L5-Evaluating A Single Project - Full

IEDA 3230
Engineering Economics and Accounting

Evaluating a single project
IEDA 3230
Engineering Economics and
Accounting
Dr. Jin QI
Department of Industrial Engineering and Decision Analytics
Hong Kong University of Science and Technology
IEDA 3230
Example 5.1
• A lottery winner wins a prize of $2 millions
– Option 1: The $2M is supposed to be paid by 10 annual
payments, with 200K each time.
– Option 2: A single immediate payment at discounted amount
$1.4M
– How to evaluate the options?
2
IEDA 3230
Example 5.2
• In 2017，HK govt provided an investment scheme for
residents to purchase 15 year government bonds with
the following terms:
– Maturity: March 2032
– Coupon: nominal rate of 1.89% paid semi-annually
• Would you buy this bond?
3
IEDA 3230
Cash flow for a project

• Question: Is this a good project?
• They all depend on an interest rate that is used to

calculate the cash flow equivalence
– MARR: minimum attractive rate of return
Salvage value
revenue (S)
Investment Operations cost

(I)
4
IEDA 3230
Minimum Attractive Rate of Return

• Every investor has a MARR.
– For example, if you can earn 5% return every year, you
would definitely not invest in a project which will only give
you 3%. You can invest elsewhere to make 5%. In this case
your MARR is 5%.
• MARR of a company
– Company’s capital (i.e., money) structure
• Debt: money borrowed from loans, bonds. Interest rate is
charged for the debt.
• Equity: money from stockholders. The stockholders require
some rate of return.
5
IEDA 3230
Alternative Views of MARR

• MARR is the interest rate if we deposit money in a
bank
– When we have enough fund by ourselves
• MARR is the interest rate if we need to borrow money
from a bank
– When we can borrow as much as we need
• A project should be carried out only if its return rate is
higher than MARR
– MARR is assumed as given
6
IEDA 3230
Main Methods
• Present worth (PW)
– Capitalized worth (CW)
• Future worth (FW)
• Annual worth (AW)
• Internal rate of return (IRR)
• External rate of return (ERR)
• Payback period
7
IEDA 3230
The Present Worth (PW) Method

• All cash inflows and outflows are discounted to the
present time at the MARR.
• To evaluate a project according to the PW method,
we use the following:
– PW Decision Rule: If PW(MARR) ≥ 0, then the project is
economically justified.
• The method has two main assumptions:
– The future is known with certainty.
– Money can be borrowed and lent at the same interest rate.
8
IEDA 3230
Example 5.3
• Given information
– A project needs an investment of $10,000
– Its output is a uniform annual revenue of $5310
– After 5 years, it has a salvage value of $2000
– Annual expense of the project is $3000
• Is this project acceptable under MARR 9%?

• How about MARR=10%
9
IEDA 3230
Example 5.3
• Solution
– Is this project acceptable under MARR 9%?
• Total PW for cash inflows at time 0
5310(P/A, 9%,5)+2000(P/F,9%,5)=21954
• Total PW for cash outflows at time 0
10000+3000(P/A,9%,5)=21669
• The project is acceptable
– How about MARR=10%
• PW(inflow) = 21371, PW(outflow) = 21372
• The project may be marginally acceptable
10
IEDA 3230
Application： Bond value

• A bond is an IOU, in which you agree to lend the bond issuer money for
a specified duration. In return, you receive periodic interest payments
from the issuer, plus a promise to return the face value of the bond when
it matures.
• Specification of the bond:
– Z = face, or par, value
– C = redemption, or disposal, price (typically equal to Z)
– r = bond rate (nominal interest) per interest period
– i = bond yield rate per period
– N = number of periods before redemption
• Payments to the bond owner
– N interest payments, each amounting to rZ
– a single payment of C when the bond is retired or sold
11
IEDA 3230
Application： Bond value

