
PI = B – CM&O If PI 1.0, accept project;

Ci otherwise, reject
145
146
IncrementalAnalysis
• Usedtocomparealternatives
• Foreachpairofalternativesbeingcompared
computeѐCi,ѐCM&O,ѐB,andѐD
– Eachshouldbeonthesamebasis(i.e.,PW,FW,orAW)
B-D
B/C conventional =
Ci + CM&O
147
IncrementalB/CAnalysis
MethodandCriteria
• SubstituteeachoftheseintotheConventional
orModifiedB/Cformula
– WhenѐB/C>1,themoreexpensivealternativeis
justified(anditbecomesthedefender for
subsequentcomparisons).
– WhenѐB/C<1,themoreexpensivealternativeis
notjustified(andthecheaperalternativeremains
thedefender forsubsequentcomparisons)
ǻB - ǻ D
ǼB/C conventional =
ǻ Ci + ǻ CM&O
148
149
InterestFactors
150
151
Whatisthe“Benefit”?
Howtocomparethesesortsofalternatives?
152
CostͲEffectivenessAnalysis(CEA)
• Oftenappliedinservicesectorprojects
– Aprojectorsystemthatprovidesintangibles to
individuals,businesses,orgovernmentunits
• Examples:heathcare,accounting,police,safetytraining,
financialservices,etc.
• Utilizedwhenbenefitsaredifficulttoestimate
– Example:whatarethebenefitsoftrafficcameras?
• (Accidentsaverted,deathsprevented,policecanfocuson
otheractivities,finescollected,etc.)
153
CEAExample
• Fourdifferentofficesprocesspassport
applications.
– ThereisanOperationsCostbudgetofupto$1600/hr.
Whichofficesshouldbeused?
Capital
rationing
(1) (2) (3) (4) (5)

