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StevenF.F.F.Barrett,
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Fundamentals of
Fundamentals of
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Fundamentals ofEngineering
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Engineering Economics
Engineering Economics
FUNDAMENTALS OF
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FUNDAMENTALS OF ENGINEERING
Economicsand
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David
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E.Terry,
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Steven
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Fundamentals of
Engineering Economics
and Decision Analysis
Synthesis Lectures on
Engineering
Editor
Steven S. Barrett, University of Wyoming
Fundamentals of Engineering Economics and Decision Analysis
David L. Whitman and Ronald E. Terry
2012
A Little Book on Teaching: A Beginners Guide for Educators of Engineering and Applied
Science
Steven F. Barrett
2012
Engineering Thermodynamics and 21st Century Energy Problems: A Textbook Companion
for Student Engagement
Donna Riley
2011
MATLAB for Engineering and the Life Sciences
Joseph V. Tranquillo
2011
Systems Engineering: Building Successful Systems
Howard Eisner
2011
Fin Shape Thermal Optimization Using Bejans Constructal Theory
Giulio Lorenzini, Simone Moretti, and Alessandra Conti
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Geometric Programming for Design and Cost Optimization (with illustrative case study
problems and solutions), Second Edition
Robert C. Creese
2010
Survive and Thrive: A Guide for Untenured Faculty
Wendy C. Crone
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Geometric Programming for Design and Cost Optimization (with Illustrative Case Study
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Robert C. Creese
2009
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DOI 10.2200/S00410ED1V01Y201203ENG018
Lecture #18
Series Editor: Steven S. Barrett, University of Wyoming
Series ISSN
Synthesis Lectures on Engineering
Print 19395221 Electronic 1939523X
Fundamentals of
Engineering Economics
and Decision Analysis
David L. Whitman
University of Wyoming
Ronald E. Terry
Brigham Young University
M
&C Morgan & cLaypool publishers
ABSTRACT
The authors cover two general topics: basic engineering economics and risk analysis in this text.
Within the topic of engineering economics are discussions on the time value of money and
interest relationships. These interest relationships are used to define certain project criteria that are
used by engineers and project managers to select the best economic choice among several alternatives.
Projects examined will include both income and serviceproducing investments. The effects of
escalation, inflation, and taxes on the economic analysis of alternatives are discussed. Risk analysis
incorporates the concepts of probability and statistics in the evaluation of alternatives. This allows
management to determine the probability of success or failure of the project. Two types of sensitivity
analyses are presented.The first is referred to as the range approach while the second uses probabilistic
concepts to determine a measure of the risk involved. The authors have designed the text to assist
individuals to prepare to successfully complete the economics portions of the Fundamentals of
Engineering Exam.
KEYWORDS
engineering economics, time value of money, net present value, internal rate of return,
cash flow analysis, probability, statistics, risk analysis
vii
Contents
Preface . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xiii
1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
1.1 Engineering Economics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
1.1.1 Basic Engineering Economics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
1.1.2 Risk Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
1.2 Decision Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
1.3 Fundamentals of Engineering Exam . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Preface
Those individuals working on the development of an incomegenerating project, either for personal
use or company use, are frequently called upon to determine if the endeavor will prove profitable if
fully developed. By profitable, we simply mean that the project will provide a desirable rate of return
on investment through the generation of revenue that offsets any capital and/or operating costs.
The intent of this book is to provide individuals with the tools to evaluate projects to determine
profitability.The subject has been called: Engineering Economics or Project Evaluation or Economic
Evaluation or Decision Analysis. Whatever one chooses to call it, the reader who studies this material
and becomes proficient in its content, will be able to analyze project cash flows and make a decision
as to the profitability of the project. The authors, mainly because of their engineering backgrounds,
have chosen to refer to the subject matter as engineering economics.
In addition to incomegenerating projects, this book will also assist those individuals who are
analyzing two or more ways of doing a serviceproducing project. A serviceproducing project is
one, that instead of generating income for the investor, provides a service at a cost to the investor.
An example could be the renting versus purchasing of a vehicle to provide a needed service for a
company.
The authors cover two general topics: basic engineering economics and risk analysis in the
text. Chapters 26 contain content relative to basic engineering economics and Chapters 79 present
material on risk analysis.
Within the topic of engineering economics are discussions on the time value of money and
interest relationships. These interest relationships are used to define certain project criteria that are
used by engineers and project managers to select the best economic choice among several alterna
tives. Projects examined will include both income and service producing investments. The effects of
escalation, inflation, and taxes on the economic analysis of alternatives are discussed.
There is always risk involved in undertaking a project. Risk analysis incorporates the concepts
of probability and statistics in the evaluation of alternatives. This allows management to determine
the probability of success or failure of the project. Two types of sensitivity analyses are presented. The
first is referred to as the range approach while the second uses probabilistic concepts to determine a
measure of the risk involved.
The authors have designed the text to assist individuals to prepare to successfully complete
the economics portions of the Fundamentals of Engineering Exam.
xiv PREFACE
The authors wish to thank Joel Claypool and his associates at Morgan & Claypool for their
encouragement and excellent work on the preparation and production of this text.
CHAPTER 1
Introduction
1.1 ENGINEERING ECONOMICS
Nearly all projects that are proposed to be undertaken by any engineering firm will be, at some point,
subjected to close economic scrutiny. The results of this analysis will be a basis (perhaps one of many)
for deciding whether or not to proceed with the project. The major emphasis of this text, therefore,
is to provide the engineer with the tools necessary to make the aforementioned economic decision.
There are two general topics which are included in this textbook: basic engineering economics
and risk analysis. A very brief overview of each of these topics is presented in the following paragraphs.
CHAPTER 2
Example 2.1
Consider the example of a 3year auto loan from the view of the lender. The lender provides
$20,000 to the client (a negative cash flow for the lender) at month 0 at an interest rate of 0.5% per
month. In exchange, the lender receives $608 per month from the client over the next 36 months.
The resulting cash flow diagram would be:
0 1 2 3 34 35 36
Before equations can be developed that relate the time value of money, it is necessary to define
a set of notations that will be used throughout the text.
P = Present sum of money. The present (time zero) is defined as any point from which the
analyst wishes to measure time.
F = Future sum of money. The future is defined as any point n that is greater than time zero.
A = Annuity. This is a uniform set of equal payments that occur at the end of each interest
period from one to n.
G = Uniform gradient. This is a series of payments that uniformly increase or decrease over
the life of the project.
i = Compound interest rate per period.
n = Total number of compounding periods in the cash flow diagram.
The cash flow diagrams that follow should help to define these sums of money.
8 2. INTEREST AND THE TIME VALUE OF MONEY
Present, P :
0 1 2 3 n2 n1 n
P
Future, F :
0 1 2 3 n2 n1 n
F
Annuity, A:
0 1 2 3 n2 n1 n
A A A A A A
Gradient, G:
0 1 2 3 n2 n1 n
F = P (1 + i)n (2.4)
The factor (1 + i)n is frequently called the Single Payment Compound Amount Factor and
is symbolized in this text by (F /P )i,n . If one is given the amount of P , one uses the (F /P )i,n factor
to find the equivalent value of F . That is,
F = P (F /P )i,n (2.5)
Similarly, if a future amount, F , is known and it is desired to calculate the equivalent present amount,
P , then Equation 2.4 can be arranged as:
P = F (1 + i)n (2.6)
The factor (1 + i)n is frequently called the Single Payment Present Worth Factor and is symbolized
in this text by (P /F )i,n . If one is given the amount of F , one uses the (P /F )i,n factor to find the
equivalent value of P . That is,
P = F (P /F )i,n (2.7)
10 2. INTEREST AND THE TIME VALUE OF MONEY
2.5.2 UNIFORM SERIES (ANNUITIES)
It is often necessary to know the amount of a uniform series payment, A, which would be equivalent
to a present sum, P , or a future sum, F . In the following formulas that relate P , F , and A, it is
imperative that the reader understands that: 1) P occurs one interest period before the first value
of A; 2) A occurs at the end of each interest period; and 3) F occurs at the same time as the last A
(at time n). These relationships were illustrated in the previous cash flow diagrams that originally
defined each of them.
