Construction Economics & Financial Management

[CEM-6105]

Adama Science and Technology University

MSc Civil Engineering

[Construction Engineering and Management] 1

Targeted Students: Instructor:

1st Year CEM Students Dr. Meseret Getnet

January, 2020
 Chapter 2
2

Time Value of Money and Economic Evaluation

2
BASIC ECONOMICS PRINCIPLES

• Owners generally wish to:

• lower costs and completion times of their construction
projects; and
• Increase the benefits such as quality, life time, profit or
serviceability etc of their construction projects.

• As a result they want their construction projects are

optimally designed, constructed and operated in order to
make their business objective viable.
• Construction Economics is useful in order to ensure such
demands of Owners.
BASIC ECONOMICS PRINCIPLES
• As a result; the following decisions need to be made in order
to fulfil such requirements:
• Deciding whether to accept a project or not;
• Deciding where to construct the project;
• Choosing how to allocate risks and responsibilities to carry out
the project (Delivery System, Contracting Method, Procurement
Method and Contract Type);
• Selecting optimal design, construction and operation
technologies: methods, materials, machineries, etc;
• Prioritizing projects to supply – demand principles and use
scarce resources
BASIC ECONOMICS PRINCIPLES
• Therefore the following basic economics principles are vital
to support such decisions:
• Supply and Demand
• Supply and Demand definitions and curves
• Monopoly and Monopsony
• Economic efficiency and optimization
• Time Value of Money & Cash Flow Diagrams
• Treatments of Price Changes
• Setting the Study Period
• Selecting a discount rate
• Decision Support Methods
BASIC ECONOMICS PRINCIPLES

• Supply and Demand

Supply
is the amount of products (services, goods and works) that
producers / suppliers are willing or making available for sell
in the market.

Demand
is the amount of products (services, goods and works) that buyers
are willing or able to buy from the market.
BASIC ECONOMICS PRINCIPLES

• Supply and Demand

Supply
is the amount of products (services, goods and works) that
producers / suppliers are willing or making available for sell
in the market.

Demand
is the amount of products (services, goods and works) that buyers
are willing or able to buy from the market.
BASIC ECONOMICS PRINCIPLES

Simple Supply Demand Curve

Price
Supply
Demand
More products are produced
when prices are higher.

Greater Quantity is demanded

when prices are lower.

Quantity
BASIC ECONOMICS PRINCIPLES

Monopoly Vs Monopsony
Monopoly
Single Supplier to Many Buyers
Monopsony
Single Buyer to Many Suppliers
BASIC ECONOMICS PRINCIPLES

• Economic Efficiency and Optimization

• A Physical Infrastructure is economic efficient if its investment is
feasible and at the same time feasible than other available
options.
• A physical infrastructure which will yield greater revenue but
cost the same or less than the alternative options, then it is the
economic efficient choice.
• Economic Optimization is a process in which economic analysis
is carried out to determine the most economically efficient choice
among alternatives.
BASIC ECONOMICS PRINCIPLES

• Time Value of Money & Cash Flow Diagrams

• Time value of money because
• Buying power of future money is less than today’s money due to
inflation
• Today’s money can be used for investment and most likely brings
profit depending of the rate of return upon different businesses
• Comparison of today’s and future money can be made in order to
support decision when to invest money
• Comparison of different investment options whose expenditures
differ in time using the same time framework
• Future money can only provide savings through deposit interests;
however borrowing for investment purposes will overcome them
BASIC ECONOMICS PRINCIPLES

• Time Value of Money & Cash Flow Diagrams

• Time value of money because
• Time Equivalent values can be used to decide to forego today’s
investment
• F = P (1 + MARR) ^ n; P and F are the present and the final values,
MARR is the minimum acceptable rate of return expressed in a
decimal and number of periods or time frame

• Interest computations as bases for determining time value

of money
• Using Simple interest; F = P(1+in); not recommended for
construction related businesses
• Using Compound interest; F = P (1+i) ^ n
BASIC ECONOMICS PRINCIPLES

• Time Value of Money & Cash Flow Diagrams

• Three financial cash flow approaches as a basis to determine
Time Value of Money
• Discrete cash flow
• F = P(1+i)^n=> fi=(1+i)^n
• Uniform cash flow often called annuity
• F = A[{(1+i)^n – 1}/i]
• P = A [{(1+i)^n – 1}/{i(1+i)^n}]
• Gradient cash flow
• Uniform gradient
• A = G[{1/i} – {n/i}{i/((1+i)^n-1)}]
• Cash flow diagram are helpful in determining time value of
money using net cash flow computations
BASIC ECONOMICS PRINCIPLES

• Time Value of Money & Cash Flow Diagrams

• Equivalence as a basis for determining time value of money
• Equivalence does not mean money today and money in the
future are equal
• Equivalence do not consider risks but can be made to consider if
quantifiable and could be framed / estimated time wise
• Equivalence can make different scenarios comparable at
different times
• Non – equivalency indicates an initiative for choice depending
on which provides better value for money
• Future money can be the choice if and only if the MARR is
acceptable
• For construction related business often today’s money is much
more important; specifically in our country context
BASIC ECONOMICS PRINCIPLES

• Treatments of Price Changes

• Treatments of price changes because
• Inflation and deflations changes purchasing power of money
• Differences between constant and current money indicates price
changes
• Escalations can be computed using such price changes
• Devaluation of money can also be accounted as one form of price
changes
• If demand and supply remains the same for all items; the
general price inflation could have been applied for
determining price escalations
BASIC ECONOMICS PRINCIPLES

• Treatments of Price Changes

• Relative changes in prices can be determined using; e =
[{1+E}/{1+I}] – 1
• Hence, the differential escalation rate, e, can be used to
determine the price escalation in constant money; i.e., F =
P(1+e)^n
BASIC ECONOMICS PRINCIPLES