C:Operations E:Applications Cumulative
Office C/E(CER)
Cost($/hr) /month Cost($/hr)
A
B $450
$875 14,000
8,900 $0.051
$0.063 $450
A
B $875
$450 14,000
8,900 $0.063
$0.051 $1,325
Sortfrommost
C $1,100 16,500 $0.067 $2,425 toleastefficient,
D $650 6,000 $0.108 $3,075 andcalculate
CumulativeCost
154
155
Whentoreplaceanitem?
1. Reducedperformance
(reliability/productivity).This
resultsinhigheroperating
costs,decreasedsafety,lost
sales,anddiminishedquality.
2. Alteredrequirements.New
specificationsthatcannotbe
metbyexistingequipment.
3. Obsolescence.Theimproved
performanceofnewer
technologiesmakesthecurrent
equipmentlesscompetitive.
156
AnnualWorthCurves
ForDeterminingEconomicServiceLife
Choosethenumber
ofyearsthat
minimizesthetotal
AWofcosts.
157
ReplacementStudyTerminology
• Defender.Thecurrentlyinstalledasset.
• Challenger.Thebestpotentialreplacement.
• Marketvalue.ThecurrenttradeͲinvalueforthe
defender,ifitissoldontheopenmarket.
• Economicservicelife(ESL).Howlongtoownan
item.Thenumberofyearsatwhichthelowest
AnnualWorthofcostoccurs.
• Defenderfirstcost:usecurrentmarketvalue.
• Challengerfirstcost:thechallenger’spurchase
price.
• Sunkcost.Previousexpendituresthatcannotbe
recoveredinthefuture.Notincludedinstudy.
158
159
160
ReplacementStudies
• Objective:Minimizecosts
• Assumptions:
– BothDefenderandChallengermeetrequired
specifications
– Whenstudyperiodisspecified,optionsexistto
matchthenumberofyearsunderexamination
161
Replacementstudy– NOStudyPeriodSpecified
• PerformEconomicServiceLife(ESL)analysisfor
bothDefenderandChallenger
• Selectthealternativewiththelowest Total
AnnualWorthofCosts
• Note:InrealͲworlduse,youmustperforma
followͲupstudyoneyearlater,incorporating
updatedestimatesofcosts
– Forexample:defendermayberetainingmarketvalue
morethanexpected,orchallenger
ICE– Part1
162
G=E+F
163
Replacementstudy– WITHStudyPeriodSpecified
• PrepareacashͲflowdiagramfordefenderand
challenger
– Studyperiodisoftenthelifeofthechallenger
– Mustidentifyamethodtoaccountfordifferentlives
ofalternatives:
• Purchaseofthechallengerafter thedefenderisretired
• Contractservices
ICE– Part2
164
ReplacementStudy
Study PeriodSpecified
• Challenger:
– Firstcost:$750,000
– AOC:$50,000
• Defender:
– CurrentMV:$70,000
– AOC:$30,000(3years)
– Thenpurchasea CR=$146,475
replacement… Duringtheseyears,theitemwill
betransferredoutsidethe
project.
165
CapitalRationing
• Everyorganizationhaslimitsontheavailable
investmentcapital.
• Capitalbudgetingstudy
– Developcashflowestimatesforeachproject
– Assumesprojectsareacceptedorrejected(nopartial
fundingofaproject)
– Budgetaryconstraintrestrictsinvestment
– Objective:maximizereturnoninvestment
166
167
MutuallyExclusiveBundles
• Formprojects,thereare2m possiblebundles.
Project InitialInvestment
A Ͳ10,000
B Ͳ5,500
C Ͳ8,500
D Ͳ15,000
ICE,Part1Ͳ Screening:
a) Forabove,howmanypossiblebundlesarethere?
b) UseMSExceltocalculatetheinitialinvestmentrequired
foreachbundle.
c) Forb=$23,500howmanyfeasible bundlesarethere?
Note:usetheMSfunction=if()
=if()functiondemo
168
ICE– Part2(Selection)
Project Initial AnnualNetCash
Investment Flow($)
A Ͳ10,000 2,500
B Ͳ5,000 1,300
C Ͳ8,000 2,100
D Ͳ15,000 3,200
• Eachprojectlastsfor8years
• TheMARR=12%
• Whichbundleshouldbeselected?
Conditionalformattingdemo
169
170
171
PriceDemand
• Priceistheindependent variable,meaningitis
“controlled”
• Demandisthedependent variable,meaningit
respondsto(i.e.,isdependenton)theprice
changes.
• Ifprice(p)increases,demandwill_________
• Ifprice(p)decreases,demandwill_________
172
Pricevs.Demand
p =sellingprice(revenue)perunit
a =pricewherethereiszero
demand(verticalintercept)
b =amountthatdemandincreases
foreachunitdecreaseinprice
D =demand(#ofunitssold)
173
TotalRevenueFunction
• Demand(D)isnumberofunitssold
• Price(P)isthepriceperunit
• TotalRevenue(TR)=p*D
Thus…forp=a– bD p =sellingprice(revenue)perunit
a =pricewherethereiszerodemand
(verticalintercept)
TR aD bD 2 b =amountthatdemandincreasesfor
eachunitdecreaseinprice
D =demand(#ofunitssold)
174
TRasaFunctionofDemand
175
Cost,Volume,andBreakevenPoints
• TotalCost(CT)=FixedCost(CF)+VariableCost(CV)
– VariableCost(CV)=v*D (variablecostperunit*demand)
• Profit=TotalRevenue(TR)– TotalCost(CT)
av
• OptimalDemand(D*)=(maximizesprofit)
2b
• BreakevenPoints(D’)= (a v) r [(a v) 4(b)(CF )]

