22

Week 1-2
Some relevant background readings
1. The Green Book [Reading5]
2. State of Victoria (2012) Investment Lifecycle and high value/high risk guidelines http://www.lifecycleguidance.dtf.vic.gov.au/section.php?section_ID=1 [Reading 6]

3. State of Victoria, Investment Management www.dtf.vic.gov.au/investmentmanagement[Reading7]

guidelines,

Project initiation process

The initiation phase of projects goes by various names with the most common being business case and feasibility study. A business case conceptually covers more of the strategic fit of a project (or solutions) to an organisations requirements and then details options for solving the strategic need. Feasibility studies are often more focussed but the key information of a feasibility study is contained within a business case. Invariably the initiation of a project involves an economic analysis. Economic analysis of projects involves conduct of a: Needs analysis and compliance with strategic planning Financial analysis of the project Socio-economic investment analysis Environmental investigation The Victorian government in its Investment Evaluation Policy and Guidelines3 proposes that potential investments be evaluated on the basis of: Government Policies Service Need: Does the project embrace Governments service priorities? A Statewide Perspective: Consider investment costs and risks incurred by the State. Total cash flow impact on State budget capital and recurrent must be assessed. Financial and Socio-economic investment criteria

The Investment Evaluation Policy and Guidelines, The Department of Treasury and Finance, State of Victoria 1996
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3

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Weighting changes from nearly totally financial for commercial projects to mainly social for non-revenue generating investments. Governments frequently produce guidelines and manuals to assist organisations to evaluate projects, such guidelines are available from the Victorian4 and NSW5 governments. It is important to understand that the single most important decision follows project appraisal. This is the decision of proceeding or not. Is the project to be sanctioned? A typical investment evaluation process is reproduced as Table 2.1. The Construction Industry Development Agency (CIDA) developed an excellent process for project initiation in 19936 when it proposed a range of methods and outcomes through the stages of idea, concept development, evaluation and definition. The CIDA framework for project initiation which puts a logical structure to the detailed and often varied tasks involved in initiating projects. The CIDA process has been replicated as Figures 2.1 to 2.3. Table2.1Typicalgovernmentinvestmentevaluationprocess Step1: Step2: Step3: Step4: Step5: Step6: Step7: Step8: Step9: Serviceneeds,GovernmentPolicy&Priorities Objectives,OutputsandOutcomes Options FinancialImpacts SocioEconomicImpacts Integration Decisiononthepreferredoption Riskmanagement Implementationmanagement

Victorian Government, (1996) Investment Evaluation Policy and Guidelines (IEPG) NSW Government, Guidelines for Economic Appraisal, www.treasury.nsw.gov.au/research) 6 Construction Industry Development Agency, 1993, Construction Industry Project Initiation Guide for Project Sponsors, Clients and Owners, Commonwealth of Australia
5 4

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Step10:
Strategic planning Opportunity identification Intuition PROJECT IDEA SOURCES IDEA Strategic planning check Develop a project strategy Market research Strategic value management

Accountability

OUTCOMES Idea

CONCEPT DEVELOPMENT EVLUATION BRIEF

Identify constraints Describe option range Select short list Test function & Objectives Cash flow Risk and NPV Special Risk Identify tradeoffs Project value management Document Define procurement strategy Revise feasibility Cost & Time planning

Outline description Basic criteria Objectives Functional analysis Evaluation brief & actions Identification of range of options Preferred option described: physical, functional, financial Definition brief & actions Descriptive & illustrative definition of preferred option Feasibility statement Procurement strategy Time & cost plan Delivery brief

EVALUATION DEFINITION BRIEF DEFINITION DELIVERY BRIEF

Figure2.1:Projectinitiationprocess

Figure2.2:Conceptdevelopment

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Figure 2.3: Project evaluation

The evaluation process illustrated in Figures 2.1 to 2.3 is undertaken through the application of methods and techniques to provide guidance for decision makers. Methods and outcomes are: METHODS Identifyconstraints Describeoptions Selectshortlist Testfunction&objectives Cashflow Risk&NPV OUTCOMES Projects are invariably studied in terms of prefeasibility and feasibility studies prior to progressing to detailed design. Some conceptual approaches to thinking Outlinedescription Basiccriteria Objectives Functionalanalysis Identifyoptions Decidepreferredoption

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about what is important is covered by the concept of Resources, Impact and Restraints.

