Medley of Project Evaluation Concepts

 
Ayodeji .E OLULEYE
 
DEPT. OF INDUSTRIAL & PRODUCTION ENGINEERING,
UNIVERSITY OF IBADAN, IBADAN.
 • Used in Present Worth Analysis
• Puts alternatives on same platform
• Assumes service is required for same
CO- TIMELINE
TERMINATION • Use LCM to get timeline
• Choose the better alternative
Two methods of solving Power Supply challenges (see table).

Cost Heads and Lifespan Method A Method B

Acquisition & Installation 1.5m Naira 2m Naira

Annual Operating & 5% of First Cost 3% of First

Maintenance Cost
Estimated Life 2 years 3 Years

Insurance cost per year 1% of Cost 1% of Cost

Estimated Salvage value 10% of Cost 10% of Cost

Capital Cost 20% 20%

 Method A
Do • Acquisition cost = 1.5m
Present • Annual operating and maintenance =
5% of 1.5m = 0.075m
Worth • Insurance = 1% of 1.5m = 0.015m
Analysis • Salvage value = 10% of 1.5m = 0.15m
• Estimated life is 2 years
Cash Flow Diagram
• PW = -1.5m – 1.5m (P/F,20,2) –
1.5m (P/F,20,4) - 0.09m (P/A,20,6) +
0.15m (P/F,20,2) + 0.15m
• (P/F,20,4) + 0.15m (P/F,20,6)
• = -1.5 – 1.5 (0.6944) – 1.5
(0.4823) - 0.09 (3.3255) + 0.15
(0.6944) + 0.15 (0.4823) +
• 0.15 (0.3349)
• = -3.338m
 • Method B
• Acquisition cost = 2m
Method B • Annual operating and maintenance
= 3% of 2m = 0.06m
• Insurance = 1% of 2m = 0.02m
• Salvage value = 10% of 2m = 0.2m
• Estimated life = 3 years
Cash Flow Diagram
• PW = -2m – 2m (P/F,20,3) –0.08m
(P/A,20,6) + 0.2m (P/F,20,3) + 0.2m
(P/F,20,6)
• = -2 – 2 (0.5787) –0.08 (3.3255) +
0.2 (0.5787) + 0.2 (0.3349)
• = -3.241m
ANNUAL • Only consider the lives of the projects
(A= 2 YEARS)
WORTH • Reduce all cash flows to an annuity
basis
ANALYSIS
Cash Flow Diagram
 • AW = -1.5 (A/P,20,2) – 0.09 + 0.15
(A/F,20,2)
• = -1.5 (0.6545) – 0.09 + 0.15
SOLUTION…. (0.45455)
• = - 1.004m
ANNUAL • Only consider the lives of the projects (B
= 3 years)
WORTH • Reduce all cash flows to an annuity
basis
ANALYSIS
Cash Flow
Diagram
• AW = -2 (A/P,20,3) – 0.08 + 0.2
(A/F,20,3)
• = - 2(0.4747) – 0.08 + 0.2(0.27473)
• = -0.974m
 • Used to estimate ALL resources
required to ensure project is a going
concern
Capitalised • Reduce all cash flows to NOW.
• Remember the concept of perpetuity:
Cost may be needed sometimes to shorten
steps required to arrive at a solution.
 • Used for alternatives with long lives
• Useful to ensure continuity
perceptually.
• Good for Scholarships, maintenance etc
• P = (A/i)
Perpetuity • Logic is to use interest to service annual
requirements.
• Interesting to find that P is not usually
as high as would be expected (by lay
man).
 • Consider a case of a road requiring 10m
naira per year to maintain.
• If it is required that the road be
perpetually in good condition, then we
Case can put an amount P in an account to
assure this.
example • Consider that capital costs 20%, then, P
is given as P = (A/i)
• P = 10m/0.2 = 50m
• That is 50m is invested at 20% to make
10m available annually for maintenance
 • KAX Ltd intends to set up an Escrow
account to cover operations and
maintenance of its critical packaging
system. Annual operations costs are
Case put at 1m Naira and maintenance
costs at 500,000 Naira only. How
Example much is required as deposit to assure
continuous operations and
maintenance of the system? Assume
capital costs 15%.
• Solution:
• Operations cost = 1m
• Maintenance costs = 0.5m
• Total Costs = 1.5m Naira
• Given that capital costs 15%, then we
use the Capitalised Cost principle:
• P = A/i
• In this case: 1.5m/ (0.15) = 10m Naira
only.
• Depositing 10m will earn 1.5m every
year .
 • Effective Interest Rate Per Period

Effective – i = (r/m); r represents nominal, m

the cycle
&
Nominal • Effective Annual Interest Rate:
Interests • ie = (1 + (r/m))m – 1
 • A savings and loan offers a 5.25% rate
per annum compound daily over 365
days per year. What is the effective
annual rate?

• In this case r=5.25% or 0.00525.

Example • Iie = (1 + (0.00525/365))365 – 1 =
0.00539

• Therefore, 5.25% interest per annum

but compounded daily is effectively
5.39% per annum
 • MARR (Minimum Acceptable rate of
Return)
• Set as Organisational Policy
• Represents rate below which we would
not like to operate.
MARR • Should not be set arbitrarily but by
examining opportunity costs.
• Two contending costs are: savings rate
(do nothing option) and lending rate
(loan option)
 • If using organisational funds, then
MARR > > savings rate
• If using a loan, then, MARR >> lending
rate
• What if it’s a mixed mode investment?
Guideline – Then logic of weighted average
should be used.
• It may be operated in a segmented
manner to discriminate between
project types. Discuss.
• MARR is Minimum Rate of Return.
• One would scan the environment for
Savings rates and lending rates.
• The MARR should be greater that
Savings rate if corporate funds are to be
utilized and greater that lending rate if
some borrowing will take place.
• Where a mix of funding sources is
anticipated, then the minimum must be
greater than that found by finding the
weighted averages.
 • Consider case of company investing
60m Naira in a new plant but taking a
loan of 40m Naira to make up.
• If savings rate is 10% and lending rate is
Case 20%, then MARR needs to be
determined given the fund mix
Example • MARR > (60S + 40L)/(60+40) = [60(10) +
40(20)]/100 = (600 +800)/100 = 14%
• The profit margin can then be added to
the 14% to determine the policy MARR