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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

- 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

- Future worth analysis
- Benefit-cost ratio analysis
- Payback period
- Sensitivity and breakeven analysis

EGR 403 - Cal Poly Pomona - SA12

- 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

- 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

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

- 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

EGR 403 - Cal Poly Pomona - SA12

EGR 403 - Cal Poly Pomona - SA12

EGR 403 - Cal Poly Pomona - SA12

- 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

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.

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

- 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

- 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

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

EGR 403 - Cal Poly Pomona - SA12

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