The value of a future sum, F , of a series of uniform payments, each of value A, can be found
by summing the future worth of each individual payment. That is, treat each A as a distinct present
value (but with a different time zero) and use (F /P )i,n to calculate its contribution to the total F :
F (1 + i) = A(1 + i)n + A(1 + i)n1 + A(1 + i)n2 + . . . + A(1 + i)2 + A(1 + i) (2.9)
F (1 + i) F = A(1 + i)n A
The term in the {} brackets is called the Uniform Series Compound Amount Factor and is symbolized
by (F /A)i,n . If one is given the amount of A, one uses the (F /A)i,n factor to find the equivalent
value of F . That is,
F = A(F /A)i,n (2.11)
Rearranging Equation 2.10 and solving for A yields
The term in the { } brackets is called the Sinking Fund Factor and is symbolized by (A/F )i,n . If one
is given the amount of F , one uses the (A/F )i,n factor to find the equivalent value of A. That is,
Substitution of Equation 2.10 into Equation 2.6 yields Equation 2.14 which contains the Uniform
Series Present Worth Factor, (P /A)i,n in the {} brackets:
0 1 2 3 n2 n1 n
Without derivation, Equations 2.18, 2.20, and 2.22 can be developed that relate the gradient,
G, to an equivalent annuity, an equivalent present sum, and an equivalent future sum:
A = G{1/i n/[(1 + i)n 1]} (2.18)
The term in the { } brackets is symbolized by (A/G)i,n . If one is given the amount of G, one uses
the (A/G)i,n factor to find the equivalent value of A. That is,
A = G(A/G)i,n (2.19)
P = G{[(1 + i)n 1]/[i 2 (1 + i)n ] n/[i(1 + i)n ]} (2.20)
The term in the { } brackets is symbolized by (P /G)i,n . If one is given the amount of G, one uses
the (P /G)i,n factor to find the equivalent value of P . That is,
P = G(P /G)i,n (2.21)
F = G{[(1 + i)n 1]/i 2 n/ i} (2.22)
The term in the { } brackets is symbolized by (F /G)i,n . If one is given the amount of G, one uses
the (F /G)i,n factor to find the equivalent value of F . That is,
F = G(F /G)i,n (2.23)
12 2. INTEREST AND THE TIME VALUE OF MONEY
The equations for the nine factors are given in Table 2.2 and numerical values are tabulated
in Appendix A for various values of interest rate, i, and number of periods, n so that the user can
look them up rather than use the actual formulas.
Rather than memorizing which factor is needed for a specific equivalency, think about the
formulas in terms of units conversion. That is, if the input to a system has units of X and the output
of that system has units of Y, the system provides a units conversion of (Y/X). Thus, if one is given
A (input) and wants to find G (output), the correct formula to use would be (G/A). Knowing the
value of the interest rate and the number of periods, one can look up or compute the value of the
formula.
Uniform Series
to F given A (F / A) i,n (1 + i) n1
Compound Amount i
i (1 + i) n
Capital Recovery to A given P (A/ P) i,n
(1 + i) n1
Uniform Gradient
(F / G) i,n (1 + i) n1 n
to F given G 
Future Value i2 i
Uniform Gradient
1 n
Uniform Series to A given G (A / G)i,n 
i (1 + i) n1
2.5. INTEREST FORMULAS FOR DISCRETE COMPOUNDING 13
2.5.4 THE USE OF FINANCIAL FUNCTIONS IN EXCEL
Many cash flow situations can be simulated by using a spreadsheet such as Microsoft Excel. This
will become more evident in future chapters, but this chapter presents the following useful financial
functions:
Unfortunately, Excel does not have a builtin function for gradienttype cash flows. That
can, however, be overcome with functions that will be presented in later chapters.
In each of these functions, the variables are as follows:
type is 0 for end of period cash flows and 1 for beginning of period cash flows
It should also be noted that in order to use these functions as equivalents for (P /A), (P /F ),
etc., the values of pmt, pv, and fv need to be input as negative numbers.
An example of a simple Excel spreadsheet that computes the six functions given above is
shown for 10% annual interest rate for 10 years. The actual formulas are shown as well. Recall that
one needs to set type equal to zero to designate that the cash flows occur at the end of each period.
An explanation of the values in the various Excel formulas may be necessary. For example, in the
formula that computes F/A (cell B7), the values are as follows: B1 is the interest rate as a fraction,
B2 is for 10 periods, B3 is for an annual annuity payment of $1 per year, 0 represents the fact
that there is no present value payment, and B6 defines that the various payments are at the end of
the period. Since the formula finds the future value of a $1 annuity, we have effectively computed
(F/A). Some additional Excel financial functions that might be of some interest at this point are:
14 2. INTEREST AND THE TIME VALUE OF MONEY
A B A B
1 rate 0.1 1 rate 0.1
2 nper 10 2 nper 10
3 pmt(A) 1 3 pmt(A) 1
4 pv (P) 1 4 pv(P) 1
5 fv (F) 1 5 fv(F) 1
6 type 0 6 type 0
7 F/A 15.937 7 F/A =FV(B1,B2,B3,0,B6)
8 F/P 2.5937 8 F/P =FV(B1,B2,0,B4,B6)
9 P/A 6.1446 9 P/A =PV(B1,B2,B3,0,B6)
10 P/F 0.38554 10 P/F =PV(B1,B2,0,B5,B6)
11 A/P 0.16275 11 A/P =PMT(B1,B2,B4,0,B6)
12 A/F 0.062745 12 A/F =PMT(B1,B2,0,B5,B6)
The effective interest table for 10% nominal interest rate can be created in Excel as follows
(note that in the case of continuous compounding, npery=1,000,000 is close enough to give the
answer to the desired number of significant digits).
One can compare Table 2.3 with Table 2.1 to see consistency between the calculations in
Excel and those performed with the specific formula for ieff .
The NPER function is useful for determining how many compounding periods are necessary
to achieve a desired result. For example, one might want to determine how many years it will take
for an original investment to double in value if the interest rate is varied from 1% per year to 25%
per year. This is shown in Table 2.4.
The explanation of the values in the NPER formulas in Table 2.4 is as follows: A3/100
represents the interest rate as a fraction, 0 is for no annuity payment, 1 is for a present value
amount of $1, 2 is for a future value of $2, and 0 defines the amounts as end of year payments.
One can also note that the product of the interest rate (as a percentage) and the # of periods to
double the value of the investment varies from 70 to 75. This is commonly known as the Rule of
2.5. INTEREST FORMULAS FOR DISCRETE COMPOUNDING 15
Table 2.3: Using Excel to compute effective interest rates for a nominal 10%
interest rate.
Table 2.4: Using Excel to compute the number of years needed to double the value of
an initial investment.
72. If one takes 72 and divides by the interest rate (as a percentage), the resultant value is a close
approximation of how long it will take for an investment to double.
Example 2.2
If $10,000 is invested in a fund earning 15% compounded annually, what will it grow to in 10
years?
Solution: F = P (F /P )i,n = 10, 000(F /P )15,10 = 10, 000(4.0456) = $40, 456
16 2. INTEREST AND THE TIME VALUE OF MONEY
Example 2.3
It is desired to accumulate $5,000 at the end of a 15year period. What amount needs to be
invested if the annual interest rate is 10% compounded semiannually? Assume the given interest
rate is a nominal rate and that the principal is compounded at 5% per period.
Solution: P = F (P /F )i,n = 5, 000(P /F )5,30 = 5000(0.23138) = $1, 157
Example 2.4
What interest rate, compounded annually, will make a uniform series investment (at the end
of each year) of $1,000 equivalent to a future sum of $7,442? The investment period is 5 years.
Solution: F = A(F /A)i,n 7, 442 = 1, 000(F /A)i,5 (F /A)i,5 = 7.442
Example 2.5
An individual wishes to have $6,000 available after 8 years. If the interest rate is 7% com
pounded annually, what uniform amount must be deposited at the end of each year?
