Chapter 9

BC ratio Payback period Sensitivity and Breakeven Analysis

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Benefit-Cost Ratio

Typically used for investments made by government entities B = equivalent worth of the benefits of a project to the user of the project (public) C = equivalent worth of the costs of the project incurred by the facilitator of the project (government entity) Benefit Cost Ratio = BC(i) = B/C
BC Value BC (BC) > 1 BC (BC) = 1 BC (BC) < 1
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Decision Accept Indifferent Reject 2

Single alternative vs multiple alternative problems

Single alternative evaluation: maximize B/C ratio Multi-alternative evaluations

Fixed inputs/outputs: Non-fixed inputs/outputs:

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Example
GTR is considering expanding the airport. Costs: land cost: Constru. Costs: 300k 600k Benefits: (annual) Rental receipts: taxes: 65k 325k

Ann maint costs: 22.5k Ann op cost of term: 75k Ann ATCs: 100k

convenience: 50k tourism: 50k

If n = 20, and I = 10%, should GTR expand?

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Solution

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Another single alternative example

Costs: Initial invest: 20 mill Ann O&M: 200k Benefits (ann): Ann sales: 1mill

New industry:200k

If n = 50, I = 5%, should you do the project?

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Multi-alternative Example
A city government is considering two types of town-dump sanitary systems. Design A requires an initial outlay of $400k, with annual operating and maintenance costs of $50k for the next 15 years. Design B calls for an investment of $300k, with annual O&M costs of $80k per year for 15 years. Fee collections from the residents would be $85k per year. The interest rate is 8% and no salvage value is associated with either system. Which system, if either, should be selected if using the BC ratio?

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Solution

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Another multi-alternative example

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BC Analysis Considerations

Extremely difficult to gather the necessary data (as seen by this example) Easily abused

Benefits to user are generally non-economic BUT analysis requires economic quantities How benefits are quantified can be debated Cannot capture all benefits Denominator vs. Numerator: not always clear

Is a fee paid by the user a cost to the user or benefit to the facilitator?

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Payback Period

Simple payback period ()how many years it takes to recover the investment (ignoring the time value of money).

Discounted payback period ( ')how many years it takes to recover the investment (including the time value of money).

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Example
Initial Investment: Study Period: $50,000

5 years $20,000

Annual Revenues: MARR:

20%

Annual Operating Costs: $2,500 Salvage Value @ EOY 5: $10,000

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Solution

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Another Example
Land cost: $300k Bldg cost: $600k Equip cost: $250k Addt capital required to start: $100k Annual expenses: $475k Sales: $750k/yr for 10 yrs Land sold: $400k Bldg sold: $350k Equip sold: $50k MARR = 25%
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Solution Continued

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Summary

As investments are risky, we prefer short payback periods because we will get our money back sooner. A project with a shorter payback period implies that the risk is lower than one with a higher payback period. Discounted payback period will always be longer than the simple payback period.

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Break-even Analysis
Determines the value of a given parameter for which a project breaks even.

Can be performed on a cash flow or a cash flow input (common factor such as initial investment, salvage value, net revenues, etc.). General procedure

Write an expression of equivalent worth for each alt in terms of the common factor IE 3913 Babski-Reeves

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Example
Reconsider our previous example. If we think the investment is sensitive to annual revenues, what is the breakeven point for the project.

Initial Investment: Study Period:

$50,000

5 years $20,000

Annual Revenues: MARR:

20%

Annual Operating Costs: $2,500 Salvage Value @ EOY 5: $10,000

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Another Example
US Steel will spend $160 million expanding its hot-dip galvanizing facility for coated steel sheets in Slovakia to supply the growing automotive industry. Startup is expected in 2007, producing 350,000 metrics tons annually. Assume a 15-year life (once operational), $600 per ton costs, $16 million annual costs, 18% annual interest, and no salvage value. The $160 million is spread equally over two years (05 and 06) and 2005 is time zero. What is the breakeven per ton price and production length?

Source: Groundbreaking for New Line at Slovakias US Steel Kosice, Dow Jones Newswires, June 23, 2005.

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Solution Continued

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Solution Continued
Assume Price is $760 per ton.

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In class problem

For the following project, determine the breakeven point for each parameter if the companies MARR = 8%.
Estimate

Parameter

Initial Investment 30,000 Annual Revenues 20,000 Annual Expenses Market Value Useful Life 5,000 1,000 5 years

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Graphical Representations of Changes in Values to Price and Production Length

$150.00 $100.00

$50.00

$40.00 $20.00 $0.00

$743
$710.00 $730.00 $750.00 $770.00 $790.00 $810.00

PW(18%)

$$650.00 $(50.00) $670.00

$690.00

$(100.00)

1 ($20.00) PW(18%)

11

13

15

$(150.00)

$(200.00)

($40.00)
Price

10 years

($60.00) ($80.00) ($100.00) ($120.00) Years Production

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Sensitivity Analysis

Analysis determines which output is most sensitive to errors -- which can change the decision

Magnitudeincreased size of the estimated cash flow the more sensitive the outcome is Closer to the presentmore impact on viability of the project

Focus estimating efforts on these parameters, not those with little influence on the decision

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Single-Parameter Sensitivity Analysis

Assume all of your estimates are correct

Perturb one estimate over some acceptable range Examine the effect of the perturbation This determines whether the parameter is critical Repeat for all parameters

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Example
Outokumpo Technology was contracted to design and deliver a new copper flash smelting point plant for Konkola Copper Mines PLC in Zambia. The plant is to take Zambian concentrates and produce 300,000 metric tons of copper per year. The contract is worth EUR20 million.

10-year production life with 15% annual interest rate. Production of 300,000 tons per year. Revenues of EUR3,800 per ton against per unit costs of EUR3,600 per ton. Fixed O&M of EUR5 million in year one, increasing EUR100,000 per year thereafter. Salvage value of EUR3 million at end of horizon.

Hotter, A., Outokumpu in 300,000 MT Zambia Copper Smelter Contract, Dow Jones Newswires, January 25, 2006.

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Solution

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Perturb the Investment Estimate

Define x as the percentage error. New equation for P:

Can now examine various error levels.

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Perturb the New Investment

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Perturb the Salvage Value

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Tornado Diagram

Used to give possible spread of resulting value ( P) if parameter experiences range of errors. Good first past: wide bars indicate sensitivity.
Created using a stackbar graph.
Sensitivity Analysis Tornado Diagram
Margin

Capacity Input

Investment

Requires low estimate of output (P) and the difference between the high and low estimate of the output parameter (P). The bar resulting from the low estimate is erased by drawing it without a border and clear color.

Salvage Value

Base Case 0 100 200 300 400 500 600

Presetn Worth (15%)

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For our Example

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Sensitivity Analysis Ex
Estimated Value Investment Useful life SV 95,000 10 yrs 10,000 20,000

Net annual receipts MARR 12%

Evaluate the sensitivity of PW to 50% changes in: (a) investment cost (b) net annual receipts (c) MARR To which factor is the decision most sensitive? IE 3913 Babski-Reeves 34

Sensitivity Ex cont

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Example
A m/c for which most likely CF est are given in the following list is being considered for immediate installation. Bcse of the new technology built into this m/c, it is desired to investigate its PW over a range of 40% in: (a) initial investment ($11,500) (b) annual net cash flow ($3,000) (c) SV ($1,000) (d) useful life (N = 6) Based on these estimates, how much can the initial investment increase w/o making the m/c an unattractive venture? Draw a diagram that summarizes the sensitivity of PW to changes in each separate parameter when MARR =10%/yr.

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Example

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Example

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Example

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