Other Analysis Techniques

Chapter 9

Future Worth Analysis

In Future Worth Analysis, he comparison was made in terms of the future consequences of taking feasible courses of actions now. Example : a companys having following plans: Year Construct Remodel new plant available factory 0 Buy Land $85000 Purchase Factory $850000 1 Design, construct 200000 Redesign 250000 2 Balance 1200000 Additional 250000 construction cost remodelling costs 3 Setup production 200000 Setup production 250000 equipment equipment

Future Worth Analysis(2)

If interest 8%, which alternative results in the lower equivalent cost when the firm begins production at the end of the third year? New plant Remodel

85000 200000

200000 250000 850000 FW

New plant : FW = 85000(P/F,8%,3) + 200000(F/A,8%,3) = $ 1.836.000

120000 FW

Future Worth Analysis(3)

Remodel available factory : FW = 850000(F/P,8%,3) + 250000(F/A,8%,3) = $ 1.882.000
The new plant is projected to have the smaller future worth of cost, and thus is the preferred alternative

Benefit Cost Ratio Analysis (BCR)

At a given MARR, we would consider an alternative acceptable, provided : PWbenefits Pwcost 0 atau EUAB - EUAC 0 Using BCR : PWbenefits EUAB = BCR = 1 PWcosts EUAC

Analisis Benefit-Cost Ratio (BCR)(2)

Situation Fixed Input Amount of money or other input resources are fixed Fixed task, benefit, or other output to be accomplished Neither amount of money ot other inputs not maount of benefits or other outputs are fixed Criterion Maximize B/C

Fixed Ouput

Maximize B/C

Neither input nor output fixed

Two alternatives : Compute incremental benefit-cost ratio (B/ C) on the increment of investment between alternatives, if B/ C 1 choose higher cost alternative, vice versa

Benefit-Cost Ratio Analysis (BCR)(3)

Example: A firm is trying to decide which of two devices to install to reduce costs in a particular situation. Both devices cost $1000 and have useful lives of five years and no salvage value. Device A can be expected to result in $300 savings anually. Device B will provide cost savings f $400 the first year, but will decline $50 anually, making the second-year savings $350, the third-year savings $300, and so forth. With interest 7%, which device should the firm purchase?

Benefit-Cost Ratio Analysis(BCR)(4)

DeviceA : PWcost = $1000 PWbenefit = 300(P/A,7%,5) = $1230 BCR = 1230 / 1000 = 1,23 Device B : PWcost = $1000 PWbenefit = 400(P/A,7%,5) 50(P/G,7%,5) = $1258 BCR = 1258 / 1000 = 1,258 To maximize BCR, buy device B.

Benefit-Cost Ratio Analysis(BCR)(5)

For more than two alternatives, use incremental analysis Example : Consider five mutually exclusive alternatives as follows: A B C D E F Cost $4000 $2000 $6000 $1000 $9000 $10000 PWbenefit 7330 4700 8730 1340 9000 9500 BCR 1,83 2,35 1,46 1,34 1 0,95

Benefit-Cost Ratio Analysis(BCR)(6)

Alternative F has B/C < 1 Discard Alternative F, Rearrange the remaining alternatives in ascending order of investment. D Pwcost $1000 PWbenefit 1340 BCR 1,34 B A $2000 $4000 4700 7330 2,35 1,83 C E $6000 $9000 8730 9000 1,46 1

Analisis Benefit-Cost Ratio (BCR)(7)

After rearranged, do incremental analysis as follows: B-D A-B C-A PWcost $1000 $2000 $2000 PWbenefit 3360 2630 1400 BCR 3,36 1,32 0,7 Shown here that : - BCR for B-D > 1 alternative B is better than D, discard alternative D. - BCR for A-B > 1 alternative A lebih baik dari B, discard alterative B - BCR for C-A < 1 alternative A is better than C Discard alternative C. - Thus, Alternative A is the best.

Public Project
Benefits (B) are advantages (in $) which happen to the owner Disbenefits (D) are disadvantages to the owner Costs (C) are the anticipated expenditures for construction, operation, maintenance, etc., less salvage value Owner as the public and the one who incurs the costs as the government B/C= (Benefits Disbenefits)/Costs = (B D)/C Modified B/C = (Benefits Disbenefits O&M Cost)/Costs The magnitude of the ratio may change but not the decision to accept or reject

Public Project
Item Expenditures of $ 11,000 for new interstate highway Classification Cost

$ 50,000 annual income to local residents Benefits from tourists because of the recreation area
$ 150,000 per year upkeep cost for irrigation canal $ 25,000 per year loss by farmers because of highway right-of-way Cost (O&M) Disbenefit