• The present worth of a bond is given by
𝑃 = 𝐶× 𝑃/𝐹, 𝑖%, 𝑁 + 𝑟𝑍× 𝑃/𝐴, 𝑖%, 𝑁
𝐶 1+𝑖 ! −1
= !
+ 𝑟𝑍×
1+𝑖 𝑖 1+𝑖 !
12
IEDA 3230
Example 5.4
• Stan Moneymaker has the opportunity to purchase a certain
U.S. Treasury bond that matures in eight years and has a face
value of $10,000. This means that Stan will receive $10,000
cash when the bond’s maturity date is reached. The bond
stipulates a fixed nominal interest rate of 8% per year, but
interest payments are made to the bondholder every three
months; therefore, each payment amounts to 2% of the face
value. Stan would like to earn 10% nominal interest
(compounded quarterly) per year on his investment, because
interest rates in the economy have risen since the bond was
issued. How much should Stan be willing to pay for the bond?
13
IEDA 3230
Example 5.4
• Solution
– Interest payments are quarterly. Because Stan Moneymaker
desires to obtain 10% nominal interest per year on the
investment, the PW is computed at i = 10%/4 = 2.5% per
quarter for the remaining 8(4) = 32 quarters of the bond’s
life:
– VN = $10,000(P/F, 2.5%, 32) + $10,000(0.02)(P/A, 2.5%, 32)
= $4,537.71 + $4,369.84 = $8,907.55.
– Thus, Stan should pay no more than $8,907.55 when 10%
nominal interest per year is desired.
14
IEDA 3230
Capitalized Worth (CW) Method

• CW is the PW of an annuity with an infinite number of time
periods
$%& ! '$ (
• 𝐶𝑊 𝑖% = 𝑃𝑊!→# = 𝐴 𝑃/𝐴, 𝑖%, ∞ = 𝐴[ lim ]=
!→# & $%& ! &
• A = CW * i
– Annuity of a CW is the interest generated per period
A A A A A A
1 2 3 4 N-1 N 15
IEDA 3230
Example 5.5
• A lab is to be built by an endowment
• The cost to be covered by the endowment
– An establishment cost: $100,000
– Annual maintenance cost: $30,000
• To be covered by the interest generated by a special
investment with 8% interest rate
• How much is needed to the endowment?
• Solution
– CW for the maintenance cost: 30,000/8%=$375,000
– Total requirement: 375,000+100,000=$475,000
16
IEDA 3230
Example 5.5
• In addition, $20,000 is needed every four years for
equipment replacement. What is the total requirement
now?
A A A A
4 8 12 16 17
IEDA 3230
Example 5.5
• Solution
– Method 1:
• Interest rate every 4 years: 1.084-1=0.3605
• CW for replacement cost: 20,000/0.3605=$55,478
• Total=475,000+55,478=530,475
– Method 2 (Convert A=20,000 to annuity of each year):
• A(per year)=20000(A/F,8%,4)=4438
• CW for replacement=4438/0.08=$55,475
A A A A
4 8 12 16 18
IEDA 3230
The Future Worth (FW) method

• Equivalent worth of all cash inflows and outflows at
the end of the planning horizon at the MARR.
• To evaluate a project according to the FW method,
we use the following:
– FW=PW(F/P, i%, N)
– FW Decision Rule: If FW(MARR) ≥ 0, then the project is
economically justified.
19
IEDA 3230
The Annual Worth (AW) method

• The AW of project is the equivalent annualized series
of dollar amounts for the cash inflows and outflows at
a given interest rate or MARR.
• Three types of cash flow:
– annual equivalent revenue or saving (denoted R)
– annual equivalent expenditure (denoted E)
– annual equivalent capital recovery (denoted CR), which is
the uniform annual cost of invested capital.
AW = Annual Profit – Capital Recovery (CR) = R-E-CR
20
IEDA 3230
The Annual Worth (AW) method

• AW = R - E – Capital Recovery (CR)
• CR is the equivalent annual cost of the capital
invested
– 𝐶𝑅 𝑖% = 𝐼× 𝐴/𝑃, 𝑖%, 𝑁 − 𝑆×(𝐴/𝐹, 𝑖%, 𝑁)
– I: capital investment at time zero
– S: salvage value at time N
• AW Decision Rule: If AW(MARR) ≥ 0, then the project
is economically justified. S
I 21
IEDA 3230
Example 5.3 revisited

