Chapter 6

Investment Evaluation

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 Introduction
 From the organization’s point of view, efficient and effective functioning of
the organization would certainly help it to provide goods/services at a
lower cost which in turn will enable it to fix a lower price for its goods or
services.
 Engineering economics deals with the methods that enable one to take
economic decisions towards minimizing costs and/or maximizing
benefits to business organizations.
 It deals with the concepts and techniques of analysis useful in evaluating
the worth of systems, products, and services in relation to their costs.
 Economists, engineering managers, project managers, and indeed any
person involved in decision making must be able to analyze the financial
outcome of his or her decision.
 The decision is based on analyzing and evaluating the activities involved
in producing the outcome of the project.
 These activities have either a cost or a benefit. Financial analysis gives us
the tools to perform this evaluation. Often the decision to make is to
proceed or not to proceed with a project.
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Role of Engineers in the Industry
 Why do engineers care about engineering economics?
 Engineering designs are intended to produce good results.
 They are accompanied by undesirables (costs).
 If outcomes are evaluated in dollars, and “good” is defined as profit,
then decisions will be guided by engineering economics.
 This process maximizes goodness only if all outcomes are anticipated
and can be monetized.

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Engineering Decision Making
STEP 1 STEP 2
Define the problem Determine the requirements that
the solution to the problem must
meet
STEP 3
Establish goals that STEP 4
solving the problem Identify alternatives that will solve
should accomplish the problem

STEP 5 STEP 6
Develop valuation Select a decision-making Tool
criteria based on the
goals
STEP 7 STEP 8
Apply the tool to select a Check the answer
preferred alternative to make sure it
solves the problem

 The factors of time and uncertainty are the defining

aspects of any engineering economic decisions.
Engineering Decision Making
 Role of Engineers: Manufacturing Profit
 Estimating a Required
investment. Planning
 Forecasting a product
demand.
 Estimating a selling
price.
 Estimating a
manufacturing cost.
 Estimating a product
life.
Investment Marketing

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Accounting Vs. Engineering Economy
Evaluating past performance Evaluating and predicting future events

Accounting Engineering Economy

Past Present Future

 Types of Strategic Engineering Economic

Decisions in Manufacturing Sector:
 Service Improvement.
 Equipment and Process Selection.
 Equipment Replacement.
 New Product and Product Expansion.
 Cost Reduction.
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Time Value of Money
 Money has value, it can be leased or rented
 The payment is called interest
 If you put $100 in a bank at 9% interest for one time period you
will receive back your original $100 plus $9.

Original amount to be returned = $100

Interest to be returned = $100 x .09 = $9

 The “value” of money depends on the amount and when it is

received or spent.
Example: What amount must be paid to settle a current debt of
$1000 in two years at an interest rate of 8% ?
Solution: $1000 (1 + 0.08) (1 + 0.08) = $1166

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Types of Costs
 There are usually two types of costs/Benefits associated with an engineering project,
one-time costs, which include first costs and salvage costs, and annual costs (or
benefits) that occur every year or several years of the project.
 One time costs:
 First Costs or Initial Costs are the costs necessary to implement a project,
including: Costs of new equipment, Costs of shipping and installation, Costs of
renovations needed to install equipment, Cost of engineering, Cost of permits,
licenses, etc.
 Salvage value is the money that can be obtained at the end of the project by selling
equipment. Salvage value is a benefit rather than a cost.
 Annual Costs/Benefits:
 Direct operating costs such as labor, supervision, janitorial, supplies,
maintenance, material, electricity, fuel, etc.
 Indirect operating costs sometimes included, such as a portion of building rent, a
portion of secretarial expenses, etc.
 Depreciation of equipment.
Finally, need to include savings or profits from the project and tax.

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Cash Flow Diagram
 The graphic presentation of the costs and benefits over the time is called the cash
flow diagram.
 It is a presentation of what costs have to be incurred and what benefits are received at
all points in time.
 The costs and benefits of engineering projects over time are summarized on a cash
flow diagram (CFD). Specifically, CFD illustrates the size, sign, and timing of
individual cash flows, and forms the basis for engineering economic analysis.
 A CFD is created by first drawing a segmented time-based horizontal line, divided into
appropriate time unit. Each time when there is a cash flow, a vertical arrow is added,
pointing down for costs and up for revenues or benefits. The cost flows are drawn to
relative scale.
Horizontal axis = time; vertical axis = costs and benefits.

