1 Lecture 1 INTRODUCTION TO MODULE 2 Module 2 Module 2 Principles of evaluation Principles of evaluation Depreciation Depreciation Income tax Income tax Breakeven analysis Breakeven analysis Choosing amongst alternative investments Choosing amongst alternative investments Brief introduction to me Brief introduction to me Introduction to Lecture 1 Introduction to Lecture 1

2 INTRODUCTION Engineering Management Engineering Management Chartered Engineer Chartered Engineer 18 years - Industrial Experience 18 years - Industrial Experience Systems Design, Programme and Technical Management Systems Design, Programme and Technical Management 13 years - Department of Electronics 13 years - Department of Electronics Deputy Head of Department Deputy Head of Department Chair, Faculty Curriculum Development Board Chair, Faculty Curriculum Development Board Chair, Local Branch of Institution of Electrical Engineers (IEE) Chair, Local Branch of Institution of Electrical Engineers (IEE) Vice President, European Association for Education in Electrical and Information Engineering (EAEEIE) Vice President, European Association for Education in Electrical and Information Engineering (EAEEIE) Engineering Management Course Director Engineering Management Course Director

3 LECTURE 1 Principles of evaluation of alternatives Principles of evaluation of alternatives Basic concepts for comparing alternatives Basic concepts for comparing alternatives Introduction to methods for evaluating and comparing Introduction to methods for evaluating and comparing Benefits - Cost ratio analysis Benefits - Cost ratio analysis Rules: Rules: If you have a question - please ask - anytime! If you have a question - please ask - anytime! If you do not understand something - stop me If you do not understand something - stop me When I ask for interaction please contribute When I ask for interaction please contribute If nobody speaks up I will pick on somebody If nobody speaks up I will pick on somebody

4 BASIS FOR COMPARISON What does ‘the same’ mean? What does ‘the same’ mean? Recall (Module 1) - ‘Equivalence’ Recall (Module 1) - ‘Equivalence’ “A basis for comparison is an index containing particular information about a series of receipts and disbursements representing an investment opportunity.” “A basis for comparison is an index containing particular information about a series of receipts and disbursements representing an investment opportunity.”

5 COMPARISON IN REALITY Reduction to a single ‘index’ or ‘value’ Reduction to a single ‘index’ or ‘value’ 120,000 m.u. > 115,000 m.u. Time value of money Time value of money 120,000 m.u. now ? 125,000 m.u. in 1 years time State and understand all assumptions State and understand all assumptions

6 BASES FOR COMPARISON Present worth Present worth Annual equivalent Annual equivalent Future worth Future worth Internal rate of return Internal rate of return Payback period Payback period

7 PRESENT WORTH The present worth is the net equivalent amount at the present that represents the difference between the equivalent disbursements and the equivalent receipts of an investment’s cash flow for a defined interest rate. The present worth is the net equivalent amount at the present that represents the difference between the equivalent disbursements and the equivalent receipts of an investment’s cash flow for a defined interest rate. Also called the Net Present Value’ or NPV of a future net cash stream Also called the Net Present Value’ or NPV of a future net cash stream The future net cash flows are discounted back to present worth, or preset value, using the discount factor The future net cash flows are discounted back to present worth, or preset value, using the discount factor The present worth of all the future net cash flows are summed to give the net present worth. The present worth of all the future net cash flows are summed to give the net present worth.

8 ANNUAL EQUIVALENT The annual equivalent amount is the amount of money that would be disbursed annually over the life of the project that is equivalent, in present worth terms, to the overall project cost. The annual equivalent amount is the amount of money that would be disbursed annually over the life of the project that is equivalent, in present worth terms, to the overall project cost. Calculate the NPV as shown in the present worth method. Calculate the NPV as shown in the present worth method. Calculate the amount that, if paid each year over the life of the project, results in the same present worth. This amount is the annual equivalent. Calculate the amount that, if paid each year over the life of the project, results in the same present worth. This amount is the annual equivalent.

9 FUTURE WORTH Because we can move the value of money forwards or backwards in time using the compound interest equation, we can, as we have seen, calculate the present worth of a future net cash flow. Because we can move the value of money forwards or backwards in time using the compound interest equation, we can, as we have seen, calculate the present worth of a future net cash flow. Equally we can project forwards the present worth of a present net cash flow into the future. The result is the future worth. Equally we can project forwards the present worth of a present net cash flow into the future. The result is the future worth.

