IPE - Capital Budgeting Decision

Engineering Economy
Capital Budgeting Decision
Copyright ©2009 by Pearson Education, Inc.

Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
Money has a time value.
• Capital refers to wealth in the form of
money or property that can be used to
produce more wealth.
• Engineering economy studies involve the
commitment of capital for extended periods
of time.
• A dollar today is worth more than a dollar
one or more years from now (for several
reasons).
Return to capital in the form of interest and
profit is an essential ingredient of
engineering economy studies.
• Interest and profit pay the providers of capital for
forgoing its use during the time the capital is being
used.
• Interest and profit are payments for the risk the
investor takes in letting another use his or her
capital.
• Any project or venture must provide a sufficient
return to be financially attractive to the suppliers
of money or property.
Simple Interest: infrequently used
When the total interest earned or charged is linearly

proportional to the initial amount of the loan
(principal), the interest rate, and the number of
interest periods, the interest and interest rate are said
to be simple.

Computation of simple interest
The total interest, I, earned or paid may be computed
using the formula below.
P = principal amount lent or borrowed

N = number of interest periods (e.g., years)
i = interest rate per interest period
The total amount repaid at the end of N interest
periods is P + I.
If $5,000 were loaned for five years at a
simple interest rate of 7% per year, the
interest earned would be
So, the total amount repaid at the end

of five years would be the original
amount ($5,000) plus the interest
($1,750), or $6,750.
Compound interest reflects both the remaining principal
and any accumulated interest. For $1,000 at 10%…
(1) (2)=(1)x10% (3)=(1)+(2)

Amount owed Interest Amount
at beginning of amount for owed at end
Period period period of period
1 $1,000 $100 $1,100
2 $1,100 $110 $1,210
3 $1,210 $121 $1,331
Compound interest is commonly used in personal and

professional financial transactions.
Economic equivalence allows us to
compare alternatives on a common basis.
• Each alternative can be reduced to an
equivalent basis dependent on
– interest rate,
– amount of money involved, and
– timing of monetary receipts or expenses.
• Using these elements we can “move” cash
flows so that we can compare them at
particular points in time.
We need some tools to find economic
equivalence.
• Notation used in formulas for compound interest
calculations.
– i = effective interest rate per interest period
– N = number of compounding (interest) periods
– P = present sum of money; equivalent value of one or
more cash flows at a reference point in time; the present
– F = future sum of money; equivalent value of one or
more cash flows at a reference point in time; the future
– A = end-of-period cash flows in a uniform series
continuing for a certain number of periods, starting at
the end of the first period and continuing through the
last
A cash flow diagram is an indispensable
tool for clarifying and visualizing a
series of cash flows.

We can apply compound interest
formulas to “move” cash flows along the
cash flow diagram.
Using the standard notation, we find that a
present amount, P, can grow into a future
amount, F, in N time periods at interest rate
i according to the formula below.
In a similar way we can find P given F by

It is common to use standard notation for
interest factors.
This is also known as the single payment

compound amount factor. The term on the
right is read “F given P at i% interest per
period for N interest periods.”
is called the single payment present worth

factor.
We can use these to find economically
equivalent values at different points in time.
$2,500 at time zero is equivalent to how much after six
years if the interest rate is 8% per year?
$3,000 at the end of year seven is equivalent to how

much today (time zero) if the interest rate is 6% per
year?

Finding the Present Value : Examples
Example 1
Example 2

Finding the Future Value : Examples
Example 3
Example 4

Nominal and effective interest rates.
• More often than not, the time between successive
compounding, or the interest period, is less than
one year (e.g., daily, monthly, quarterly).
• The annual rate is known as a nominal rate.
• A nominal rate of 12%, compounded monthly,
means an interest of 1% (12%/12) would accrue
each month, and the annual rate would be
effectively somewhat greater than 12%.
• The more frequent the compounding the greater
the effective interest.
The effect of more frequent
compounding can be easily
determined.
Let r be the nominal, annual interest rate and M the
number of compounding periods per year. We can
find, i, the effective interest by using the formula
below.

Finding effective interest rates.
For an 18% nominal rate, compounded quarterly, the
effective interest is.
For a 7% nominal rate, compounded monthly, the

effective interest is.

Interest can be compounded
continuously.
• Interest is typically compounded at the end
of discrete periods.
• In most companies cash is always flowing,
and should be immediately put to use.
• We can allow compounding to occur
continuously throughout the period.
• The effect of this compared to discrete
compounding is small in most cases.
We can use the effective interest
formula to derive the interest
factors.
As the number of compounding periods

gets larger (M gets larger), we find that

To be attractive, a capital project
must provide a return that exceeds
a minimum level established by
the organization. This minimum
level is reflected in a firm’s
Minimum Attractive Rate of
Return (MARR).

