PROJECT COST ACCOUNTING AND ECONOMICS

Lecture 5. ROR and Other Analysis Techniques

Qingbin Cui
 REVIEW: SEAT

• Systematic Economic Analysis Technique

- Identify the feasible alternatives
- Define the planning horizon Method NPW NFW AW

- Specify the discount rate Single NPW > 0 NFW > 0 AW >0
Project
- Estimate the cash flows
Multiple Max Max Max (AW)
- Compare the alternatives (criteria) Projects (NPW) (NFW)
- Perform supplementary analysis
- Select the preferred alternative
F F F

0 1 n 0 1 n 0 1 n

P P P

Slide 2
Criteria

Method NPW NFW AW ROR

Single NPW > 0 NFW > 0 AW >0 IRR > MARR
Project
Multiple Projects Max (NPW) Max (NFW) Max (AW) > MARR

NPWIRR = NFWIRR = AWIRR = 0

F F F

0 1 n 0 1 n 0 1 n

P P P

Slide 3
Chapter Outline
1. ROR
2. Benefit-Cost Ratio
3. Payback Period
4. Uncertainty Analysis: Sensitivity and What-if Analysis

Slide 4
IRR Analysis

Incremental Analysis: Procedure

1) Rank ALTs by initial investment (increasing)
2) Compare first 2 ALTs.
If ΔIRR > MARR → Select high-cost alternatives; (ΔNPW or ΔAW>0 )
If ΔIRR < MARR → Low-cost alternatives. (ΔNPW or ΔAW<0 )
3) Continue pairs comparison until completing all ALTs
Year 0 1 2 3 4 5

A -3000 1000 1000 1000 1000 1000

B -2000 700 700 700 700 700

NPWA=790.80; NPWB = 653.55; IRRA=19.86%; IRRB = 22.11%

Slide 5
 Calculating Rate of Return
1. Convert various consequences of investment
into a cash flow
2. Use one of the following equations to find the
unknown value of the internal rate of return
(IRR): (7-1)

(7-2)

(7-3)

(7-4)

(7-5)
 Year Cash Flow
25 32
0 -$700 17 5
100 0
1 +100 5
0 1 2 3 4
2 +175
3 +250
700
4 +325

Try
Try
Try

Excel function: IRR()

 Plot of NPW versus Interest Rate
Investment Cases
Year Cash Flow
0 -P
1
1 +A
+A +
2
2 +A
+A
3
3 +A
+A
NPW
4
4 +A
+A 0 i
: :
: :
: : 
: : IRR
: :
: :
 Plot of NPW versus Interest Rate
Borrowing Cases
Year Cash Flow
0 +P
1 -A +
2 -A
3 -A
NPW
4 -A 0 i
: :
: :  IRR
: :
 Incremental Analysis

• When there are two or more alternatives, rate of return

analysis is performed by computing the incremental rate
of return, ΔIRR, on the difference between two
alternatives.
• The cash flow of the incremental investment is computed
by taking the higher initial-cost alternative minus the
lower initial-cost alternative.
• If ΔIRR≥MARR, choose the higher-cost alternative.
• If ΔIRR<MARR, choose the lower-cost alternative.
An equipment can save $1200/year, has no salvage value at the end
of 5 years useful life. Two suppliers:
• Leaseco: 3 beginning-of-year payment of $1000 each
• Saleco: 1 payment of $2783
A=1200 A=1200
1000

