Chapter 9 - Benefit-Cost Ratio and Other Analysis Methods
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Chapter 9 - Benefit-Cost Ratio and Other Analysis Methods Click here for Streaming Audio To Accompany Presentation (optional). EGR 403 Capital Allocation Theory Dr. Phillip R. Rosenkrantz Industrial & Manufacturing Engineering Department Cal Poly Pomona. EGR 403 - The Big Picture.

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EGR 403 Capital Allocation Theory Dr. Phillip R. Rosenkrantz

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Chapter 9 - Benefit-Cost Ratio and Other Analysis MethodsClick here for Streaming Audio To Accompany Presentation (optional)

EGR 403 Capital Allocation Theory

Dr. Phillip R. Rosenkrantz

Industrial & Manufacturing Engineering Department

Cal Poly Pomona


EGR 403 - The Big Picture

  • Framework:Accounting& Breakeven Analysis

  • “Time-value of money” concepts - Ch. 3, 4

  • Analysis methods

    • Ch. 5 - Present Worth

    • Ch. 6 - Annual Worth

    • Ch. 7,7A,8 - Rate of Return (incremental analysis)

    • Ch. 9 - Benefit Cost Ratio & other methods

  • Refining the analysis

    • Ch. 10, 11 - Depreciation & Taxes

    • Ch. 12 - Replacement Analysis

EGR 403 - Cal Poly Pomona - SA12


Chapter 9 - Other Analysis Methods

  • Future worth analysis

  • Benefit-cost ratio analysis

  • Payback period

  • Sensitivity and breakeven analysis

EGR 403 - Cal Poly Pomona - SA12


Future Worth Analysis

  • Answers the question, what will the future situation be, if we take some particular course of action now?

    • Example 9.1, FW = P(F/P,i , n), FW = A(F/A, i, n)

EGR 403 - Cal Poly Pomona - SA12


Future Worth Analysis

  • When constructing a building, the issue is:

    • not the dollars out of pocket,

    • but the invested cost at start- up.

    • Example 9-2: The remodel project costs less out of pocket, but has a higher “up front” cost. That makes it less desirable.

EGR 403 - Cal Poly Pomona - SA12


Benefit-Cost Ratio Analysis

Example 9-3

  • If the PW of benefits - PW of costs ³ 0.

    The alternative is considered acceptable.

  • Restated:

    Benefit-cost ratio B/C =.

    PW of benefit/PW of cost ³ 1.

  • Fixed input, maximize B/C.

EGR 403 - Cal Poly Pomona - SA12


Benefit-Cost Ratio Analysis

  • If the EUAB - EUAC ³ 0.

    The alternative is considered acceptable.

  • Restated:

    Benefit-cost ratio: B/C = EUAB/EUAC ³ 1

    Or, using PW: B/C = PWB/PWC ³ 1

  • Neither input or output fixed - use incremental B/C.

  • Note: Salvage Value is considered a “negative cost”, not a benefit

  • B/C Ratio Analysis is popular in government

  • Very easy to use with databases and spreadsheets

EGR 403 - Cal Poly Pomona - SA12


Benefit Cost Ratio Analysis ExampleReject increment if incremental B/C Ratio is < 1

EGR 403 - Cal Poly Pomona - SA12


Benefit Cost Ratio Analysis ExampleFirst Increment is B-D. Incremental B/C > 1, so choose higher cost alternative

EGR 403 - Cal Poly Pomona - SA12


Benefit Cost Ratio Analysis ExampleReject increment if incremental B/C Ratio is < 1

EGR 403 - Cal Poly Pomona - SA12


Payback Period: Important Points

  • Approximate economic analysis method.

  • Prior to payback the effect of timing is ignored.

  • After payback all economic consequences are ignored.

  • Will not necessarily produce a recommended alternative consistent with equivalent worth and rate of return methods.

EGR 403 - Cal Poly Pomona - SA12


Payback Period

9-6

  • The period of time required for the profit or other benefits of an investment to equal the cost of the investment.

  • How many years are required to get my money back?

EGR 403 - Cal Poly Pomona - SA12


  • What is wrong here?

    • Payback and IRR analysis do not agree.

Payback Analysis

Example 9-8

With alternative A we get our money back in 4 years but never make a return on the investment.

With alternative B we get our money back in 5 years and make a return on the investment of 19%.

  • How should we make a decision?

  • Liquidity vs. profitability.

  • Life of project.

EGR 403 - Cal Poly Pomona - SA12


Sensitivity and Break-even Analysis

  • Economic data represent projections of expenditures and returns.

  • These projections ultimately affect our decisions.

  • To more fully consider our choice of a decision, we should play a “what if” game to determine the amount of change in a data point that might change the decision.

EGR 403 - Cal Poly Pomona - SA12


Consider Problem 6-21

  • Diesel engine is preferred based on values assumed.

  • How much would changes in assumptions have to be in order to change the preferred alternative?

EGR 403 - Cal Poly Pomona - SA12


How much would price of diesel fuel need to go up before Gas would be the preferred alternative?

Price of Diesel would have to go up to $.75 to change decision.

EGR 403 - Cal Poly Pomona - SA12


What is the impact of the variability of resale value on the analysis?

By varying the resale value, we find that at about $4200 resale value for the gasoline powered vehicle the EUAC is almost equal

EGR 403 - Cal Poly Pomona - SA12


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