Engineering Systems Analysis Richard de Neufville © Massachusetts Institute of Technology Economic Evaluation Slide 1 of 22 Economic Evaluation l Objective of Analysis l Criteria – Nature – Peculiarities l Comparison of Criteria l Recommended Approach

Engineering Systems Analysis Richard de Neufville © Massachusetts Institute of Technology Economic Evaluation Slide 2 of 22 Objectives of Economic Evaluation Analysis l Is individual project worthwhile? Above minimum standards? –This is a “choice”, is it better or not? –This is easier l Is it best? Is it at top of ranking list? –This is a “judgment” about details –This is more difficult l Note difference between “choice” and “judgment” -- a key consideration in selection of method to be used in real options analysis

Engineering Systems Analysis Richard de Neufville © Massachusetts Institute of Technology Economic Evaluation Slide 3 of 22 Principal Evaluation Criteria l Net Present Value l Benefit - Cost Ratio l Internal Rate of Return l Cost-Effectiveness Ratio l Pay-Back Period

Engineering Systems Analysis Richard de Neufville © Massachusetts Institute of Technology Economic Evaluation Slide 4 of 22 l NPV = B - C (stated in present values) l Objective: To Maximize l Advantage: Focus on Result l Disadvantages –Interpretation of NPV –No account for scale, thus difficult to use for ranking Net Present Value

Engineering Systems Analysis Richard de Neufville © Massachusetts Institute of Technology Economic Evaluation Slide 5 of 22 Present Value and Net Present Value: Example Calculations

Engineering Systems Analysis Richard de Neufville © Massachusetts Institute of Technology Economic Evaluation Slide 6 of 22 Difficulty in Interpreting Meaning of NPV l Suppose for example that a project –costs 1000 –sells 4 years later for 1500 l The obvious profit is 500 = l From an NPV perspective, however, we get –NPV = 1500 / (1+r) exp –This amount depends on discount rate, r –If r = 10%, NPV ~ 1500 / ~ 20 –Try telling that to tax authorities -- or others!

Engineering Systems Analysis Richard de Neufville © Massachusetts Institute of Technology Economic Evaluation Slide 7 of 22 Evaluation of Projects S and T When you spend the same total budget !

Engineering Systems Analysis Richard de Neufville © Massachusetts Institute of Technology Economic Evaluation Slide 8 of 22 Benefit - Cost Ratio =  B /  C (Present Values) l Objective: –To Maximize l Advantage: –Common Scale, Useful in Ranking l Disadvantages: –Treatment of Recurring Costs  B /  C or Net Benefits/Investment = > Bias against operating projects –Ranking sensitive to r low r = > higher rank for long-term projects

Engineering Systems Analysis Richard de Neufville © Massachusetts Institute of Technology Economic Evaluation Slide 9 of 22 A Comparison of a Capital Intensive and Operations Project (Benefits in Present Values)

Engineering Systems Analysis Richard de Neufville © Massachusetts Institute of Technology Economic Evaluation Slide 10 of 22 The Ranking of Projects by Benefit-Cost Criterion Can Depend on DR

Engineering Systems Analysis Richard de Neufville © Massachusetts Institute of Technology Economic Evaluation Slide 11 of 22 Internal Rate of Return l IRR = r such that NPV = 0 l Objective: –Maximize IRR l Advantages: –No need to choose r –Manipulation by r impossible l Disadvantages: –Calculations complex -- but easy in spreadsheet –Ambiguous l Note: ranking by IRR and B/C ratio may differ

Engineering Systems Analysis Richard de Neufville © Massachusetts Institute of Technology Economic Evaluation Slide 12 of 22 Data for calculation of IRR Repeat of Example in Present Value/DCF lecture Example:

Engineering Systems Analysis Richard de Neufville © Massachusetts Institute of Technology Economic Evaluation Slide 13 of 22 Spreadsheet Determination of IRR

Engineering Systems Analysis Richard de Neufville © Massachusetts Institute of Technology Economic Evaluation Slide 14 of 22 Graphical Determination of IRR

Engineering Systems Analysis Richard de Neufville © Massachusetts Institute of Technology Economic Evaluation Slide 15 of 22 Projects can Lead to Ambiguous Solutions for the Internal Rate of Return 310 NPV DR 5 % Cash flow t

Engineering Systems Analysis Richard de Neufville © Massachusetts Institute of Technology Economic Evaluation Slide 16 of 22 Ranking of Projects by Internal Rate of Return and Benefit-Cost Ratio Can Differ

Engineering Systems Analysis Richard de Neufville © Massachusetts Institute of Technology Economic Evaluation Slide 17 of 22 Pay-Back Period l PBP = Cost/Annual Benefits –Note: undiscounted l Objective: –To minimize l Advantages: –Really simple –No choice of r l Disadvantages –Difficult to rank correctly projects with different useful lives or uneven cash flows

Engineering Systems Analysis Richard de Neufville © Massachusetts Institute of Technology Economic Evaluation Slide 18 of 22 Evaluation of Projects V and W

Engineering Systems Analysis Richard de Neufville © Massachusetts Institute of Technology Economic Evaluation Slide 19 of 22 Cost- Effectiveness Ratio l Ratio = (Units of Benefit) / Cost –example: “lives saved/million dollars” l Objective: To Maximize l Advantage: Avoids problem of trying to assign money (example, $) values to “intangibles” such as a “life”, “ton of pollution”, etc. l Disadvantage: No sense for minimum standard or limits

Engineering Systems Analysis Richard de Neufville © Massachusetts Institute of Technology Economic Evaluation Slide 20 of 22 Data for of Cost-Effectiveness Analysis NOTE: Each project has its own cost-effectiveness. Overall cost-effectiveness might sometimes just add projects. In general, however, an advanced technology often substitutes for a lesser one. In this example, MRI (Magnetic Resonance Imagining) thus substitutes for X-Rays, and so on. Possible ProjectsCost-Effective Combinations Lives SavedCostCost-Effect.Combo.∑ Lives∑ CostMarginal CE Visual Exam VE X-Rays VE + X-Ray Lab Tests X-Ray + Lab MRIs MRI + Lab Biopsy MRI + Bio

Engineering Systems Analysis Richard de Neufville © Massachusetts Institute of Technology Economic Evaluation Slide 21 of 22 Cost-Effectiveness Analysis If budget is fixed, we deploy combination that maximizes results. If not, then we have to ask if extra results are worth the extra expense, that is, “Is the marginal cost-effectiveness worthwhile?”

Engineering Systems Analysis Richard de Neufville © Massachusetts Institute of Technology Economic Evaluation Slide 22 of 22 Recommended Procedure (if you have discretion to choose) l Examine Nature of projects –Easy to put into $ terms? Steady cash flows? or with closure costs? Or various project lifetimes? –An operating or a straight capital investment? l Choose Method Accordingly l No method is perfect -- ultimately a judgment l Current “best practice” uses several criteria; uses judgment to decide on project