2 0. 5
2(b)
176
177
ICE– Breakeven&MaxProfit
• Acompanyproducesanelectronictimingswitch.
Thefixedcostis$73,000/monthandthevariable
costis$83/unit.Thesellingpriceperunitis
p=$180Ͳ 0.02D
a) Determinetheoptimalvolume(demand)forthisproduct.
b) Whatisthemaximumprofit?
c) Findthevolumesatwhichbreakevenoccurs(i.e.,“domainof
profitabledemand”)
d) Sketchthecurvesandlabelthepoints
178
179
EconomicTerms
• PerfectCompetition– aproductissuppliedbya
largenumberofvendorsandnorestrictionon
additionalsuppliersenteringthemarket
– Example:
• Monopoly – uniqueproductorserviceonly
availablefromasinglesupplierandvendorcan
prevententryofothers
• Examples?
– Truemonopoliesarerarebecause:
• Substitutes
• Regulations
180
• FixedCosts– includesexpensesthatdonotdirectly
changeasafunctionofthelevelofproductivity(i.e.,
numberofitemssold)
– E.g.)rent,insurance,salariedemployees,equipmentcapital
recovery,computersystems
• VariableCosts– expensesthataredirectlyinfluenced
bythelevelofproductivity
– E.g.)Costsofmaterials,shipping,hourlylabor,warranty,
equipmentmaintenance
181
CostandNumberofUnits
Linear CostRelation NonͲLinear CostRelation
Question:Whatsortoffactorscould
causeanonͲlinearityaspicturedabove?
182
Revenue:(numberof Whatisgoing
itemssold)x(sales onhere?
priceperitem)
183
Whenvariablecostsarereduced
Forlinearanalysis,
breakevenquantity,
QBE…
Costcurveis
FC
QBE lower…
r v
r =revenueperunit
v =variablecostperunit
Fixed
Cost,FC
Breakevent point
movesleft…
184
BreakevenBetweenAlternatives
• Onealternativehasa
lowerfixedcost(Alt1)
• Anotheralternativehasa
lowervariablecost(Alt2)
– Whichalternativeto
selectdeterminesonthe
levelofproduction
Breakeven:thepointatwhichboth
alternativeshavethesamecost. ICE:Whichequipmentto
(Revenuesarenotconsidered). buy?
185
186
Whatif…
• Steamrollercost:$XX,XXX
• TakealoanoutatY.Y%interest
• Netrevenue:$ZZ,ZZZperyear
Howlonguntiltheloancanbe
paidofffully?
Thisisthetypeofquestiontobeaddressedwith“PaybackAnalysis”
187
We’veseenthis
sortofanalysis
before…
188
PaybackͲ Terminology
• Paybackperiodnp – estimatedtimefor
revenuesandsavingstocovertheinitial
investment plusarateofreturni
• Simplepayback– recoveryofonlytheinitial
investment,withoutprofit/interest(i =0%)
• Discountedpayback– theinflowamountthat
will,whendiscountedati,equaltheinitial
investment.
189
UseofPaybackAnalysis
• Initialscreeningtool.
– Determineiftheanticipatedusefullifeofequipmentis
longerthanpaybackperiod(np)
• Comparison tool.
– Forequipmentwithsameusefullifeandrevenue,
selectthealternativethatcanpaidoffquickest.
• Warning:paybackanalysisdisregardscashflows
afterthepaybackperiod.
– Thusitshouldnotbeusedforprojectselectionwhen
usefullifeofalternativesisdifferent.
190
InthetableͲlookupfactors,P/Aforacertain
Nandi tellsyouwhenthepresentvalueisin
balancewiththeannualvalue.
UnrecoveredInvestmentBalanceiscalculated
bysubtractingthePresentWorthofinflows
fromtheinitialcostofanalternative.
191
192
NotesforICE
• InthetableͲlookupfactors,P/AforacertainN
anditellsyouwhenthepresentvalueisin
balancewiththeannualvalue
• UnrecoveredInvestmentBalanceiscalculated
bysubtractingthePresentWorthofinflows
fromtheinitialcostofanalternative.
• Thefunction=NPER(rate,pmt,pv)tellsyou
howmanyyearstopayoffanitemhaving
initialcost“pv”whenusingthepayment
amount“pmt”.
193
OriginalMSRP:$2365
194
Whydocarscostsomuchtoday?
195
Source:wsj.com
196
Effect#1– Priceinflationseemstooccurwhenwagegrowthoccurs.[Demandforgoods
increaseswhenpeoplehavemoremoney.]
Effect#2– Wagesfallduringperiodsofrecession.[Whentheeconomy‘slows’,morepeople
areoutofwork,increasingthelaborsupply,decreasingtheneedforcompaniestoincrease
wages.]
197
InflationͲ Terminology
• Inflation – increaseintheamountofmoney
neededtoobtainthesamegoodsorservices.
• Inflationrate,f – ameasureoftherate (percent,