Resources, impacts and restraints

Resources
The project selection process is influenced by the availability of resources. These can include:
financial resources the availability of capital through cash, equity, borrowings land including its terms of tenure (freehold or leasehold) technology access to the world's best practice, state of the art or research and development facilities human resources management and technical skills, construction and operations workforce infrastructure transport, utilities, services.

Impact
Aprojectwillhaveanimpactonitsimmediateandregionalenvironment,whichwill needtobeaddressedintheselectionprocess.Keyimpactsare:
economy the effects of an extraordinary circulation of money to the local, regional, state and national economies community the changes in relationships between long term and new inhabitants of the area relevant to the project employment the demands on local and imported staff during both the construction and operation of the project environment the effects on the ecosystems and balances at and near the project.

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Restraints
It is an important part of the selection process to identify early the restraints and barriers which could render a proposed project uneconomical or indeed prevent it proceeding at all. These restraints can take many and surprising forms, for example:
political changes both party and policy heritage and historical preservation of artefacts, structures, sacred sites environmental eradication of species (fauna and flora), hydrology pattern changes etc. completion date it may not be possible to execute the project by the appropriate date industrial relations traditional union coverage, work practices, demarcation disputes.

Thesefactorsaregenerallyconsolidatedinabusinesscase. In terms of developing the business case some key matters need to be addressed. Step1: Developandquantifytheserviceneedfortheproject: Thisstageoftenrequiresdetailedengineeringandmodellingofthe facility,itsnetworkandhowtheadvancesintroducedbytheproject respondtocurrentandfuturerequirements.Thisoftenbringsintoplay demographicchangesorotherrelateddevelopments. GovernmentPolicy&Priorities:Clearlyifthebusinesscaseneedsto considerscenariosoffutureoutcomesthetestingoftheserviceneedhas toalignwithknownpoliciesandpriorities. Partofquantifyingtheserviceneedistoidentifyandquantifythebenefits fromtheinvestment.Theinvestmentlogicmapprovidesamechanismfor identifyingwhattasksneedtobeinvestigatedindetail.Itisthedetailthat isprovidedinthebusinesscase.Itisoftenusefultousethesummaryof theILMinasimilarwaytoatableofcontentsforthissectionofthe report. Objectives,OutputsandOutcomes Specificrequirementsfortheprojectaredetailedinthissection.The emphasismaybebestthoughtofintermsofwhatserviceisrequired,
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Step2:

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whatqualityorservicestandardisanticipated,whatfeaturesaremust haveitems. Theoutcomesresultinahighleveloutputspecificationforaproject,NB: theemphasistothispointoftimeisoutcomesratherthanspecificwaysto achievetheoutcome. Thisphasealsoinvolvesdetailedstakeholderdiscussionstorefinewhatis required. Options Theoptionsectiondevelopsarangeofpotentialsolutionsandcompares thepotentialsolutionsastowhatislikelytobeachieved.Itislikelythat someoptionsmaynotmeet(oronlypartiallymeet)theoutputsrequired. Theoptionswillinclude: Donothing Demandmanagesolutions(i.e.nontechnicalsolutions) Viable technical solutions. Designs are developed in conceptually to the point where functional performance, risks and estimated costs of the proposedoptioncanbeestablished. Ashortlistofpreferredoptionscanbeestablishedbasedonaninitial assessmentoffunctionandfulfilmentoftheobjectives,outputsand outcomes. Step4: Analysisofoptions Theanalysisofoptionsattemptstorefinetheanalysisasquicklyas possibletothepreferredoutcome.Thisincludesconsiderationof: FinancialImpacts;SocioEconomicImpacts;Integrationofalldecision processes;Adecisionisrecommendedonthepreferredoption;Risk management. Considerationsduringthisphasearedoneonawholeoflifebasisand specificinputsinclude: projectestimates benefitsestimates
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Step3:

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Step5: Implementationmanagement Thissectionofthebusinesscasedetailstheproposedprocessfor implementingtheproject.Thisapproachisparticularlyimportantinterms ofachievingtheprojectscost,time,riskandqualityoutcomes. Specificsectionscoveredinthissectiondetail: Proposedgovernancestructure Proposed commercial arrangements to procure the works. This interfaces closely with resources, relationship management, pricing and risk allocationarrangements. Proposedtimetable Processforimplementation Riskmanagementplanandprojectprofile Detailed project budgetary requirements based o risk adjusted, whole of lifecosts Stakeholdermanagementplan Communicationplan Accountability Detailedprocessestoachievetherequiredapprovals riskassessmentandquantification multicriteriaevaluation budgetingrequirementsbywayofcashflow

Step6:

Steps to prepare an economic appraisal

Theissuesandnecessarydecisionsdiscussedabovearegenerallyarticulatedthrougha detailedeconomicappraisal.Stepstoprepareaneconomicappraisalinvolve: Defineobjectivesandscopeofproject Identifyoptions Identifyquantifiablecosts Identifyquantifiablebenefits Calculatenetbenefits Identifyqualitativefactorsandsummariseresults
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A detailed financial analysis of the project is undertaken. This involves identification of critical impacts prior to analysing the financial impacts and then conducting sensitivity style analyses.

