Engineering Economics

Syllabus
Academic Year 2024/2025 – 2nd Quarter (P2)

Problem Set

Chapter 5: Investment Selection

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Exercises

Problem 5.1

A company has two possibilities for substituting a machine. In option A, the new
machine, which costs 80,000 and has linear depreciations in 4 years, will reduce
energy costs by 22,000 per year and wages by 5,000 per year. This machine may last
up to 5 years at which time it will have no residual value. In option B, the machine costs
60,000 and depreciates in the same time as A but should not last more than 3 years at
which time it will have no market value. In this case, the reduction in energy costs will
be of 25,000 per year and the costs with workers will be the same as in A. In either
case the machines will have to be substituted at the end of their useful life. It is also
known that the company will keep with its usual financing practice of using 70% equity
and 30% debt, with an average cost of debt of 6%. The company has a risk premium of
5%, and the return of Treasury Bonds with the same duration as the project is 4%.
Consider that the company is profitable and pays 30% taxes on profits. Which machine
should the company buy?

Problem 5.2

A food company wants to invest in a new machine to produce a particular product line.
The company is lucrative and pays tax at the rate of 30%.

It is known that:

• personnel costs are reduced to 40% of the costs with the previous machine, for a
total of 30.0000 euros per year;
• consumption and maintenance are reduced to 2/3, settling in 9,000 per year;
• the decrease in consumption causes a decrease in the inventory level of raw
materials and supplies of around 20,000 euros;
• the new machine costs 100,000 euros, has a useful life of 8 years and depreciates
linearly. The old machine is worth 12,000 in the market today and still has two
yearly depreciations of 10,000€ left. At the end of the fourth year it will have no
market value although it may still be able to operate after it. On the other hand, it is
expected that the new machine be worth 20,000 euros after 4 years.

a) Assuming that the company’s best alternative investment option has a guaranteed
return of 10%, should it invest in the new machine if it wants a 4-year payback?

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b) Calculate the discounted payback and the profitability index (of the ‘differential’
project).

c) We know that the company’s 10,000 shares of the company have a nominal value of
1 euro, are quoted at 5 euro each. The company is expected to pay dividends of
25 cents, since it is company policy that dividends grow at an average of 4% per
year. In turn, it is hoped that the project financing structure will be identical to the
company’s policy, being that the level of debt is about 30% of the market value of
equity. Do a post-financing profitability analysis of the project, taking into account a
debt cost of 6% per year.

Problem 5.3

A producer of accessories for cars purchased a special machine to produce a specific

part one year ago. The machine has been depreciated at the annual rate of 25% and is
expected to last for three more years. The machine cost 88,000 monetary units (m.u.)
and now has a market value of 29,000 m.u.. Its market value is 6,000 m.u. but, for the
purposes of depreciation, the residual value was considered null.

However there is a new machine on the market that is much more efficient, which costs
63,000 m.u. and will allow for a reduction in annual operating costs from 63,000 m.u. to
50,000 m.u.. It is expected that this machine has a useful life of 3 years, being linearly
depreciable over that period, and that, at the end of this, will have a null residual value.

During the next years, the company will continue to pay tax on profits at the rate of
50%. The applicable discount rate is 5%.

a) Should the machine be replaced?

b) How would this situation change if the company was actually unprofitable now
and for the next 5 years, meaning it would not pay taxes?

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Problem 5.4

A company intends to replace a machine by a newer model. The purchase of the new
machine requires a cost of 2,000 m.u. in personnel training, would allow for a 6,000
m.u. yearly reduction in energy consumption and a reduction in maintenance costs of
2,000 m.u. per year. The new machine cost 20,000 m.u. and has a useful life of 5
years. The old machine has a market value of 8,000 m.u. The old machine is
completely depreciated and at the end of the fourth year it will have no market value. It
is expected that the new machine be worth 4,000 m.u. at the end of the 4 years. The
company is profitable, pays 50% tax rate and has a capital cost of 15%.

a) If the company wants payback in 4 years, should it invest in the new

machine?

b) Calculate the payback.