Many elements contribute to
determining the MARR.
• Amount, source, and cost of money available
• Number and purpose of good projects
available
• Perceived risk of investment opportunities
• Type of organization

Project Selection
• Mutually exclusive means that if one project is
taken on, the other must be rejected
• Project Selection Methods:

1. Net Present Value
2. Internal Rate of Return
3. Pay back period
4. Benefit Cost Ratio

Net Present Value
Determines whether the project is or is not an acceptable
investment.
Example:

Net Present Value
Solution:

Net Present Value
Single Project:
•Principle: Compute Net Present Value for a given interest rate of i
•Decision Rule: Accept the project if the NPV is positive
Comparing More Than One Alternative:

 If you need to select the best alternative, based on the net-present-
worth criterion, select the one with the highest PW or NPV, as long as
all the alternatives have the same service lives.
Internal Rate of Return
• The internal rate of return (IRR) method is
the most widely used rate of return method
for performing engineering economic
analysis.
• It is also called the investor’s method, the
discounted cash flow method, and the
profitability index.
• If the IRR for a project is greater than the
MARR, then the project is acceptable.
How the IRR works
• The IRR is the interest rate that equates the
equivalent worth of an alternative’s cash
inflows (revenue, R) to the equivalent
worth of cash outflows (expenses, E).
• The IRR is sometimes referred to as the
breakeven interest rate.
The IRR is the interest i'% at which

If the IRR for a project is greater than the MARR, then the project is
acceptable.
$2000 $3000 $3000 $4000
1 2 3 4
-9000
IRR= 11.31%
Say, MARR is 11.32%,
Now, with IRR, FW=2000(1+0.1131)^3+3000(1+0.1131)^2+3000(1+0.1131)+4000=$13814
But with MARR=11.32%,
FW= 9000(1+0.1132)^4=$13820

Internal Rate of Return (IRR)
The IRR is defined as the discount rate that forces the
project’s NPV to equal zero.

Computational methods for IRR
The most practical methods are-
– Direct-solution method,
– Trial-and-error method. and
– Excel method.
Example: The cash flows for projects S an L are shown below. What are the
projects’ IRRs, and which one would the IRR method select if the
firm has a 10% cost of capital and the projects are mutually
exclusive?

Payback period
payback period, defined as the number of years required
to recover a project’s cost from operating cash flows.
Two types-
 conventional-payback period-doesn’t consider the cost
of fund
 discounted-payback period- considers the cost of fund

Conventional Payback Period
Ashland Company has just bought a new spindle machine at a cost of $105.000 to
replace one that had a salvage value of $20,000. The projected annual after tax
savings due to improved efficiency, are as follows:
Here a negative balance of $10,000 remains at the start of year 4. If the $45,000 is
expected to be received as a more or less continuous flow during year 4, then the
total investment will be recovered two-tenths ($10,000/$45.000) of the way
through the fourth year. In this situation, the prorated payback period is thus 3.2
years.
Conventional Payback Period
Example 2: Assumption?

Discounted Payback Period
Discounted Payback Calculations at 9% Cost of Capital

Applying the benefit-cost ratio method
• The consideration of the time value of
money means this is really a ratio of
discounted benefits to discounted costs.
• Recommendations using the B-C ratio
method will result in identical
recommendations to those methods
previously presented.
• B-C ratio is the ratio of the equivalent worth
of benefits to the equivalent worth of costs.
Private Versus Public Projects
• PURPOSE
Private Project -- Maximize profit, minimize costs
Public Project -- Offer social benefits (i.e., health,
employment ) without profit
• CAPITAL SOURCES
Private Project -- Private investors and lenders
Public Project -- Taxation; Private Lenders
• FINANCING
Private Project -- Individuals (for sole proprietorships and
partnerships); stocks and corporate bonds (for corporations)
Public Projects -- Direct taxes, Low, no-interest or private loans,
bonds, subsidies
• MULTIPLE PURPOSES
More frequently for public projects ( i.e., reservoir for: flood control,
power source, irrigation, recreation)
• PROJECT LIFE
Private Project -- 5 to 20 years;
Public Project -- 20 to 60 years
• CAPITAL PROVIDER RELATIONSHIP TO PROJECT
Private Project -- Direct
Public Project -- Indirect or none
• NATURE OF BENEFITS
Private Project -- Monetary or near monetary
Public Project -- Non-monetary; difficult to equate to monetary terms
• PROJECT BENEFICIARIES
Private Project -- Those undertaking project
Public Project -- General public
• CONFLICT OF PURPOSES
More common for public projects (i.e., dam for flood control vs environmental
preservation)
• CONFLICT OF INTERESTS
More common for public projects (i.e., intra-agency conflicts)
• POLITICAL INFLUENCE
More common for public projects ( i.e., changing decision makers, pressure
groups, financial and residential restrictions)
• EFFICIENCY MEASUREMENT
Private Project -- Rate of Return on capital
Public Project -- No direct comparison with private projects
Two B-C ratios
Conventional B-C ratio with PW
Modified B-C ratio with PW
A project is acceptable when the B-C ratio is greater

