Ec 12

ENGINEERING ECONOMICS
LECTURE ASST PROF. ENGR

12
ALI SALMAN
alisalman@
ceme.nust.edu.pk
DEPARTMENT
DEPARTMENT
OF
OF
ENGINEERING
ENGINEERINGMANAGEMENT
MANAGEMENT
NUST
NUSTCOLLEGE
COLLEGEOF
OFEE&
&ME
ME
ALI SALMAN 1
Cost/Benefit Analysis
A systematic comparison of the expected
costs and benefits of a course of action.
When benefits and costs are measured on the same scale,
such as dollars, the benefits should exceed the costs for a
given course of action.
When the alternatives are estimated to provide the same

benefit, the alternative with the lowest cost should be
selected.
Benefit Measurement Methods
Economic Models
The process of identifying the financial (economic)

benefits is called Capital Budgeting.
It is the decision-making process by which

organizations evaluate and select projects .
Cost/Benefit Analysis
Benefit Measurement Methods
Economic Models
• Payback Period
• Discounted Cash Flow
– Net Present Value
• Benefit/Cost Ratio
• Internal Rate of Return (IRR)
Payback Period
Payback period is the length of time, usually
expressed in years or fractions there of, needed for
a firm to recover its initial investment on a project.
For example, a $1000 investment which returned

$500 per year would have a two year payback period .
An assumption in the use of payback period is that
returns to the investment continue after the payback
period.
Payback Period Example
Initial Project Expense = $5,000
Year Amount Remaining

Paid Amount
Year 1 $1,000 ($4,000)
Year 2 $2,000 ($2,000)
Year 3 $2,000 $0
Payback Period (Criteria)
An organization that uses Payback Period

would also have to define what the payback
period criteria would be?
Some organizations would be very happy
with a payback period of three years.
Others would no doubt use a much shorter
payback period criteria.
Future Worth and Present Worth Concepts
Future Worth
FW = PW (1+interest rate)
raised to the (number of years) power.
Example: Lets say we have $1,000 invested at 6%

for three years. Calculate Future Worth.
Future Worth and Present Worth Concepts
Future Worth
FW = PW (1+interest rate)
raised to the (number of years) power.
Example: Lets say we have $1,000 invested at 6%

for three years. Calculate Future Worth.
FW = $1,000 (1+.06) to the third power.
FW = $1,000 * (1.1910)
FW = $1,191
Discount rate
The rate used to discount future cash flows to
their present values.
Explanation:
The discount rate is the interest rate you need to

earn on a given amount of money today to end up
with a given amount of money in the future. The
discount rate accounts for the time value of
money, which is the idea that a dollar today is
worth more than a dollar tomorrow given that the
dollar today has the capacity to earn interest.
Present Worth
The result of discounting one or more
amounts to be received or paid in the
future by a discount rate.
PW = FW * 1 / ((1+discount rate) to the

(number of years) power).
Example 01:
$100 invested at 6% will amount to $106 at the end
of one year (this is a future worth).
Therefore:
The present worth of $106 is $100.

Example 02:
Lets say $1,000 being sent to us 3 years from now
and the discount rate is at 3%. Calculate PW?
Example 02:
Lets say $1,000 being sent to us 3 years from now
and the discount rate is at 3%. Calculate PW?
PW = $1,000 * 1/((1+.03) to the third power
PW = $1,000 * (.9151)
PW = $915.10
Present Worth Analysis
It is the recognition that any amount due in the
future is worth less than that same amount if it
were due today.
Discounted Cash Flow
The present worth of all expected net cash receipts

from a project, discounted by an appropriate
discount rate.
(Payback) Discounted Cash Flow at 6%.

Future Present
Value Value
Year 1 $1,000 $ 943 ($4,057)
Year 2 $2,000 $1,780 ($2,277)
(Payback) Discounted Cash Flow at 6%.

