Chapter 5 Objectives How do firms screen potential investment opportunities? How do you determine the net present worth (cost), net annual worth (cost) and the internal rate of return of a project? XL Chemicals is to install a computer process control system that cost $650,000. The benefits of the computer control include: $2.00 per kg increase in selling price due to higher quality, 4000 kg increase in production volume due to reduced waste.
Chapter 5 Objectives How do firms screen potential investment opportunities? How do you determine the net present worth (cost), net annual worth (cost) and the internal rate of return of a project? XL Chemicals is to install a computer process control system that cost $650,000. The benefits of the computer control include: $2.00 per kg increase in selling price due to higher quality, 4000 kg increase in production volume due to reduced waste.
Chapter 5 Objectives How do firms screen potential investment opportunities? How do you determine the net present worth (cost), net annual worth (cost) and the internal rate of return of a project? XL Chemicals is to install a computer process control system that cost $650,000. The benefits of the computer control include: $2.00 per kg increase in selling price due to higher quality, 4000 kg increase in production volume due to reduced waste.
Chapter 5 Objectives How do firms screen potential investment opportunities? How do you determine the net present worth (cost), net annual worth (cost) and the internal rate of return of a project? XL Chemicals is to install a computer process control system that cost $650,000. The benefits of the computer control include: $2.00 per kg increase in selling price due to higher quality, 4000 kg increase in production volume due to reduced waste.
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Initial Project
Screening Method: Payback Period Lecture No. 12 Chapter 5 Contemporary Engineering Economics Third Canadian Edition Copyright 2012
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Toronto, Ontario
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Chapter Opening Story
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Ultimate Questions
Municipalities Point of View:
Would there be enough new revenues from installing the
expensive parking monitoring devices? How many devices could be installed to maximize the revenue streams?
Manufacturer's Point of View:
Would there be enough demand for their product to justify
the investment required in new facilities and marketing? What would be the potential financial risk if the actual demand is far less than its forecast or adoption of technology is too slow?
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Ontario
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Chapter 5 Objectives
How do firms screen potential investment
opportunities? How do firms evaluate the profitability of an investment project by considering the time value of money? How do you determine the net present worth (cost), net annual worth (cost), net future worth (cost), and the internal rate of return of a project? 2012 Pearson Canada Inc., Toronto, Ontario
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Chapter 5 Objectives
(continued) How do you determine the capital recovery cost
when you purchase an asset?
How do you determine unit cost or unit profit? What is the meaning of the rate of return? What are some of the various methods to compute the rate of return? How do you resolve the multiple rates of return problem? How to make an accept or reject decision with each of the PW, FW, AE, and IRR criteria? 2012 Pearson Canada Inc., Toronto, Ontario
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Lecture 12 Objectives
How do firms screen potential investment
opportunities? How do firms evaluate the profitability of an investment project by considering the time value of money?
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Bank Loan vs. Investment
Project
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Ontario
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Example 5.1
XL Chemicals is to install a computer process control system that cost
$650,000. The plant uses 40% of it time to produce demulsification chemical and 60% of its time for other specialty chemicals. Annual amount of the chemical is 30000 kg and it sells $15 per kg. The benefits of the computer control include: $2.00 per kg increase in selling price due to higher quality, 4000 kg increase in production volume due to reduced waste, reduced number of operators one per shift with $25.00 per hr savings, increase in maintenance costs $53,000 per year, expected life of the system 8 yrs. If the company decides not to buy the system, what will it do with the $650,000? Invest it in what? And what type of interest will it get for it? These are the type of questions that will be addressed in this chapter The table shows the project cash flow. 2012 Pearson Canada Inc., Toronto, Ontario
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Example 5.1: Describing
Project Cash Flows Year (n)
Cash Inflows (Benefits)
Cash Outflows (Costs)
Net Cash Flows
$650,000
-$650,000
215,500
53,000
162,500
215,500
53,000
162,500
215,500
53,000
162,500
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Example 5.1: Identifying
Project Cash Flows
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Independent versus Mutually
Exclusive Investment Projects
Independent:
Costs and benefits of one project do not depend on whether
another is chosen. Economic attractiveness of each project is measured and decision to reject or accept is made without reference to the other
Mutually Exclusive:
A project is excluded if another is chosen. The most economic
attractive project is selected in the presence of competing alternatives
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Initial Project Screening: Payback
Period
Payback method: Is a non-rigorous method used to screen capital
investments, it screen projects on the basis of how long it takes for net receipts to equal investment outlays.
Method: time value of money could be ignored or included
Screening Guideline: If the payback period is shorter than a maximum acceptable specified payback period, the project would be considered for further analysis.
Weakness: it does not consider the time value of money
Payback screening is not an end in itself, rather a method of screening
out certain obviously unacceptable alternatives
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Example 5.2: Conventional
Payback Period
How long does it take to recover the initial
investment for the computer process control system project in Example 5.1?
Initial Cost Payback Period = Uniform annual benefit $650,000
$162,500 4 years 2012 Pearson Canada Inc., Toronto, Ontario
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Example 5.3: Conventional
Payback Period With Salvage Value
Autonumerics Company has just bought a new
spindle machine at a cost of $105,000 to replace one that had a salvage value of $20,000. The projected annual after-tax savings via improved efficiency, which will exceed the investment cost, are provided in the next slide.
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Example 5.3: Conventional
Payback Period With Salvage ValueN Cash Flow Cum. Flow 0 1 2 3 4 5 6
between N = 3 and N = 4. 2012 Pearson Canada Inc., Toronto, Ontario
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Example 5.3: Conventional Payback Period
Calculation $45,000 $45,000 Annual cash flow
$35,000
$35,000
$25,000 $15,000 0 1
Cumulative cash flow ($)
$85,000 150,000 100,000
3.2 years Payback period
50,000 0 -50,000 -100,000 0
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Years (n)
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Advantages and Disadvantages of the Payback Period Method
Disadvantages
Advantages
easy to understand adjusts for uncertainty of later cash flows reduces time spent analyzing some alternatives
fails to measure profitability
ignores the time value of money biased against long-term projects
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Discounted Payback Period
Discounted Payback Period: Takes into account time value of money How fast can I recover my initial investment plus interest?
Method: Based on the cumulative discounted cash flow
Screening Guideline:
If the discounted payback period (DPP) is less than or equal to some
specified payback period, the project would be considered for further analysis.
Weakness: Cash flows occurring after DPP are ignored
Let us consider the previous example with a 15% interest on any outstanding fund Observe the payback period has shifted to 4.2 years 2012 Pearson Canada Inc., Toronto, Ontario
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Example 5.3: Discounted
Payback Period Calculation Period
Cash Flow
-$85,000
Cost of Funds (15%)*
Cumulative Cash Flow
-$85,000
15,000
-$85,000(0.15) = -$12,750
-82,750
25,000
-$82,750(0.15) = -12,413
-70,163
35,000
-$70,163(0.15) = -10,524
-45,687
45,000
-$45,687(0.15) =-6,853
-7,540
45,000
-$7,540(0.15) = -1,131
36,329
35,000
$36,329(0.15) = 5,449
76,778
Cost of funds = (Unrecovered beginning balance) X (interest rate)
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Example 5.3: Discounted
Payback Period Calculation
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Summary
Independent projects are considered one at a time and
are either accepted or rejected. Payback periods can be used as a screening tool for liquidity, but we need a measure of investment worth for profitability.
