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EBTM3103 - SLIDES - Topic 3

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16 views26 pages

EBTM3103 - SLIDES - Topic 3

Uploaded by

syahidaisy
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© © All Rights Reserved
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EBTM3103

TOPIC 3
ENGINEERING
ECONOMICS
ANALYSIS
TOPIC 3 - LO
1. Discuss the concept of cash flow and the use of cash flow
statements and cash flow diagrams;
2. Describe the factors of time value of money and accuracy
in cost analysis;
3. Describe the foundational concepts and formulas for cost
analysis including depreciation and rate of return;
4. Describe the four methods of evaluation available i.e. net
present value, internal rate of return, payback period and
profitability index; and
5. Evaluate projects using these four methods.
Introduction
Quantitative approach

Time value of money

To solve problems in the project context

Evaluate alternatives and select the most economically


efficient alternative
Cash Flow Diagram
Continue CF Diagram
COST ANALYSIS
Cost accounting to project managers
Investing resources
Factors: Time and Accuracy
Characteristics:
a) Single-Period Analysis- same basis, no
time value, short period
b) Multiple-Period Analysis – time value of
money, long period of time
While deriving the different compound interest factors, it is assumed that the
interest is compounded once per interest period i.e. discrete
compounding. Further the cash flows are assumed to be discrete i.e. they occur
at the end of interest period.
Single Payment Present Worth
Factor
Uniform Series Present Worth
Factor
ROR
The rate of return is the amount you receive after
the cost of an initial investment, calculated in the
form of a percentage.
The percentage can be reflected as a positive,
which is considered a gain or profit.
When the percentage is negative, it reflects a loss.
This information is very useful in determining
whether or not the initial investment you made
was a good one.
https://global.oup.com/us/companion.websites/97
80199339273/student/interactive/rra/cal/#
Depreciation
Depreciation is a reduction in value of an
asset. It is not a cash flow, but does reduce
taxable income and thus does affect net
cash flow after taxes.
Methods: Straight line, Declining balance,
Unit of production
Net Present Value (NPV)
Net present value is the difference between
the present value of cash inflows and the
present value of cash outflows that occur as
a result of undertaking an investment
project. It may be positive, zero or negative.
Continue NPV
Positive NPV:
If present value of cash inflows is greater than the present
value of the cash outflows, the net present value is said to be
positive and the investment proposal is considered to be
acceptable.
Zero NPV:
If present value of cash inflow is equal to present value of
cash outflow, the net present value is said to be zero and the
investment proposal is considered to be acceptable.
Negative NPV:
If present value of cash inflow is less than present value of
cash outflow, the net present value is said to be negative and
the investment proposal is rejected.
Summary of NPV

https://www.accountingformanagement.org/net-present-val
ue-method
Internal Rate of Return (IRR)
The internal rate of return sometime
known as yield on project is the rate at
which an investment project promises to
generate a return during its useful life. It is
the discount rate at which the present value
of a project’s net cash inflows becomes
equal to the present value of its net cash
outflows. In other words, internal rate of
return is the discount rate at which a
project’s net present value becomes equal to
zero.
Formula of internal rate of return factor
Example of IRR
https://www.accountingformanagement.org/
internal-rate-of-return-method
/
Payback
The payback period is the time required for
the amount invested in an asset to be repaid
by the net cash flow generated by the asset.
Simple way to evaluate the risk associated
with a proposed project.
An investment with a shorter payback
period is considered to be better, since the
investor's initial outlay is at risk for a
shorter period of time.
https://
www.accountingtools.com/articles/2017/5/17/pay
back-method-payback-period-formula
When net annual cash inflow is even (i.e., same cash flow
every period), the payback period of the project can be
computed by applying the simple formula given below:
Example of Payback
Example 1:
The Delta company is planning to purchase a machine known as
machine X. Machine X would cost $25,000 and would have a useful
life of 10 years with zero salvage value. The expected annual cash
inflow of the machine is $10,000.
Required: Compute payback period of machine X and conclude
whether or not the machine would be purchased if the maximum
desired payback period of Delta company is 3 years.
Solution:
Since the annual cash inflow is even in this project, we can simply
divide the initial investment by the annual cash inflow to compute the
payback period. It is shown below:
Payback period = $25,000/$10,000
= 2.5 years
According to payback period analysis, the purchase of machine X is
desirable because its payback period is 2.5 years which is shorter than
the maximum payback period of the company.
More examples of Payback
https://www.accountingformanagement.org/
payback-method
/
Advantages of payback method
An investment project with a short payback period
promises the quick inflow of cash. It is therefore, a useful
capital budgeting method for cash poor firms.
A project with short payback period can improve the
liquidity position of the business quickly. The payback
period is important for the firms for which liquidity is very
important.
An investment with short payback period makes the funds
available soon to invest in another project.
A short payback period reduces the risk of loss caused by
changing economic conditions and other unavoidable
reasons.
Payback period is very easy to compute.
Disadvantages of payback method

The payback method does not take into account the time
value of money.
It does not consider the useful life of the assets and inflow
of cash after payback period.
For example, If two projects, project A and project B require
an initial investment of $5,000. Project A generates an annual
cash inflow of $1,000 for 5 years whereas project B generates
a cash inflow of $1,000 for 7 years.
It is clear that the project B is more profitable than project A.
But according to payback method, both the projects are
equally desirable because both have a payback period of 5
years ($5,000/$1,000).
Profitability Index
A profitability index attempts to identify the relationship between the
costs and benefits of a proposed project.

The profitability index is calculated by dividing the present value of


the project's future cash flows by the initial investment.

A PI greater than 1.0 indicates that profitability is positive, while a PI


of less than 1.0 indicates that the project will lose money. As values on
the profitability index increase, so does the financial attractiveness of
the proposed project.

Read more: Profitability Index


https://www.investopedia.com/walkthrough/corporate-finance/4/npv-irr/profitability-index.aspx#ixz
z5Enpb5diu
Present Worth
https://
www.youtube.com/watch?v=VaZLXTULX
qE

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