Primary Analysis

Techniques

Supplemental Reading, Chapter 5, and 6

Newnan, D., Whittaker, J., Eschenbach, T., and Lavelle, J. (2018). Engineering Economic
Analysis (4th Canadian edition). Oxford University Press.

ENG 3000
© Nish Balakrishnan, 2020
Learning Objectives
• Be able to understand the concept of Net Present Worth/Value
(NPV) and Annual Worth (AW).
• Be able to understand why and how cash flows can be compared
based on NPV or AW.

• Be able to modify a given economic situation and assess what

options there are to be compared using NPV or AW analysis.
• Be able to assess to allow flows to be compared using either of these
techniques.

• Be able to understand the limitations of both analysis techniques and

when each one is useful.
Cash Flow Analysis
• Cash flows represent a model of a real world problem:
• Flows represent how a financial situation will likely occur over a period of time,
• Reflect the best judgment of the modeler.
• Simplifications are often made to describe real world expenses over
a period of time
• Any cash flow shown will have a relevant NPV: the net present worth
of the whole flow at year 0.
• Once a problem is taken down to cash flows, it can be analyzed to:
• Determine which of the options, represents the best financial decision in terms of
overall worth
• Determine which of the options represents the best financial efficiency (input vs
output)
• Understand the sensitivity of the cash flow to a variety of changes
Cash Flow Analysis
• Once cash flows have been set up for a variety of alternatives, you
can analyze them to select the best option.
• There are a variety of approaches that can be used:
• (Net) Present Worth Analysis (NPV analysis or NPW analysis)
• Annual Worth Analysis
• Payback Period Analysis
• Rate of Return Analysis.
• Each of these methods have a similar end goal: Determine which
economic option presented proves to be the most viable.
Cash Flow Analysis
• Why are there different types of analysis?
• Simple example- High economic efficiency (rate of return) but low
worth: selling pop corn in movie theater at a cost of 25 cents vs $8
return.
• Simple example - high economic return (present worth) but low
efficiency: fancy VIP movie theatre tickets, might bring in $18-20 per
seat but at what cost?
• Typically a business will have a variety of different types of economic
returns.
• Big businesses are often more varied than little ones.
NPV Analysis

Part 1
Net Present Worth
• As discussed in previous sections, any cash flow has a net present
worth i.e. an equivalent present day cost for a cash flow.
• The present worth represents the valuation of the cash flow if:
• all the future flows turn out as predicted/modeled
• the discount rate used to compute the NPW is correct
• inflation is accounted for in either the discount rate or discretely in the analysis
(later discussion).
• A positive NPV means that the cash flow will result in the equivalent
of that amount of money being given to you in present day terms
• A negative NPV means that the cash flow will result in the equivalent
of that amount of money being paid out by you in present day terms
• NPV vs. NPW vs. PV vs. PW
Net Present Worth
Net Present Worth
• For a single options (situations):
• The more positive an NPV value is, the more you can expect to make off the
investment, i.e. NPV of +200k vs +300k on an investment.
• If the goal is a project that costs money, the less negative an NPW is, the less
money the project costs overall, i.e. NPV of -400k vs -500k to build a bridge.
• For a break even option, NPW should equal zero.
• A positive NPV means that the cash flow will result in the equivalent
of that amount of money being given to you in present day terms
• A negative NPV means that the cash flow will result in the equivalent
of that amount of money being paid out by you in present day terms.
Net Present Worth
• For multiple options:
• NPW lets you compare worth, but ONLY if the options are equal time scale.
• Why? Example: buying a car vs buying a bus pass (yearly)
NPV Analysis Rules
• Lifespan of all options compared must be the same
• Options may need to be repeated to match lifespan

• Discount rate of all options compared must be the same

• Always evaluate the NPV of the do-nothing option
• Cost to do nothing might not be zero

• Steps for NPV analysis:

1. Determine all the options being compared
2. Modify options as needed until conditions above are met
3. Determine NPV for each option
4. Compare NPV’s, closest to zero if negative, highest if positive.
Simple NPV Examples
A city plans to build a rapid transit system over the next 50 years. The
system can be built now at a reduced cost for $300 million and enlarged
in 25 years for an additional $325 million. An alternative is to construct
the full-sized system now for $400 million.