• Setting the Study Period

• Factors
• Investor’s / developer time horizon
• Life time of the development
• Decision basis; accept / reject or prioritize
• Public Vs Private development
• When the study period is longer or shorter than the life
time of the development; take into account salvage /
residuals and replacement values
• Guidelines
• Study period = investor’s / developer time horizon if it is < life time
of the development
BASIC ECONOMICS PRINCIPLES

• Setting the Study Period

• Guidelines
• Study period = Life time of the development for accept / reject
decisions with a replacement considerations for the shortest life times
• Study period = Least Common Multiple for priority decision and if
LCM < Life time of the development
• Study period shall be similar among alternatives for priority
decisions with the consideration of their salvage / residual
replacement values
• Study period = Life time of the development for public projects
• Study period = Shortest life time for preventing technological
obsolescence
BASIC ECONOMICS PRINCIPLES

• Selecting a discount rate

• Imposes a condition of minimum profitability for a development to
qualify for acceptance
• Affects whether a project is accepted or rejected
• Reflect the rate of return available on the next best investment
opportunity
• Represents the opportunity cost developer’s expected to obtain when
foregone the next best alternative
• Analysis of business decisions require an after tax discount rate {Dat =
Dbt(1-T)}
• Real Vs Market Discount Rates
• Real for Constant value of cash flows
• Market for Current value of Cash flows
BASIC ECONOMICS PRINCIPLES

• Selecting a discount rate

• The higher the risk to development / investment; the greater its
expected rate of return (risk – return relationship)
• When evaluations are made on the bases of risk – free discount
rates; a separate risk adjustment is made to cash flows
BASIC ECONOMICS PRINCIPLES

• Decision Support Processes, Methods and Techniques

• Decision Types
• Accept / Reject
• Ranking
• Size
• Location
• Own Vs Rent or Lease
• Replacement
• Risk
BASIC ECONOMICS PRINCIPLES
• Decision Support Processes, Methods and Techniques
• Decision Support Processes
• Defining the problem and objective of the business
• Identify feasible alternatives taking into account constraints
encountered
• Selecting method of economic evaluations
• Selecting risk consideration techniques
• Compile data and make to good to be true assumptions
• Estimate intangible benefits
• Compute measures of economic performances
• Compare and / or prioritize as part of evaluation to identify the best
alternative
BASIC ECONOMICS PRINCIPLES

• Decision Support Methods and Techniques

• Methods and Techniques
• Traditional Methods (Without considering Monetary Values)
• Annual Net Profit and Pay Back (Rate of Return on Capital)
• Methods based on an assumed IRR or discount rate
• Equivalent annual cost method (for regular cash flows)
• Present Worth Method or NPV (for irregular cash flows)
• Capitalized Cost (Particular case of NPV)
• Methods used to determine IRR (To determine IRR)
• IRR based on NPV (Using Trial and Error)
• ERR based on NFV (To alleviate IRR technical Problems)
BASIC ECONOMICS PRINCIPLES

• Decision Support Methods and Techniques

• Methods and Techniques
• Methods Considering intangible / irreducible factors
• Benefit Cost Ratio (BCR)
• Breakeven Analysis
• Sensitivity Analysis
• Methods Considering Risks
• Decision Matrix using Laplace / MaxMin / MaxMax / MinMax Criteria
• Certainty Equivalent
• Expected Monetary Value
• Decision Tree
• Utility Functions
BASIC ECONOMICS PRINCIPLES

• Decision Support Methods and Techniques

• Methods Considering Risks
• Value Analysis based on Quotient / Difference / Limit Value
Methods / Profitability Analysis
• Other Methods
• Life Cycle Cost
• Valuation
• Influence Diagram
BASIC ECONOMICS PRINCIPLES

• Economic Evaluation Report

• Front Loads
• Summary / Abstract; Table of Content; Lists of Figures, Boxes and
Tables; Glossary; Abbreviations; Acknowledgement; Introduction
and Background
• Main Body
• Socio - Economic Profile; Demand Analysis; Proposed
Intervention Development and Analysis; Economic Evaluation; and
Environment Impact Assessment
• Back Loads
• Conclusion & Recommendations; References / Bibliography; and
Appendixes / Annexes / Attachments
TIME VALUE OF MONEY

• Interest: The Cost of Money

• Option 1: Single lump sum payment of 10 million Birr.
• Option 2: Annual payment of 3 million for 10 years [total of
30 m]
• Which one is better from a strictly economic
viewpoint?
• Over time money can earn money = interest, therefore the earlier
a sum of money is received, the more it is worth
• Engineering projects are commitments of capital for extended
periods of time, therefore the effect of time on value of money
must always be considered.
TIME VALUE OF MONEY

• Interest …
• Used to designate a rental for the use of money.
• Same as the rental paid for the use of equipment, building
etc.
• Usually expressed as a percentage of the amount owed.
• It is due and payable at the close of each period of time
involved in the agreed transaction [usually every year or
month].
TIME VALUE OF MONEY

• Interest Rate [i]

• Rate of capital growth.
• Rate of gain received from an investment over a period of
time.
• Usually expressed on an annual basis.
• For the lender, it consists, for convenience, of [1] risk of
loss, [2] administrative expenses, and [3] profit or pure
gain.
• For the borrower, it is the cost of using a capital for
immediately meeting his or her needs.
TIME VALUE OF MONEY

• Time Value of Money [TVM]

• Money- Time Relationships
• Means that two equal amount at different points of time do
not have equal value if the interest rate is greater than zero.
• Money has both earning power [it can be put in the bank to
earn interest] and purchasing power [Usually decreases over
time: inflation]
• Money has a time value because it can earn interest over time.
• One birr today is worth more than one birr tomorrow.
• Failure to pay the bills results in additional charge termed
interest.
TIME VALUE OF MONEY

• Simple Interest
• Total interest is directly proportional to the amount of loan
[principal], the interest rate, and the number of interest
periods
I = [P] [n] [i]
• I : total interest
• P : principal
• n : number of interest periods
• i : interest rate per interest period.
TIME VALUE OF MONEY