0 1 2 3 4 5 - 0 1 2 3 4 5 =0 1 2 3 4 5

1000 1783
2783
Saleco Leaseco Incremental

IRR 8%
0 = -1783 + 1000 (P/A, i, 2)
 A=1200 A=1200
1000

0 1 2 3 4 5 - 0 1 2 3 4 5 =0 1 2 3 4 5

1000 1783
2783 IRR 8%
Saleco Leaseco Incremental

Leaseco Saleco Sal - Lea NPV

-1000 -2783 -1783
200 1200 1000 $2,500
200 1200 1000 $2,400
1200 1200 0
1200 1200 0
$2,300
1200 1200 0 $2,200
IRR 49% 33% 8% $2,100
NPV
$2,000
5% $ 2,336 $ 2,412 $ 76.41
6% $ 2,221 $ 2,272 $ 50.39 $1,900
7% $ 2,112 $ 2,137 $ 25.02 $1,800
8% $ 2,008 $ 2,008 $ 0.26 $1,700
9% $ 1,908 $ 1,885 $ (23.89)
10% $ 1,813 $ 1,766 $ (47.46) $1,600
11% $ 1,723 $ 1,652 $ (70.48) $1,500
5% 6% 7% 8% 9% 10% 11% 12%
12% $ 1,636 $ 1,543 $ (92.95)
Leaseco Saleco Sal - Lea
 A device can be installed to reduce cost. It has no salvage value at the end of 5
years useful life. Two options:
• Device A: Costs $10000 and saves $3000 annually
• Device B: Costs $13500 and saves $3000 the 1st year and increases $500
annually
45005000
4000
3500
3000 A=3000
15002000
5001000
0 1 2 3 4 5 - 0 1 2 3 4 5 =0 1 2 3 4 5

3500
13500
Device B 10000 Device A Incremental
,

By interpolation,
 Machine X Machine Y
Initial Cost $200 $700
Uniform annual benefit 95 120
End-of-useful-life salvage value 50 150
Useful life, in years 6 12
A=95 50
Machine X 0 1 2 3 4 5 6
200

A=120 150

Machine Y 0 1 2 3 4 5 6 7 8 9 10 11 12
700
 A=120 150

Machine Y 0 1 2 3 4 5 6 7 8 9 10 11 12

700 50 50
A=95 A=95
Machine X 0 1 2 3 4 5 6 7 8 9 10 11 12
200 200
A=25 150 100
Incremental 0 1 2 3 4 5 6 7 8 9 10 11 12
500

Solving
In order for a higher-cost alternative to be attractive, the incremental rate of return must
be__________________.
A. Greater than MARR
B. Less than or equal to MARR
C. Less than MARR
D. Greater than or equal to MARR
The incremental cash flow between two alternatives is shown below.
Year Incremental Cash Flow
0 -$20,000
1 through 10 +$3,000
10 +$400
The equation(s) that can be used to correctly solve for the incremental rate of return is
(are):
A. 0 = -20,000 + 3000 (P/A, i, 10) + 400 (P/F, i, 10)
B. 0 = -20,000 (A/P, i, 10) + 3000 + 400 (A/F, i, 10)
C. 0 = -20,000 (F/P, i, 10) + 3000 (F/A, i, 10) + 400
D. All of the above
Given that two projects have the same rate of return of 12% each. The incremental rate of
return is 16%.
If MARR is 15%, determine which alternative should be chosen
A. Choose the higher-cost alternative
B. Choose the lower-cost alternative 7.2%
C. Choose neither one
D. Choose either one
Koether Inc., a German company located in Dunlap, Tennessee is
considering two different makes of blow molding machine for one of
its automotive products. The cost data for the two alternatives are
provided in table below. MARR =12%.
Machine X Machine Y
Initial cost $160K $285K
Annual 45K 45K
operating
cost
Benefits /Year 90K 105K
Salvage value 20K 40K
Life 10 Years
IRR Example

Consider the following three mutually exclusive alternatives and determine

the range of values of MARR in which Alternative C is the preferred
alternative?
A B C
First Cost 200 300 600
Uniform Annual Benefit 59.7 77.1 166.4
Useful Life (years) 5 5 5
Salvage Value 0 0 0
Computed Rate of Return 15% 9% 12%