• Given information
– Its output is a uniform annual revenue of $5,310
– After 5 years, it has a salvage value of $2,000
– Annual expense of the project is $3,000
• How much is the CR under MARR 10%?
22
IEDA 3230

• Solution
I = 10000, S = 2000
CR = 10000(A/P, 10%,5) - 2000(A/F,10%,5)=2310
(=PMT(10%, 5, -10000, 2000) = 2310 )
• The project is marginally acceptable because
AW = 5310 – 3000 – 2310 = 0
23
IEDA 3230

• The loss in value of this asset over five years is
$8,000.
• The equivalent annual CR is

24
𝐶𝑅 10% = 8 758 𝐴/𝑃 10% 5 = 2 310
IEDA 3230
CR as the lease fee

• Let’s consider the following situation: a company buys
a machine (initial cost I) not for production, but will
lease it out. The machine is supposed to last U years
with salvage value S. What should be the annual
lease fee? The company looks for a rate of return
equal to MARR.
• Suppose the annual lease fee is X. Then X should
satisfy
– I = X(P/A, MARR, U) + S(P/F, MARR, U)
⇒ X = I(A/P, MARR, U) − S(A/F, MARR, U) = CR.
• Hence CR can be interpreted as the annual lease fee.
25
IEDA 3230
Application: Leasing an apartment

• A real–estate agency decides to build a 25–unit apartment
complex for leasing. The costs are as follows:
– Land $50,000 Building $225,000
– # of years 20 Maintenance $420/year/occ. unit
– Tax 10% of investment
• Suppose the occupancy is 90% and the MARR is 12%.
Furthermore, suppose that the agency can sell the entire
complex at the end of the 20th year for $400,000.
• Question: How much rent per month should the agency
charge?
26
IEDA 3230
Application: Leasing an apartment

• The initial investment is
𝐼 = 50,000 + 225,000 ×1.1 = 302,500
• The annual maintenance expenditure equals
420×25×0.9 = 9,450
• The salvage value is 𝑆 = 400,000
• Hence, the annual equivalent expenditure is
302,500× 𝐴/𝑃, 12%, 20 − 400,000× 𝐴/𝐹, 12%, 20 + 9,450
= 44,396.82
• It follows that the minimum monthly rent should be
44,396.82
= 3699.74
12
27
IEDA 3230
Main Methods
• Payback period
28
IEDA 3230
The Internal Rate of Return (IRR) method
• Given a cash flow, the internal rate of return (IRR) is

the interest rate that makes the PW of all cash outflow
equal to the PW of all cash inflow
• A project is acceptable only if IRR≥MARR
• Mathematically, i’ is the IRR if it satisfies
! !
6 𝑅" × 𝑃/𝐹, 𝑖 % %, 𝑘 = 6 𝐸" × 𝑃/𝐹, 𝑖 % %, 𝑘

"#$ "#$
– 𝑅! : total revenue of the k-th period;
– 𝐸! : total expenditure of the k-th period;
– N: number of periods in the planning horizon
29
IEDA 3230
The Internal Rate of Return (IRR) method
% %
𝑃𝑊 𝑖 " = E 𝑅! × 𝑃/𝐹, 𝑖 " %, 𝑘 − E 𝐸! × 𝑃/𝐹, 𝑖 " %, 𝑘 = 0

!#$ !#$
– 𝑅! : total revenue of the k-th period;
– 𝐸! : total expenditure of the k-th period;
– N: number of periods in the planning horizon
30
IEDA 3230
Example 5.6
• AMT, Inc., is considering the purchase of a digital camera.
The capital investment requirement is $345,000 and the
estimated market value of the system after a six-year
study period is $115,000. Annual revenues attributable to
the new camera system will be $120,000, whereas
additional annual expenses will be $22,000. You have
been asked by management to determine the IRR of this
project and to make a recommendation. The corporation’s
MARR is 20% per year.
31
IEDA 3230
Example 5.6
• Solution
– PW(i’) =−$345,000 + ($120,000 − $22,000)(P/A, i’%, 6) +
$115,000(P/F, i’%, 6)=0
– Try and error
• At i = 20%: PW(20%)=−$345,000 + $98,000(3.3255) +
$115,000(0.3349) =+$19,413, i’%> 20%
• At i = 25%: PW(25%)=−$345,000 + $98,000(2.9514) +
$115,000(0.2621) =−$25,621, i’%< 25%
– Linear interpolation
"#$% '( "#$% *( +,%.+/% # ! %.+/%
• = → =
"#$% ') "#$% *% 01,304.(.+,,6+0) 01,304./
8
• 𝑖 % ≈ 22.16% ≥ 𝑀𝐴𝑅𝑅
32
IEDA 3230
To Calculate IRR
• Linear interpolation
• Use Microsoft Excel functions
– irr(cell ranges, guess): for non-regular cash flow
• The cash flow is in the cells specified by the cell ranges
• You may provide a guessed IRR, but not necessary
– rate(nper, pmt, pv): for an annuity
• nper: number of period of the annuity
• pmt: amount of the annuity
• pv: present value of the annuity
33
IEDA 3230