• Simple Interest [i] :- Example:

• If 1,000.00 birr is borrowed at 14% interest, then interest on
the principal of 1,000.00 birr after one year is 0.14 x 1, 000,
or 140.00 birr.
• If the borrower pays back the total amount owed after one
year, she/he will pay 1,140.00 birr.
TIME VALUE OF MONEY

• Compound Interest [i]:

• If someone does not pay back any of the amount owed after
one year, then normally the interest owed, but not paid, is
considered now to be additional principal, and thus the
interest is compounded
• After two years she will owe 1,140.00 birr + 0.14 X
1,140.00, or 1,299.60.
TIME VALUE OF MONEY

• Economic Equivalency
• The banker in the previous example normally does not care
whether you pay him 1,140.00 birr after one year or
1,299.60 birr after two years.
• To him, the three values [1,000, 1,140, and 1,299.60 birr]
are equivalent.
• 1,000 Birr today is equivalent to 1,140 birr one year from
today and 1,000 Birr today is equivalent to 1,299.60 Birr
two years from today.
• The three values are not equal but equivalent
TIME VALUE OF MONEY

• Economic Equivalency
• Equivalence means that one sum or series differs from
another only by the accumulated interest at rate i for n
periods of time.
• The concept of equivalence involves timing of money,
amount of money receipt/expenses and a specified rate of
interest.
• The three preceding values are only equivalent for an
interest rate of 14%, and then only at the specified times.
TIME VALUE OF MONEY

• Cash Flow Diagram

• It is strongly recommended for situations in which the
analyst needs to visualize what is involved when flows of
money occur at various times.
• The usefulness of cash flow diagram for economic analysis
problems is analogous to that of the free body diagrams of
Engineering mechanics problems.
TIME VALUE OF MONEY
• Cash Flow Diagram

P = a present single amount of money

F = a future single amount of money, after n periods of time
A = end-of-period cash flows in a uniform series for a specified number of
periods, starting at the end of first period and continuing through the last period.
i = the rate of interest per interest period [usually one year]
n = the number of periods of time [usually years]
TIME VALUE OF MONEY

• Cash Flows Over Time

TIME VALUE OF MONEY

• In a cash-flow diagram:
• Horizontal line represents time scale,
• Arrows represent cash flows.
• Downward arrows represent expenses [negative cash flows
or cash outflows] and upward arrows represent receipts
[positive cash flows or cash inflows].
• The CFD is dependent on the point of view. In the course,
without explicitly mention, the company’s [investor’s] point
of view will be taken.
TIME VALUE OF MONEY

• Example [CFD]
• You are analysing a project with five-year life. The project
requires a capital investment of $50,000 now, and it will
generate uniform annual revenue of $6,000. Further, the
project will have a salvage value of $4,500 at the end of the
fifth year and it will require $3,000 each year for the
operations.
• Develop the cash-flow diagram for this project from the
investor’s viewpoint.
TIME VALUE OF MONEY

• Example [CFD]
• You are analysing a project with five-year life. The project
requires a capital investment of $50,000 now, and it will
generate uniform annual revenue of $6,000. Further, the
project will have a salvage value of $4,500 at the end of the
fifth year and it will require $3,000 each year for the
operations.
• Develop the cash-flow diagram for this project from the
investor’s viewpoint.
TIME VALUE OF MONEY

• Three Rules for Performing Cash Flow Computations

• Cash flows cannot be added or subtracted unless they occur
at the same point in time.
• To move a cash flow forward in time by one time unit,
multiply the magnitude of the cash flow by [1 + i].
• To move a cash flow backward in time by one time unit,
divide the magnitude of the cash flow by [1 + i].
TIME VALUE OF MONEY

• Single Payment Series:

1. Single Payment Compound-Amount Factor [SPCAF]:
Find F when P is given;

OR
TIME VALUE OF MONEY

• Single Payment Series:

2. Single Payment Present-Worth Factor [SPPWF]: Find P
when F is given;

OR

• Notation: P = F [P/F, i%, N] where the factor in the

parentheses is read "find P given F at i% interest per period
for N interest periods.
TIME VALUE OF MONEY

• Example 1:
• A contractor wishes to set up a revolving line of credit at
the bank to handle his cash flow during the construction of
a project. He believes that she needs to borrow12,000 Birr
with which to set up the account, and that he can obtain the
money at 1.45% per month. If he pays back the loan and
accumulated interest after 8 months, how much will she
have to pay back?
Solution:
F = 12,000[1 + 0.0145]8 = 12,000[1.122061]= 13,464.73 =13,465 Birr.
The amount of interest will be:13,465 - 12,000 = 1,465 Birr.
TIME VALUE OF MONEY
• Example 2:
• A construction company wants to set aside enough money
today in an interest-bearing account in order to have 100,000
Birr five years from now for the purchase of a replacement
piece of equipment. If the company can receive 8% interest on
its investment, how much should be set aside now to collect
the100,000 Birr five years from now?
Solution:
P = 100,000/[I + 0.08]5 =100,000/[1.46933] = 68,058.32 Birr = 68,060 Birr
To solve this problem you can also use the interest tables.
P = 100,000 [P/F, 8%, 5] = 100,000[0.6805832] 68,058.32 Birr= 68,060
Birr.
TIME VALUE OF MONEY

• Uniform/Equal Payment Series

• Often payments or receipts occur at regular intervals, and
such uniform values can be handled by the use of additional
functions.
• Another symbol: A = uniform end-of-period payments or
receipts continuing for a duration of n periods
• If a uniform amount A is invested at the end of each period
for n periods at a rate of interest i per period, then the total
equivalent amount F at the end of the n periods will be:
TIME VALUE OF MONEY

• Uniform/Equal Payment Series

• By multiplying both sides of above equation by [1+i] and
subtracting from the original equation, the following
expression is obtained:

• Which can be rearrange to give

TIME VALUE OF MONEY

• Uniform/Equal Payment Series

1. Uniform [Equal payment] Series Compound-Amount
Factor [USCAF]: Find F when A is given;

OR
TIME VALUE OF MONEY

• Uniform/Equal Payment Series

2. Uniform [Equal payment] Series Sinking-Fund Factor
[USSFF]: Find A when F is given;

OR

3. Uniform [Equal payment] Series Capital-Recovery Factor

[USCRF]: Find A when P is known;

OR

Note: This is the case of loans [mortgages]

TIME VALUE OF MONEY

• Uniform Gradient Payment Series

• Involve receipts or disbursements that are projected to
increase or decrease by a uniform amount each period thus
contributing an arithmetic series.
• Linear Gradient Example:
TIME VALUE OF MONEY

• Example: Linear Gradient typical negative, Increasing Gradient:

G = $50.