A B C B-A C-A
IRR 15% 9% 12% 0% 11%

Slide 20
Benefit-Cost Ratio Analysis

At a given minimum attractive rate of return (MARR), an

alternative is acceptable, provided
𝑁𝑃𝑊 =𝑃𝑊 ( 𝐵𝑒𝑛𝑒𝑓𝑖𝑡𝑠 ) − 𝑃𝑊 (𝐶𝑜𝑠𝑡𝑠)≥ 0
𝐸𝑈𝐴𝑊 =𝐸𝑈𝐴𝐵− 𝐸𝑈𝐴𝐶 ≥ 0
These criteria could also be stated as a ratio:
𝐵 𝑃𝑊 (𝐵𝑒𝑛𝑒𝑓𝑖𝑡𝑠) 𝐸𝑈𝐴𝐵
= = ≥1
𝐶 𝑃𝑊 (𝐶𝑜𝑠𝑡𝑠) 𝐸𝑈𝐴𝐶

Slide 21
Benefit-Cost Ratio Analysis

Situation Criterion
Neither input nor output Incremental B/C Ratio Analysis:
fixed: Typical situation • Compute incremental B/C ratio
• If ΔB/ΔC≥1, choose higher-cost
alternative
• If ΔB/ΔC<1, choose lower-cost
alternative
Fixed input: amount of Maximize B/C
money or other input
resources are fixed
Fixed output: fixed task, Maximize B/C
benefit, or other outputs

Slide 22
Example 9-3 Benefit-Cost Ratio Analysis

Device A Device B Incremental

450 500
A=300 300 350 400 150 200
50 100
0 1 2 3 4 5 0 1 2 3 4 5 0 1 2 3 4 5

P=350
P=1000 P=1350

( )
𝐵
𝐶 𝐴
=
𝑃𝑊 (𝐵𝑒𝑛𝑒𝑓𝑖𝑡𝑠) 𝐴 300( 𝑃 / 𝐴, 7 % ,5) 1230
𝑃𝑊 (𝐶𝑜𝑠𝑡𝑠) 𝐴
=
1000
=
1000
=1.23

(𝐶)
𝐵
𝐵− 𝐴
=
𝑃𝑊 ( 𝐵𝑒𝑛𝑒𝑓𝑖𝑡𝑠)𝐵 − 𝐴 50 (𝑃 /𝐺 , 7 % , 5) 382
𝑃𝑊 (𝐶𝑜𝑠𝑡𝑠)𝐵− 𝐴
=
350
=
350
=1.09

Slide 23
Example 9-4 Benefit-Cost Ratio Analysis

Machine X Machine Y
Initial Cost $200 $700
Uniform annual benefit 95 120
End-of-useful-life salvage value 50 150
Useful life, in years 6 12

𝐸𝑈𝐴𝐵 𝑋
( )
𝐵
𝐶 𝑋
= =
95 95
= =2.38
𝐸𝑈𝐴𝐶 𝑋 200 ( 𝐴/𝑃 , 10 % ,6 ) − 50( 𝐴/ 𝐹 ,10 % , 6) 40

𝐵 𝐸𝑈𝐴𝐵𝑌−𝑋 𝐸𝑈𝐴𝐵𝑌 −𝐸𝑈𝐴𝐵 𝑋

() = = =
120−95 25 25
= = =0.45
𝐶 𝑌 −𝑋 𝐸𝑈𝐴𝐶𝑌 −𝑋 𝐸𝑈𝐴𝐶𝑌 −𝐸𝑈𝐴𝐶 𝑋 [ 700 ( 𝐴/𝑃,10%,12) − 150 ( 𝐴/𝐹,10%,12)] − 40 96−40 56

Slide 24
Example 9-5 Benefit-Cost Ratio Analysis

A B C D E F
Initial Cost $4000 $2000 $6000 $1000 $9000 $10000
PW of Benefit 7330 4700 8730 1340 9000 9500
B/C 1.83 2.35 1.46 1.34 1.00 0.95