Identifynetfinancialimpacts Analysisoffinancialimpacts Sensitivity,SwitchingandScenarioanalysis Scoringfinancialimpacts

Cashflowisveryimportantandshouldconsider: CashOutflows Capitalexpenditure Operatingcosts Oneoffcosts Opportunitycost Taxes Depreciation Financingcosts Governmentfinancecharge Sunkcosts Incrementalcashflows Timingofcashflows Cashflowstobeinnominalterms Stateassumptions Reliabilityofestimates CashInflows Revenues Avoidedcashoutflows Releaseofcapital Residualvalue Productionsavings Subsidies&grants Taxes

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Thepurposeofundertakingafinancialinvestigationistoassesstheinvestmentvalueof theproject.Thecashflowofatypicalprojectthroughoutitslifecycleispresentedas Figure2.5.

APPRAISAL IMPLEMENTATION OPERATION

Regulatory Approval

Planning Approval

CONCEIVE

SANCTION

(+)

Definition

MONEY

Design Construction Com

Concept

COMPLETION

Contract Award

TIME

(-)

PROJECT ACCOUNT BALANCE

(P.Thompson)

Figure2.5Projectcashflow Fromafinancialpointofview,thedecisionwhethertoproceedwiththeprojectwill dependontheavailabilityofcapitalandtheforecastbenefitsfromdetailedanalysis. Suchanalysismayinvolve: NetPresentValue(NPV) Netpresentvalueperunitofcapitalinvested(NPVI) EquivalentAnnualCost(EAC) Internalrateofreturn(IRR) Benefitcostratio(BCR) Paybackperiod

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Tools of trade
Projectselectioncriteria,or"toolsoftrade",aprojectmanagercandrawontofacilitate theprojectselectionprocess.Specifictechniquesinclude: Budgetestimate Lifecyclecosting Financialevaluation Costofmoney Depreciation Valuation Environmentalandsocialfactors

Othertechniquesinclude: Riskassessment ReferenceClassForecasting RealOptions Contractrelationships Personnelmanagement Assetmanagement

Budget Estimate
This kind of estimate is used to set the budget for the project and obtain ownership approval. If detailed design information is available, the estimate should be done in the same level of detail as a normal estimate. If not, as is more likely the case at this stage of the project, the estimate should reflect the information available which is considered firm. One of the most important concepts in cost estimating is establishing the basis of the estimate. A cost estimate consists of three bases; they are the design basis, the planning basis and the cost basis. The Design Basis: What Is to Be Built

The design basis usually takes the form of drawings, sketches, and specification. The most significant things about the design basis are the level of definition and the potential for change. The original design often assumes that facilities can be installed in most straightforward ways. Sometimes the facts turn out otherwise. Therefore, the potential for change is as important as the level of detail of design definition. The more that is defined, the less the estimate must predict, and more

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"solid" the basis. The estimate will be correct to the extent that it correctly reflects the design basis and predicts the extent of changes. The Planning Basis: How It Is to Be Built

The planning basis usually consists of the network plan, bar chart schedule, and resource plan. The relationship between how the project is managed and its cost has now been discussed sufficiently that it can be seen that the estimate should reflect the contract plan as well as any costs associated with maintaining or accelerating the schedule. The estimate will be correct to the extent that it correctly reflects the planning basis and predicts how the project will actually be built. The Cost Basis : What Pricing Levels Will Be Experienced

The cost basis is the pricing used in the estimate. It consists of the data used for estimating, the estimating, the assumptions made as to escalation, productivity and other estimating parameters, and the judgements made by the estimator. Since most estimates are done at some base date and then escalated, the basis should also define the base cost level. The estimate will be correct to the extent that it correctly reflects cost data and predicts what pricing and performance will actually be experienced.