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Cash Flow Diagram
P-Pattern “present”
1 2 3 n

F-Pattern “future”
1 2 3 n

A-Pattern “annual”
1 2 3 n

G-Pattern “gradient”
1 2 3 n

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Drawing Cash Flow Diagram
 In a cash flow diagram (CFD) the end of period t is the same as the
beginning of period (t+1).
 Beginning of period cash flows are: rent, lease, and insurance
payments.
 End-of-period cash flows are: salvages, revenues, overhauls.
 The choice of time 0 is arbitrary. It can be when a project is
analyzed, when funding is approved, or when construction begins.
Eg.1: A man borrowed $1,000 from a bank at 8% interest. Two end-of-year
payments: at the end of the first year, he will repay half of the $1000
principal plus the interest that is due. At the end of the second year, he will
repay the remaining half plus the interest for the second year. Cash flow for
this problem is:
End of year Cash flow
0 +$1000
1 -$580 (-$500 - $80)
2 -$540 (-$500 - $40) 11
Drawing Cash Flow Diagram
Eg.2: A car leasing (renting) company buys a car from a wholesaler for
$24,000 and leases it to a customer for four years at $5,000 per year. Since
the maintenance is not included in the lease, the leasing company has to
spend $400 per year in servicing the car. At the end of the four years, the
leasing company takes back the car and sells it to a secondhand car dealer for
$15,000. For the moment, in constructing the cash flow diagram, we will not
consider tax, inflation, and depreciation.
Solution:

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Interest Formulas and Their Applications
 Interest rate: is the rental value of money. It represents the
growth of capital per unit period. The period may be a month, a
quarter, semiannual or a year. An interest rate 15% compounded
annually means that for every hundred dollar invested now, an
amount of $15 will be added to the account at the end of the first
year. So, the total amount at the end of the first year will be $
115.
 At the end of the second year, again 15 % of $ 115, i.e. $ 17.25
will be added to the account. Hence the total amount at the end
of the second year will be $ 132.25. The process will continue
thus till the specified number of years.

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Interest formulas:

Simple interest: the interest is

calculated, based on the initial deposit for
every interest period. In this case,
calculation of interest on interest is not
applicable.
Compound interest: the interest for the
current period is computed based on the
amount (principal plus interest up to the
end of the previous period) at the
beginning of the current period.

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Interest Formulas and Application
 The notations which are used in various interest formulae are as
follows:
 P = principal amount (Initial amount).
 n = No. of interest periods.
i = interest rate (It may be compounded monthly, quarterly,
semiannually or annually).
 F= future amount at the end of year n.
 A = equal amount deposited at the end of every interest period.

 Single-Payment Compound Amount: Here, the objective is to

find the single future sum (F) of the initial payment (P) made at
time 0 after n periods at an interest rate i compounded every
period.
 The formula to obtain the single-payment compound amount is:
 F= P(1 + i)n = P(F| P, i, n)
 Where (F|P, i, n) is called as single-payment compound amount
factor. 15
Interest Formulas and Application
Eg: A person deposits a sum of $ 20,000 at the interest rate of 18% compounded
annually for 10 years. Find the maturity value after 10 years.
Solution: P= $ 20,000, i = 18% compounded annually, n= 10 years
 F= P(1 + i)n = P(F|P, i, n)
= 20,000 (F|P, 18%, 10)
= 20,000 * 5.234 = $ 1,04,680
 Single-Payment Present Worth Amount: Here, the objective is to find the
present worth amount (P) of a single future sum (F) which will be received after n
periods at an interest rate of i compounded at the end of every interest period.

Eg.: A person wishes to have a future sum of $100,000 for

his son’s education after 10 years from now. What is the
single-payment that he should deposit now so that he gets
the desired amount after 10 years? The bank gives 15%
interest rate compounded annually. Ans: $24,720

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Interest Formulas and Application
 Equal-Payment Series Future Worth Amount: In this type of investment
mode, the objective is to find the future worth of n equal payments which
are made at the end of every interest period till the end of the n-th interest
period at an interest rate of i compounded at the end of each interest period.

Eg: A person who is now 35 years old is planning for his retired life. He plans to
invest an equal sum of $10,000 at the end of every year for the next 25 years
starting from the end of the next year. The bank gives 20% interest rate,
compounded annually. Find the maturity value of his account when he is 60
years old. Ans: $ 4,719,810

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Interest Formulas and Application
 Equal-Payment Series Sinking Fund: In this type of investment
mode, the objective is to find the equivalent amount (A) that should
be deposited at the end of every interest period for n interest
periods to realize a future sum (F) at the end of the nth interest
period at an interest rate of i.