52

MESERET G. [CENG 5011] 10/10/2013/14

TIME VALUE OF MONEY

Arithmetic Gradient Factors

• The “G” amount is the constant arithmetic change from one time
period to the next.

• The “G” amount may be positive or negative!

• The present worth point is always one time period to the left of the
first cash flow in the series or,

• Two periods to the left of the first gradient cash flow!

53

MESERET G. [CENG 5011] 10/10/2013/14

TIME VALUE OF MONEY

• Derivation: Gradient Component Only: Focus Only on the

gradient Component.

54

10/10/2013/14
TIME VALUE OF MONEY

• The Present worth point of a linear gradient is always:

• 2 periods to the left of the “1G” point or,
• 1 period to the left of the very first cash flow in the
gradient series.
• DO NOT FORGET THIS!

55

10/10/2013/14
TIME VALUE OF MONEY

• Gradient Component

56

MESERET G. [CENG 5011] 10/10/2013/14

TIME VALUE OF MONEY

Cont’d…

• PW of the Base Annuity is at t = 0

• PW Base Annuity= $100 (P/A,i%,7)

57

10/10/2013/14
TIME VALUE OF MONEY

• Present Worth [PW]: Linear Gradient

• The present worth of a linear gradient is the present worth of
the two components:
1. The Present Worth of the Gradient Component and,
2. The Present Worth of the Base Annuity flow
• Requires 2 separate calculations!

58

MESERET G. [CENG 5011] 10/10/2013/14

TIME VALUE OF MONEY

Cont’d…

• The PW of the Base Annuity is simply the Base Annuity: A{P/A, i

%, n} factor

• What is needed is a present worth expression for the gradient

component cash flow.

• We need to derive a closed form expression for the gradient

component.
59

10/10/2013/14
TIME VALUE OF MONEY

• General CF Diagram – Gradient Part Only

• To Begin- Derivation of P/G, i%, n

60

MESERET G. [CENG 5011] 10/10/2013/14

TIME VALUE OF MONEY

Cont’d…

• Factor out G and re-write as ….. Factoring G out…. P/G factor

• What is inside of the { }’s?

• Replace (P/F’s) with closed-form

61

MESERET G. [CENG 5011] 10/10/2013/14

TIME VALUE OF MONEY

• Multiply both sides by (1+i)

• We have 2 equations [1] and [2].

• Next, subtract [1] from [2] and work with the resultant equation.

62

10/10/2013/14
TIME VALUE OF MONEY

• The P/G factor for i and N

63

10/10/2013/14
TIME VALUE OF MONEY

• The A/G factor

• Some authors also include the derivation of the A/G factor.
• A/G converts a linear gradient to an equivalent annuity cash
flow.

• Remember, at this point one is only working with gradient

component.

• There still remains the annuity component that you must also
handle separately!
64

10/10/2013/14
TIME VALUE OF MONEY

• The A/G Factor Cont’d…

• Convert G to an equivalent A; How to do it…………
•  A/G factor using A/P with P/G

• The results follow…..

• Resultant A/G factor 65

10/10/2013/14
TIME VALUE OF MONEY

• Gradient Example: Consider the following cash flow

• Base Annuity: First, The Base Annuity of $100/period

66

10/10/2013/14
TIME VALUE OF MONEY

• PW(10%) of the base annuity = $100(P/A,10%,5)

• PW Base = $100(3.7908)= $379.08
• Not Finished: We need the PW of the gradient component and
then add that value to the $379.08 amount.

•  Focus on the Gradient Component

67

10/10/2013/14
TIME VALUE OF MONEY

• We desire the PW of the Gradient Component at t = 0

• The Set Up

68

10/10/2013/14
TIME VALUE OF MONEY

• Calculating or looking up the P/G,10%,5 factor yields the

following:
•  Pt=0 = $100(6.8618) = $686.18 for the gradient PW

• Final Result
• PW(10%)Base Annuity = $379.08
• PW(10%)Gradient Component = $686.18
• Total PW(10%) = $379.08 + $686.18 = $1065.26

69

10/10/2013/14
TIME VALUE OF MONEY

• Note: The two sums occur at t =0 and can be added together: -

concept of equivalence

•  Example Summarized; This Cash Flow…

 

70

MESERET G. [CENG 5011] 10/10/2013/14

TIME VALUE OF MONEY

• Shifted Gradient Example: i =10%; Consider the following

Cash Flow

71

10/10/2013/14
TIME VALUE OF MONEY

1. This is a “shifted” negative, decreasing gradient.

2. The PW point in time is at t = 3 (not t = o)

• The base annuity is a $600 cash flow for 3 time periods

72

10/10/2013/14
TIME VALUE OF MONEY

• PW of the Base Annuity: 2 Steps

73

MESERET G. [CENG 5011] 10/10/2013/14

TIME VALUE OF MONEY

• PW of Gradient Component: G = -$50

74

MESERET G. [CENG 5011] 10/10/2013/14

 TIME VALUE OF MONEY

• E.G 3: You plan to deposit $2,000 to your savings account at the

end of every month for the next 15 months starting from the next
month. If the interest rate you can earn is 2% per month how much
money will accumulate immediately after your last deposit at the
end of the 15th month?
Solution: A = $2,000, i = 2% per month, N = 15 months.
 F =?

