Engineering Economics

Tutorial Sheet 4

1 Concept of Rate of Return

1.1 You are going to buy a new car worth $14,500. The dealer computes your monthlypayment to be $267
for 72 months’ financing. What is the dealer’s rate of returnon this loan transaction?
1.2 You wish to sell a bond that has a face value of $1,000. The bond bears an interestrate of 6%, payable
semiannually. Four years ago, the bond was purchased at$900. At least an 8% annual return on the
investment is desired. What must be theminimum selling price of the bond now in order to make the
desired return on theinvestment?
1.3 In 1970, Wal-Mart
Mart offered 300,000 shares of its common stock to the public at aprice of $16.50 per
share. Since that time,Wal-Mart
Mart has had 11 two
two-for-one
one stocksplits. On a purchase of 100
1 shares at
$16.50 per share on the company’s first offering,the number of shares has grown to 204,800 shares
worth $10,649,600 onJanuary 2006. What is the return on investment for investors who purchased
thestock in 1970 (say, over a 36-year
year ownership peperiod)?
riod)? Assume that the dividendsreceived during
that period were not reinvested.
1.4 Johnson Controls spent more than $2.5 million retrofitting a government complexand installing a
computerized energy-management
management system for the State of Massachusetts.As a result,
resul the state’s energy
bill dropped from an average of $6 milliona year to $3.5 million. Moreover, both parties will benefit
year life ofthe contract. Johnson recovers half the money it saved in reduced utility
from the 10-year
costs(about $1.2 million a year overer 10 years); Massachusetts has its half to spend onother things.
What is the rate of return realized by Johnson Controls in this energycontrolsystem?

2 Investment Classification and Calculation of i*

2.1 Consider fourr investments with the given
sequences of cash flows
(a) Identify all the simple investments.
(b) Identify all the non simple investments.
(c) Compute fori* each investment.
(d) Which project has no rate of return?

2.2 Consider an investment project with the following cash flows:

(a) Find the IRR for this investment.
(b) Plot the present worth of the cash flow as a function of i.
(c) On the basis of the IRR criterion, should the project be accepted
atMARR= 15%?
Consider the following investment projects
projects. Assuming MARR=
12%that in the following questions:
(a) Compute for projects A andd B. If the project has
more than one identifyall of them.
(b) Classify each project as either a pure or a mixed
investment.
(c) Compute the IRR for each investment.
(d) Determine the acceptability of each project.
3 IRR Analysis
3.1 Agdist Corporation distributes agricultural equipment. The board of directors isconsidering a proposal
to establish a facility to manufacture an electronically controlled“intelligent” crop sprayer invented by
a professor at a local university. Thiscrop sprayer project
project would require an investment of $10 million
in assets andwould produce an annual after-tax
after tax net benefit of $1.8 million over a service life ofeight
years. All costs and benefits are included in these figures. When the projectterminates, the net
proceedsds from the sale of the assets will be $1 million. Computethe rate of return of this project. Is this
a good project at MARR = 10%?
3.2 You are considering a luxury apartment building project that requires an investmentof $12,500,000.
The building has 50 units.. You expect the maintenance costfor the apartment building to be $250,000
the first year and $300,000 the secondyear. The maintenance cost will continue to increase by $50,000
in subsequentyears. The cost to hire a manager for the building is estimated to be $80,000per year.
After five years of operation, the apartment building can be sold for$14,000,000. What is the annual
rent per apartment unit that will provide a returnon investment of 15%? Assume that the building will
remain fully occupied duringits five years of operation.
3.3 Champion Chemical Corporation is planning to expand one of its propylenemanufacturingfacilities. At
a piece of property costing $1.5 million mustbe purchased to build a plant. The building, which needs
to be expanded duringthe firstt year, costs $3 million. At the end of the first year, the company needs
tospend about $4 million on equipment and other start start-up
up costs. Once the buildingbecomes
operational, it will generate revenue in the amount of $3.5 million duringthe first operating year. This
will increase at the annual rate of 5% over the previousyear’s revenue for the next 9 years. After 10
years, the sales revenue will stayconstant for another 3 years before the operation is phased out. (It
will have aproject life of 13 years aft
after
er construction.) The expected salvage value of theland at the end
of the project’s life would be about $2 million, the building about$1.4 million, and the equipment
about $500,000. The annual operating and maintenancecosts are estimated to be approximately
approximatel 40% of
the sales revenue eachyear. What is the IRR for this investment? If the company’s MARR is 15%,
determinewhether the investment is a good one. (Assume that all figures represent theeffect of the
income tax.)

4 Comparing Alternatives
4.1 Consider two investments
estments A and B with the following sequences
of cash flows:
(a) Compute the IRR for each investment.
(b) AtMARR= 15%, determine the acceptability of each project.
(c) If A and B are mutually exclusive projects, which project would
you select,based on the rate of retu
return on incremental investment?
4.2 With $10,000 available, you have two investment options. The first is to buy a certificateof deposit
from a bank at an interest rate of 10% annually for five years.The second choice is to purchase a bond
for $10,000 and invest the bond’s interestin the bank at an interest rate of 9%. The bond pays 10%
interest annually and willmature to its face value of $10,000 in five years. Which option is better?
Assumethat your MARR is 9% per year.
4.3 You are considering two types of automobiles. Model A costs $18,000 and model Bcosts $15,624.
Although the two models are essentially the same, after four years ofuse model A can be sold for
$9,000, while model B can be sold for $6,500. Model Acommands a better resale value because its
styling is popular among young collegestudents. Determine the rate of return on the incremental
investment of $2,376. Forwhat range of values of your MARR is model A preferable?

5 Short Case Studies

5.1 Critics have charged that, in carrying out an economic analysis, the commercialnuclear power industry
does not consider the cost of decommissioning, or “mothballing,”a nuclear power plant and that the
analysis is therefore unduly optimistic.As an example, consider the Tennessee Valley Authority’s
Bellefont twin nucleargenerating facility under construction at Scottsboro, in northern Alabama:The
initialcost is $1.5 billion (present worth at the start of operations), the estimated lifeis 40 years, the
annual operating and maintenance costs the first year are assumedto be 4.6% of the initial cost and are
expected to increase at the fixed rate of 0.05%of the initial cost each year, and annual revenues are
estimated to be three timesthe annual operating and maintenance costs throughout the life of the plant.
(a) The criticism that the economic analysis is overoptimistic because it omits“mothballing” costs is not
justified, since the addition of a cost of 50% of theinitial cost to “mothball” the plant decreases the
10% rate of return only to approximately9.9%.
(b) If the estimated life of the plants is more realistically taken to be 25 years insteadof 40 years, then the
criticism is justified. By reducing the life to 25years, the rate of return of approximately 9% without
a “mothballing” costdrops to approximately 7.7% when a cost to “mothball” the plant equal to
50%of the initial cost is added to the analysis.
Comment on these statements.