Go over Exam 1:

Parts of Chapters 5,6, 7, 9 Lecture Is a single investment a good

investment or not?

Weve looked at basic accounting, cost estimating, and mathematical

techniques to evaluate cash flows.

Now, well learn how to evaluate a single project to see if it is an

acceptable investment for a company.

Give out handout:

Case study (Read, 5 minutes, 5 minute discussion in groups of 2,3 or

4):

Stadium Expansion Project Case Study

The WVU athletic department is considering adding 20 luxury boxes that seat 40
people each to the stadium. To add the boxes, 1000 current seats would need to be
removed.

Is this a good investment?

What information do you need to decide this?

$8,000,000 initial investment for construction costs

Removes 1000 $40 seats (concessions lost per game = $10 per seat, assume
6 home games a year)
Adds 20 luxury boxes seats 40 people each
Each luxury box owner pays $200,000 up front, plus $50,000 a year for use
including catering costs and special events
Assume life of 20 years
Construction can be completed in the off-season---all games covered
Assume down payment on 18 boxes are paid for as construction begins
Assume 90% occupancy rate throughout the life of the project.
WVU is happy with a 8% return on investment for this project
Is this a good investment?
Can owners for the boxes be found?
How would a high inflation rate over the 20 years affect the numbers in your
analysis? Construction costs remain the same, but the future benefits
increase even more.

How would you use this information to decide whether this was a good investment?
Case study (Read, 5 minutes class, 5 minutes):

Gold technologies, Pittsburgh plant, are an old plant that has been around for
60 years. The electrical engineer in charge has a dangerous situation that is
occurring in the plant. A 40 year old transformer is dripping a liquid and tests
show that the liquid has PCBs in it and that the liquid is considered a
hazardous material by federal regulations. The transformer needs to be
replaced. Due to the hazardous nature of this liquid, the companys
maintenance crews are not qualified to handle this material. The EE in
charge will have to hire an outside contractor to replace the transformer with
a new one and clean up the contaminated area. What is the cost of handling
this situation?

This is an example of a cost only project. It has to be done, find the lowest
cost.

Get quotes for cleanup and replace Quote 1 = 5000 Quote 2 = 4800

New transformer: from purchasing/supplier $3000

In house labor to manage contractor: 1000

Total 4800+ 3000+ 1000 = 8800

Asking for money----Who Signs off:

If the total investment is . . .

Then approval is
More than But less than
through

$50 $5,000 Plant manager

$5,000 $50,000 Division vice pre

$50,000 $125,000 President

$125,000 -- Board of director

 Leasing and signoff authority example:

A plant manager may get around sign off authority by leasing rather
than buying (with upfront investment greater than the managers
signature authority)

If the total investment is . . .

Then approval is
More than But less than
through

$50 $5,000 Plant manager

Managers will you leasing to get around signoff authority.

Buying a high quality Copying Machine $12,000

Lease it for 400/month = 4800/year Leasing may include maintenance plan,

new copier every x years, etc.

Sign one year lease----the idea is to renew the lease each year.

Asking for money----the corporate capital budgeting process:

The projects are diverseneed standard process to evaluate

Initial investment for startup

Investments after startup

from setting up a meeting room, $7500

to new product development, $5 Million

new facilities, add-on to current facility, $20 Million

new ERP software, $1 Million, depends on size of

company

new machinery, $600,000

marketing program, $500,000

new office equipment, $100,000

Company cars, $25,000

Companys have standard forms/spreadsheets that are required to be
filled out and formal presentations/signoffs.

How are we going to determine if an individual investment is acceptable?

Five methods used to evaluate whether a single project is a good

investmentdifferent companies use different methods:

The first 3 methods use an interest rate, known as the Minimum Rate of
Return (MARR) or hurdle rate, to move the proposed problem solution to an
equivalent at some point in time.

Present Worth (PW) Chapter 5 p151

Special case: Capital Cost---Endowments

Future Worth (FW) Chapter 9 p299

Annual Worth (AW) Chapter 6 p 189

The next method calculates the rate of return for the project and compare it
to the MARR.

Internal Rate of Return (IRR) Chapter 7 page 219

A last method, called Payback period, is also covered in this chapter and is
often used as a rough gauge as to whether an investment is good or not.
This method ignores the time value of money. Chapter 9 page 309

Minimum Attractive Rate of Return (MARR) or Hurdle Rate:

This rate of return is determined by top management of an organization.

This is the rate of return that is required by the company for its investments.

The rate of return is determined by:

Companys demand for money

Availability and cost of money from banks, potential shareholders and

other sources of money

Later on we will look at some of the techniques to calculate this.

Evaluation methods:

The Present Worth Method:

Find the equivalent worth of all cash flows relative to the present.

Example 1:

Consider a project that has an initial investment of $50,000 and

that returns $18,000 per year for the next four years. If the
MARR is 12%, is this a good investment?

PW = -50,000 + 18,000 (P/A, 12%, 4)

PW = -50,000 + 18,000 (3.0373)

PW = $4671.40 this investment returns the required 12% plus

more. This is a good investment.

If PW > 0 then the investment got the required rate of return

plus more (good)

If PW = 0 then the investment got the required rate of return

(good investment)

If PW < 0 didnt get the required rate of return (bad

investment)

The Future Worth Method:

Find the equivalent worth of all cash flows relative to a future point in time.

Example:
 A $45,000 investment in a new conveyor system is projected to
improve throughput and increasing revenue by $14,000 per year for
five years. The conveyor will have an estimated market value of
$4,000 at the end of five years. Using FW and a MARR of 12%, is this a
good investment?

N in cash flow diagram should be 5

years, not 4 years

FW = -$45,000(F/P, 12%, 5)+

$14,000(F/A, 12%, 5)+$4,000

FW = -$45,000(1.7623)+
$14,000(6.3528)+$4,000

FW = $13,635.70 This is a good

investment!

FW = or > 0 (good investment)

FW < 0 (bad investment)

The Annual Worth Method

Find the equivalent worth annuity of all cash flows

Example:

A project requires an initial investment of $45,000, has a salvage value of

$12,000 after six years, incurs annual expenses of $6,000, and provides
annual revenue of $18,000. Using a MARR of 10%, determine the AW of this
project.
 Can combine the 18000 in rev and 6000 in expenses for 12000 a year----re-
draw diagram

AW (10%) = -45000 (A/P, 10%, 6) + 12000 + 12000 (A/F, 10%, 6)

= -45000(.2296) +12000 + 12000(.1296)

= -10332 12000 + 1555

= $3223 since the AW is positive, its a good investment.

AW = or > 0 (good investment)

AW< 0 (bad investment)

Homework for practice:

Ch 5 15,18, 22 PW

Ch 6 10, 12, 32 use 5% Marr---Marr not in book AW

Ch 9 22 FW

Ch 5 28 Capitalized Cost