6.
1 Project Life Cycle and Economic Feasibility
Facility investment decisions represent major commitments of corporate resources and
have serious consequences on the profitability and financial stability of a corporation. In
the public sector, such decisions also affect the viability of facility investment programs
and the credibility of the agency in charge of the programs. It is important to evaluate
facilities rationally with regard to both the economic feasibility of individual projects and
the relative net benefits of alternative and mutually exclusive projects.
This chapter will present an overview of the decision process for economic evaluation of
facilities with regard to the project life cycle. The cycle begins with the initial conception
of the project and continues though planning, design, procurement, construction, start-up,
operation and maintenance. It ends with the disposal of a facility when it is no longer
productive or useful. Four major aspects of economic evaluation will be examined:
1. The basic concepts of facility investment evaluation, including time preference
for consumption, opportunity cost, minimum attractive rate of return, cash flows
over the planning horizon and profit measures.
2. Methods of economic evaluation, including the net present value method, the
equivalent uniform annual value method, the benefit-cost ratio method, and the
internal rate of return method.
3. Factors affecting cash flows, including depreciation and tax effects, price level
changes, and treatment of risk and uncertainty.
4. Effects of different methods of financing on the selection of projects, including
types of financing and risk, public policies on regulation and subsidies, the effects
of project financial planning, and the interaction between operational and
financial planning.
In setting out the engineering economic analysis methods for facility investments, it is
important to emphasize that not all facility impacts can be easily estimated in dollar
amounts. For example, firms may choose to minimize environmental impacts of
construction or facilities in pursuit of a "triple bottom line:" economic, environmental and
social. By reducing environmental impacts, the firm may reap benefits from an improved
reputation and a more satisfied workforce. Nevertheless, a rigorous economic evaluation
can aid in making decisions for both quantifiable and qualitative facility impacts.
It is important to distinguish between the economic evaluation of alternative physical
facilities and the evaluation of alternative financing plans for a project. The former refers
to the evaluation of the cash flow representing the benefits and costs associated with the
acquisition and operation of the facility, and this cash flow over the planning horizon is
referred to as the economic cash flow or the operating cash flow. The latter refers to the
evaluation of the cash flow representing the incomes and expenditures as a result of
adopting a specific financing plan for funding the project, and this cash flow over the
planning horizon is referred to as the financial cash flow. In general, economic evaluation
and financial evaluation are carried out by different groups in an organization since
economic evaluation is related to design, construction, operations and maintenance of the
facility while financial evaluations require knowledge of financial assets such as equities,
bonds, notes and mortgages. The separation of economic evaluation and financial
evaluation does not necessarily mean one should ignore the interaction of different
designs and financing requirements over time which may influence the relative
desirability of specific design/financing combinations. All such combinations can be duly
considered. In practice, however, the division of labor among two groups of specialists
generally leads to sequential decisions without adequate communication for analyzing the
interaction of various design/financing combinations because of the timing of separate
analyses.
As long as the significance of the interaction of design/financing combinations is
understood, it is convenient first to consider the economic evaluation and financial
evaluation separately, and then combine the results of both evaluations to reach a final
conclusion. Consequently, this chapter is devoted primarily to the economic evaluation of
alternative physical facilities while the effects of a variety of financing mechanisms will
be treated in the next chapter. Since the methods of analyzing economic cash flows are
equally applicable to the analysis of financial cash flows, the techniques for evaluating
financing plans and the combined effects of economic and financial cash flows for
project selection are also included in this chapter.
6.2 Basic Concepts of Economic Evaluation
A systematic approach for economic evaluation of facilities consists of the following
major steps:
1. Generate a set of projects or purchases for investment consideration.
2. Establish the planning horizon for economic analysis.
3. Estimate the cash flow profile for each project.
4. Specify the minimum attractive rate of return (MARR).
5. Establish the criterion for accepting or rejecting a proposal, or for selecting the
best among a group of mutually exclusive proposals, on the basis of the objective
of the investment.
6. Perform sensitivity or uncertainty analysis.
7. Accept or reject a proposal on the basis of the established criterion.
It is important to emphasize that many assumptions and policies, some implicit and some
explicit, are introduced in economic evaluation by the decision maker. The decision
making process will be influenced by the subjective judgment of the management as
much as by the result of systematic analysis.
The period of time to which the management of a firm or agency wishes to look ahead is
referred to as the planning horizon. Since the future is uncertain, the period of time
selected is limited by the ability to forecast with some degree of accuracy. For capital
investment, the selection of the planning horizon is often influenced by the useful life of
facilities, since the disposal of usable assets, once acquired, generally involves suffering
financial losses.
In economic evaluations, project alternatives are represented by their cash flow profiles
over the n years or periods in the planning horizon. Thus, the interest periods are
normally assumed to be in years t = 0,1,2, ...,n with t = 0 representing the present time.
Let Bt,x be the annual benefit at the end of year t for a investment project x where x = 1, 2,
... refer to projects No. 1, No. 2, etc., respectively. Let Ct,x be the annual cost at the end of
year t for the same investment project x. The net annual cash flow is defined as the
annual benefit in excess of the annual cost, and is denoted by At,x at the end of year t for
an investment project x. Then, for t = 0,1, . . . ,n:
(6.1)
where At,x is positive, negative or zero depends on the values of Bt,x and Ct,x, both of
which are defined as positive quantities.