• Consider a project:
– Its output is a uniform annual revenue of $5310
– After 5 years, it has a salvage value of $2000 =irr(A2:A7)
– Annual expense of the project is $3000
4310 10%
2310 2310 2310 2310
-10000
2310
2310
10000
2310
2310 2310 2310 2310 4310 2310
10000 = + + + +
1 + i (1 + i ) (1 + i ) (1 + i ) (1 + i ) 5
2 3 4
4310
34
IEDA 3230
Application: Bond yield

• Recall that payments to the bond owner include
– N interest payments, each amounting to rZ; and
– a single payment of C when the bond is retired or sold.
• The yield i is then defined by the IRR of the promised
cash flow, where P is the present worth of the bond.
;
𝑟𝑍 𝐶
0 + =𝑃
1 + 𝑖∗ 9 1 + 𝑖∗ ;
9:0
• In particular, for a zero-coupon bond (i.e., r=0), the

yield is given by
$/!
∗
𝐶
𝑖 = −1
𝑃 35
IEDA 3230
Application: A loan deal

• A small company needs to borrow $160,000.
• The local banker makes the following statement:
– We can loan you $160,000 at a very favourable rate of 12% per
year for 5 years. However, to ensure this loan you must agree to
establish a checking account in which there is no interest and the
minimum average balance is $32,000. In addition, your interest
payments are due at the end of each year and the principal will be
repaid in a lump-sum amount at the end of year five.
• Questions
– Determine the cash flows and their timing.
– What is the true effective annual interest rate being charged?
36
IEDA 3230
Application: A loan deal

• Hence, the effective annual interest rate i’ satisfies the
following equation:
𝑃$ = 𝐹& 𝑃/𝐹, 𝑖 % %, 5 + 𝐴(𝑃/𝐴, 𝑖 % %, 5)
,
19,200 128,000
0 8 9
+ 8 ,
= 128,000
1+𝑖 1+𝑖
9:0
• Upon solving, we get 𝑖 % = 15%, which is higher than

what the banker claimed.
37
IEDA 3230
Example 5.7
• A loan of $7000 will be paid by 50 payments
– There is a payment for every 3 months
– Each payment is 7% of the loan
• What are the effective rates for one year?
• Solution:
– This is an annuity of 7000*7%=490 for every 3 months
7000=490(P/A, i%, 50), i%=?
using Excel function “=rate(50, −490, 7000)” returns 6.73%
– 6.73% is the effective rate for every 3 months
– Effective rate for one year is 1.06734−1=29.76%
38
IEDA 3230
Drawbacks of IRR
• Calculation is difficult
• The solution may not be unique
• There may not be feasible solution
39
IEDA 3230
Example 5.8: Existence of the IRR

• We find both i=30% and i=62% satisfy the IRR
equation
– Which one should be used to evaluate the project?
– IRR method fails
i% PW(i%)
0 250
10 105
20 32
30 ~0
500
40 -11 250 250 250
62 ~0
80 24
1000 40
IEDA 3230

• We find both i=30% and i=62% satisfy the IRR
equation
– Which one should be used to evaluate the project?
– IRR method fails
500
250 250 250
1000 41
IEDA 3230

• IRR does not exist
5000 2000 2000
7000 42
IEDA 3230
Main Methods
• Payback period
43
IEDA 3230
External Rate of Return (ERR)