Discounted cash flow measures

Life Cycle Costing Lifecyclecostisthetotalcostofproviding,owning,operatingandmaintainingaproject overitsusefullife.Theultimateobjectiveoflifecyclecostingisthedeterminationof optimumdesigndecisionsfollowingtheevaluationofallviabledesignalternatives.Life cyclecostsareexpressedinequivalentmonetaryterms,andcanbedividedintothe followingcomponents. CapitalCost
Capital costs are those associated with initial procurement including planning, design, construction and commissioning as at the date of the study.

Potential capital costs are:

land cost, surveys, demolition and relocation, legal fees; o design costs, including cost of consultants and/or in-house staff as well as special studies or tests.

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o construction costs, including costs of labour, material, equipment, administration, overheads, overtime, profit, insurances, permits, fees, and other expenses; and o commissioning and testing costs. Such costs are usually non-recurring. Cost-In-Use Cost-in-use is the ownership cost of a total project or any of its components, including maintenance, cleaning, alterations, replacement and support. Cost-inuse excludes initial capital costs and demolition and disposal costs. Operating costs - comprise the cost of fuel, energy sources and charges and all labour necessary for the effective functioning of an asset including security. Maintenance costs - these are the costs of retaining an asset in, or restoring it to, an agreed condition, and include all costs associated with the custodian care and repair. Cleaning costs - those required to reduce contamination to an acceptable standard. Alteration and replacement costs - are those associated with future changes in function; replacement costs of replacing capital equipment and materials which cannot economically survive for the expected life span of a facility. Support costs - include insurance, rates, management expenses, etc. Discounted cash flow analysis Money cannot be taken as if it were an unambiguous standard for measuring the value of resources used to create a system. The dollar value of resources used at one time cannot be compared directly with the dollar value of resources used at other times. Money now is worth more than money later7. Money and resources in fact have a time value, usually expressed in terms of percent per year. In most large-scale engineering projects, the costs are incurred and the benefits are received over a considerable period of time. The construction of a large dam, for example, may extend over three or four years and may produce water supply, flood control and other benefits over a period of fifty years or more. This poses a problem of monetary comparison for economic evaluation, because money values change over time, and $1000 now cannot be directly compared with $1000 in ten years' time. Distinct reasons for this are inflation and potential loss of opportunity or value in use of money. The time cost of money is considered by computation a notional future value (FV) based on discounting with a discount rate. It is normal to use a pure value-in-use discount rate,
7

Samson, D. (Ed.) Management for Engineers, Chapter 2 Page | 34

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i.e. inflation free. Analyses are therefore comparative and a useful tool for making decisions and should not be confused with actual monetary sums. Typical financial indicators adopted are: Net Present Value (NPV)-the sum of the discounted benefits minus the discounted costs; the greater the NPV the more attractive the bid. Benefit Cost Ratio-is the ratio of discounted benefits to discounted cost. The larger the ratio, the better the outcome. Internal Rate of Return (IRR)- is the discount rate at which the Net Present Value of a project is equal to zero (ie. discounted benefits equal discounted costs) for a given return period. The higher the IRR the better the outcome. The mathematical equations for these financial indicators are:
PV FV (1 i ) n

NPV PV (benefits ) PV (cos ts ) BCR

PV (benefits) PV (cos ts)

PV = Presentvalue

FV i n

= = =

Futurevalue discountrate numberofperiods,e.g.years,monthsetc

Benefit-cost analysis is a way of setting out the factors that need to be taken into account in making certain economic choices. Most of the choices to which it has been applied involve investment projects and decisions - whether or not a particular project is worthwhile, which is the best of several alternative projects, or when to undertake a particular project. The benefit-cost ratio is merely the total discounted estimated benefits divided by the total discounted estimated costs. In short-term projects total income and total costs are used, whilst long-term (everlasting to all practical purposes) projects it is often more
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convenient to use annual income and annual amortised costs. In the private sector, it is usually sufficient to consider merely financial costs, whilst in the public sector external factors must often be quantified in financial terms. It is in this field that complications arise since it is difficult, if not impossible, to agree on a financial value of, for example, social benefits. Annex A & B provide a useful check of computations involving discounted cost analysis.