Both alternatives would provide the needed capacity for the 50-year
analysis period. Maintenance costs are the same between the options.
At 5% interest, which alternative should be selected?
Simple NPV Examples
Simple NPV Examples
 Larger Example Problems
Take a quick break here to reflect on the techniques shown, and make
sure you understand the process/steps before proceeding
Case Study: LED Street Lights
As an engineer for the city, you're tasked with assessing the feasibility of running a set of
LED street lights vs. a set of conventional sodium lamps. A previous feasibility study that
cost $80,000 provides you with some key details. The city has 2200 high pressure sodium
lamps, each with a lifespan (bulb life) of 5 years. The cost for a new lamp head (cheaper
than bulb replacement) is ~$500. There is also a nominal maintenance cost that equates
to an average of $33 per year to upkeep the lamps. The cost to run the bulbs $15 per
month (each).A local firm has pitched an LED equivalent for these bulbs. Due to the
lighting range of the bulbs there is a 10% decrease in the number of lamps needed. The
retrofits cost $1200 each, and the life expectancy is 20 years. There is a lamp driver that
needs to be replaced every 5 years at a cost of $200. The nominal maintenance cost
equates to cleaning and inspection and ends up costing $50 per year. The cost to run the
bulbs is $7 per month (each). There is a $4 million dollar initial cost to retrofit all the
existing infrastructure for LED's. Of these two options, which one is more viable from a
purely economic standpoint? You're told you have a WACC of 4% for projects like this.
Case Study: LED Street Lights – Opt. 1
Case Study: LED Street Lights – Opt. 2
Case Study: Fleet Vehicles
As a chief engineer for a local concrete lifting company you decide to look into a few
options for a fleet concrete lifting truck. So far your company has been using your truck
and your partners truck as the fleet vehicles. Both of you agree that you cannot continue
to do this and want to look at other options, so you approach a local manufacturing firm
who says they can prep fleet trucks for you to use. Which of the following options would
you consider if you WACC is 5%?

Option 1: The firm can get you a set of used fleet trucks (approximately 6 years old) from
a local rail company for $8k each. They would already have a service cab on them. They
would charge $5,000 to retrofit your pump system to them. These trucks would need
about $2000 in other retrofits to work, and have an annual operating cost of ~$2000. They
require overhaul at every year end ($900), and a yearly inspection of $150. Insurance for
these trucks is $1400 a year, and their expected life is 5 years with $100 scrap value. If
you replace these trucks with the same ones later on, your retrofit costs are halved.
Case Study: Fleet Vehicles
Option 2: The firm can get you a set of used fleet trucks (approximately 4 years old) from
a local contractor for $13k each. They would charge $6,000 to retrofit your pump system
to them. These trucks would need about $3000 in other retrofits to work, and have an
annual operating cost of ~$1200. They require overhaul at every year end ($700).
Insurance for these trucks is $1800 a year, and their expected life is 5 years with $9k
resale value (working).

Option 3: The firm can get you brand new trucks for 40k each. They would charge $5,000
to retrofit your pump system to them. These trucks would need about $4000 in other
retrofits to work, and have an annual operating cost of ~$1000. They require overhaul at
every year end ($300) and need a yearly inspection ($150). Insurance for these trucks is
$2200 a year (for 7 years, dropping to $1400 after that) and their expected life is 15 years
with $15000 resale value (working)

Option 4: Do Nothing?
Case Study: Fleet Vehicles – Opt. 1
Case Study: Fleet Vehicles – Opt. 2
Case Study: Fleet Vehicles – Opt. 3
Case Study Considerations:
• From a purely economic perspective:
• LED lights: from a purely economic perspective, given the NPV values,
stick to HPS lamps.
• Fleet vehicle: from a purely economic perspective, given the NPV
values, pick option 3 (new truck)

• Why would an engineer consider other options?