• Assumption
– There exists an external interest rate ε
– A cash inflow should be re-invested at rate ε until the last
period
– A cash outflow should be pre-borrowed at ε at time zero
FW
PW
44
IEDA 3230
External Rate of Return (ERR)

• Observation
– The FW of all cash inflow at ε is the total future revenue
– The PW of all cash outflow at ε is the present cost of
acquiring your capital
– ERR will try to link the above PW and FW
– Usually, the MARR can be used as the ε
FW
PW
45
IEDA 3230
Steps to Calculate ERR

• Steps to calculate ERR
– All net cash outflows are converted to PW using ε
– All net cash inflows are converted to FW using ε
• As if there are only two cash transactions
– The ERR is the interest rate i’ under which the above two
quantities are equivalent
% %
E 𝐸! 𝑃/𝐹, 𝜀%, 𝑘 𝐹/𝑃, 𝑖 " %, 𝑁 = E 𝑅! (𝐹/𝑃, 𝜀%, 𝑁 − 𝑘)

!#$ !#$
FW
– A project is acceptable
only if ERR≥MARR
PW PW(F/P, i%, N)=FW
46
IEDA 3230
Example 5.10
• Suppose the MARR=20%. What is ERR?
• Solution
– FW for cash inflow
• 8000(F/A,20%,5)+(13000-8000) = 64533
– PW for cash outflow = 25000
– Solve the equation: PW(1+ERR)5=FW
• 25000(1+ERR)5 = 64533 à ERR = 0.2088 ≥ 20%
8000 13000
25000 47
IEDA 3230
ERR Method
• Get ERR by Excel function mirr( )
– mirr (cell range, ε1, ε2)
• Interest rate ε1: for cash outflows
• Interest rate ε2: for cash inflows
• ERR is also known as the modified IRR
• Advantages of ERR
– Easy to solve
– Always has a unique solution
48
IEDA 3230
Example 5.10
• Suppose the MARR=20%, is the project acceptable?
– IRR method: irr( )=21.58%>20%, acceptable
– ERR method: mirr(…,0.2,0.2)=20.88%>20%
8000 13000
25000 49
IEDA 3230
Example 5.8 revisited: when IRR fails
• We find both i=30% and i=62% satisfy the IRR equation

• What is the ERR under MARR=10%
1,000(P/F, 10%, 1)(F/P, i%, 5) = $500(F/P, 10%, 5) + $250(F/A, 10%, 3)
(P/F, 10%, 1)(F/P, i% ,5) = 1.632
i = 0.124 (12.4%).
• In addition, PW(10%)=105, so both the ERR and PW methods
indicate that this project is acceptable when the MARR is 10%
per year.
500
250 250 250
1000 50
IEDA 3230
Example 5.9 revisited: when IRR fails
• Recall that the IRR does not exist for this example
– If ε=15%, MARR=15%
– $7,000(P/F, 15%, 1)(F/P, i%, 3)
= $5,000(F/P, 15%, 3)+$2,000(F/P, 15%, 1) + $2,000
– ERR=25.1% > MARR
• How about PW method?
– PW=5000-7000(P/F,0.15,1)+2000(P/F,0.15,2)
+2000(P/F,0.15,3) =1740.36>0
5000 2000 2000
7000 51
IEDA 3230
Main Methods
• Payback period
52
IEDA 3230
Payback period method

• Assumption
– A typical project has cash outflow in the beginning periods,
then followed by cash inflows
• Definition
– The (simple) payback period (θ) is the earliest time period
when the accumulative cash inflow is no less than the
accumulative cash outflow
=
0 𝑅9 − 𝐸9 𝑃/𝐹, 𝑖%, 𝑘 − 𝐼 ≥ 0
9:0
– I is the initial investment
53
IEDA 3230
Payback period method

• Assumption
– A typical project has cash outflow in the beginning periods,
then followed by cash inflows
• Definition
– The (simple) payback period (θ) is the earliest time period
when the accumulative cash inflow is no less than the
accumulative cash outflow
• A rough measure of how quick the project can
become breakeven, indicating the degree of risk
– Usually used as a supplement
54
IEDA 3230
Example 5.11
Year Cash Sum of cash

flow flow until year k
We may recommend
0 -25000 -25000 rejecting the project
1 8000 -17000 if payback period is
2 8000 -9000 required to be limited
to 3 years
3 8000 -1000
4 8000 7000
5 13000
simple payback period: θ=4