10 INTERNAL RATE OF RETURN The present worth or Net Present Value of a future net cash stream is determined for a particular interest rate. The present worth or Net Present Value of a future net cash stream is determined for a particular interest rate. Generally the Present worth decreases with increasing interest rate. Generally the Present worth decreases with increasing interest rate. There exists, in general, a value for the interest rate at which the Present worth equals zero. There exists, in general, a value for the interest rate at which the Present worth equals zero. This value of interest rate is called the Internal rate of Return or IRR This value of interest rate is called the Internal rate of Return or IRR IRR=15%

11 PAYBACK PERIOD The payback period without interest is commonly defined as the length of time required to recover the first cost of an investment from the net cash flow produced by that investment. The payback period without interest is commonly defined as the length of time required to recover the first cost of an investment from the net cash flow produced by that investment. 2003/4 Interest Rate is ignored Cumulative Net Cash Flow is zero between 2003 and 2004.

12 CAPITALIZED EQUIVALENT AMOUNT The Capitalized Equivalent Amount is the amount at Present Worth which, at a given interest rate, is equivalent to an repetitive Net Cash Flow amount that continues in perpetuity. The Capitalized Equivalent Amount is the amount at Present Worth which, at a given interest rate, is equivalent to an repetitive Net Cash Flow amount that continues in perpetuity.

13 PRIVATE VERSUS PUBLIC Private organisations Private organisations Profit Profit Public organisations / activities Public organisations / activities General welfare General welfare Value to beneficiaries Value to beneficiaries Beneficiaries are unique individuals Beneficiaries are unique individuals Value = f (personal values, beliefs, etc.) Value = f (personal values, beliefs, etc.)

14 BENEFIT - COST ANALYSIS General rule: General rule: Maximise the value gained from the use of available resources Maximise the value gained from the use of available resources The benefits may accrue to anyone The benefits may accrue to anyone Those who pay may or may not be the beneficiaries (generally not) Those who pay may or may not be the beneficiaries (generally not) Benefits Benefits Those things that provide a gain to the user Those things that provide a gain to the user Disbenefits Disbenefits Those things that provide unfavorable benefits to the user Those things that provide unfavorable benefits to the user Net benefits Net benefits Benefits - Disbenefits Benefits - Disbenefits Net “good” that will be engendered by the project

15 BENEFIT - COST ANALYSIS Costs: Costs: Project cost less any savings gained from its implementation Project cost less any savings gained from its implementation All benefits and costs are expressed in Present Worth terms summed over the different benefits Project us deemed desirable if: Project us deemed desirable if: The benefits exceed the costs The benefits exceed the costs

16 TYPES OF BENEFITS How far should one go to identify all the consequences of a project? How far should one go to identify all the consequences of a project? This question is important This question is important All considered consequences should be fully understood and quantified All considered consequences should be fully understood and quantified Poor choice can have a substantial impact on the cost of undertaking the Benefit - Cost analysis Poor choice can have a substantial impact on the cost of undertaking the Benefit - Cost analysis Too many consequences - too expensive Too many consequences - too expensive Too few - loss of key component and possible political impact Too few - loss of key component and possible political impact

17 CLASSIFYING BENEFITS Primary benefits Primary benefits Primary benefits are those that represent the value of the direct products or services realized from the project activities. Primary benefits are those that represent the value of the direct products or services realized from the project activities. Example: A new irrigation system increases crop yield Example: A new irrigation system increases crop yield Secondary benefits Secondary benefits Secondary benefits are those that represent the value of additional products or services stimulated by the project activities. Secondary benefits are those that represent the value of additional products or services stimulated by the project activities. Beneficial by products of the project Beneficial by products of the project Example: The new irrigation system increases the economic strength of the farming community. Example: The new irrigation system increases the economic strength of the farming community.