MESERET G. [CENG 5011] 10/10/2013/14 75

 TIME VALUE OF MONEY

E.G. 4: What uniform monthly amount should you deposit in your

savings account at the end of each month for the following 10
months in order to accumulate $75,000 at the time of the 10th
deposit? Assume that the interest rate you can earn is 4% per month
and the first deposit will be made next month.
Solution: F = 75; 000, i = 4% per month, N = 10 months.
A =?

MESERET G. [CENG 5011] 10/10/2013/14 76

 TIME VALUE OF MONEY

• E.G 5: How much should you deposit to your savings account

now at an annual interest rate of 10% to provide for 5 end-of-year
withdrawals of $15,000 each?
Solution: A = 15; 000, i = 10% per year, N = 5 years.
 P =?

MESERET G. [CENG 5011] 10/10/2013/14 77

 TIME VALUE OF MONEY

• E.G 6: You plan to borrow a loan of $100,000 which you will

repay with equal annual payments for the next 5 years. Suppose
the interest rate you are charged is 8% per year and you will make
the first payment one year after receiving the loan. How much is
your annual payment?
Solution: P = 100; 000, i = 8% per year, N = 5 years.
A =?

MESERET G. [CENG 5011] 10/10/2013/14 78

 TIME VALUE OF MONEY

• E.G. 7: A machine cost $45,000 to purchase. Fuel, oil, grease

[FOG], and minor maintenance are estimated to cost $12.34

per operating hour [those hours when the engine is operating

and the machine is doing work]. A set of tires cost $3,200

to replace, and their estimated life is 2,800 use hours. A

$6,000 major repair will probably be required after 4,200 hr

of use.
MESERET G. [CENG 5011] 10/10/2013/14 79
 TIME VALUE OF MONEY

E.G. 7 Cont’d…

• The machine is expected to last for 8,400 hr, after which it

will be sold at a price [salvage value] equal to 10% of the
original purchase price. A final set of new tires will not be
purchased before the sale. How much should the owner of the
machine charge per hour of use, if it is expected that the
machine will operate 1,400 hr per year? The company's cost of
capital rate is 15%.
MESERET G. [CENG 5011] 10/10/2013/14 80
TIME VALUE OF MONEY

• First solve for n, the life;

10/10/2013/14 81
 TIME VALUE OF MONEY

• Solution

MESERET G. [CENG 5011] 10/10/2013/14 82

MESERET G. [CENG 5011] 10/10/2013/14 83
MESERET G. [CENG 5011] 10/10/2013/14 84
 Evaluating Alternative/s
85

Time Value of Money: Applications

 We will learn how to evaluate the profitability and liquidity of a
single problem solution (or alternative). Minimum Attractive Rate of
Return (MARR) is useful for this analysis. MARR ["hurdle rate“] is
usually organization-specific and determined based on the following:

1. Cost of money available for investment

2. Number of good projects available for investment

3. Risks involved in investment opportunities

Meseret G. [CENG 5011] 11/23/2020
 Evaluating Alternative/s
86

Central question: Is a proposed project solution economically

profitable?
 Outflow: capital investment and expenditure
 Inflow: revenue, savings, return on capital
 Timing of the cash flows

Technique: Converting the cash flows into their equivalent

worth at some point of time using an interest rate called
Minimum Attractive Rate of Return (MARR)
Meseret G. [CENG 5011] 11/23/2020
 Evaluating Alternative/s
87

How to use MARR?

 Use it as an interest rate to convert cash flows into equivalent
worth at some point in time.
 The proposed problem solution [project or alternative] is
profitable if it generates sufficient cash flow to recover the initial
investment and earn an interest rate that is at least as high as
MARR.

Meseret G. [CENG 5011] 11/23/2020

 Evaluating Alternative/s
88

Why not just use the interest rate? Because there may be other
considerations:
 Cost and amount of money available for investment
 Number of good projects available for investment and their
purpose
 Amount of perceived risk associated with an investment
 Estimated administration cost as determined by the planning
horizon
Meseret G. [CENG 5011] 11/23/2020
 Evaluating Alternative/s
89

MARR Cont’d
 One popular approach for establishing MARR involves the
opportunity cost, which arises when there is capital rationing.
 We assume that MARR is constant throughout the course of the
project.
 Thus, MARR serves as an interest rate in our considerations.

Meseret G. [CENG 5011] 11/23/2020

 Evaluating Alternative/s
90

Quantitative Methods to evaluate profitability

 Net Present Worth [NPW]
 Incremental Net Present Value [INPV]
 Future Worth [FW]
 Annual Worth [AW]
 Rate of Return [ROR]: Internal Rate of Return [IRR] and External Rate of Return
[ERR]
 Incremental Rate of Return
 Payback Period with and without interest
 Project Balance [PB] Meseret G. [CENG 5011] 11/23/2020
 Evaluating Alternative/s
91

1. Net Present Value or Present Worth[NPV]

 It compares alternatives based on their present values at the time of the
initial investment at the MARR.

 If NPV is positive, the alternative produces a return greater than the

MARR [Accepted].
 If NPV is zero, the alternative produces a return equal to the MARR.
 If NPV is negative, the alternative produces a return less than the
MARR and, if possible, the investment should be rejected.

Meseret G. [CENG 5011] 11/23/2020

 Evaluating Alternative/s
92

Net Present Value Cout’d

 All cash inflows and outflows are discounted to the present time at
the MARR.
 The present worth of a series of cash inflows and outflows at an
interest rate (or MARR) of i% is given by

 where
 i = effective interest rate, or MARR, per period;
 Fk = cash flow at the end of period k; and
 N = number of periods in the planning horizon.
Meseret G. [CENG 5011] 11/23/2020
 Evaluating Alternative/s
93

Net Present Value Cout’d

 The method has two main assumptions:

The future is known with certainty.