Solution: A = F (A/F )i,n = 6, 000(A/F )7,8 = 6, 000(0.09747) = $585
Example 2.6
An individual wishes to place an amount of money in a savings account and, at the end of
one month and for every month thereafter for 30 months, draw out $1,000. What amount must be
placed in the account if the interest rate is 12% (nominal rate) compounded monthly?
Solution: i(monthly) = 0.12/12 = 0.01(1%)
P = A(P /A)i,n = 1, 000(P /A)1,30 = 1, 000(25.808) = $25, 808
Example 2.7
A principal of $50,000 is to be borrowed at an interest rate of 15% compounded monthly for
30 years. What will be the monthly payment to repay the loan?
Solution: i (monthly) = 0.15/12 = 0.0125(1.25%). Since Appendix A does not contain a
table for that interest rate, one must use the formulas.
Example 2.9
Calculate the future worth of the following 6year cash diagram if the interest rate is 10%
compounded annually.
0 1 2 3 4 5 6
There are a number of ways to solve this economic problem, which is the case for most cash
flow evaluations. One technique might be shorter in terms of the number of formulas to look up or
calculate, but all will result in the same answer.
Solution 1:
Note that this series of cash flows can be broken into an annuity of $1,000 per year and a
gradient of $200 per year. One can compute the future value of each of these contributions separately
and then add to get the final result.
Solution 3:
Treat each cash flow as an individual, single payment, find the future value of each individual
payment and then add to get the total future value.
Example 2.10
Calculate the present worth of the following 10year cash flow diagram if the annual interest
rate is 20% compounded annually.
0 1 2 3 8 9 10
Solution: Again, there are a variety of methods to solve this problem. One technique is to
recognize that the cash flow is made up of an annuity of $2,000 and a gradient of $100.
2.7 PROBLEMS
2.1. Given a nominal rate of 20%, what is the effective annual interest rate if the interest is
compounded under each of the following scenarios:
(a) Quarterly
(b) Monthly
(c) Daily
(d) Continuously
2.2. What is the percentage difference between the effective rates determined by annual and
continuous compounding for nominal interest rates of:
(a) 10%
(b) 20%
(c) 30%
2.3. A company has decided to invest in a project to make a product. The initial investment cost
will be $1,000,000 to be spread over the first two years with $700,000 in the first year and
$300,000 in the second. The plan calls for producing products at the following rates: 5,000
units in year 2; 10,000 in year 3; 30,000 in year 4; 30,000 in year 5; $10,000 in year 6; and
$5,000 in year 7. Products will be sold for $50 each throughout the life of the project and
cash operating expenses will be $60,000 per year for years 2 through 7. Construct a cash
flow diagram for the project.
2.7. PROBLEMS 21
2.4. Example 2.1 presented a cash flow diagram for an automobile loan as seen through the eyes
of the lender. Construct the corresponding cash flow diagram as seen through the eyes of
the borrower.
2.5. A $1,000 investment has grown to $2,476 in 8 years. What interest rate (compounded
annually) has it earned?
2.6. What present sum is equivalent to a future sum of $25,000 (after 5 years) at an interest rate
of 8% compounded annually?
2.7. If $200 is placed at the end of each year for 10 years in an account earning 7% interest
compounded annually, what amount will be accumulated at the end of 10 years?
2.8. What uniform series would be equivalent to a future sum of $10,000 if the series extends
for 10 years and earns 12% interest compounded semiannually?
2.9. An annual deposit of $1,000 is placed in an account at the beginning of each year for 5 years.
What is the present value of that series if interest is 12% compounded annually? What is
the future value at the end of the 5th year?
2.10. What will be the future value, 10 years from the first payment, of the series of deposits in
problem 2.9?
2.11. What monthly car payments for the next 30 months are required to amortize a loan of
$4,000 if interest is 12% compounded monthly?
2.12. Payments of $1,000 are to be made at the end of each year for the next 3 years. What is the
present worth of the three payments if interest is 12% compounded monthly? What series
of monthly payments would be equivalent to the $1,000 year payments?
2.13. An individual agrees to lease a building to a firm with yearly payments shown on the cash
flow diagram below. What is the future worth of the payments if interest is 15% compounded
annually?
0 1 2 3 4 5 6 7 8 9 10
3000 3000 3000 3000 3300 3600 3900 4200 4500 4800
2.14. An engineer wishes to buy a house but can only afford monthly payments of $1500. 30
year loans are available at 5.75% interest compounded monthly. If the engineer can make
a $20,000 down payment, what is the price of the most expensive house that the engineer
can afford to purchase?
22 2. INTEREST AND THE TIME VALUE OF MONEY
2.15. A young woman placed $200.00 in a savings account paying monthly interest. After one
year, her balance has grown to $214.00. What was the effective annual interest rate? What
was the nominal annual interest rate?
2.16. Find the value of cash flow X that will make the two cash flows equivalent. Interest is 10%
compounded annually. Time on the diagram is given in years.
0 1 2 3 4 5 6
0 1 2
X X X
2.17. It takes a full $10,000 to put on a Festival of Laughingly Absurd Walks (FLAW) each year.
Immediately before this years FLAW, the sponsoring committee finds that it has $40,000
in an account paying 15% interest compounded annually. After this year, how many more
FLAWs can be sponsored without raising more money?
2.18. If $10,000 is borrowed at 12% interest compounded monthly, what would the monthly
payments be if the loan is for 5 years? What would the annual payment be if the loan is for
5 years? Assume all payments occur at the end of a given period.
2.19. Calculate the value of the following cash flow diagram at the end of year 4. Interest is 10%
per year compounded annually.
0 1 2 3 4 5 6 7 8 9 10
(a) Annual interest is 10% compounded continuously and payments are received at the
end of each year
(b) Annual interest is 10% compounded continuously and payments are received contin
uously over the year
2.22. A gas station sells $125,000 worth of gasoline over the course of a year. If this revenue is
collected and deposited continuously into an account that earns 8% interest, compounded
annually, how much money would the station have in its account at the end of the year?
2.23. Develop an Excel spreadsheet that computes the six functions (P /A), (P /F ), (F /A),
(F /P ), (A/P ), (A/F ) for a fixed interest rate and the number of periods ranging from
1 to 100.
2.24. Use the Excel NPER function to determine how long it will take for an investment to
triple in value at interest rates of 1%, 5%, 10%, 15%, 20%, and 25%. Can you determine
an approximate Rule for how to quickly calculate how long it takes for an investment to
triple in value?
25
CHAPTER 3
1,000,000
B:
0 1 2 3 18 19 20
Since there are no cash flows for A after period 0, the present value of cash flow A is simply
$1,000,000. For B, since the $100,000 occurs at the end of each period for 20 periods, multiplying
the $100,000 by (P /A)i,20 will yield a present value for the interest rate used in the formula. For
example, if the interest rate is 12% per year, the present value would be $746,944. If the question
which cash flow represents the largest present value? is asked, the answer is obviously cash flow A.
Now consider a different question. Suppose you have just won a lottery and you have a choice
of receiving $1,000,000 now or receiving $100,000 at the end of each year for 20 years. If interest
is expected to be constant at 12% for the next 20 years as in the previous paragraph, which set of
payments would you prefer? Since this question is represented by the cash flow diagrams shown
above and the interest rate of 12%, the choice can be made by analyzing the present values of the two
cash flow diagrams. Since cash flow A yields a larger present value than cash flow B at an interest
rate of 12%, the proper choice would be to accept option A.
26 3. PROJECT EVALUATION METHODS
However, what if the interest rate is expected to be 0% over the 20 year period? What would
the best choice be under that scenario? If interest is 0%, then money is worth the same no matter
when it occurs. At 0% interest, the present value of cash flow B becomes $2,000,000 and cash flow
B becomes the correct choice.
The discussion in the previous two paragraphs infer that at some interest rate between 0%
and 12%, the two cash flow diagrams are equivalent. A trial and error solution yields this interest
rate to be about 7.75%.
This discussion has just introduced two of the more popular techniques (equivalence methods
and rate of return methods) used to evaluate the financial value of projects and help the evaluator
choose between multiple projects. These will be discussed in more detail later in this chapter.
0 1 2 3 4 5
Since the N P V is greater than zero, this project would be an acceptable one to the investor.