Eg: A company has to replace a present facility after 15 years at an outlay of

$500,000. It plans to deposit an equal amount at the end of every year for the next 15
years at an interest rate of 18% compounded annually. Find the equivalent amount
that must be deposited at the end of every year for the next 15 years.
 Ans: $ 8,200, The annual equal amount which must be deposited for 15 years is
$ 8,200.
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Interest Formulas and Application
 Equal-Payment Series Present Worth Amount : The objective of
this mode of investment is to find the present worth of an equal
payment made at the end of every interest period for n interest
periods at an interest rate of i compounded at the end of every
interest period.

 Example: A company wants to set up a reserve which will help the

company to have an annual equivalent amount of $1,000,000 for the
next 20 years towards its employees welfare measures. The reserve is
assumed to grow at the rate of 15% annually. Find the single-payment
that must be made now as the reserve amount.
 Ans: $ 6,259,300 19
Interest Formulas and Application
 Equal-Payment Series Capital Recovery Amount: The objective
of this mode of investment is to find the annual equivalent
amount (A) which is to be recovered at the end of every interest
period for n interest periods for a loan (P) which is sanctioned
now at an interest rate of i compounded at the end of every
interest period.

Eg: A bank gives a loan to a company to purchase an equipment worth $ 1,000,000

at an interest rate of 18% compounded annually. This amount should be repaid in
15 yearly equal installments. Find the installment amount that the company has to
pay to the bank. Ans: $196,400

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Economic Analysis Methods
 Three commonly used economic analysis methods are:
 Present Worth Analysis
 Future Worth Analysis
 Annual Worth Analysis
 Rate of Return Analysis
 Present Worth Analysis
In this method of comparison, the cash flows of each alternative will be
reduced to time zero by assuming an interest rate i. Then, depending on
the type of decision, the best alternative will be selected by comparing
the present worth amounts of the alternatives.
Steps to do present worth analysis for a single alternative
(investment):
 Select a desired value of the return on investment (i).
 Using the compound interest formulas bring all benefits and costs to
present worth.
 Select the alternative if its Net Present Value (Present worth of benefits –
Present worth of costs) ≥ 0.
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Present Worth Analysis
 Steps to do present worth analysis for selecting a single alternative
(investment) from among multiple alternatives:
 Step 1: Select a desired value of the return on investment (i).
 Step 2: Using the compound interest formulas bring all benefits
and costs to present worth for each alternative.
 Step 3: Select the alternative with the largest net present worth
(Present worth of benefits – Present worth of costs).
Eg1:A construction enterprise is investigating the purchase of a new dump
truck. Interest rate is 9%. The cash flow for the dump truck are as follows:
First cost = $50,000, annual operating cost = $2000, annual income =
$9,000, salvage value is $10,000, life = 10 years. Is this investment worth
undertaking?
 P = $50,000, A = annual net income = $9,000 - $2,000 = $7,000, S =
10,000, n = 10.
 Evaluate net present worth = present worth of benefits – present worth of
costs.
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Present Worth Analysis
 Present worth of benefits = $9,000(P|A,9 %,10) = $9,000(6.418) =
$57,762
 Present worth of costs = $50,000 + $2,000(P|A,9 %,10) -
$10,000(P|F,9 %,10)= $50,000 + $2,000(6.418) - $10,000(.4224)
= $58,612
 Net present worth = $57,762 - $58,612 < 0  do not invest.
 What should be the minimum annual benefit for making it a
worthy of investment at 9% rate of return?
 Present worth of benefits = A(P|A,9 %,10) = A(6.418)
 Present worth of costs = $50,000 + $2,000(P|A,9 %,10) -
$10,000(P|F,9 %,10)= $50,000 + $2,000 (6..418) - $10,000(.4224)
= $58,612
 A(6.418) = $58,612  A = $58,612/6.418 = $9,312.44

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Present Worth Analysis
Eg 2: Alpha Industry is planning to expand its production operation. It has
identified three different technologies for meeting the goal. The initial outlay
and annual revenues with respect to each of the technologies are summarized
below. Suggest the best technology which is to be implemented based on the
present worth method of comparison assuming 20% interest rate,
compounded annually.
Initial Outlay ($) Annual Revenue ($) Life (yrs)
Technology 1 1,200,000 400,000 10
Technology 2 2,000,000 600,000 10
Technology 3 1,800,000 500,000 10