Money can be borrowed and lent at the same interest rate.

Meseret G. [CENG 5011] 11/23/2020

 Evaluating Alternative/s
94

E.G. 1: Your company is looking at purchasing a front-end

loader at a cost of $120,000. The loader would have a useful life
of five years with a salvage value of $12,000 at the end of the
fifth year. The loader can be billed out at $95.00 per hour. It
costs $30.00 per hour to operate the frontend loader and $25.00
per hour for the operator. Using 1,200 billable hours per year
determine the net present value for the purchase of the loader
using a MARR of 20%. Should your company purchase the
loader? Meseret G. [CENG 5011] 11/23/2020
 Evaluating Alternative/s
95

Solution: The hourly profit [HP] on the loader equals the billing
rate less the operation cost and the cost of the operator.
 HP = $95.00 – [$30.00 + $25.00] = $40.00 per hr
 Annual Profit = $40.00/hr x [1,200 hr/yr] = $48,000/yr

Cash Flow

Diagram

Meseret G. [CENG 5011] 11/23/2020

 Evaluating Alternative/s
96

 The present value of the annual profits [PAP] by using USPWF:

PAP = $48,000[(1+0.20)5-1] / [0.20(1+0.20)5] = $143,549

 The PAP is positive because it is a cash receipt.

 The present value of the salvage value [PSV] by using SPPWF

PSV = $12,000/(1+0.20)5 = $4,823

Meseret G. [CENG 5011] 11/23/2020

 Evaluating Alternative/s
97

 The present value purchase price [PPP] of the loader = purchase

price. Because the net present value is measured at the time of
the initial investment.

 The PPP is negative because it is a cash disbursement.

NPV = PAP + PSV + PPP = $143,549 + $4,823 - 120,000 = $28,372

Meseret G. [CENG 5011] 11/23/2020

 Evaluating Alternative/s
98
 Because the NPV is greater than zero, the purchase of the front-
end loader will produce a return greater than the MARR and your
company should invest in the front-end loader.
 When comparing two alternatives with positive net present
values, the alternative with the largest net present value
produces the most profit in excess of the MARR.

Meseret G. [CENG 5011] 11/23/2020

 Evaluating Alternative/s
99
E.G. Suppose that there are two projects: A and B.
 Project A requires an investment of $10,000 and will return $12,000 in
one year.
 Project B requires an investment of $100,000 investment and will
return $115,000 in one year.
 Suppose that your MARR is 10%, that the projects are mutually
exclusive, and that you can take up either project (i.e., there are no
budget concerns).
 Question: What do you do? First of all, are the projects economically
justified? Meseret G. [CENG 5011] 11/23/2020
 Evaluating Alternative/s
100
E.G. Cout’d

 By the PW decision rule, we have

 Thus, both projects are economically justified. However, it is not

clear which is better:

Meseret G. [CENG 5011] 11/23/2020

 Evaluating Alternative/s
101

 To compare the alternatives, remember one of the engineering

economic analysis rule: focus on the difference.
 In our current setting, we take it to mean the following:
 The alternative that requires the minimum investment of capital
and produces satisfactory functional results will be chosen,
unless the incremental capital associated with an alternative
having a larger investment can be justified with respect to its
incremental benefits.
Meseret G. [CENG 5011] 11/23/2020
 Evaluating Alternative/s
102

Continuing the previous example,

 Project B requires an additional $90,000 in investment and
produces an additional return of 103,000 in one year over Project
A. (Why?)
 The present worth of the incremental cash flows at MARR =
10% is
 Conclusion: The use of the additional $90,000 for Project B is
justified, and hence Project B is preferred over Project A.
Meseret G. [CENG 5011] 11/23/2020
 Evaluating Alternative/s
103

 The evaluation of two mutually exclusive alternatives can be

conveniently carried out by cash flow diagrams.
 Consider the following two projects, both of which will run for 4
years:

 They can be represented by the following cash flow diagrams:

Meseret G. [CENG 5011] 11/23/2020

 Evaluating Alternative/s
104

 Our analysis of the alternatives then reduces to applying your

favorite decision rules to each of the diagrams.
 Continuing the above example, if MARR = 10% and we use
the PW decision rule, then

 The last equation shows that Project B is preferred over Project

Meseret G. [CENG 5011] 11/23/2020
 Evaluating Alternative/s
105

E.G. 2: Your company needs to purchase a dump truck and has

narrowed the selection down to two alternatives. The 1st alternative is to
purchase a new dump truck for $65,000. At the end of the seventh year
the salvage value of the new dump truck is estimated to be $15,000.
The 2nd alternative is to purchase a used dump truck for $50,000. At the
end of the fourth year the salvage value of the used dump truck is
estimated to be $5,000. The annual profits, revenues less operation
costs, are $17,000 per year for either truck. Using a MARR of 18% and
a twenty-eight year study period, calculate the net present value for
each of the dump trucks. Which truck should your company purchase?
Meseret G. [CENG 5011] 11/23/2020
 Evaluating Alternative/s
106

Solution: The present value of the annual profits for either truck is
determined by using USPWF:
 PAP = $17,0003[(1+0.18)28–1] / 0.18[1+0.18]28] = $93,527

1. Alternative 1[New]: The PSV for the new dump truck is determined by
summing the PSVs occurring in years 7, 14, 21, and 28. The present
value for each salvage value is calculated using SPPWF as follows:

Meseret G. [CENG 5011] 11/23/2020

 Evaluating Alternative/s
107

 The PPP for the new dump truck is determined by summing the
present value of purchase prices occurring in years 0, 7, 14, and
21.
 The present value for each purchase price is calculated using
SPPWF as follows:

Meseret G. [CENG 5011] 11/23/2020

 Evaluating Alternative/s
108

 The NPV for the purchase of the new dump truck is calculated as
follows:
 NPV [New] = $93,527 + $6,797 + [ -$93,822] = +$6,502