An alternative method to calculate the NP V is to treat each individual cash flow as a future
value at various values of n. While this technique might require more formulas than recognizing
annuities and gradients in the cash flow diagram, it will always yield a correct value for NP V :
In Excel , one can use the NP V function to make the same calculation. However, some
caution is necessary.
The function is: = NP V (rate, value1, value2, ).
One can see that the NPV function does not include the investment period 0. Therefore, in order
to calculate the N P V of the entire cash flow diagram, one needs to include the initial investment.
For example, the complete Excel formula to compute the NP V of a series of cash flows would be
as shown in Figure 3.1:
= CF0 + NP V (rate, value1, value2,)
One can see that the results from Excel match the NP V calculations from the other two
methods.
Example 3.2
Consider the project represented by the following cash flow diagram. The project requires an
initial investment of $1,000 that returns positive cash flows as shown. The MARR is 10%.
0 1 2 3 4 5
A B A B
1 MARR = 10% 1 MARR = 0.1
3 Year CF 3 Year CF
4 0 1000 4 0 1000
5 1 500 5 1 500
6 2 600 6 2 600
7 3 700 7 3 700
8 4 800 8 4 800
9 5 900 9 5 900
10 10
11 NPV = 1582 11 NPV = =B4+NPV(B1,B5:B9)
Since the N P V is negative, the project will not earn the MARR and, therefore, is not accept
able to this investor. Now a question arises: What does the investor do with the $1000? Since the
timeline represents the only new investment opportunity available to the investor and the NP V
analysis suggests that it is not acceptable, the investor will choose to do nothing with the $1000.
The concept of the do nothing project will be defined in the next section.
Example 3.3
Consider the following two investment opportunities. The investors MARR is 10% and the
investor only has enough funds to invest in one of the projects. Which one should be chosen?
Project A:
0 1 2 3 4 5
Project B:
0 1 2 3 4 5
Both projects show positive values of NP V . Therefore, both would be acceptable as long as
the investor had at least $800 to invest. In addition, the do nothing alternative does not need to be
considered. If the investor only has enough funds to invest in one of the projects, the NP V values
indicate that Project B is the best economic choice.
3.6. RATE OF RETURN METHODS 31
3.6 RATE OF RETURN METHODS
The second general type of project evaluation technique involves the determination of an unknown
interest rate for a given cash flow diagram. This interest rate is usually referred to as a rate of return.
There are several rates of return that can be calculated. Two will be presented in this chapter. The
first is called the Internal Rate of Return (IRR) which is also known as the Discounted Cash Flow
Rate of Return (DCFROR). The second is the External Rate of Return (ERR) which is also known
as the Growth Rate of Return. The I RR is the rate of return earned by a particular individuals or
companys investment.The ERR represents the overall growth of invested dollars for an individual or
a company. The differences will become apparent in the following discussion and example problems.
n
n
CFj
NP V = 0 = CFj (P /F )I RR,j = (3.5)
(1 + I RR)j
j =0 j =0
It should be noted that one cannot normally solve explicitly for the I RR from Equation 3.5.
Therefore, a trial and error solution is usually required. Graphically, the relationship between NP V ,
interest rate, and I RR is demonstrated in Figure 3.2.
Once the I RR is calculated, it is then compared with the MARR. If the I RR is greater than
the MARR, the project is considered to be acceptable to the investor.
32 3. PROJECT EVALUATION METHODS
100
0
100 0 0.05 0.1 0.15 0.2 0.25
200
300
Interest Rate, fraon
Figure 3.2: General form of net present value as a function of interest rate. (Note, for this example, when
N P V = 0, the interest rate, or I RR, is 0.125.)
Example 3.4
Consider the two investment opportunities examined in Example 3.3. The investors MARR
is 10% and the investor only has enough funds to invest in one of the projects. What are the I RRs
for each project?
Project A:
0 1 2 3 4 5
As noted, the calculation of I RR usually involves a trial and error approach. While the NP V
versus interest rate curve is not a straight line, it is generally accurate enough to bracket the I RR
solution within 5% and then linearly interpolate for the answer.
Project A: N P V for Project A = 800 + 215(P /A)i,5
Interpolating for I RR: I RR = 10.0 + 15.00
15.0(79.3) (15.0 10.0) = 10.8%
Interest rate, % N P V
0.0 100.0
10.0 75.8
15.0 67.0
Interpolating for I RR: I RR = 10.0 + 75.8(67.0)
75.80
(15.0 10.0) = 12.6%. It should be
noted that Figure 3.2 was generated with the cash flows from Project B. Thus, the true answer for
I RR is 12.5% compared to the interpolated value of 12.6%.
In this example, the I RRs of both projects are greater than the investors MARR, so both
projects are acceptable. It would appear that since the I RR of Project B is greater than the I RR of
Project A, then Project B is the best alternative. This is, indeed, the proper interpretation but only
because the initial investment values for both projects were the same. One must be very careful in
ranking projects by I RR values as will be shown in Chapter 5.
A B A B
1 MARR = 10% 1 MARR = 0.1
3 Year CF 3 Year CF
4 0 800 4 0 800
5 1 100 5 1 100
6 2 100 6 2 100
7 3 100 7 3 100
8 4 100 8 4 100
9 5 900 9 5 900
10 10
11 NPV = 75.8 11 NPV = =B4+NPV(B1,B5:B9)
12 IRR = 12.5% 12 IRR = =IRR(B4:B9,0.1)
As in Figure 3.2, Excel provides the true value for I RR without the need for a trial and
error solution and without interpolating.
Example 3.5
Consider the two investment opportunities examined in Example 3.4. The investors MARR
is 10% and the investor only has enough funds to invest in one of the projects. What are the ERRs
for the projects?
Project A:
0 1 2 3 4 5
In this example, the ERRs of both projects are greater than the investors MARR, so both
projects are acceptable. It would appear that since the ERR of Project B is greater than the ERR
of Project A, then Project B is the best alternative. This is, indeed, the proper interpretation but
only because the initial investment values for both projects were the same. Again, one must be very
careful in ranking projects by ERR values as will be shown in Chapter 5.
One additional observation can be made about the relationship between MARR, I RR, and
ERR. The ERR will always lie between the MARR and the I RR. Thus,
Example 3.6
Consider the investment opportunity below. The investors MARR is 10%. What are the
N P V , I RR, and ERR values for the project?
Project A:
0 1 2 3 4 5
IRR:
Interest rate, %
NP V
10.0 369.4
20.0 90.2
30.0 100.8
25.0 13.8
Interpolating between 20% and 25%: I RR = 20.0 + 90.2(13.8)
90.20
(25.0 20.0) = 24.3%
All three economic indicators show that this project is an acceptable one.
One needs to set both the finance_rate and the reinvestment_rate to MARR. As with I RR, this
function automatically takes care of the year 0 cash flow without having to include it as a separate
term. Figure 3.4 demonstrates this formula (along with NPV and IRR) for the cash flows given in
Example 3.6.
A B A B
1 MARR = 10% 1 MARR = 0.1
3 Year CF 3 Year CF
4 0 1000 4 0 1000
5 1 500 5 1 500
6 2 500 6 2 500
7 3 200 7 3 200
8 4 500 8 4 500
9 5 500 9 5 500
10 10
11 NPV = 369.5 11 NPV = =B4+NPV(B1,B5:B9)
12 IRR = 24.3% 12 IRR = =IRR(B4:B9,0.1)
13 ERR = 16.3% 13 ERR = =MIRR(B4:B9,B1,B1)
Figure 3.4: Demonstration of the use of the N P V , I RR, and MI RR(ERR) functions in Excel .
evaluation methods used. Surveys have indicated that a vast majority of the companies polled use
I RR either by itself or in conjunction with other methods when evaluating projects. However, in
spite of the popularity of the I RR method, many evaluators still question its meaning and validity.
The basic question has to do with whether or not a reinvestment of incomes is implied in the
calculation procedure. That is, one argument is that in order for the original project investment to
earn the I RR, the positive cash flows generated by the project must be reinvested in another project
that earns the same I RR. The other argument is that reinvestment is not necessary to earn the
I RR. In fact, both arguments may be true depending on the evaluators perception of what is meant
by the phrase earning the IRR.