Future Present
Value Value
Year 1 $1,000 $ 943 ($4,057)
Year 2 $2,000 $1,780 ($2,277)
Year 3 $2,000 $1,680 ($ 597)
Year 4 $2,000 $1,584 $987
Net Present Worth or Net Present Value
The algebraic sum of the present worth of all
outflows and inflows associated with a given
project or investment.
Calculation of net present worth usually involves

subtracting the initial outflow cost of an
investment from the present worth of all future
cash flows.
Net Present Worth
Discounted Cash Flow at 6%.

Year 1 $1,000 $ 943
Year 2 $2,000 $1,780
Year 3 $2,000 $1,680
Year 4 $2,000 $1,584
Total $5,987 accrued benefit
Less Investment -$5,000
Net Present Worth $987
Benefit/Cost Ratio
B/C ratio is actually a ratio of discounted

benefits to discounted costs.
B/C =
$PW (Benefits)
$ PW (Cost)
B=Benefits
B/C = $ PW (B)
I=Initial Investment
I+$ PW (O&M)
O&M= Operating
and maintenance cost
Modified B/C = PW (B)-PW(O&M)
I
Note: A project is acceptable when B/C ratio is greater or equal to 01.
Benefit/Cost Ratio
Project Benefit $ 5987
Project Cost $ 5000
Benefit/Cost Ratio = 1.2
An organization could establish any “criteria” that

they wanted for the purposes of evaluating a
project. Company A might have a Benefit/Cost
Ratio requirement of 1.5 or greater. Company B
might simply make the decision to do the project if
it had a Benefit/Cost Ratio of 1.0.
Internal Rate of Return (IRR)
The discount rate often used in capital budgeting that makes
the net present value of all cash flows of a particular
project equal to zero.
Generally speaking, the higher a project's internal rate of

return, the more desirable it is to undertake the project. As
such, IRR can be used to rank several prospective projects a
firm is considering.
Assuming all other factors are equal among the various

projects, the project with the highest IRR would probably be
considered the best and undertaken first.
IRR is sometimes referred to as "economic rate of return
(ERR)".
Internal Rate of Return: IRR
0 1 2 3
CF0 CF1 CF2 CF3

Cost Inflows
IRR is the discount rate that forces

PV inflows = cost. This is the same
as forcing NPV = 0.
NPV: Enter r, solve for NPV.
n
CFt

t  0 1  r 
t
 NPV .
IRR: Enter NPV = 0, solve for IRR.

n CFt
  0.
t  0 1  IRR
t
Find IRR if CFs are constant:
0 1 2 3
IRR = ?
-100 40 40 40
IRR = 9.70%.
Calculate IRR
0 1 2 3
IRR = ?
-100.00 10 60 80
PV1
PV2
PV3
0 = NPV
Note: See problems

IRR = 18.13%. with solution in word
files as well.
27

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ENGINEERING ECONOMICS

LECTURE ASST PROF. ENGR

When the alternatives are estimated to provide the same

The process of identifying the financial (economic)

It is the decision-making process by which

For example, a $1000 investment which returned

Year Amount Remaining

An organization that uses Payback Period

Example: Lets say we have $1,000 invested at 6%

Example: Lets say we have $1,000 invested at 6%

The discount rate is the interest rate you need to

PW = FW * 1 / ((1+discount rate) to the

The present worth of $106 is $100.

Discounted Cash Flow

The present worth of all expected net cash receipts

(Payback) Discounted Cash Flow at 6%.

(Payback) Discounted Cash Flow at 6%.

Calculation of net present worth usually involves

Discounted Cash Flow at 6%.

B/C ratio is actually a ratio of discounted

An organization could establish any “criteria” that

Generally speaking, the higher a project's internal rate of

Assuming all other factors are equal among the various

CF0 CF1 CF2 CF3

IRR is the discount rate that forces

IRR: Enter NPV = 0, solve for IRR.

Note: See problems

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