Engineering Economy Chapter 5x

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ENGINEERING ECONOMY, Sixth Edition by Blank and Tarquin

CHAPTER 5PRESENT WORTH ANALYSIS

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Chapter 5 Learning Objectives1. 2. 3. 4. 5. 6. 7. 8. 9.Formulating Alternatives; PW of Equal-life Alternatives; PW of Different-life Alternatives; FW Analysis; Capitalized Cost (cc); Payback Period; Life-cycle cost (LCC); PW of Bonds; Spreadsheets.

Authored by Don Smith, Texas A&M University 2004

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Section 5. 1 Mutually Exclusive Alternatives

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One of the important functions of financial management and engineering is the creation of alternatives. If there are no alternatives to consider then there really is no problem to solve! Given a set of feasible alternatives, engineering economy attempts to identify the best economic approach to a given problem.

Authored by Don Smith, Texas A&M University 2004

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5.1. Evaluating AlternativesPart of Engineering Economy is the selection and execution of the best alternative from among a set of feasible alternatives. Alternatives must be generated from within the organization. In part, the role of the engineer. Feasible alternatives to solve a specific problem/concern Feasible means viable or do-ableAuthored by Don Smith, Texas A&M University 2004 4

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5.1 Projects to AlternativesCreation of Alternatives.Ideas, Data, Experience, Plans, And Estimates

Generation of ProposalsP1 P2 Pn

Authored by Don Smith, Texas A&M University 2004

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5.1 Projects to AlternativesProposal Assessment.P1 Pj

P2

. .Pn

Economic Analysis And Assessment

PkInfeasible or Rejected!

Viable POK POK

Authored by Don Smith, Texas A&M University 2004

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5.1 Assessing AlternativesFeasible AlternativesEconomic Analysis And Assessment

. .

POK

Feasible Set Mutually Exclusive Set OR Independent Set

POK

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5.1. Three Types of Categories:1. The Single Project 2. 3. Mutually Exclusive Set, Independent Project Set.

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5.1 The Single ProjectCalled The Unconstrained Project Selection Problem; No comparison to competing or alternative projects; Acceptance or Rejection is based upon:

Comparison with the firms opportunity cost; Opportunity Cost is always present;

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5.1 Opportunity CostA firm must always compare the single project to two alternatives;

Do Nothing ( reject the project) or, Accept the project Involve the alternative use of the firms funds that could be invested in the project!

Do Nothing:

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5.1 Do Nothing OptionThe firm will always have the option to invest the owners funds in the BEST alternative use:

Invest at the firms MARR; Market Place opportunities for external investments with similar risks as the proposed project;

Authored by Don Smith, Texas A&M University 2004

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5.1 The Implicit Risk Single ProjectFor the single project then:

There is an implicit comparison with the firms MARR vs. investing outside of the firm; Simple: evaluate the single projects present worth at the firms MARR; If the present worth > 0 - conditionally accept the project; Else, reject the project!

Authored by Don Smith, Texas A&M University 2004

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5.1 Mutually Exclusive Set1. Mutually Exclusive (ME) SetOnly one of the feasible (viable) projects can be selected from the set. Once selected, the others in the set are excluded. Each of the identified feasible (viable) projects is (are) considered an alternative.

It is assumed the set is comprised of doable, feasible alternatives. ME alternative compete with each other!

Authored by Don Smith, Texas A&M University 2004

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5.1 Alternatives

Do Nothing

Alt. 1

Problem

Alt. 2

Analysis

SelectionAlt. m

Execute!14

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5.1 Alternatives: The Selected Alternative

Problem

Alt. 2

Execution

Audit and Track

Selection is dependent upon the data, life, discount rate, and assumptions made.Authored by Don Smith, Texas A&M University 2004 15

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5.1 The Independent Project SetIndependent Set

Given the alternatives in the set: More than one can be selected; Deal with budget limitations, Project Dependencies and relationships. Often formulated as a 0-1 Linear Programming model With constraints and an objective function.

More Involved Analysis

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5.1 Independent ProjectsMay or may not compete with each other depends upon the conditions and constraints that define the set! Independent Project analysis can become computationally involved! See Chapter 12 for a detailed analysis of the independent set problem!

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5.1 The Do-Nothing AlternativeDo-nothing (DN) can be a viable alternative; Maintain the status quo;

However, DN may have a substantial cost associated and may not be desirable. It might be that something has to be done and maintaining the status quo is NOT and option!

DN may not be an option;

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5.1 Rejection Default to DN!It could occur that an analysis reveals that all of the new alternatives are not economically desirable then: Could default to the DN option by the rejection of the other alternatives! Always study and understand the current, in-place system!

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5.2 THE PRESENT WORTH METHOD

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A process of obtaining the equivalent worth of future cash flows BACK too some point in time. called the Present Worth Method. At an interest rate usually equal to or greater than the Organizations established MARR.

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5.2 Present Worth A Function of the assumed interest rate.If the cash flow contains a mixture of positive and negative cash flows We calculate:

PW(+ Cash Flows) at i%; PW( - Cash Flows) at i%; Add the result!

We can add the two results since the equivalent cash flows occur at the same point in time!

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5.2 Present Worth A Function of the assumed interest rate.

If P(i%) > 0 then the project is deemed acceptable. If P(i%) < 0 then the project is deemed unacceptable! If the net present worth = 0 then,

The project earns exactly i% return Indifferent unless we choose to accept the project at i%.Authored by Don Smith, Texas A&M University 2004 22

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5.2 Present Worth A Function of the assumed interest rate. Present Worth transforms the future cash flows into:

Equivalent Dollars NOW! Converts future dollars into present dollars. One then COMPARE alternatives using the present dollars of each alternative. Present Worth requires that the lives of all alternatives be EQUAL.

Problem:

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