than or equal to one.
Pause and solve
Stillwater has initiated discussions on attracting rail service. A depot
would need to be constructed, which would require $500,000 in land and
$5.2 million in construction costs. Annual operating and maintenance
costs for the facility would be $150,000, and personnel costs would be
an additional $120,000. Other assorted costs would be born by the
railroad and federal authorities. Annual benefits of the rail service are
estimated as listed below.
$1,300,000 Railroad annual payments

$200,000 Rail tax charged to passengers
$180,000 Convenience benefits to local residents
$120,000 Additional tourism dollars for Stillwater
Apply the B-C ratio method, with a MARR of 8% per year and 5 year study
period, to determine if the rail service should be established.
Selecting projects
• If projects are independent, all projects that
have a B-C great than or equal to one may
be selected.
• For projects that are mutually exclusive, a
B-C greater than one is required, but
selecting the project that maximizes the B-C
ratio does not guarantee that the best project
is selected.
Incremental B-C analysis for mutually
exclusive projects.
• Incremental analysis must be used in the case of B-
C and mutually exclusive projects.
• Rank alternatives in order of increasing total
equivalent worth of costs.
• With “do nothing” as a baseline, begin with the
lowest equivalent cost alternative and determine the
incremental B-C ratio (B/C), selecting the
alternative with the higher equivalent cost if the
ratio is greater than one.
Which, if any, of the MEA projects below should
be selected using B-C analysis? Assume a 20
year study period and MARR=10%.
A B C
Investment $125,000 $160,000 $180,000
Annual O&M 10,000 10,000 9,500
MV (20 yrs.) 40,000 50,000 50,000
Benefit/yr. 35,000 42,000 44,000
PW(10%)-costs 204,190 237,703 253,447
PW(10%)-benefits 297,975 357,570 374,597
B-C ratio 1.46 1.50 1.47
Each alternative is attractive.

Incremental analysis
-A) (C-B)
Investment $35,000 $20,000
Annual O&M 0 -500
MV (20 yrs.) 10,000 0
Benefits/yr. 7,000 2,000
PW(10%)-costs 33,514 15,743
PW(10%)-benefits 59,595 17,027
B-C ratio 1.78 1.08
Conclusion B is better C is better
Choose alternative C.


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Engineering Economy

Capital Budgeting Decision

Copyright ©2009 by Pearson Education, Inc.

When the total interest earned or charged is linearly

Copyright ©2009 by Pearson Education, Inc.

P = principal amount lent or borrowed

So, the total amount repaid at the end

(1) (2)=(1)x10% (3)=(1)+(2)

Compound interest is commonly used in personal and

Copyright ©2009 by Pearson Education, Inc.

In a similar way we can find P given F by

Copyright ©2009 by Pearson Education, Inc.

This is also known as the single payment

is called the single payment present worth

$3,000 at the end of year seven is equivalent to how

Copyright ©2009 by Pearson Education, Inc.

Copyright ©2009 by Pearson Education, Inc.

Copyright ©2009 by Pearson Education, Inc.

Copyright ©2009 by Pearson Education, Inc.

For a 7% nominal rate, compounded monthly, the

Copyright ©2009 by Pearson Education, Inc.

As the number of compounding periods

Copyright ©2009 by Pearson Education, Inc.

Copyright ©2009 by Pearson Education, Inc.

Copyright ©2009 by Pearson Education, Inc.

• Project Selection Methods:

Copyright ©2009 by Pearson Education, Inc.

Copyright ©2009 by Pearson Education, Inc.

Copyright ©2009 by Pearson Education, Inc.

Comparing More Than One Alternative:

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$2000 $3000 $3000 $4000

Copyright ©2009 by Pearson Education, Inc.

Copyright ©2009 by Pearson Education, Inc.

Copyright ©2009 by Pearson Education, Inc.

Copyright ©2009 by Pearson Education, Inc.

Copyright ©2009 by Pearson Education, Inc.

Copyright ©2009 by Pearson Education, Inc.

Modified B-C ratio with PW

A project is acceptable when the B-C ratio is greater

$1,300,000 Railroad annual payments

Each alternative is attractive.

Copyright ©2009 by Pearson Education, Inc.

Copyright ©2009 by Pearson Education, Inc.

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