annualbasis)ofchangeinthevalueofcurrency.
– Ifyoursavingsaccountinterestrate=inflationrate,
youhavenogaininpurchasingpower.
• Realinterestrate,i – rateatwhichinterestis
earnedwhentheeffectofinflationisremoved.
– Representsactualgaininpurchasingpower.
198
InflationͲadjustedinterestrate,if
(a.k.a.,Marketinterestrate)
• Theinterestrateadjustedtoaccountfor
inflation.
– Theinterestrateif youshouldearninanenvironment
experiencinginflationoff whenyouwanttoachieve
aninterestrate(increaseinpurchasingpower)ofi
F 1 1
P F
1 f 1 i N
N
1 i f if N
Accountsfor Accountsfor
inflation interest
if i f if
199
PurchasingPower
Pricetoday:$25forf =3%Pricein15years?
Save$25today.Howmanybasketsoffoodcanyoupurchasein15yearsif
themarketinterestrate(i.e.,bankpays)7%.
200
ICE:Inflation– Part1
• Anitemthatcosts$5000nowisexpectedto
experience4%peryearpriceinflationduringthe
nextseveralyears.
a) Whatistheexpectedcostin5years?
b) Ifyourinvestmentsmustproducearealinterestrate
of10%,whatistheinflationͲadjustedinterestrate
theyshouldearntoachievethis?
c) Howmuchshouldbeinvestedtodaytopurchasethe
itemin5years?
201
ICE:Inflation– Part2
• ThepriceofanAirbusA380is$340million.Ifthe
priceisexpectedtoinflateat9%peryear,how
manyyearswillittakeuntilthecostis$500
million?
202
Deflation Whymight
demandfall?
Why?
Why?
Why?
Why?
• Deflationisadecreaseinpricesovertime(i.e.,
moneyisbecomingmorevaluableovertime)
203
MarketInterestRate
(InflationͲadjustedinterestrate),if
• Theinterestratebanksactuallycharge/pay(adjustedto
accountforinflation).
if i f if
204
EarningInterestDuringInflation
• Bankspayamarketinterestrate (thisisanother
descriptionforif)thatisaffectedbyinflation
– Itmaybemorethanf(i.e.,i ispositiveand
purchasingpowerwillincrease)
– Itmaybelessthanf (i.e.,i isnegativeand