55
IEDA 3230
Example 5.11
• Discounted payback period (θ’)
– Same concept, but using the MARR to convert each cash
flow to the present equivalence MARR=20%
Year Cash Sum of cash flow PW for Sum of PW of
flow to year k year k cash flow
0 -25000 -25000 -25000 -25000
1 8000 -17000 6667 -18333
2 8000 -9000 5556 -12777
3 8000 -1000 4630 -8147
4 8000 7000 3858 -4289
5 13000 5223 934
simple payback period: θ=4 discounted payback period: θ’=5 56
IEDA 3230
Summary of methods
• Methods to evaluate economic profitability
– The 1st perspective: Future Worth (FW), Present Worth
(PW), Annual Worth (AW).
– The 2nd perspective: Internal Rate of Return (IRR), External
Rate of Return (ERR).
– PW, FW, AW convert cash flows to their equivalent worth at
some time point using MARR as the interest rate. IRR and
ERR computes investment returns and compare to MARR.
• Methods to evaluate liquidity (how fast investment
costs can be recovered)
– Simple payback period
– Discounted payback period 57
IEDA 3230
Which method to use

• Payback period should always be secondary to other
methods
• PW, FW, AW are always equivalent.
• IRR is equivalent to PW (FW, AW) if there is a unique
IRR. When there is no or there are multiple IRR, use
PW (FW, AW) or ERR.
• When ε=MARR, ERR is equivalent to PW (FW, AW).
59
IEDA 3230
• Chapter 5 of the course textbook.
60

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IEDA 3230

Engineering Economics and Accounting

Evaluating a single project

• Would you buy this bond?

Cash flow for a project

• They all depend on an interest rate that is used to

Investment Operations cost

Minimum Attractive Rate of Return

Alternative Views of MARR

The Present Worth (PW) Method

• Is this project acceptable under MARR 9%?

Application： Bond value

Application： Bond value

Capitalized Worth (CW) Method

The Future Worth (FW) method

The Annual Worth (AW) method

AW = Annual Profit – Capital Recovery (CR) = R-E-CR

The Annual Worth (AW) method

Example 5.3 revisited

Example 5.3 revisited

Example 5.3 revisited

• The equivalent annual CR is

CR as the lease fee

Application: Leasing an apartment

Application: Leasing an apartment

The Internal Rate of Return (IRR) method

• Given a cash flow, the internal rate of return (IRR) is

6 𝑅" × 𝑃/𝐹, 𝑖 % %, 𝑘 = 6 𝐸" × 𝑃/𝐹, 𝑖 % %, 𝑘

The Internal Rate of Return (IRR) method

𝑃𝑊 𝑖 " = E 𝑅! × 𝑃/𝐹, 𝑖 " %, 𝑘 − E 𝐸! × 𝑃/𝐹, 𝑖 " %, 𝑘 = 0

Example 5.3 revisited

Application: Bond yield

• In particular, for a zero-coupon bond (i.e., r=0), the

Application: A loan deal

Application: A loan deal

• Upon solving, we get 𝑖 % = 15%, which is higher than

Example 5.8: Existence of the IRR

Example 5.8: Existence of the IRR

Example 5.9: Existence of the IRR

5000 2000 2000

External Rate of Return (ERR)

External Rate of Return (ERR)

Steps to Calculate ERR

E 𝐸! 𝑃/𝐹, 𝜀%, 𝑘 𝐹/𝑃, 𝑖 " %, 𝑁 = E 𝑅! (𝐹/𝑃, 𝜀%, 𝑁 − 𝑘)

Example 5.8 revisited: when IRR fails

• We find both i=30% and i=62% satisfy the IRR equation

Example 5.9 revisited: when IRR fails

Payback period method

Payback period method

Year Cash Sum of cash

simple payback period: θ=4

Which method to use

• Chapter 5 of the course textbook.

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