Meseret G. [CENG 5011] 11/23/2020

 Evaluating Alternative/s
109

2. Alternative 2[Used]: The PSVs for the used dump truck is determined
by summing the present value of salvage values occurring in years 4, 8,
12, 16, 20, 24, and 28.
 The present value for each salvage value is calculated using SPPWF as

follows:

Meseret G. [CENG 5011] 11/23/2020

 Evaluating Alternative/s
110

 The PPPs for the used dump truck is determined by summing the
present value of purchase prices occurring in years 0, 4, 8, 12, 16,
20, and 24.
 The present value for each purchase price is calculated using
SPPWF as follows:

Meseret G. [CENG 5011] 11/23/2020

 Evaluating Alternative/s
111

 The net present value [NPV] for the purchase of the used dump
truck is calculated as follows:
NPV = $93,527 + $5,275 + [ -$102,257] = -$3,455

 The new truck has the highest NPV; therefore, your company
should purchase the new truck.

Meseret G. [CENG 5011] 11/23/2020

 Evaluating Alternative/s
112

Incremental Net Present Value [INPV]

 Step 1: Order the alternatives by increasing initial capital
investment.
 Step 2: Find a base alternative [current best alternative]: Cost
alternatives: the first alternative in the ordered list [the one with
the least capital investment].
 Step 3: Evaluate the difference between the next alternative and
the current best alternative.
Meseret G. [CENG 5011] 11/23/2020
 Evaluating Alternative/s
113

Incremental Net Present Value [INPV] Cout’d

 If the incremental cash flow is positive, choose the next
alternative as the current best alternative.
 Otherwise, keep the current best alternative [i.e. negative] and
drop the next alternative from further consideration.
 Step 4: Repeat Step 3 until the last alternative is considered.
Select the current best alternative as the preferred one.

Meseret G. [CENG 5011] 11/23/2020

 Evaluating Alternative/s
114

E.G. 3: Your company is looking at purchasing a new front-end loader

and has narrowed the choice down to four loaders. The purchase price,
annual profit, and salvage value at the end of five years for each of the
loaders is found in figure below. Which front-end loader should your
company purchase based on the incremental net present values using a
MARR of 20% and a useful life of five years?
Cash Flow Loader A [$] Loader B [$] Loader C Loader D [$]
[$]
Purchase Price 110,000 127,000 120,000 130,000
Annual Profit 37,000 43,000 40,000 44,000
Salvage Value 10,000 13,000 12,000 13,000
Meseret G. [CENG 5011] 11/23/2020
 Evaluating Alternative/s
115

Solution:
Step 1: Rank the alternative in order of initial cost [purchase
price]. Loader A  Loader C  Loader B  Loader D. Because
Loader A has the lowest initial cost [current best alternative].

Step 2: Compare Loader A to Loader C.

 Difference in purchase price is $10,000 [$120,000 - $110,000].
 Difference in annual profit is $3,000 [$40,000 - $37,000].
 Difference in salvage value is $2,000 [$12,000 - $10,000].
Meseret G. [CENG 5011] 11/23/2020
 Evaluating Alternative/s
116

 The difference in the cash flows for these two alternatives is

shown in Figure below.

Meseret G. [CENG 5011] 11/23/2020

 Evaluating Alternative/s
117

 The present value of the difference in annual profits is determined

by using USPWF as follows:
PAP = $3,000[(1 0.20)5 -1]/ [0.20(1+0.20)5] = $8,972
 The present value of the difference in salvage values is
determined by using SPPWF as follows:
PSV = $2,000[1+0.20]5 = $804
 The incremental net present value for the purchase of Loader C in
lieu of Loader A is calculated as follows:
11/23/2020
INPV = $8,972 + $804 + [ -$10,000] = -$224
Meseret G. [CENG 5011]
 Evaluating Alternative/s
118

 Because the incremental net present value is negative, Loader A

continues to be the current best alternative.

Next, we compare Loader A to Loader B, the loader with the

next lowest initial cost.
 Difference in purchase price is $17,000 [$127,000 - $110,000].
 Difference in annual profit is $6,000 [$43,000 - $37,000].
 Difference in salvage value is $3,000 [$13,000 - $10,000].

Meseret G. [CENG 5011] 11/23/2020

 Evaluating Alternative/s
119

 The difference in the cash flows for these two alternatives is

shown in Figure below.

 The present value of the difference in annual profits is determined

by using USPWF as follows:
 PAP = $6,0003 [(1+0.20)5 -1] / 0.20(1+0.20)5 = $17,944 11/23/2020
Meseret G. [CENG 5011]
 Evaluating Alternative/s
120

 The present value of the difference in salvage values is

determined by using SPPWF as follows:

PSV = $3,000[1+ 0.20]5 = $1,206

 The incremental net present value for the purchase of Loader B
in lieu of Loader A is calculated as follows:

INPV = $17,944 + $1,206 + [-$17,000] = $2,150

Meseret G. [CENG 5011] 11/23/2020

 Evaluating Alternative/s
121

 Because the incremental net present value is positive, Loader B

becomes the new current best alternative and Loader A is
eliminated from comparison.

Next, Compare Loader B to Loader D

 Difference in PP is $3,000 [$130,000 - $127,000].
 Difference in AP is $1,000 [$44,000 - $43,000].
 Difference in SV is zero [$13,000 - $13,000].

Meseret G. [CENG 5011] 11/23/2020

 Evaluating Alternative/s
122

 The present value of the difference in annual profits is determined by

using USPWF as follows:

PAP = $1,000 [(1 0.20)5 -1] / [0.20(1+0.20)5] = $2,991

 The incremental net present value for the purchase of Loader B in lieu
of Loader D is calculated as follows:

INPV = $2,991 + $0 + [- $3,000] = - $8

 Because the INPV is negative, Loader B continues to be the current
best alternative. Therefore, your company should purchase Loader
B.
Meseret G. [CENG 5011] 11/23/2020
 Evaluating Alternative/s
123

3. Future Value [FW]

 It compares alternatives based on their future values at the end of the
study period.
 If the FW is positive, the alternative produces a return greater than the
MARR.
 If the FW is zero, the alternative produces a return equal to the MARR.
 If the FW is negative, the alternative produces a return less than the
MARR and, if possible, the investment should be rejected.

