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This chapter will present an overview of the decision process for economic evaluation
of facilities with regard to the project life cycle. The cycle begins with the initial
conception of the project and continues though planning, design, procurement,
construction, start-up, operation and maintenance. It ends with the disposal of a
facility when it is no longer productive or useful. Four major aspects of economic
evaluation will be examined:
2. Methods of economic evaluation, including the net present value method, the
equivalent uniform annual value method, the benefit-cost ratio method, and the
internal rate of return method.
3. Factors affecting cash flows, including depreciation and tax effects, price level
changes, and treatment of risk and uncertainty.
In setting out the engineering economic analysis methods for facility investments, it is
important to emphasize that not all facility impacts can be easily estimated in dollar
amounts. For example, firms may choose to minimize environmental impacts of
construction or facilities in pursuit of a "triple bottom line:" economic, environmental
and social. By reducing environmental impacts, the firm may reap benefits from an
improved reputation and a more satisfied workforce. Nevertheless, a rigorous
economic evaluation can aid in making decisions for both quantifiable and qualitative
facility impacts.
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5. Establish the criterion for accepting or rejecting a proposal, or for selecting the
best among a group of mutually exclusive proposals, on the basis of the
objective of the investment.
It is important to emphasize that many assumptions and policies, some implicit and
some explicit, are introduced in economic evaluation by the decision maker. The
decision making process will be influenced by the subjective judgment of the
management as much as by the result of systematic analysis.
The period of time to which the management of a firm or agency wishes to look ahead
is referred to as the planning horizon. Since the future is uncertain, the period of time
selected is limited by the ability to forecast with some degree of accuracy. For capital
investment, the selection of the planning horizon is often influenced by the useful life
of facilities, since the disposal of usable assets, once acquired, generally involves
suffering financial losses.
(6.1)
where At,x is positive, negative or zero depends on the values of B t,x and Ct,x, both of
which are defined as positive quantities.
Once the management has committed funds to a specific project, it must forego other
investment opportunities which might have been undertaken by using the same funds.
The opportunity cost reflects the return that can be earned from the best alternative
investment opportunity foregone. The foregone opportunities may include not only
capital projects but also financial investments or other socially desirable programs.
Management should invest in a proposed project only if it will yield a return at least
equal to the minimum attractive rate of return (MARR) from foregone opportunities
as envisioned by the organization.
In general, the MARR specified by the top management in a private firm reflects
the opportunity cost of capital of the firm, the market interest rates for lending and
borrowing, and the risks associated with investment opportunities. For public projects,
the MARR is specified by a government agency, such as the Office of Management
and Budget or the Congress of the United States. The public MARR thus specified
reflects social and economic welfare considerations, and is referred to as the social
rate of discount.