purchasingpowerwilldecrease)
• Banksseldom(never?)quotea“realinterest
rate”
if i f if
205
InflationandFutureWorth
Twowaystoaccountforinflationineconomic
analyses:
1) ConvertallcashflowsintoconstantͲvalue
dollars (usingf)andthenusei (realinterest
rate)incalculationoffutureamounts.
2) Leavecashflowsasinflated dollarsanduseif
(inflationadjustedinterestrate)incalculations
offutureamounts.
206
InflationandCapitalRecovery
• Today’smoney(morevaluable)mustbe
recoveredwithfutureinflatedmoney(less
valuable).
– Performcapitalrecoverycalculationsusingthe
interestrateif thatincludesinflationf andthereal
interestratei thatisdesired.
207
Part3
Part4
208
Howarecostestimatesused?
• Todeterminewhatfeaturestoinclude.
Basedonthebudget,canafacilityaffordbothanAEDandawheelchairlift?
209
Estimatesshould:
1. Bebasedonsoundinformationgatheredovera
rangeofconditionsthatarerepresentativeof
thecurrentsituation.
– Usereasonabledata.
2. Useacceptedtheoryandtechniquesintaking
statisticalsamples,buildingbudgetelements,
anddrawingconclusions.
– Useacceptedmethods.
3. Keeppersonalandworkingrelationships
separatewhenmakingestimates.
– Avoidbias
210
211
212
213
DirectvsIndirectCosts
• DirectcostsͲ canbereasonablymeasuredand
allocatedtoaspecificoutputorworkactivity
– Canbeestimatedwithsomedetail:howmuch“X”
doesittaketomake“Y”
– Example:materials,laborersalaries,production
expenses
• IndirectcostsͲ coststhatcannoteasilybe
allocatedtoatask
– Usuallyrecoveredusingstandardratesandfactors
– Example:computersystems,accountingservices,
supervisorysalaries,buildingrent
214
BottomͲUpApproach(“RequiredPrice”) TopͲDownApproach(“CompetitivePrice”)
Priceisanoutputvariable;workswell Priceisaninputvariable;encourages
whencompetitionisnotadominantfactor. innovation,newdesign,andefficiency.
Cost
Estimation
Techniques
215
EstimateAccuracy
Accurateestimatesrequiresignificanttimetoprepare,andare
thereforecostlytoobtain.Oneshouldbalancetheneedforaccuracy
withthecostofobtainingit.
216
Costsavingsareeasiestto
LifeͲCycleCosts obtainatthebeginningof
aproject,beforetoo
muchcapitalhasbeen
committedtoacertain
courseofaction.
217
TheUnitMethod
• Totalestimatedcost,CT isthecostperunit(u)
multipliedbythenumberofunitsrequired(N)
CT uuN
– Examples:
• Operatingacar:$0.52permile
• Buildingahighway:$6.2millionpermile
• Constructingahouse:$225persquarefoot
• Pouringconcrete:$93percubicyard
218
219
CostIndexes
• Costindex:aratioofthecostofsomething
todaytoitscostsometimeinthepast
Constructionindex
CPI– CategoryWeights
CPI– TableoverTime
220
UsingaCostIndex
§I ·
Ct C0 ¨¨ t ¸¸
© I0 ¹
• Ct =estimated costatpresenttimet
• C0 =costatprevioustimet0
• It =indexvalueattimet
• I0 =indexvalueattimet0
221
ICE:CostIndex
§I ·
Ct C0 ¨¨ t ¸¸
© I0 ¹
222
DefiningTerms
Firstshirtshe
sewedtook12
minutes.
K=12min
223
DefiningTerms
OilPan#5took40secondstoinstall.
OilPan#10took37secondstoinstall
S=37/40=0.925
Automation
224
LearningandImprovement
• Learningcurve: amodelthatexplainsincreasedworker
efficiencyandimprovedorganizationalperformance
withrepetitiveproductionofagoodorservice.
• Sometimescalledanexperiencecurveormanufacturing
progressfunction
K =thenumberofinputresourceunitsneeded.
toproducethefirst outputunit
S =thelearningcurveslopeparameter(decimal)
(ratiooftimetodoublethenumberpreviouslymade.)
n =log S / log 2 =learningcurveexponent
u =theoutputunitnumber
Zu K un Zu =thenumberofinputresourceunitsneeded.
toproduceoutputunitu
225
Example:LearningCurve
• Ittakesyou85minutestosewyourfirst pairof
pants.Thesecond pairofpantsyousewtakes76.5
minutes,andthefourth pairtakes68.85minutes.
a. Howlongwillittaketosewyour10th pairofpants?
b. Whatisthetotaltimerequiredtosew10pairsofpants?
S =thelearningcurveslopeparameter(decimal)
(ratiooftimetodoublethenumberpreviouslymade.)