Public Project
Initial cost of project to be paid by government is 100 PW of future maintenance to be paid by government is 40 PW of benefits to the public is 300 PW of additional public user costs is 60 Salvage value is 5 Toll revenue is 10 ? B/C

Payback Period
Payback Period is the period of time required for the profit or other benefits of an investment to equal the cost of the investment. Example : Cashflows for two alternatives as follows : Tahun A B 0 -$1000 -$2783 1 +200 +1200 2 +200 +1200 3 +1200 +1200 4 +1200 +1200 5 +1200 +1200

Payback Period(2)
Using Payback Period analysis : Alternative A : On year 1 and 2, only $400 of the $1000 cost is converted. The remaining $600 cost is recovered in the first half of Year 4. Thus the payback period for Alt A. is 2.5 years Alternative B : Since the annual benefits are uniform, the payback period is simply : $2783 / $1200 = 2,3 years. To minimize the payback period, choose alternative B.

Payback Period(3)
Four points to be understood about payback period calculations : 1. This is an approximate, rather than an exact, economic analysis calculation 2. All cost and all profits, or savings of the investment, prior to payback are included without considering differences in their timing. 3. All the conomic coseqences beyond the payback are completely ignored. 4. Being an approximate calculation, payback period may or may not select the correct alternative. That is, the payback period calculation may select a different alternative from that found by exact economic analysis techniques.

Payback Period(4)
However, Payback periode criterion may result in an unwise decision. Example : Two alternative machines are being considered for a particular operation :
Tempo machine Installed cost Net Annual Benefit after deducting all annual expenses. Useful life, in years $30.000 $12.000 the first year, declining $3000 per year thereafter 4 Dura Machine $35.000 $1.000 the first year, increasing $3000 per year thereafter 8

Payback Period(5)
Solusi :

Without considering time value of money, the graphic shows that payback period for tempo machine is 4 years and Dura machine is 5 years To minimize the. the payback period, the Tempo is selected.

Payback Period(6)
While, considering time value of money, the cash flows for the two alternatives are as follows :
Tahun 0 1 2 3 4 5 6 7 8 Tempo -$ 30000 +$12000 +$ 9000 +$ 6000 +$ 3000 +$ 0 +$ 0 +$ 0 +$ 0 +$ 0 Dura -$ 35000 +$ 1000 +$ 4000 +$ 7000 +$ 10000 +$ 13000 +$ 16000 +$ 19000 +$ 22000 +$ 57000

Payback Period(7)
Tempo machine : Since the sum of the cash flows for the Tempo machine is 0, $30000 investment just equals the subsequent benefits. The resulting rate of return is 0% Dura machine:$35000 =1000(P/A,i,8) + 3000(P/G,i,8) Calculation then shows that i = 19% Considering Time value of Money, Dura machine is chosen. Summary : Payback period and Time value of Moneys given different result. To assure, Time value of money is more reliable as it resembles the real situation better.

Sensitivity and Breakeven Analysis

Sensitivity Analysis is an analysis being made on variation to a particular estimate that would be necessary to change a particular decision. Breakeven analysis is a form of sensitivity analysis. Both methods are useful in engineering problems called stage construction : whether a facility be constructed now to meet its future full-scale requirement, or should it be constructed in stages as the need for the increased capacity arises ?

Sensitivity and Breakeven Analysis(2)

Example : a project may be constructed to full capacity now or may be constructed in two stages: Construction costs Two stage construction Construct first stage now $100000 Construct second stage n years from now $120000 Full capacity construction Construct full capacity now $140000

Sensitivity and Breakeven Analysis(3)

Other factors : - All facilities will last until 40 years from now regardless of when they are installed, at that time they will have 0 salvage value. - The annual cost of operation and maintenance is the same for two stage construction and full-capacity construction - Assume an 8% interest rate Mark the break even point. What is the sensitivity of the decision to second-stage construction sixteen or more years in the future ?

Sensitivity and Breakeven Analysis(4)

Solution : Construct full capacity now : PWcost = $140000 Two-stage construction : First stage constructed now and the second stage to be constructed n years hence : PWcost = $100000 + $120000(P/F,8%,n) n = 5 PW = 100000 + 120000(0,6806) = $181700 n = 10 PW = 100000 + 120000(0,4632) = $155600 n = 15 PW = 100000 + 120000(0,2145) = $125700 n = 20 PW = 100000 + 120000(0,0994) = $111900

Sensitivity and Breakeven Analysis(5)

PWcost for second alternative is plotted on the graphic as follows :

We see that if, in two stage construction, the second stage is deferred for 15 years, then the PW of cost of two-stage construction is equal to one-stage construction; Year 15 is the breakeven point. Second construction made prior to year 15, then one-stage construction, with its smaller PW of cost would be preferred.