Benefit-Cost Ratio (BCR)

Benefit-cost analysis is a way of setting out the factors that need to be taken into account in making certain economic choices. Most of the choices to which it has been applied involve investment projects and decisions - whether or not a particular project is worthwhile, which is the best of several alternative projects, or when to undertake a particular project. The benefit-cost ratio is undoubtedly the most useful project justification tool available to the engineer. It is merely the total discounted estimated benefits divided by the total discounted estimated costs. In short-term projects total income and total costs are used, whilst long-term (everlasting to all practical purposes) projects it is often more convenient to use annual income and annual amortised costs. In the private sector, it is usually sufficient to consider merely financial costs, whilst in the public sector external factors must often be quantified in financial terms. It is in this field that complications arise since it is difficult, if not impossible, to agree on a financial value of, for example, social benefits. It is obvious that a scheme is viable if the BCR exceeds unity. However an owner is unlikely to be willing to embark upon a project which complies with this rule unless satisfied that, if future predicted conditions change, the project will still remain viable. Most important of these is likely to be interest rates, others will be construction costs, the market price of products, forecast maintenance costs (which may include the labour rate), forecast lifespan, taxation and inflation. In the private sector the motive for a project is the maximisation of profit, whilst in the public sector the motive is, ultimately, the raising of living standards. The public sector pays no tax and can work on lower borrowing rates, since government (including municipalities) can borrow externally or internally, and can offer security in that it can repay loans even if a scheme proves not to be a paying proposition. Thus a scheme which may be unprofitable under private enterprise may be viable in the public sector. Government might even proceed with a project which has a BCR of less than unity in order to create employment, or to produce subsidised goods which will make other
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industries, which may be private, viable. Finally, government is concerned with other external factors such as social costs, which are seldom the concern of the entrepreneur.

Valuation
There are three main bases for value which we will address. They are: Open market value for existing use Open market value for alternative use. Depreciation replacement cost.

Other less significant bases of value are negative value and going concern value. Open market value for existing use is

- the best price or rent that could reasonably be expected for the interest in the property - between a willing seller/buyer or lessor/lessee - assuming a reasonable time for negotiation, taking account of the nature of the property and state of the market, and - that the property will be freely exposed to the market, - that values will remain static during that period, and - that no account will be taken of higher bids from special purchasers or tenants, and - that the property will remain in its existing state and current use. Open market value for alternative use

Basic accounting for companies is done within the concept of continuing business and as part of this concept the continuing use and occupation of the company's premises for their present use forms the normal basis for valuation. But there are sometimes properties, usually semi-obsolete, which are occupied because they are there and which may be worth more than their current use value if they were to be developed. Similarly there are properties that although not truly obsolete, have been affected by economic changes and are worth more for some other use. When valuing properties, it is normal to use the appropriate valuation techniques in arriving at open market value for either existing use or any alternative use. The
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appropriate techniques are those used by all valuers and are set out in standard text books. However, they are all based on the analysis of open market transactions and comparisons with other property in the market. Problems may arise where no such comparison exists.

Depreciated replacement cost There are sometimes properties that cannot be valued by normal comparison methods because there is no market in such properties. In these circumstances other techniques need to be called upon to supply an estimate of value for such assets. In brief, this is that the value of a fixed asset should be the amount of loss that should be suffered by the owners if they were to be deprived of this asset. This loss can be fairly expressed by the open market value of properties of which there is a market because if an owner were notionally deprived of, say, a factory of 2000m2 he/she could replace it by buying any other in the market at market With properties for which there is no market value the procedure is not simple and other means must be sought. Rating surveyors have for over a century dealt with this problem by taking into consideration the estimated capital cost of such premises and have called their method 'contractor's test'. By this method the value of the land for its current use, and depreciated cost of the existing buildings are added together and thus an estimated replacement cost is arrived at. This method is applicable to the valuation of assets and is consistent with the view of estimating the loss suffered by deprival referred to above. Instead of the owner notionally going out and buying another factory, he/she notionally buys land and constructs a new building or set of buildings on that land for his/her own purposes.

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Annex A To Bid Analysis Evaluation Best Practice COMPARISON OF PURCHASE OPTIONS FOR EQUIPMENT WITH SAME EXPECTED LIVES Assumptions

The estimated useful life of the equipment is 5 years. No major innovations in this technology during the evaluation period. Costs incurred throughout the year are discounted at the rate applicable at the end of the year for ease of calculation. Estimated volume is 2,500 units per annum. It has been assumed that the cost of capital to be 7.98%. (The net discount rate therefore is 7.75%).