1. Rearrange the alternatives in order of increasing cost

D B A C E
Initial Cost $1000 $2000 $4000 $6000 $9000
PW of Benefit 1340 4700 7330 8730 9000
B/C 1.34 2.35 1.83 1.46 1.00
2. Calculate ΔB/ΔC of the incremental investments, if ΔB/ΔC≥1, choose the higher-
cost alternative
B-D A-B C-A E-A
Initial Cost $2000-1000 $4000-2000 $6000-4000 $9000-4000
PW of Benefit 4700-1340 7330-4700 8730-7330 9000-7330
ΔB/ ΔC 3.36 1.32 0.70 0.33

Slide 25
Graphical Representation of Benefit-Cost Ratio Analysis

B/C=2.0 B/C=1.5 B/C=1.0

PW of Benefits

B/C=0.5

PW of Costs

Slide 26
Graphical Representation of Benefit-Cost Ratio Analysis

B/C=2.0 B/C=1.5 B/C=1.0

10000
9000 C F
8000
A
E
7000
PW of Benefits

6000
5000 B B/C=0.5
4000
3000
2000
1000 D
0
$0 $2,000 $4,000 $6,000 $8,000 $10,000
PW of Costs

Slide 27
Variations on Benefit-Cost Ratio

• Government B/C ratio in Public Sector:

𝐵 𝐴𝑙𝑙 𝑐𝑜𝑛𝑠𝑒𝑞𝑢𝑒𝑛𝑐𝑒𝑠𝑡𝑜 𝑡h𝑒𝑢𝑠𝑒𝑟𝑠 𝑜𝑟 𝑡h𝑒𝑝𝑢𝑏𝑙𝑖𝑐
=
𝐶 𝐴𝑙𝑙𝑐𝑜𝑛𝑠𝑒𝑞𝑢𝑒𝑛𝑐𝑒𝑠𝑡𝑜 𝑡h𝑒 𝑠𝑝𝑜𝑛𝑠𝑜𝑟𝑠 𝑜𝑟 𝑔𝑜𝑣𝑒𝑟𝑛𝑚𝑒𝑛𝑡
• Present Worth Index in Private Sector:
𝐵 𝐴𝑙𝑙𝑐𝑜𝑛𝑠𝑒𝑞𝑢𝑒𝑛𝑐𝑒𝑠𝑒𝑥𝑐𝑒𝑝𝑡 𝑡h𝑒 𝑓𝑖𝑟𝑠𝑡 𝑐𝑜𝑠𝑡
=
𝐶 ′
𝑃𝑟𝑜𝑗𝑒𝑐 𝑡 𝑠 𝑓𝑖𝑟𝑠𝑡 𝑐𝑜𝑠𝑡
• All B/C ratios use same criterion: B/C ≥ 1
• Various B/C ratios may differ in value, but they provide
consistent recommendations

Slide 28
Example 9-6 Government B/C Ratio Analysis

Right turn Left turn

lanes lanes Incremental
Initial Cost $8.9M X $3M
Uniform annual benefit 1.6M $2.2M Y
Annual maintenance $150K Z 75K
Disbenefit $900K 2.1M M
Useful life, in years 15 15

( )
𝐵
𝐶 𝑅
=
𝑃𝑊 (𝐵𝑒𝑛𝑒𝑓𝑖𝑡) 1.6 𝑀 ( 𝑃 / 𝐴 ,10 % , 15 ) −900 𝐾 11.27 𝑀
𝑃𝑊 (𝐶𝑜𝑠𝑡)
=
8.9 𝑀 +150 𝐾 ( 𝑃 / 𝐴 , 10 % , 15 )
=
10.04 𝑀
=1.122

( )
𝐵
𝐶 𝐿− 𝑅
=
∆ 𝑃𝑊 (𝐵𝑒𝑛𝑒𝑓𝑖𝑡) 0.6 𝑀 ( 𝑃 / 𝐴 ,10 %, 15 ) −1.2 𝑀 3.364 𝑀
∆ 𝑃𝑊 (𝐶𝑜𝑠𝑡)
=
3 𝑀+75 𝐾 ( 𝑃 / 𝐴 ,10 % , 15 )
=
3.570 𝑀
=0.942