Problem 5.5

Suppose that Sally’s Doughnut Shop is considering purchasing one of two machines.
Machine A is a dough mixing machine that has a useful life of 6 years. During this time,
the machine will enable Sally to realize significant cost savings and represents an NPV
of $4 million.

Machine B is an icing machine with a useful life of 4 years. During this time, the
machine will allow Sally’s to reduce icing waste and represents an NPV of $3 million.
Sally’s Doughnut Shop has a cost of capital of 10%. Which machine should the
company invest in?

a) Using the Equivalent Annual Annuity method.

b) EAAC allows managers to compare NPVs of different projects over different

periods, to accurately determine the best option. Consider two alternative
investments in machinery equipment:

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 Machine A has the following:

• An initial capital outlay of $105,000

• An expected lifespan of three years

• An annual maintenance expense of $11,000

Machine B has the following:

• An initial capital outlay of $175,000

• An expected lifespan of five years

• An annual maintenance expense of $8,500

The cost of capital for the company making the decision is thus 5%. Which
should be the chosen machine?

Problem 5.6

Assuming that mutually exclusive Projects X and Y are attributable to the following
cash-flow releases (amounts in thousands of euros):

Calculate for each of the projects the Net Present Value, with a discount rate of 12%

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Problem 5.7

Assuming that you are looking at the following two alternative projects, where the
investment amount is 125 103 euros for each project and present the following Cash-
Flows (amounts 103 euros):

Assuming a discount rate of 5.25% say which project should be chosen using the
following method:

a) Equivalent Average Annual Cash-Flow (EAACF)

b) Minimum Common Time Horizon (MCTH)

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Solutions

Problem 5.1

WACC= 70% x (5% + 4%) + 30% x 6% x (1-0,3)= 0,0756

Alternative A
anos 0 1 2 3 4 5
c.f. Investimento -80000

c. energia 22000 22000 22000 22000 22000

c.pessoal 5000 5000 5000 5000 5000
(c.energia+pessoal)x(1-t) 18900 18900 18900 18900 18900
amort 20000 20000 20000 20000
amort x t 6000 6000 6000 6000
c.f.exploração 24900 24900 24900 24900 18900
c.f.totais -80000 24900 24900 24900 24900 18900
c.f.totais actualizados -80000 23149,87 21522,75 20009,99 18603,56 13128,28

VAL= 16414,46
an¬i= 4,039444 anuidade A = 4063,544
Alternative B
anos 0 1 2 3
c.f. Investimento -60000 4500

c. energia 25000 25000 25000

c.pessoal 5000 5000 5000
(c.energia+pessoal)x(1-t) 21000 21000 21000
amort 15000 15000 15000
amort x t 4500 4500 4500
c.f.exploração 25500 25500 25500
c.f.totais -60000 25500 25500 30000
c.f.totais actualizados -60000 23707,7 22041,37 24108,43

VAL= 9857,495

an¬i= 2,597695 anuidade B = 3794,708

Anuidade A > anuidade B, pelo que escolho A.

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Problem 5.2

a) Analisys New - Old

ICF 0 1 2 3 4
Inv Fixed C. -100000
Res.V FC 14400 29000 (=MV-(MV-BV)*0,3)
WCN 20000
Res.VWC -20000
Total ICF -65600 9000
OCF
Personel C. 45000 45000 45000 45000 (=0,6/0,4*30000)
Maintenaince C. 4500 4500 4500 4500 ((1/3)*9000/(2/3))
(=-100000/8-(-
Amortization -2500 -2500 -12500 -12500 10000))
EBIT 47000 47000 37000 37000
EBIT*(1-t) 32900 32900 25900 25900
Amort 2500 2500 12500 12500
Total OCP 35400 35400 38400 38400
Total CF -65600 35400 35400 38400 47400
Actualiz CF (10%) -65600 32181,82 29256,2 28850,49 32374,84