To begin the discussion of the reinvestment question, consider Example 3.7.
3.7. THE REINVESTMENT QUESTION IN RATE OF RETURN CALCULATIONS 39
Example 3.7
An investment of $5000 will yield $1931.45 at the end of each year for 4 years. What is the
value of the projects I RR? If the MARR is 15%, what is the projects ERR?
0 1 2 3 4
Examining the interest tables in Appendix A, one can determine that the I RR is 20.0%.
By definition, the calculation of ERR requires that the incomes be reinvested at the MARR of
15%. If the MARR had been higher, say 18%, the value of the ERR would have been higher. If
the MARR were 20%, one can show that the ERR is now equal to 20% (same as the I RR). Thus,
if the interest rate used for the reinvestment of incomes and for finding the present value of the
costs (negative cash flows) is the I RR, then the values of MARR, I RR, and ERR will be identical.
While not shown here, this can be demonstrated, mathematically, for any set of cash flows.
Now, lets expand on this example in order to determine the effect of different perceptions of
an investment earning a particular interest rate.
3.7.1 PERCEPTION #1
The first perception of an investment earning a particular interest rate parallels the concept of
investing money in a savings account for a specified period of time. In this perception, earning
means that an initial investment will yield a future value given by (F /P )i,n . Using the values from
this example, a $5000 investment earning 20% (the I RR) for 4 years should result in a future sum
of:
F = 5000(F /P )20,4 = $10, 368
However, if the individual cash flows of $1931.45 (recall that these cash flows yielded an I RR of
20%) were buried in a can under a tree (thus earning no interest), the total future accumulated
40 3. PROJECT EVALUATION METHODS
amount would be:
F = (4)(1931.45) = $7, 725.80
Since the four individual cash flows yield a future sum significantly less than $10,368, the initial
investment has not earned a 20% interest rate according to this perception of earning. In fact,
the actual rate of return would be:
However, if the individual cash flows were reinvested in an account that earned 20% interest,
the future sum accumulated in that account would be:
and the earned interest rate would indeed be 20%. Thus, in this perception, in order to earn the
I RR (20%) interest rate on the entire initial investment ($5,000), any cash flows received before the
end of the project must be reinvested in another project that has the same I RR.
3.7.2 PERCEPTION #2
The second perception more closely parallels the concept of making a loan to a project and having
that loan be paid back at some interest rate. In this perception, interest is earned only on the portion
of the total loan that is still unpaid. The unpaid portion of the loan is also known as the unamortized
portion.
Again, consider the cash flows in Example 3.7. During the first year, interest is earned on
the entire $5000 investment (or loan). The required interest amount at the calculated I RR of 20%
would be:
I1 = 5000(0.20) = $1000
This means that $931.45 can be used to payback a portion of the original investment, leaving an
unamortized amount of $4,068.55. The required interest amount in the second year would then be:
I2 = 4068.55(0.20) = $813.71
The reminder of that years cash flow, $1,117.74, would be used to further reduce the unamortized
portion of the investment to $2,950.81. Table 3.1 summarizes this sequence for the entire project
life.
Note that the total interest earned is the same as would have been earned under perception
#1 if the cash flows were not reinvested. However, banking institutions agree that this repayment
scheme has indeed earned 20% on the original loan of $5,000.
In the opinion of the authors, the final conclusion is that the question of whether reinvestment
of the cash flows at the I RR must occur or not is really more of an issue of perceiving what is meant
by earning a return. Banking institutions readily invest in projects via loans to companies or
3.8. ACCELERATION PROJECTS 41
individuals and receive the I RR as defined in perception #2 without automatic reinvestment at that
same rate. However, an individual or company that is expecting to generate a future sum of money
based on earning the I RR on the original investment for the entire life of the project must depend
on reinvestment of the cash flows at that specific I RR in order to actually have the desired future
sum.
It should be noted that, independent of the reinvestment question, I RR analysis still results
in a powerful economic evaluation tool.
Since the 5th order polynomial only has one sign change, there is only one positive value of
I RR for the cash flows in Example 3.6. Example 3.8 will demonstrate a situation where more than
one positive value exists.
3.8. ACCELERATION PROJECTS 43
Example 3.8
Given the following cash flow diagram, plot the NP V versus interest rate and determine the
two positive values of I RR that would be predicted by Descartes rule. Assume an MARR of 5%.
Solution: From the plot of NP V versus interest rate and the Excel spreadsheet, it can be
seen that there are two values for I RR: 9.1% and 57.2%. One can use Excel to find both rates of
return by adjusting the initial guess. An initial guess of 10% will yield the 9.1% value and an initial
guess of 50% will yield the 57.2% value. This creates an unfortunate situation in that one must have
an idea of the value of the larger root in order to have Excel compute it.
The 6th order polynomial that could be developed is:
I RR 6 + 5.1 I RR 5 + 9.3 I RR 4 + 5.4 I RR 3 2.7 I RR 2 3.1 I RR + 0.3 = 0
One can see that there are two sign changes in the list of terms and, therefore, two positive values
for I RR.
As mentioned before, the multiple values of IRR cause difficulties in interpretation. With a
total investment (without time value of money) of $320 and the total of the positive incomes (without
time value of money) of $290, one would be hard pressed to accept that this project earns 9.1%,
let alone 57.2%! Comparing 9.1% to the MARR of 5% would seem to indicate that this project is
acceptable.
44 3. PROJECT EVALUATION METHODS
Lets examine the ERR, NP V , and modified I RR for this project:
The modified I RR would be calculated by replacing the negative cash flows with PC calculated
above to create a new set of cash flows as follows:
0 1 2 3 4 5 6
274 90 120 80 0 0 0
Using the trial and error solution technique or Excel , the modified I RR is 2.9%.
Thus, the ERR, the modified I RR, and the NPV indicate that this project is not an acceptable
project for the investor.
In summary, acceleration projects have the potential to add another level of complexity to
the calculation of I RR in that multiple positive rates may exist. The authors strongly suggest that
evaluators utilize N P V or ERR calculations to determine the economic viability of acceleration
projects.
3.9 PAYOUT
A supplementary evaluation technique that is frequently used is payout period or simply payout.
Payout may be calculated with or without discounting although it is usually calculated without
considering the time value of money. Payout refers to the time that it takes for a project to return its
initial investment. Thus, its a quick measure of how long the investment is at risk. Although this
time may be a very useful piece of information to compute for a particular project, payout analysis is
limited in its use as an evaluation criterion. It does not serve as a useful screening criterion since it
ignores any cash flows occurring past the payout period. Therefore, it must be used in conjunction
with one of the evaluation techniques that have already been presented.
Example 3.9
Given the following cash flow diagram, compute the undiscounted payout time and the
discounted payout time if MARR is 15%.
3.9. PAYOUT 45
0 1 2 3 4
100 60 60 60 60
Undiscounted Payout:
Interpolate between years 1 and 2 to find when the cumulative cash flow equals zero:
40 0
Payout = 1 + (2 1) = 1.67 years
40 (20)
Discounted Payout:
Interpolate between years 2 and 3 to find when the cumulative cash flow equals zero:
2.4 0
Payout = 2 + (3 2) = 2.06 years
2.4 (37.0)
Discounted payout measures the time for the project to return the initial investment and a 15% rate
of return on that initial investment.
46 3. PROJECT EVALUATION METHODS
3.10 PROBLEMS
3.1. Calculate the present value and annual value of the following cash flow diagram. MARR
is 15%.
0 1 2 3 4 5 6 7
3.2. Calculate the I RR and ERR for the cash flow diagram given in Problem 3.1.
3.3. An individual is considering the purchase of a property that he believes he can resell for
$25,000 at the end of 10 years. The property will generate positive cash flows of $1,500 per
year for the 10 years. What is the maximum that the individual should pay for the property
if his MARR is 12%?
3.4. An investment of $10,000 will yield $33,000 at the end of 5 years with no other cash flows.
What is the I RR of this investment?