Costs Capital Cost option A $66,250. option B $75,000. Maintenance Costs option A $9,000 per annum in advance. Option B $5,000. Variable Costs option A $8.86 per unit option B $8.03. Residual Value option A $2,000. Option B $2,200. Evaluation Excluding Inflation from Data

i.e. costs in present day dollar values discount at 7.75% Option A Year 0 $ Capital Cost Maintenance Variable Costs ($8.86 x 2,500) Residual Value Cash Flow Discount factor @ 7.75% 1.0 0.9281 0.8614 0.7994 0.7419 0.6886 75,250 31,150 31,150 31,150 31,150 22,150 22,150 22,150 22,150 22,150 -2,000 20,150 66,250 9,000 9,000 9,000 9,000 9,000 Year 1 $ Year 2 $ Year 3 $ Year 4 $ Year 5 $

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Discounted Cash Flow 75,250 28,910 26,831 24,902 23,111 13,875

Total Present Value (PV) = $192,880

Option B

Capital Cost Maintenance Variable Costs ($8.03 x 2,500) Residual Value Cash Flow Discount Factor @ 7.75% Discounted Cash Flow

75,000 5,000 5,000 5,000 5,000 5,000

20,075

20,075

20,075

20,075

20,075 -2,200

80,000

25,075

25,075

25,075

25,075

17,875

1.0 80,000

0.9281 23,320

0.8614 21,565

0.7994 20,060

0.7419 18,555

0.6886 12,334

Total Present Value (PV) = $175,834 Option B has the highest capital cost but is preferred because the NPC is lower than Option A. Note: If inflation is included in the appropriate data, the same NPC above will also result

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Annex B To Bid Analysis Evaluation Best Practice

COMPARISON OF PURCHASE OPTIONS FOR EQUIPMENT WITH DIFFERENT EXPECTED LIVES The net present cost is useful for comparing alternatives which have the same expected life or where the cash flow profiles can be extended to the same time period. (e.g. In comparing option C and D where option C has an expected life of 4 year and option D has an expected life of 8 years it may be possible to extend the cash flow profile of option C to 8 years by replacement of the equipment after 4 years). Alternatively and more practical when comparing several options which have different expected lives, is to use the common factor of equivalent annual costs. The equivalent annual cost (EAC) is calculated as follows: EAC (Annuity Cost*) Where: N = life in years of the option R = Rate of discount * Annuity Cost can be found in Present Cost and Annuity Cost Tables An example in the use of this technique is shown on the next page where the supplier of option A has guaranteed to buy back the equipment after 4 years for $15,000 and all other assumptions in the first example in Annex A remain the same. If discount tables are not available, the following formula can be used to establish the appropriate discount factor. 1 (1 + r)n
100

Net Present Value Present Cost of $1. per annum for N years at R%

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n = no. of years r = discount rate Spreadsheets such as Excel and Lotus are available to compute these calculations.

An example of the calculation is: If the discount rate is 7.75%, the discount factor can be calculated as follows: Year 1 1/1.0775 Year 2 1/(1.0775)2 Year 3 1/(1.0775)3 Year 4 1/(1.0775)4 Year 5 1/1/0775)5

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Option A Year 0 Year 1 Year 2 Year 3 Year 4

Capital Cost Maintenance Variable Costs ($8.86 x 2,500) Residual Value Cash Flow Discount factor @ 7.75% Discounted Cash Flow

66,250 9,000 9,000 9,000 9,000 9,000

22,150

22,150

22,150

22,150 -15,000

75,250

31,150

31,150

31,150

7,150

1.00000 75,250

0.9281 28,910

0.8614 26,831

0.7994 24,902

0.7419 5,305

Total Present Value = $161,198

EAC factor for 4 years at 7.75% is 3.33 i.e. 0.9281 + 0.8614 + 0.7994 + 0.7419 (the sum of the discount factors for years 1 to 4)

The EAC of option A = $161,198 = $48,408 3.33 Option B

Capital Cost

75,000

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Maintenance Variable Costs ($8.03 x 2,500) Residual Value Cash Flow Discount Factor @ 7.75% Discounted Cash Flow 1.00000 80,000 0.9281 23,272 0.8614 21,600 0.7994 20,045 0.7419 18,603 0.6886 12,309 80,000 25,075 25,075 25,075 25,075 20,075 20,075 20,075 20,075 20,075 -2,200 17,875 5,000 5,000 5,000 5,000 5,000

Total Present Value = $175,829

EAC factor for 5 years @ 7.75% is 4.02 (i.e. 0.9281 + 0.8614 + 0.7994 + 0.7419 + 0.6886 (the sum of the discount factors for years 1 to 5)

The EAC of Option B = $175,829 = $43,738 4.02

The EAC for option B - $43,738 is less than the EAC for option A - $48,408 and therefore is preferable

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