NPV(new-old) 10%= 57063,34

b)
Payback

Sum actualized CF = -65600 -33418,2 -4161,98 24688,5 57063,34

28850,49 1,731125
2 year e 1,73
answer: mounths

Profitability Index
OCF/ICF= 1,869868
NPV/ICF= 0,869868

c) Po=div1/(r-g) » ROE=0,25/5+0,04= 0,09

Equity=10000*5=50000 Debt=.3*Equity=15000
Equity+Debt=65000
WACC= 0,09*(50/65)+0,06*(15/65)*(1-0.3)= 0,078923

Act CF (WACC= 7,89%) -65600 32811,2 30411,71 30576,49 34982,72

NPV post-financing = 63182,12

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Problem 5.3
a) coc 5%, tax 50%

0 1 2 3
Inv -63000
Var WC
RV 47500 -3000
ICF -15500 0 0 -3000
Costs 13000 13000 13000
AMT 1000 1000 1000
EBIT 0 14000 14000 14000
Tax 0 -7000 -7000 -7000
NP100%E 7000 7000 7000
AMT -1000 -1000 -1000
OCF 0 6000 6000 6000
TCF -15500 6000 6000 3000
TCF act -15500 5714,286 5442,177 2591,513
VAL= -1752,02
b) coc 5%, imp 0%

0 1 2 3
Inv -63000
Var WC
RV 29000 -6000
ICF -34000 0 0 -6000
Costs 13000 13000 13000
AMT 1000 1000 1000
EBIT 0 14000 14000 14000
Tax 0 0 0 0
NP100%E 14000 14000 14000
AMT -1000 -1000 -1000
OCF 0 13000 13000 13000
TCF -34000 13000 13000 7000
TCF act -34000 12380,95 11791,38 6046,863
VAL=-3780,8

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Problem 5.4

Dif CF 0 1 2 3 4
C Form -2.000
C Energ 6.000 6.000 6.000 6.000
C Manut 2.000 2.000 2.000 2.000
dif AMT -4.000 -4.000 -4.000 -4.000
EBT -2.000 4.000 4.000 4.000 4.000
Tax 1.000 -2.000 -2.000 -2.000 -2.000
NP -1.000 2.000 2.000 2.000 2.000
Amt 4.000 4.000 4.000 4.000
OCF -1.000 6.000 6.000 6.000 6.000
Inv -20.000
MV + (MV-BV) x t 4.000 4.000
ICF -16.000 0 0 0 4.000
TCF -17.000 6.000 6.000 6.000 10.000
TCF act -17.000 5.217 4.537 3.945 5.718
TCF acum -17.000 -11.783 -7.246 -3.301 2.417

VAL: 2.417
Payback: 3 anos e 7 meses

Problem 5.5

a) Choose the largest EAA form the values below:

b) calculate the EAAC, which is equal to the net present value (NPV) divided by
the present value annuity factor or A(t,r), while taking into account the cost of
capital or r, and the number of years in question or t. Choose the lowest EAC
form the two values below:

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Problem 5.6

NPV X = 24,5; NPV Y = 41,8

Problem 5.7

a) Choose Project B assuming the EAACF method

Project A Project B
NPV@5,25% 13,963 NPV@5,25% 24,080
Annual factor 1,853 Annual factor 2,711
EAACF 7,536 EAACF 8,884

b) Choose Project B assuming the MCTH method

0 1 2 3 4 5 6
A -125 75 75
-125 75 75
-125 75 75
Cft -125 75 -50 75 -50 75 75

VAL@5,25% 37,947

0 1 2 3 4 5 6
B -125 55 55 55
-125 55 55 55

Cft -125 55 55 -70 55 55 55

VAL@5,25% 44,733

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