0 1 2 3 4 5
3.6. A company invests $30,650 in a project which yields an income (positive cash flow) of
$10,000 in the first year, $9,000 in the second, $8,000 in the third, etc and $1,000 in
the tenth, along with an extra $10,000 income at the end of year 10. The companys MARR
is 10%. Determine the I RR and ERR of this project.
3.10. PROBLEMS 47
3.7. Determine the N P V , ERR, and modified I RR for the following cash flow diagram. Use
an MARR of 15%.
0 1 2 3
3.8. Determine the N P V , NAV , modified I RR, and ERR for the following cash flow diagram
if the MARR is 10%.
0 1 2 3 4
3.9. You are a project engineer and you have to make a choice between two contractors to perform
some rebuilding work on a manufacturing facility. One contractor proposes that he will do
the work for $1,300,000 payable immediately. The other contractor proposes that he will
perform the same job for $1,400,000 payable in eight equal quarterly payments, starting 3
months after the job begins. A nominal rate of 14% should be used as the MARR. What
equivalent annual interest rate is the second contractor offering? Which contractors offer
would you accept? Repeat the analysis with the NP V technique.
3.10. John Q. Customer has received his bill for the next 6 months premium on his auto insurance.
The bill allows him two methods to pay his premium of $189.00. He can either pay the
entire amount now, or he can pay $99.00 now, which includes half of the premium plus a
$4.50 prepaid service charge and $94.50 in two months, the other half of the premium.
The insurance company is, implicitly, offering John a loan. What is the effective annual
interest rate of the loan? Would you take the loan? Why or why not?
48 3. PROJECT EVALUATION METHODS
3.11. A project is expected to cost $2,000,000 and have the following net revenues:
Calculate the undiscounted and discounted payout periods. The MARR is 15%.
3.12. Engineer A retires at the age of 65 with a retirement account worth $500,000. At what
interest rate would this amount need to be invested in order to withdraw $50,000 at the
end of each of the next 15 years?
3.13. Develop an Excel spreadsheet to compute NP V , NAV , NF V , I RR, and ERR for the
cash flow diagram given in Problem 3.1.
3.14. Develop an Excel spreadsheet to solve Problem 3.3 for MARR values of 5%, 10%, 12%,
15% and 20%.
3.15. Develop an Excel spreadsheet to solve Problem 3.4 for initial investments of $5000,
$10000 and $15000.
3.16. Develop an Excel spreadsheet to solve Problem 3.5 for initial investments of $2000, $1500,
and $1000.
3.17. Develop an Excel spreadsheet to solve Problem 3.6.
3.18. Develop an Excel spreadsheet to solve Problem 3.7.
3.19. Develop an Excel spreadsheet to solve Problem 3.8.
3.20. Develop an Excel spreadsheet to solve Problem 3.9.
3.21. Develop an Excel spreadsheet to solve Problem 3.10.
3.22. Develop an Excel spreadsheet to solve Problem 3.11 for MARR values of 5%, 10%, and
15%.
3.23. Develop an Excel spreadsheet to solve Problem 3.12.
49
CHAPTER 4
NAC:
N ACA = 12000(A/P )15,5 + 3500 5000(A/F )15,5 = $6, 340
N ACB = 20000(A/P )15,5 + 1500 10000(A/F )15,5 = $5, 980
Both NPC and NAC analysis indicate that Alternative B is the best economic choice since it
has the lowest cost under these conditions.
Interest Rate, % NP V
15 1190.1
20 9.4
Interpolation yields an I RR = 20%. Since I RR > MARR, B is the best economic choice.
Again, the ERR would indicate that Alternative B is the best economic choice.
Example 4.3
Given the 3 alternatives below that provide the same service over a 4 year period, develop
an Excel spreadsheet that uses IRR analysis to determine which alternative is the best economic
choice. MARR is 10%.
Alternative A:
0 1 2 3 4
Alternative B:
0 1 2 3 4
The N P V and I RR functions are the same as presented in Chapter 3. The spreadsheet shows
the comparisons between all three projects. Since the initial investment of Alternative A is greater
than the initial investment of Alternative B and the initial investment of Alternative B is greater
than the initial investment of Alternative C, the alternatives are already correctly ordered by size
of initial investment. NPC analysis shows that Alternative B has the lowest net present cost and,
therefore, should be the alternative of choice.
The analysis of the incremental I RR calculations would be completed as follows:
2. Since the I RR of Incremental Project AB (5.7%) is less than the MARR (10%), Alternative B
is a better choice than Alternative A.
54 4. SERVICE PRODUCING INVESTMENTS
3. Now compare Alternative B with Alternative C.
4. Since the I RR of Incremental Project BC (23.5%) is greater than the MARR (10%), Alter
native B is a better choice than Alternative C.
Therefore, Alternative B is the best economic choice (same as determined from the NPC
method).
Note that since Alternative B was a better choice than Alternative A, one never utilizes the incremen
tal IRR that is calculated for the Incremental Project AC. However, it is a necessary portion of the
Excel spreadsheet since one does not know, ahead of time, which Alternatives will be eliminated
during the analysis of the results.
Example 4.4
The cash flows shown below represent two alternatives which can provide the same service.
Assume that the MARR is 15%. Use both methods described above to determine which alternative
is the best economic choice. (Numbers are in $1,000.)
Alternative A:
0 1 2 3 9 10
150 3 3 3 3 3
L = 10
Alternative B:
0 1 2 3 4 5
N P C Analysis:
N P C analysis indicates that Alternative B is the best economic choice under the assumptions
that were made (e.g., no increase in costs for the second 5 years). If costs increase or if technology
makes Alternative B obsolete, then this analysis will be inaccurate and one may need to consider
other noneconomic factors in making this decision.
Common Study Period Technique: Lets shorten Alternate A to 5 years by neglecting the costs
in the final 5 years and by increasing the salvage value that could be received at year 5 to $80,000.
Alternative A (shortened to 5 years):
0 1 2 3 4 5
150 3 3 3 3 3
L = 80
N P C Analysis:
4.4 PROBLEMS
4.1. A mining company is in need of four trucks. Suppliers will offer the options of purchasing
or leasing the trucks. The purchase price is $200,000. Maintenance, insurance, and general
operating costs (payable at the end of each year) will be $30,000 in year 1, $40,000 in year 2,
and $50,000 in year 3 with an expected salvage value of $70,000 at the end of year 3. The
lease price is $80,000 per year for the 3 years (payable at the beginning of each year). The
lease covers maintenance costs, but insurance and general operating costs will be $25,000
per year (payable at the end of each year). If the companys MARR is 20%, determine the
best economic choice.
4.2. A natural gas producing company is considering two engine systems for use in driving a
small compressor. System A can be purchased for $120,000 and is expected to have a life of 4
years. Annual diesel fuel consumption is estimated to be 60 gallons per day of use. System B
can be purchased for $150,000 and is expected to have a life of 4 years. Annual propane fuel
consumption is estimated to be 40 gallons per day of use. Both engines have salvage values
equal to 15% of initial cost and both will accomplish the needed requirements. Estimates
of fuel costs for each system and expected days of use each year are as follows:
Assume that MARR is 8% and that all other costs besides fuel will be the same for both
systems. Which system is the best economic choice?
58 4. SERVICE PRODUCING INVESTMENTS
4.3. Use ERR analysis to determine which alternative would be the best economical choice.
Verify your decision with NPC analysis. Assume the MARR equals 10%.
Alternative A:
0 1 2 3 4
Alternative B:
0 1 2 3 4
Alternative C:
0 1 2 3 4
Alternative D:
0 1 2 3 4
0 1 2 3
Alternative B:
0 1 2 3 4
4.5. Use Excel to solve Problem 4.1 for values of MARR of 10%, 15%, 20%, and 25%.
4.6. Use Excel to solve Problem 4.2 for values of MARR of 5%, 8%, and 12%.
4.7. Use Excel to determine what initial cost of Alternative A in Problem 4.2 would make the
two systems equal at an MARR of 8%.
4.8. Use Excel to solve Problem 4.3.
4.9. Use Excel to solve Problem 4.4.
61
CHAPTER 5
0 1 2 3 9 10
Since N P V > 0, I RR > MARR, and ERR > MARR, this project would be acceptable to
the investor.