n =log S / log 2 =learningcurveexponent
Zu K un u =theoutputunitnumber
K =thenumberofinputresourceunitsneeded.
toproducethefirstoutputunit
Zu =thenumberofinputresourceunitsneeded.
toproduceoutputunitu
226
227
InͲClassExercise
• LearningCurve. Thetablebelowshowshowlong
ittakesyoutosolveaRubik’scubeasafunction
ofhowmanytimesyouhavetried.Howlongwill
ittaketosolvetheRubik’scubethe100th time
youtry?
Try(#) Time(minutes)
1 Forgottotimeit
2 24.00
3
4
5
22.71
21.84
Forgottotimeit
Zu K un
6 20.67
7 20.24
8 19.87
228
229
CostͲEstimatingRelationship
Usesdesignvariablestoestimatecost.(Effectofsizevariation)
• CostͲcapacityequation:
x
§Q ·
• Ifx<1,thereisaneconomyofscale
C1 ¨¨ 2 ¸¸
(costadvantageforlargersize)
C2 • Ifx>1,therearediseconomiesof
© Q1 ¹ scale(largersizeismoreexpensive)
• Ifx=1,linearrelationship(noeffect
fromsize)
• C1 =costatcapacityQ1
• C2 =costatcapacityQ2
• x=correlatingexponent
– Illustration:A0.5MGDwatertreatmentplantcost
$1.7million.Thecorrelatingexponentis0.14.
• Thecostofa2.0MGDplantwillbe____million.
230
ICE39Part1
231
CostEstimation:FactorMethod
• Thecostofanentireprojectissomemultiplier
(i.e.,“factor”)ofthecostofanindividual
component.
• CT =totalcost
• H=overallcostfactor(ofsumof
CT hC E individualcostfactor)
• CE =totalcostofmajorequipment
– Illustration:Thecostofanentiremealcanbe
estimatedbythecostofwaterx10.
• IftherestaurantchargesAED3forwater,youcanestimate
thattheentiremealwillcostAED30.
• IftherestaurantchargesAED20forwater,youcan
estimatedthatthemealwillcostAED200.
232
FactorMethod:IndirectCosts
CT >C 1 ¦ f @1 f
E dc I
• CT =totalcost
• CE =totalcostofmajorequipment
• fdc =directcostfactor
• fI =indirectcostfactor
• ICE
233
CharacteristicsofMoney
• Durability:Objectsusedasmoneymustwithstand
physicalwearandtear
• Portability: Peopleneedtobeabletotakemoneywith
themastheygoabouttheirbusiness
• Divisibility: Tobeuseful,moneymustbeeasilydivided
intosmallerdenominations,orunitsofvalue
• Uniformity: Anytwounitsofmoneymustbeuniform
orthesameinthetermsofwhattheywillbuy
• LimitedSupply:Moneymustbeavailableonlyin
limitedquantities
• Acceptability: Everyonemustbeabletoexchangethe
moneyforgoodsandservices
234
235
IndirectCostRatesandAllocation
CostEstimation:howtoaccountforandrecovertheindirectcosts?
• Indirectcostsaredifficulttoassigntoaspecific
output.
– Theymustberecovered.
– Thetotalamountcanbedividedaccordingtovarious
criteria
236
237
ActivityͲBasedCosting(ABC)
• Costcenters:thefinalproductsorservicesofa
company.
– Theyreceive allocatedindirectcosts(i.e.,sothattheir
truecostofoperationscanbeaccountedfor)
• Activities:departmentsthatprovidesupport
– Forexample:purchasing,qualitycontrol,IT,
supervision
– Theygenerate theindirectcosts
• Costdrivers:volumesthatdrivetheconsumption
ofasharedresource
– Example:numberofequipmentorders,numberof
itemsinspected,supporttickets,projectvolume,etc.
ICEPt.2
238
c)NumberofStudents
239
Depreciation
Depreciation: decrease in value of physical properties with
the passage of time and use.
• Tax deprecation is an annual deduction against income such that
the effect of time and use on an asset’s value can be reflected in a
firm’s financial statement.
Cost Basis (B) The initial cost of acquiring an asset (plus sales tax) and
costs to make it serviceable (e.g., transportation, installation).
Book Value (BVk) The value of asset as shown on the accounting
records. Represents amount of money still invested in the property.
BVk = book value at EOY k
240
TaxDepreciationCriteria
Typicalcriteriaforpropertytobedepreciable:
1. Itmustbeusedinbusinessorheldtoproduceincome.
2. Itmusthaveadeterminableusefullife(longerthan1
year).
3. Itmustbesomethingthatwearsout,decays,getsused
up,becomesobsolete,orlosesvaluefromnaturalcauses.
4. Itisnotinventory,stockintrade,orinvestmentproperty.
Whywouldabusinesswant theirpropertytodepreciate?
241
DepreciationMethods
Straightline (SL)(includesSVN)
Ͳ Depreciationamount isequal eachyear
Ͳ Salvagevalueisconsidered
Decliningbalance (DB)
Ͳ Depreciationfraction isequal eachyear
Ͳ Salvagevaluecanbe considered
MACRS (GeneralDepreciationSystem– GDS)(noSVN

considered)usePropertyClass
Ͳ UsespreͲformatteddepreciationfractions
Ͳ Salvagevalueisnot considered
242
CommonDepreciationTerms
FirstcostP orunadjustedbasisB:Totalinstalledcostofasset
BookvalueBVt: Remainingundepreciatedcapitalinvestmentinyeart
Recoveryperiodn:Depreciablelifeofassetinyears
MarketvalueMV:Amountrealizableifassetweresoldonopenmarket
SalvagevalueS:EstimatedtradeͲinorMVatendofasset’susefullife
Depreciationratedt:Fractionoffirstcostorbasisremovedeachyeart
Personalproperty:Possessionsofcompanyusedtoconductbusiness
Realproperty:Realestateandallimprovements(landnotdepreciable)
HalfͲyearconvention:Assumesassetsareplacedinserviceinmidyear
243
StraightLineDepreciation
Book value decreases linearly with time
BS Where: Dt = annual depreciation charge