18 VALUING BENEFITS Not always an easy task Not always an easy task Should be measured in terms meaningful to the stakeholders Should be measured in terms meaningful to the stakeholders A good Benefits - Cost analysis should not only compare the quantifiable consequences of a project but should also describe the non-quantifiable characteristics in whatever terms are feasible. A good Benefits - Cost analysis should not only compare the quantifiable consequences of a project but should also describe the non-quantifiable characteristics in whatever terms are feasible. Consideration of taxes: Consideration of taxes: Economic gains or losses in respect of taxes should be taken into account in the analysis Economic gains or losses in respect of taxes should be taken into account in the analysis Example: loss of company tax where a project displaces businesses to a different geographic location. Example: loss of company tax where a project displaces businesses to a different geographic location. Example: increase in sales tax where a project leads to more sales Example: increase in sales tax where a project leads to more sales

19 IDENTIFYING BENEFITS Benefits to Public Benefits to Public Reduced vehicle operating costs (excluding Fuel tax) Reduced vehicle operating costs (excluding Fuel tax) Reduced commercial and noncommercial travel time Reduced commercial and noncommercial travel time Increased safety Increased safety Increased accessibility between communities Increased accessibility between communities Ease of driving Ease of driving Appreciation of land values Appreciation of land values Savings to State Savings to State Toll revenues Toll revenues Increased taxes due to appreciated land and increased business activity Increased taxes due to appreciated land and increased business activity Disbenefits to the Public Land removed from agricultural production Damages resulting from changes to water flow Decreased movement of livestock across highway Increased air pollution and litter Costs to State Construction costs Maintenance costs Administrative costs

20 COSTS Total project cost = Capital (Investment cost) ‘I’ Total project cost = Capital (Investment cost) ‘I’ + Annual recurrent cost ‘C’ So: Alternative expression: (Benefit - Annual cost) / Investment Net gain to beneficiary per unit of invested capital

21 THE SOMETOWN STONE COMPANY A toll road has been opened between two cities. Your business is in one of these cities. You need to travel between the two cities regularly as you have a customer to whom you deliver goods has their factory in the other city. The distance between you and your customer is 102 miles via the shortest free road and 95 miles via the new toll road. Determine the economic advantage of using the toll road, if any, given the following conditions: Toll cost 5.50 m.u. Driver cost m.u./hour Average driving speed is 60 mph via the toll road and 50 mph via the free road The estimated average cost of operating the truck per mile is 0.18 m.u./mile via the toll road and 0.20 m.u./mile via the free road

22 EVALUATING PUBLIC PROJECTS Select the proper point of view Select the proper point of view Sociological - classes of people, organisations, demographic Sociological - classes of people, organisations, demographic Environmental - geographic region Environmental - geographic region Who receives the benefits? Who receives the benefits? Who pays? Who pays? Project Point of view National highway, Major water-resource project, Mass-transit system National Regionally funded air-quality control project, Regional highway Regional City park, Local community projects City

23 EVALUATING IN PRACTICE Great care needs to be taken Great care needs to be taken Some projects benefit some at the expense of others Some projects benefit some at the expense of others Decisions are political Decisions are political The impact on the environment ????? The impact on the environment ????? Public Sector Private Sector Variable viewpoint Organizational viewpoint Benefits are larger than local for local projects (visitors, people in transit, etc.) Benefits = Profit, Growth, Shareholder wealth Government funds are ‘free’ to local community Source of funds = Debt or Equity

24 BENEFIT - COST ANALYSIS Project impact Project impact With the project outcomes With the project outcomes Without the project outcomes Without the project outcomes (Not the same as before and after the project!) (Not the same as before and after the project!) General welfare benefits General welfare benefits Enhancement of personal economic situation Enhancement of personal economic situation Desire for clean air Desire for clean air Desire for clean water Desire for clean water Pleasant surroundings Pleasant surroundings Personal security Personal security Improvement of quality of life Improvement of quality of life

25 BENEFIT - COST ANALYSIS What interest rate should we choose? What interest rate should we choose? At least the government’s cost of borrowing money At least the government’s cost of borrowing money “ “ To maintain public and private expenditures on a comparative basis, it seems logical that the interest rate selected should represent the opportunity forgone when taxes are paid. That is, the interest rate should reflect the rate that should have been earned if the funds had not been removed from the private sector.” Rate is a matter of judgment Interest Rate Government cost of borrowing Individuals’ investment opportunity Organization's return on investment

26 CASE STUDY - 2 State Highways Dept