Example 5.2
In addition to the alternative given in Example 5.1, consider the situation where an investor
with an MARR of 15% has the choice between that alternative and the two additional ones given
below. Assume that the investor has $80,000 to invest. Also assume that the three alternatives are
mutually exclusive projects. This may occur because they represent alternatives in which only one
can actually be built or may occur because the investor only has $80,000 to invest so he only has
enough capital to invest in one.
Lets call the project in Example 5.1 Alternative A. Thus, new alternatives are Alternative B
and Alternative C.
Alternative B:
0 1 2 3 9 10
Alternative C:
0 1 2 3 9 10
Since N P VA , N P VB , and NP VC are all greater than zero, all three alternatives would be
acceptable to the investor. However, since these are mutually exclusive alternatives, Alternative B is
the overall best economic choice because its NP V is the largest.
One might think that the evaluator should directly compare any two projects (such as A
and B in the previous example) by using incremental NPV analysis. The following calculations will
demonstrate that this approach is not necessary because the NPV of an incremental project such as
BA is governed by the following relationship:
NP V BA = NP V B NP V A
From Example 5.1, N P V A = $20, 115 and from Example 5.2, NP V B = $26, 560. Using the
relationship above, N P V BA should be $6,445. The following cash flow diagram represents the
incremental project BA:
Alternative BA:
0 1 2 3 9 10
3. If all alternatives have I RR or ERR < MARR, then the investors decision should be the do
nothing alternative.
4. If one or more alternatives have I RR or ERR MARR, then those alternatives should be
rank ordered from the one with the highest initial investment to the one with the lowest initial
investment.
5. A comparison is made between the alternatives with the two largest initial investments. Create
an incremental project cash flow diagram by subtracting the cash flows of the lower initial
investment from those of the higher initial investment.
7. If additional alternatives are still available, return to step 5 and compare the alternative that
was kept from step 6 with the one with the next lower initial investment.
8. If no additional alternatives remain, the best economic choice is the alternative that was kept
from step 6.
Example 5.3
Consider the three alternatives A, B, and C introduced in the earlier example problems. Use
IRR and ERR analysis to determine the best economic choice. The MARR is 15%.
Alternative A:
0 1 2 3 9 10
Alternative B:
0 1 2 3 9 10
Alternative C:
0 1 2 3 9 10
As one can see, all three alternatives have I RR and ERR MARR. Therefore, all three
alternatives are acceptable. Putting them in ranked order by initial investment yields:
Ini al
Alterna ve Investment I RR ERR
B $80,000 22.7% 18.3%
C $70,000 22.7% 18.3%
A $20,000 36.7% 23.3%
At this point, one cannot simply choose the alternative with the highest I RR or ERR as the
best overall economic choice.
First, compare Alternative B to Alternative C:
Alternative BC:
0 1 2 3 9 10
Since both the I RR and ERR are greater than the MARR, this indicates that Alternative B
is better than Alternative C. Eliminate Alternative C from further consideration and compare
Alternative B to the next alternative.
68 5. INCOME PRODUCING INVESTMENTS
Comparing Alternative B to Alternative A:
Alternative BA:
0 1 2 3 9 10
Since both the I RR and ERR are greater than the MARR, this indicates that Alternative B
is better than Alternative A. Since the list of mutually exclusive alternatives has been exhausted,
Alternative B is the best overall economic choice.
In summary, one cannot use the values of the I RR and ERR from individual alternatives to
determine the best economic choice. If one were to do that, the results shown in the table for this
example would indicate that Alternative A is the best economic choice since it has the largest values
of I RR and ERR. However, both NP V and incremental rate of return analyses clearly show that
Alternative B is the best economic choice.
Example 5.4
To further reinforce the fact that one should not rank investments through the use of rate
of return, consider the following example. You are an investor with only $10 in your pocket. Two
friends offer you the following opportunities: Friend #1 needs $1 from you, but will give you $2 back
at the end of the day. Friend #2 needs all $10 of your money, but will give you $12 back at the end
of the day. Which opportunity is better for you from an economic point of view?
Examine this using NPV and incremental IRR approaches. Since the time frame is short (1
day), your daily MARR can be considered to be very close to 0%.
5.3. MUTUALLY EXCLUSIVE ALTERNATIVES 69
Friend #1 Alternative:
0 1
1 2
NP V : N P V = 1 + 2(P /F )0,1 = $1
Friend #2 Alternative:
0 1
10 12
NP V : N P V = 10 + 12(P /F )0,1 = $2
NPV analysis indicates that Friend#2 Alternative is the best economic choice, but IRR analysis
appears to indicate that Friend#1 Alternative is the best.
Friend #1 is offering a 100% rate of return and Friend #2 is offering a 20% rate of return. One
might think that Friend #1s offer is the best. However, at the end of the day, you only have $11 in
your pocket if you invest with Friend #1, but $12 if you invest with Friend #2. It is clear, therefore,
that you should invest with Friend #2 even though that friend is offering a lower rate of return. The
reason that the higher rate of return option is not the best option in this case is that the other $9
in your pocket is earning 0% rate of return. Combining 0% rate of return on $9 and 100% rate of
return on $1 ends up yielding a 10% overall rate of return if you invest with Friend #1.
70 5. INCOME PRODUCING INVESTMENTS
Incremental Alternative of Friend#2 Friend#1:
0 1
9 10
Since the incremental I RR is greater than your MARR, this indicates that Friend #2 Alter
native is, indeed, the best economic choice.
This example also introduces the notion of risk in an investment. Obviously, the mathematical
analysis has shown that loaning Friend #2 is the better investment. But, it requires you, the lender,
to give up all of your money. If there was a chance that neither friend could come through with
their repayment, then it might be better to keep the $9 in your pocket and invest in Friend #1. In
the event that neither friend could provide their repayment, at least you would still have $9 left of
your money. The concept of risk in investments will be discussed much more in Chapter 9.
1. Note that the values of NP V given in cells B17, C17, and D17 are all positive. This
indicates that all three alternatives are acceptable.
2. Note that Cell C17 contains the largest value of NP V . This would indicate that Alter
native B is the best economic choice.
71
5.3. MUTUALLY EXCLUSIVE ALTERNATIVES
1. Note that the values of I RR given in cells B18, C18, and D18 are all greater than the
MARR. This indicates that all three alternatives are acceptable.
2. Examine cell F18, which is the result of comparing the first pair of projects: B and C.
Since this value (22.7%) is larger than the MARR, this would indicate that Alternative B
is better than Alternative C. Alternative C is thus removed from further consideration
and the next viable pair would be BA.
3. Examine cell G18, which is the result of comparing projects B and A. Since this value
(17.6%) is larger than the MARR, this would indicate that Alternative B is better than
Alternative A.
4. Since all necessary pairs have been examined, Alternative B is the best economic choice.
5. While column H is required to calculate the NP V , I RR, and ERR of the CA pair, it
is not utilized in this example since Alternative C was removed from consideration after
its comparison against Alternative B. However, when developing this spreadsheet, one
does not know the result of the incremental analyses and, thus, all possible pairs must be
included. In addition, depending on the value of MARR, column H might be utilized
in other scenarios.
Example 5.5
Use NPV, NAV, NFV, IRR, and ERR analyses to evaluate the unequal life alternatives below.
MARR is 12%.
5.4. UNEQUAL LIFE ALTERNATIVES 73
Alternative A:
0 1 2 3 4
Alternative B:
0 1 2 3 4 5 6
300 90 90 90 90 90 90
NPV analysis:
0 1 2 3 4 5 6
N AV :
N AVBA = 100(A/P )12,6 10(P /A)12,4 (A/P )12,6 + 90(F /A)12,2 (A/F )12,6
= $ 8.20
Since the incremental NAV is less than zero, Alternative A is the best economic choice.
NF V :
Since the incremental NF V is less than zero, Alternative A is the best economic choice.
I RR:
ERR:
Since ERRBA is less than the MARR, Alternative A is the best economic choice.