• LED lights case
• HPS lamp case

• Economic Risk?
NPV analysis summary
• For a variety of options, the NPW analysis tells you which option is
the cheapest over a period of time with a time bias on the analysis
(i.e. flow based analysis).
• Options with a cheaper NPW will end up costing you less if and only
if all the costs are accurate.
• Common issues:
• Repeated lifecycle costs are not necessarily accurate
• Repeated lifecycles and the inconvenience are not factored in
• Examples of where this analysis may not work well:
• Times when the NPW is quite close
• Times when the NPW is low, but the economic efficiency is quite high
AW Analysis

Part 2
Annual Worth
• As mentioned in previous sections, any cash flow has a annual worth
i.e. an equivalent annuity for a cash flow.
• The annual worth represents the valuation of the cash flow if:
• all the future flows turn out as predicted/modeled
• the discount rate used to compute the AW is correct
• inflation is accounted for in either the discount rate or discretely in the analysis
(later discussion).

• A positive AW means that the cash flow will have a yearly benefit
associated with it (money coming into you), i.e. it's profitable.
• A negative AW means that the cash flow will have a yearly cost
associated with it (money being spent), i.e. it costs you money.
Annual Worth
Annual Worth
• NPV vs. AW
• Example: You're paid an annuity of $200 for 20 years and a lump sum
of $5000 10 years from now in exchange for a loan of $7000 today.
What is the NPV and what is AW?
Annual Worth
• For a single options:
• The more positive an AW value is, the more you can expect to make off the
investment
• If the goal is a project that costs money, the less negative an AW is the less money
the project costs overall.
• For a break even option, AW should equal zero.

• A positive AW means that the cash flow will result in the equivalent of
that amount of money being given to you over a number of years as
an annuity.
• A negative AW means that the cash flow will result in the equivalent of
that amount of money being paid out by you over a number of years
as an annuity.
Annual Worth
• For multiple options:
• AW lets you compare worth, but does not require options to have an equal yearly
value
• Why? Example: buying a car vs buying a bus pass (yearly)
AW Analysis Rules
• Lifespan of all options does not need to be the same,
• Issues with options with wildly different lifespans: replacements, etc…
• Discount rate of all options compared must be the same
• Options must be set up to be repeatable
• Always evaluate the AW of the do nothing option
• Cost to do nothing might not be zero
• Steps for AW analysis:
1. Determine all the options being compared
2. Modify options as needed until conditions above are met
3. Determine AW for each option
4. Compare AW’s, closest to zero if negative, highest if positive.
Simple AW Examples
A city plans to build an aqueduct to bring water in from the mountains in
the west. The aqueduct can be built now at a reduced size for $300
million and enlarged in 25 years for an additional $320 million. An
alternative is to construct the full-sized aqueduct now for $400 million.

Both alternatives would provide the needed capacity for the 50-year
analysis period. Maintenance costs are small and may be ignored. At
5% interest, which alternative should be selected?
Major Issue with AW
• What do P/A and A/P do?

• What do A/F and F/A do?