Dt t = year
n B = first cost or unadjusted basis
S = salvage value
n = recovery period
BVt B tDt Where: BVt = book value after t years
SL depreciation rate is constant for each year: d = dt = 1/n
244
Example:SLDepreciation
Anargongasprocessorhasafirstcostof$20,000witha
$5,000salvagevalueafter5years.Find:
(a) D3
(b) BV3 foryearthree.
(c) Plotbookvaluevs.time.
(c) Plot BV vs. time

Solution: (a ) D3 = (B – S)/n
BVt
= (20,000 – 5,000)/5 20,000
= $3,000
11,000
(b) BV3 = B – tDt 5,000

= 20,000 – 3(3,000)
0 3 5 Year, t
= $11,000
245
DecliningBalanceDepreciation
Determined by multiplying BV at beginning of year by a fixed percentage
Fixed percentage d is sometimes stated directly
Max rate for d is twice straight line rate, i.e., d 2/n
Cannot depreciate below salvage value
Depreciation for year t: Dt d BVt 1

1/ n
% §S·
d or d 1 ¨ ¸
100 * n ©B¹
Definedbypercentage Definedbysalvagevalue
B1 d
t
Book value for year t is given by: BVt
246
Example:DecliningBalance
Adepreciableconstructiontruckhasafirstcostof$80,000witha
lifespanof10years.Finddepreciationandbookvalueovertimefor:
(a)150%depreciation
(b)Aknownsalvagevalueof$10,000
247
248
249
MACRSDepreciation
Always depreciates to zero; no salvage value considered
Incorporates switching from DDB to SL depreciation
Standardized recovery periods (n) are utilized
MACRS recovery time is always n+1 years;

half-year convention assumes purchase in midyear
250
Chapter7 251
251
Chapter7 252
252
MACRSDepreciation
Required method to use for tax depreciation in USA
Originally developed to offer accelerated depreciation for economic growth
Where: Dt = depreciation charge for year t

Dt = dtB B = first cost or unadjusted basis
dt = depreciation rate for year t (decimal)
Get value for dt from IRS table for MACRS rates

j=t
BVt = B - Dj Where: Dj = depreciation in year j
j=1 Dj = all depreciation through year t
253
254
255
ConceptComprehension
1. Brieflyexplainthe“repeatabilityassumption”.
2. Iftherepeatabilityassumptiondoesnotapply,
howcantwoprojectswithdifferentusefullives
becompared?
3. WhatmainadvantagedoestheERRmethod
havecomparedtotheIRRmethodofproject
analysis?
4. Whyis“moneynow”morevaluablethan
“moneyinthefuture”?
5. IdentifyoneshortcomingwiththeBͲCmethod.
256
257
258
VAT– ValueAddedTax
259
260
261
262
TaxesͲ Terminology
Excisetaxesarefederaltaxesassessedasafunctionofcertaingoodsor
servicesoftenconsiderednonͲnecessitiesandgenerallyconsideredas
independentofoutputandprofitofacompany
Salestaxesareassessedonthebasisofpurchasesofgoodsorservicesand
arethusindependentofgrossincomeorprofits.Normallyleviedbystate,
municipal,orcountygovernments.Salestaxesarerelevantinengineering
economyonlytotheextentthattheyaddtothecostofitemspurchased.
Propertytaxesareassessedasafunctionofthevalueofpropertyowned
(bothlandandbuildingsandequipment).Unlikeincometaxes,property
taxesareindependentoftheoutputandprofitofacompany.
Incometaxesareassessedasafunctionofgrossrevenueminusallowable
deductions.Incometaxesareleviedbythefederalgovernment,statesand
somelocalgovernments.
263
PropertyTaxinCabellCounty
• Taxrates:https://cabellassessor.com/faq.html
– AppraisedValuex0.60=AssessedValue
– AssessedValuexTaxRate/100=PropertyTax
– ICE43
264
IncomeTax
• IntheUS,institutedin1861tohelppayforthe
CivilWar
– Was3%ofallincomeover$800.
– Laterreducedto2%ofincomeover$4000
(equivalentto$113,000intoday’sterms)
265
IncomeTaxRates:“Progressive”
https://taxfoundation.org/2019ͲtaxͲbrackets/
266

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© 2012 by McGraw-Hill, New York, N.Y All Rights Reserved

© 2012 by McGraw-Hill, New York, N.Y All Rights Reserved

interest accrued per time unit

© 2012 by McGraw-Hill, New York, N.Y All Rights Reserved

P=$10,000 i =6%peryear N=5years F=?