 Solution: Technology 1  Technology 2

Initial outlay, P= $ 1,200,000 Initial outlay, P= $ 2,000,000
Annual revenue, A= $ 400,000 Annual revenue, A= $ 600,000
Interest rate, i= 20%, Interest rate, i= 20%,
n= 10 years  NPV= A(P|A, i, n) – p = $ 515,500
Net Present Value (NPV) = revenue – cost
 NPV= A(P|A, i, n) – p = $ 477,000  Technology 3
Initial outlay, P= $ 1,800,000
Annual revenue, A= $ 500,000
 Technology 2 has more NPV value so
Interest rate, i= 20%,
it is the best alternative.  NPV= A(P|A, i, n) – p = $ 296,250 24
Future Worth Analysis
 In the future worth method of comparison of alternatives, the future worth
of various alternatives will be computed. Then, the alternative with the
maximum future worth of net revenue or with the minimum future worth of
net cost will be selected as the best alternative for implementation.
 If it is for single alternative select the alternative if it has positive NFV (net
future value).
Eg: A man must decide which of the several alternatives to select in trying to obtain a
desirable return on his investment. After much study and calculation, he decides that the
two best alternatives are as given in the following table:

Building Gas Station Building Restaurant

First cost ($) 2,000,000 3,600,000
Annual property taxes ($) 80,000 150,000
Annual income ($) 800,000 980,000
Life 20 20
Salvage value ($) 0 0

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Future Worth Analysis
 Solution: Alternative 1—Build gas station
 First cost = $ 2,000,000, Life (n) = 20 years, Interest rate (i) = 12%,
 Net annual income = Annual income – Annual property tax
= $ 800,000 – $ 80,000 = $ 720,000
 Net future value (NFV) = Future benefit – Future cost
= 720,000 (F|A, 12%, 20) – 2,000,000 (F|P, 12%, 20)
= 7,20,000 (72.052) – 2,000,000 (9.646) = $ 32,585,440

 Alternative 2—Build restaurant

 First cost = $ 3,600,000, Life (n) = 20 years, Interest rate (i) = 12%,
 Net annual income = Annual income – Annual property tax
= $ 980,000 – $ 150,000 = $ 830,000
 Net future value (NFV) = Future benefit – Future cost
= 830,000 (F|A, 12%, 20) – 3,600,000 (F|P, 12%, 20)
= 830,000 (72.052) – 2,000,000 (9.646) = $ 25,077,560
 Alternative 1 is the best option with highest NFV.

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Annual Worth Analysis
 In the annual equivalent method of comparison, first the annual
equivalent cost or the revenue of each alternative will be
computed. Then the alternative with the maximum annual
equivalent revenue in the case of revenue-based comparison or with
the minimum annual equivalent cost in the case of cost-based
comparison will be selected as the best alternative.
Eg: A company invests in one of the following two alternatives. The life of both alternatives
is estimated to be 5 years with the following investments, annual returns and salvage
values. Determine the best alternative based on the annual equivalent method by assuming
i= 25%.
Alternatives
A B
Investment ($) 150,000 175,000
Annual equal return ($) 60,000 70,000
Salvage value ($) 15,000 35,000

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Annual Worth Analysis
 Solution: Alternative A
 Initial investment, P= $150,000, Annual equal return, A= $ 60,000, Salvage value
at the end of machine life, S= $ 15,000
 Life = 5 years, Interest rate, i= 25%, compounded annually.
 Annual Equivalent Value (AEV) = Annual Revenue- Annual cost
= 60,000 + 15,000(A|F, 25%, 5) – 150,000(A|P, 25%, 5)
= 60,000 + 15,000(0.1218) – 150,000(0.3718)
= $ 6,057

 Alternative B
 Initial investment, P= $175,000, Annual equal return, A= $ 70,000, Salvage value at
the end of machine life, S= $ 35,000
 Life = 5 years, Interest rate, i= 25%, compounded annually.
 Annual Equivalent Value (AEV) = Annual Revenue- Annual cost
= 70,000 + 35,000(A|F, 25%, 5) – 175,000(A|P, 25%, 5)
= 70,000 + 35,000(0.1218) – 175,000(0.3718)
= $ 9,198
 Alternative B is the best option with highest annual return.

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End !!

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