Engineering Economics

Chapter 9
Other Analysis Techniques

1. Benefit-Cost Ratio (B/C) Analysis

• Given an MARR, we know that an alternative is acceptable if its NPW (and hence, EUAW) is
> 0.

• Likewise, an alternative is acceptable if its ____________________ (and hence,

_______________________).

• Benefit-Cost Ratio Analysis is commonly used by Civil Engineers because of its high
utilization for public projects.

• If the B/C ratio equals 1.0, the alternative earns an interest rate _________to the_________.

• If the B/C ratio is greater than 1.0, the alternative earns an interest rate that is _______ than
the MARR.

• If the B/C ratio is less than 1.0, the alternative earns an interest rate that is _______ than the
MARR.

2. Making a Decision: One Alternative

• If the B/C ratio > 1.0, the alternative is acceptable.

• If the B/C ratio < 1.0 and do-nothing is an option, choose do-nothing.

• If the B/C ratio < 1.0 and do-nothing is NOT an option, choose the alternative because it is the
only available alternative.

3. Incremental B/C (∆B/∆C) Analysis

• Incremental B/C ratio analysis must be used when choosing __________________________.

• The Incremental B/C ratio is the ratio that is found on the ___________________________
_____________________________.
• While you may use either present worth or uniform annual cash flow equations, it is often
more convenient to use uniform annual cash flow equations (especially for alternatives with
_____________________________ since present worth requires calculations based on the
LCM).

• RECOMMENDATION: Use uniform annual cash flow equations!

• The difference is calculated by taking the higher cost alternative __________ the lower cost
alternative.

• The high cost alternative is based on the higher EUAC (or PWCost ).

∆EUAB
• For example: =
∆EUAC

4. Accounting for Salvage Values

• As discussed in annual cash flow analysis, a salvage value is considered a
__________________________ (i.e., a negative cost).

• Therefore, salvage values belong in the _________________ of the B/C and ∆B/∆C ratios.

5. Making a Decision: Two Alternatives

• If ∆B/∆C > 1, choose the ___________________________.

• If ∆B/∆C < 1, choose the ____________________________.

*The above rules assume at least one alternative is acceptable based on a given MARR.
6. Example of Benefit Cost Ratio Analysis
• The following costs and benefits are associated with equipment being considered by a local
organization. Use Benefit Cost Ratio Analysis to determine which, if any, should be chosen.
• MARR = 15%

Option #1 Option #2
Initial Cost $50,000 $70,000
$25,000 in year 1;
Benefits $30,000 per year
$2,000 annual decrease

O&M Costs $5,000 per year $10,000 per year

Salvage $10,000 $15,000
Life (in years) 5 7

CFD for Option #1

Option #1
$25,000 $23,000 $21,000 $27,000
$19,000

0 1 2 3 4 5
$5,000 $5,000 $5,000 $5,000 $5,000

$50,000
CFD for Option #2

Option #2 $45,000
$30,000 $30,000 $30,000 $30,000 $30,000 $30,000

0 1 2 3 4 5 6 7
$10,000 $10,000 $10,000 $10,000 $10,000 $10,000 $10,000

$70,000
7. Conventional Payback Period Analysis
• The payback period is the period of time required for ________________________________
___________________________.

8. Example of Conventional Payback Period

EOY 0 1 2 3 4 5
Net Cash Flow

• Since the net cash flows (beyond year 0) are uniform, the conventional payback calculation is
simple.

• Conventional Payback Period = (investment)/(equal annual benefit)

• Conventional Payback Period =

=

9. Another Example of Conventional Payback Period

EOY 0 1 2 3 4 5
Net Cash Flow

• Since the net cash flows (beyond year 0) are not uniform, the conventional payback
calculation requires a little more work.

EOY 0 1 2 3 4 5
Net Cash Flow
"Cumulative”

• Notice that investments equal benefits between the __________________ years.

• Therefore, to “break-even”, we need $___________ of the $____________ net cash flow in

year _______.

• Conventional Payback Period =

10. Example of Benefit Cost Ratio Analysis
• The following costs and benefits are associated with equipment being considered by a local
organization. Use Benefit Cost Ratio Analysis to determine which, if any, should be chosen.
• MARR = 15%

Option #1 Option #2
Initial Cost $50,000 $70,000
$25,000 in year 1;
Benefits $30,000 per year
$2,000 annual decrease

O&M Costs $5,000 per year $10,000 per year

Salvage $10,000 $15,000
Life (in years) 5 7

CFD for Option #1

Option #1
$25,000 $23,000 $21,000 $27,000
$19,000

0 1 2 3 4 5
$5,000 $5,000 $5,000 $5,000 $5,000

$50,000
CFD for Option #2

Option #2 $45,000
$30,000 $30,000 $30,000 $30,000 $30,000 $30,000

0 1 2 3 4 5 6 7
$10,000 $10,000 $10,000 $10,000 $10,000 $10,000 $10,000

$70,000
11. Shortcomings of Conventional Payback Period Analysis
• Ignores ________________________________________

• Ignores ______________________________________________________

• Because of the above, only considering the payback period may lead to __________________
_____________________.

12. Example of Shortcomings of Conventional Payback Period Analysis

Alternative #1

EOY 0 1 2 3 4 5
Net Cash Flow -1000 1000 500 250 100 50
"Cumulative” -1000 0 500 750 850 900

• Conventional Payback Period =

Alternative #2

EOY 0 1 2 3 4 5
Net Cash Flow -1000 500 500 1000 2000 2000
"Cumulative” -1000 -500 0 1000 3000 5000

• Conventional Payback Period =

• Alternative #1 has the quickest payback period (and a great ROR!).

• However, it is quite obvious that Alternative #2 is the best economic choice for any
reasonable MARR.

• Therefore, a decision based solely on conventional payback analysis may lead to wrong and
costly decisions.
13. Discounted Payback Period Analysis
• This method incorporates the _______________________________.

• The discounted payback period is the period of time required for equivalent benefits to
equal the equivalent investment(s).

14. Conventional vs Discounted Payback Period Analysis

Conventional Payback Period

EOY 0 1 2 3 4 5
Net Cash Flow -7000 2000 2500 3000 2500 2000
"Cumulative” -7000 -5000 -2500 500 3000 5000

*Conventional Payback Period =

Discounted Payback Period

EOY 0 1 2 3 4 5
Net Cash Flow -7000 2000 2500 3000 2500 2000

*Discounted Payback Period =

15. Shortcomings of Discounted Payback Period Analysis

• The Discounted Payback Period Analysis method does consider the time value of money.
This makes it a conceptually better method. However, it …

• Ignores cash flows beyond the payback period.

• Therefore, neither method indicates the overall profitability of the project.