Meseret G. [CENG 5011] 11/23/2020

 Evaluating Alternative/s
124

 Find the equivalent worth of all cash flows at the end of the study
period by using the MARR as the interest rate.

 Note that FW and PW of a project are equivalent at the interest

rate of i%, i.e., FW = PW [F/P,i%,N].

Meseret G. [CENG 5011] 11/23/2020

 Evaluating Alternative/s
125

E.G. 4: Consider a project that has the following cash flows over
a study period of 5 years:
 Initial investment: $100,000
Solution:
 Annual revenues: $40,000
FW(20%)=-100,000(F/P,20%,5)
 Annual expenses: $5,000 +(40,000-5,000)(F/A,20%,5)
 Salvage value: $20,000 +20,000 =$31,624.
 MARR: 20%.  Since FW(20%) > 0, the project
is profitable.
Meseret G. [CENG 5011] 11/23/2020
 Evaluating Alternative/s
126

E.G. 5: Your company is looking at purchasing the front-end

loader at cost of $120,000. The loader would have a useful life of
five years with a salvage value of $12,000 at the end of the fifth
year. The annual profit of loader [revenue less operation cost] is
$48,000. Determine the future worth for the purchase of the
loader using a MARR of 20%. Should your company purchase
the loader?

Meseret G. [CENG 5011] 11/23/2020

 Evaluating Alternative/s
127

Solution: The future value of the purchase price is determined by

using SPCAF as follows:

FPP = $120,000 [1+0.20)5 = - $298,598
 The future value of the purchase price is negative because it is a cash
disbursement.
 The FW of the annual profits is determined by using USCAF as
follows:
FAP = $48,0003 [(1+0.20) 5 -1] / 0.20 = $357,197
 The FW of the annual profits is positive
Meseret G. because
[CENG 5011]it is a cash receipt.
11/23/2020
 Evaluating Alternative/s
128

 The future value of the salvage value is equal to the salvage value
because the future value is measured at the end of the study period.
The FW of the salvage value is positive because it is a cash receipt.
 The future worth for purchasing the loader equals the sum of the
future values of the individual cash flows and is calculated as
follows:
 FW = - $298,598 + $357,197 + $12,000 = $70,599 > MARR
 So, it is attractive for the company to purchase
11/23/2020
Meseret G. [CENG 5011]
 Evaluating Alternative/s
129

4. Annual Equivalent [AE]

 It compares alternatives based on their equivalent annual receipts

less the equivalent annual disbursements.

 The AE is calculated by converting the cash receipts and

disbursements into a uniform series of annual cash flows occurring

over the study period using the equations.

 If the AE is positive, the alternative produces a return greater than

the MARR. Meseret G. [CENG 5011] 11/23/2020

 Evaluating Alternative/s
130

 If the AE is zero, the alternative produces a return equal to the

MARR.
 If the AE is negative, the alternative produces a return less than
the MARR and, if possible, the investment should be rejected.
 Because any PV can be converted to a uniform series by USSFF.
The AE produces the same result as the net present value.
 Similarly, because any FW can be converted to a uniform series
by USCRF, the AE produces the same result as the future value.
Meseret G. [CENG 5011] 11/23/2020
 Evaluating Alternative/s
131

E.G. 6: Consider a project that has the following cash flows over
a study period of 5 years:
Solution:
 Initial investment: $100,000
AE [20%] = $100,000
 Annual revenues: $40,000 [A/P,20%,5] + [$40,000 -
 Annual expenses: $5,000 $5,000] + $20,000 [A/Sv,20%,5]
 Salvage value: $20,000
 MARR: 20%.

Meseret G. [CENG 5011] 11/23/2020

 Evaluating Alternative/s
132

E.G 7: Your company needs to purchase a dump truck and has narrowed
the selection down to two alternatives. The first alternative is to purchase
a new dump truck for $65,000. At the end of the seventh year the salvage
value of the new dump truck is estimated to be $15,000. The second
alternative is to purchase a used dump truck for $50,000. At the end of
the fourth year the salvage value of the used dump truck is estimated to
be $5,000. The annual profits, revenues less operation costs, are $17,000
per year for either truck. Using a MARR of 18% calculate the annual
worth for each of the dump trucks. Which truck should your company
purchase?
Meseret G. [CENG 5011] 11/23/2020
 Evaluating Alternative/s
133

Solution: Alternative 1[New]  The useful life of the new truck is

seven years, which is used as the study period for the new truck.
 The purchase price for the new truck is converted to a uniform
series of annual cash flows by USCRF as follows:

APP = - $65,000 [0.18(1+0.18)7] / [(1 0.18)7 -1] = - $17,054

 The salvage value for the new truck is converted to a uniform series
of annual cash flows by USSFF as follows:

ASV = $15,000(0.18) / [ (1+0.18)7 -1] = $1,235

Meseret G. [CENG 5011] 11/23/2020
 Evaluating Alternative/s
134

 The annual profits for the new truck are already a uniform series.
 The annual equivalent for purchasing new loader is;

AE [New] = - $17,054 + $1,235 + $17,000 = $1,181

Alternative 2 [Used]

APP = $50,000[0.18(1+0.18)4] / [(1+0.18)4 1] = - $18,587

ASV = $5,000(0.18) / [(1+0.18)4 -1] = $959

The annual equivalent for purchasing used loader is;

AE = - $18,587 + $959 + $17,000

Meseret=G.-[CENG
$6285011] 11/23/2020
 Evaluating Alternative/s
135

 The new truck has the highest annual equivalent; therefore, your
company should purchase the new truck.

Meseret G. [CENG 5011] 11/23/2020

136