Simple AW Examples
Simple NPV Examples
 Larger Example Problems
Take a quick break here to reflect on the techniques shown,
and make sure you understand the process/steps before
proceeding
Case Study: LED Street Lights
As an engineer for the city, you're tasked with assessing the feasibility of running a set of
LED street lights vs. a set of conventional sodium lamps. A previous feasibility study that
cost $80,000 provides you with some key details. The city has 2200 high pressure sodium
lamps, each with a lifespan (bulb life) of 5 years. The cost for a new lamp head (cheaper
than bulb replacement) is ~$500. There is also a nominal maintenance cost that equates
to an average of $33 per year to upkeep the lamps. The cost to run the bulbs $15 per
month (each).A local firm has pitched an LED equivalent for these bulbs. Due to the
lighting range of the bulbs there is a 10% decrease in the number of lamps needed. The
retrofits cost $1200 each, and the life expectancy is 20 years. There is a lamp driver that
needs to be replaced every 5 years at a cost of $200. The nominal maintenance cost
equates to cleaning and inspection and ends up costing $50 per year. The cost to run the
bulbs is $7 per month (each). There is a $4 million dollar initial cost to retrofit all the
existing infrastructure for LED's. Of these two options, which one is more viable from a
purely economic standpoint? You're told you have a WACC of 4% for projects like this.
Case Study: LED Street Lights – Opt. 1
Case Study: LED Street Lights – Opt. 2
Case Study: Fleet Vehicles
As a chief engineer for a local concrete lifting company you decide to look into a few
options for a fleet concrete lifting truck. So far your company has been using your truck
and your partners truck as the fleet vehicles. Both of you agree that you cannot continue
to do this and want to look at other options, so you approach a local manufacturing firm
who says they can prep fleet trucks for you to use. Which of the following options would
you consider if you WACC is 5%?

Option 1: The firm can get you a set of used fleet trucks (approximately 6 years old) from
a local rail company for $8k each. They would already have a service cab on them. They
would charge $5,000 to retrofit your pump system to them. These trucks would need
about $2000 in other retrofits to work, and have an annual operating cost of ~$2000. They
require overhaul at every year end ($900), and a yearly inspection of $150. Insurance for
these trucks is $1400 a year, and their expected life is 5 years with $100 scrap value. If
you replace these trucks with the same ones later on, your retrofit costs are halved.
Case Study: Fleet Vehicles
Option 2: The firm can get you a set of used fleet trucks (approximately 4 years old) from
a local contractor for $13k each. They would charge $6,000 to retrofit your pump system
to them. These trucks would need about $3000 in other retrofits to work, and have an
annual operating cost of ~$1200. They require overhaul at every year end ($700).
Insurance for these trucks is $1800 a year, and their expected life is 5 years with $9k
resale value (working).

Option 3: The firm can get you brand new trucks for 40k each. They would charge $5,000
to retrofit your pump system to them. These trucks would need about $4000 in other
retrofits to work, and have an annual operating cost of ~$1000. They require overhaul at
every year end ($300) and need a yearly inspection ($150). Insurance for these trucks is
$2200 a year (for 7 years, dropping to $1400 after that) and their expected life is 15 years
with $15000 resale value (working)

Option 4: Do Nothing?
Case Study: Fleet Vehicles – Opt. 1

Vs.

“…used fleet trucks…for $8k each…they would charge $5,000 to retrofit your pump…
trucks would need about $2000 in other retrofits to work…If you replace these trucks with
the same ones later on, your retrofit costs are halved.”
Case Study: Fleet Vehicles – Opt. 1
Case Study: Fleet Vehicles – Opt. 2
Case Study: Fleet Vehicles – Opt. 3
AW analysis summary
• For a variety of options, the AW analysis tells you which option is the
cheapest over a period of time with a time bias on the analysis (i.e.
flow based analysis).
• Options with a cheaper AW will end up costing you less if and only if
all the costs are accurate.
• Common issues:
• Option cannot be repeated as often as desired
• Analysis is skewed if the overall lifespan is different than the lifespan of the option.

• Examples of where this analysis may not work well:

• Times when the AW is quite close
• Times when the AW is low, but the economic efficiency is quite high
Overview

• By now you should be able to:

• Be able to understand the concept of Net Present Worth/Value (NPV) and
Annual Worth (AW).
• Be able to understand why and how cash flows can be compared based
on NPV or AW.
• Be able to modify a given economic situation and assess what options
there are to be compared using NPV or AW analysis.
• Be able to assess to allow flows to be compared using either of these
techniques.
• Be able to understand the limitations of both analysis techniques and
when each one is useful.
Module 5
ENG 3000