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Lecture 1 INTRODUCTION TO MODULE 2

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

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Lecture 1 INTRODUCTION TO MODULE 2

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

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

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

  4. BASIS FOR COMPARISON • What does ‘the same’ mean? • 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.”

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

  6. BASES FOR COMPARISON • Present worth • Annual equivalent • Future worth • Internal rate of return • 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. • 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 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. • 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.

  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. • 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. • 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. • 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. • Interest Rate is ignored • Cumulative Net Cash Flow is zero between 2003 and 2004. 2003/4

  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.

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

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

  15. BENEFIT - COST ANALYSIS • Costs: • 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: • The benefits exceed the costs

  16. TYPES OF BENEFITS • How far should one go to identify all the consequences of a project? • This question is important • 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 • Too many consequences - too expensive • Too few - loss of key component and possible political impact

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

  18. VALUING BENEFITS • Not always an easy task • 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. • Consideration of taxes: • 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: increase in sales tax where a project leads to more sales

  19. Benefits to Public Reduced vehicle operating costs (excluding Fuel tax) Reduced commercial and noncommercial travel time Increased safety Increased accessibility between communities Ease of driving Appreciation of land values Savings to State Toll revenues 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 IDENTIFYING BENEFITS

  20. COSTS • 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 12.50 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 • Sociological - classes of people, organisations, demographic • Environmental - geographic region • Who receives the benefits? • Who pays?

  23. EVALUATING IN PRACTICE • Great care needs to be taken • Some projects benefit some at the expense of others • Decisions are political • The impact on the environment ?????

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

  25. BENEFIT - COST ANALYSIS • What interest rate should we choose? • 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 Individuals’ investment opportunity Government cost of borrowing • Organization's return on investment Interest Rate 30 10 20

  26. CASE STUDY - 2 State Highways Dept

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