© 2012 by McGraw-Hill, New York, N.Y All Rights Reserved

© 2012 by McGraw-Hill, New York, N.Y All Rights Reserved

0 1 2 3 4 5 6 © 2012 by McGraw-Hill, New York, N.Y All Rights Reserved

Howitworks:Userate i andtimet inupcoming

© 2012 by McGraw-Hill, New York, N.Y All Rights Reserved

The amount of $100 now is economically equivalent to the

Note:Adepositisnotequivalenttoawithdrawal! © 2012 by McGraw-Hill, New York, N.Y All Rights Reserved

P=F/(1+i)N =$100/(1.10)1 =$90.91

F=??? F=4,500 A=??? A=12,500

P=11,000 P=??? P=7,500 P=???

FindFgivenP. FindPgivenF. FindAgivenP. FindPgivenA.

F/P P/F A/P P/A

© 2012 by McGraw-Hill, New York, N.Y All Rights Reserved

© 2012 by McGraw-Hill, New York, N.Y All Rights Reserved

(A) $2,792 (B) $9,000 (C) $10,795 (D) $12,165

The cash flow diagram is:

© 2012 by McGraw-Hill, New York, N.Y All Rights Reserved

(A) $10,000 (B) $ 31,050 (C) $ 33,250 (D) $319,160

The cash flow diagram is: Solution:

© 2012 by McGraw-Hill, New York, N.Y All Rights Reserved

The cash flow diagrams are:

P = A(P/A,i,n) Standard Factor Notation A = P(A/P,i,n)

(A) $11,170 (B) 13,640 (C) $15,300 (D) $18,950

The cash flow diagram is as follows: Solution:

© 2012 by McGraw-Hill, New York, N.Y All Rights Reserved

Cash flow diagrams are:

F = A(F/A,i,n) Standard Factor Notation A = F(A/F,i,n)

© 2012 by McGraw-Hill, New York, N.Y All Rights Reserved

(A) $45,300 (B) $68,500 (C) $89,228 (D) $151,500

The cash flow diagram is:

© 2012 by McGraw-Hill, New York, N.Y All Rights Reserved

The cash flow diagram for the PG

NotethatPG is locatedTwo Periods

WhenusingbuiltͲin formulas Thenanegativesignmustbe

*Range of values: highlight cells containing future amounts.

*Note: only include FUTURE VALUES in this function!!!!!

© 2012 by McGraw-Hill, New York, N.Y All Rights Reserved

The interest rate that balances a FV and payments:

© 2012 by McGraw-Hill, New York, N.Y All Rights Reserved

PWB =? OptionB

P=11,500 F=11,500 F=11,500

PWB =? OptionB

PWB =? OptionB

PWB =? OptionB

Must compare alternatives for equal service

Basic equation is: CC = P = A

© 2012 by McGraw-Hill All Rights Reserved

R:revenue E:Expense(R– E)=profit

ICE– Bond VN =C(P/F,i%,N)+rͼZ(P/A,i%,N)

Step1 – DiscountOutflowstoPresentusinggivenii Note:ifbothinflowandoutflow

Step4 – KeepchangingERRi’untilPWinflow =ͲPWoutflow

CashOutflows (expenses) CashInflows (revenue)

Discountedtotimezero Compoundedtothefuture (endofproject)

ICE– Bond VN =C(P/F,i%,N)+rͼZ(P/A,i%,N)

Step4 – KeepchangingERRi’untilPWinflow =ͲPWoutflow

MARR=4% ComparingIRRs– Whyyoushouldn’tdoit.

Example: Either of the cost alternatives shown below can be used in

PI = B – CM&O If PI 1.0, accept project;

• BreakevenPoints(D’)= (a v) r [(a v) 4(b)(CF )]

BS Where: Dt = annual depreciation charge

BVt B tDt Where: BVt = book value after t years

Depreciation for year t: Dt d BVt 1