Slide 29
Payback Period

• It is the period of time required for the project’s profit or other

benefits to equal the project’s cost
• It is an approximate economic analysis method
• The effect of timing is ignored
• All economic consequences after payback are ignored
• May not consistent with equivalent worth and rate of return
methods

Slide 30
Example 9-8 Payback Period

Year 0 1 2 3 4 5
A -$1000 +200 +200 +1200 +1200 +1200
B -$2783 +1200 +1200 +1200 +1200 +1200

$3,000 $3,000

$2,500 $2,500

Accumulative Benefits
Accumulative Benefits

$2,000 $2,000

$1,500 $1,500

$1,000 $1,000 Payback Period

Payback Period =2.33 years
$500 =2.5 years $500
$0 $0
0 1 2 3 4 5 0 1 2 3 4 5
Year Year
Alternative A Alternative B

Slide 31
Example 9-9 Payback Period

Alternatives Cost Uniform Annual Benefit Salvage Value

Atlas $2000 $450 $100
Tom Thumb $3000 $600 $700

$4,000 $4,000
$3,500 $3,500

Accumulative Benefits
Accumulative Benefits

$3,000 $3,000
$2,500 $2,500
$2,000 $2,000
$1,500 $1,500
$1,000 $1,000
Payback Period Payback Period
$500 = 4.4 years $500 = 5 years
$0 $0
0 1 2 3 4 5 6 0 1 2 3 4 5 6
Year Year
Atlas Tom Thumb

Slide 32
Example 9-9 Payback Period

Alternatives Cost Annual Benefit Useful Life

Tempo $30000 $12000, 9000, 6000,… 4
Dura $35000 $1000, 4000, 7000,… 8

$40,000 $40,000
$35,000 $35,000

Accumulative Benefits
Accumulative Benefits

$30,000 $30,000
$25,000 $25,000
$20,000 $20,000
$15,000 $15,000
$10,000 Payback Period $10,000
= 4 years Payback Period
$5,000 $5,000 = 5 years
$0 $0
0 1 2 3 4 5 6 0 1 2 3 4 5 6
Tempo Year Year
Dura

Slide 33
Sensitivity and Breakeven Analysis

• Sensitivity Analysis:
– Projections of expenditures and returns ultimately affect economic
decisions
– To what extend do variations in the data affect the decision?
• Breakeven Analysis
– It is a form of sensitivity analysis
– In what conditions, two alternatives are viewed as “indifferent”?
– One application is “staged construction”

Slide 34
Example 9-11 Breakeven Analysis

Construction Cost $250,000

Full-capacity $140,000
$100,000 now + $200,000
Two-stage 120,000 n years Two-stage

PW(Costs)
from now $150,000
Full capacity
$100,000

$50,000
Breakeven-point

$0
0 5 10 15 20 25 30
Year

Slide 35
Example 9-12 Breakeven Analysis

A B C
Initial Cost $2000 X $5000
Uniform Annual Benefit 410 639 700
$7,000
$6,000
$5,000
$4,000

NPW
$3,000
For Alternative B to be selected,
$2,000
$1,000
$0
0 50 10 15 20 25 30 35 40 45 50 55 60
0 00 00 00 00 00
X 00 00 00 00 00 00

Slide 36
Example 9-12 Breakeven Analysis

Right turn lanes Left turn lanes

Initial cost $8.9M $11.9M
Uniform annual benefit 1.6M 2.2M
Annual maintenance 0.15M 0.225M
Disbenefit 0.9M 2.1M

$3,000
Breakeven for Right turn lanes
$2,500
$2,000 Breakeven for
NPW (in $1000s) Left turn lanes
$1,500 Breakeven for
Incremental
$1,000 Investment
$500
$0
10 11 12 13 14 15 16 17 18 19 20
($500)
($1,000)
Life of project, n (years)

Slide 37
Example 9-15 What-if Analysis

Slide 38
Questions?

Thank You!