In summary, each of the analysis techniques of NPV, NAV, NFV, incremental IRR, and
incremental ERR, indicate that Alternative A is the best economic choice. However, of these five
options, the authors strongly suggest the NPV method because it usually involves the least amount
of calculations and never requires the use of incremental analyses.
5.5. INDEPENDENT AND CONTINGENT INVESTMENTS 75
5.5 INDEPENDENT AND CONTINGENT INVESTMENTS
5.5.1 INDEPENDENT INVESTMENTS
Consider the case when an investor is faced with the choice of investing in one or more projects (rather
than just one from a list of mutually exclusive alternatives) depending upon how much investment
capital is available. These alternatives are said to be independent alternatives. The final decision of
which projects to invest in will be based on maximizing the NP V for the given investment dollars.
This could mean that several combinations of projects will need to be evaluated.
1 0 0 0 None
2 1 0 0 A
3 0 1 0 B
4 0 0 1 C
76 5. INCOME PRODUCING INVESTMENTS
(b) If the projects are independent, then the investor can invest in any or all projects. Therefore, the
list of combinations would be:
1 0 0 0 None
2 1 0 0 A
3 0 1 0 B
4 0 0 1 C
5 1 1 0 A,B
6 1 0 1 A,C
7 0 1 1 B,C
8 1 1 1 A,B,C
(c) For the contingencies given, the list of combinations would be:
1 0 0 0 None
2 1 0 0 A
3 0 1 0 B
4 0 1 1 B,C
Of the list from (b) in this example, the following combinations are missing for the following
reasons:
2. A,B Since A and B are mutually exclusive, they cannot be combined together
3. A,C Since C is contingent on project B and project B is not in this combination, A and C
cannot be combined
4. A,B,C Since A and B are mutually exclusive, they cannot be combined together
5.5. INDEPENDENT AND CONTINGENT INVESTMENTS 77
5.5.3 LIMITED INVESTMENT CAPITAL
When investment capital is unlimited and more than one project may be chosen, the analysis simply
requires the determination of which project(s) will earn more than the MARR. This can be done
with any of the analysis techniques discussed previously. Once the list of acceptable alternatives has
been generated, the economic choice is to invest in all of them.
When investment capital is limited, the analysis approach is a bit more complicated. The
basic approach is to determine all possible combinations of projects in which the total investment
is within the capital constraints and then to analyze each of the combinations as being mutually
exclusive. The combination with the highest NPV will represent the set of projects in which one
should invest.
Example 5.7
The cash flow diagrams of six projects, A through F, are shown below. For these projects,
determine what combination of projects is the best economic choice using NPV analysis and a
MARR of 10%. Projects B, C, and E are mutually exclusive. Projects A and D are mutually exclusive
but both are contingent on the acceptance of C. Project F is contingent on the acceptance of either
B or E. Consider two separate scenarios:
(a) Assume unlimited capital
(b) Assume limited capital of $30,000
0 1 2 3
A:
Project NP V
A $1,220
B $3,570
C $9,870
D $4,920
E $4,870
F $12,360
5.6. RANKING ALTERNATIVES 79
The table of mutually exclusive alternatives would be:
Mutuall y I n v es t m e nt
Exclusive Projects Possible Capital
Alterna ve A B C D E F Combina ons Needed NP V
1 0 0 0 0 0 0 None 0 0
2 0 1 0 0 0 0 B $30,000 $3,570
3 0 0 1 0 0 0 C $15,000 $9,870
4 0 0 0 0 1 0 E $20,000 $4,870
5 1 0 1 0 0 0 A,C $20,000 $11,090
6 0 0 1 1 0 0 C,D $25,000 $14,790
7 0 1 0 0 0 1 B,F $45,000 $14,930
8 0 0 0 0 1 1 E,F $35,000 $17,230
(a) There are eight mutually exclusive alternatives that result from the original six individual
projects and their interrelationships. When capital is unlimited, the correct economic choice is
the alternative that maximizes the NPV. In this case, alternative #8, which consists of investing
in projects E and F is the correct economic choice because it has the largest NPV.
(b) When capital is limited to $30,000, alternatives #7 and #8 are no longer considered. With
those removed, the correct economic choice will be alternative #6 since it will maximize the
NPV for those projects whose total investment is less than or equal to $30,000.
Example 5.8
For the six projects listed in Example 5.7, use the IRR and ERR techniques to choose the
best mutually exclusive alternative.
It can be shown that mutually exclusive alternatives 1 through 8 have the following I RRs and
ERRs:
80 5. INCOME PRODUCING INVESTMENTS
Alternave I RR ERR
1 10.0% 10.0%
2 16.7% 14.2%
3 44.6% 30.2%
4 23.4% 18.3%
5 39.5% 27.4%
6 41.3% 28.4%
7 29.2% 21.7%
8 36.3% 25.7%
Direct ranking by I RR or ERR would indicate that Alternative 3 (project C alone) would
be the best economic choice. This is, of course, inconsistent with the previous NPV analysis. To
overcome this inconsistency, the evaluator must perform incremental IRR or incremental ERR
analyses. For example, the incremental IRR technique is shown below:
0 1 2 3
0 1 2 3
Since the incremental I RR is greater than the MARR, Alternative #8 is better than Alter
native #2. Keep Alternative #8, discard Alternative #2, and compare Alternative #8 with the
next one on the list (#6).
4. Continue in this manner (comparing the best choice with the next one on the list) until one
has exhausted all of the alternatives. Alternative #8 will be the last remaining alternative and,
thus, will be the best economic choice. This result is now consistent with the one from NPV
analysis. A similar method for ERR will yield the same ultimate results of Alternative #8 being
the best economic choice.
Another way to complete the incremental IRR technique is to compare each alternative with
all other alternatives that have a lower capital investment and compute the incremental IRR. This
would result in a table of incremental IRRs as given below:
Alterna ve with
Row # higher capital Alterna ve with lower capital investment
investment
8 2 6 4 5 3 1
1 7 2.5* 52.8 6.1 33.8 20.7 21.2 29.2
2 8 139 23.4 52.8 32.1 29.9 36.3
3 2 1 7 4 2.5 4 2 . 4  15.9 1 6.6
4 6 106 48.7 36.3 41.3
5 4 23.4
6 5 23.4 3 9 .5
7 3 44.6
*IRR78
82 5. INCOME PRODUCING INVESTMENTS
The use of this table would be as follows (see the arrows):
1. Start in row 1. Compare incremental alternative 78. Since the incremental I RR (2.5%) is less
than the MARR (10%), choose Alternative #8. Drop to row 2 (that belongs to Alternative #8).
2. Compare incremental alternative 82. Since the incremental I RR (139%) is greater than the
MARR (10%), choose Alternative #8. Stay in row 2.
3. Compare incremental alternative 86. Since the incremental I RR (23.4%) is greater than the
MARR (10%), choose Alternative #8. Stay in row 2.
4. Compare incremental alternative 84. Since the incremental I RR (52.8%) is greater than the
MARR (10%), choose Alternative #8. Stay in row 2.
5. Compare incremental alternative 85. Since the incremental I RR (32.1%) is greater than the
MARR (10%), choose Alternative #8. Stay in row 2.
6. Compare incremental alternative 83. Since the incremental I RR (29.9%) is greater than the
MARR (10%), choose Alternative #8. Stay in row 2.
7. Compare incremental alternative 81. Since the incremental I RR (36.3%) is greater than the
MARR (10%), choose Alternative #8. Since there are no more alternatives to be compared
with Alternative #8, then Alternative #8 is the best economic choice.
For the case of limited capital ($30,000), omit Alternatives #7 and #8 from the table. Follow
the arrows to show that Alternative #6 is the best economic choice.
Alterna ve with
higher capital Alterna ve with lower capital investment
investment
6 4 5 3 1
2 174 2.5 42.4 15.9 16.6
6 106 48.7 36.3 41.3
4   23.4
5 23.4 39.5
3 44.6
In summary, once the incremental I RR table has been created, start with the alternative
with the largest initial investment and compare it to the alternative with the second largest initial
investment. If the incremental I RR is less than the MARR, drop to the row of the lower initial
investment and proceed to compare with the next alternative. If the incremental I RR is greater than
the MARR, stay on the same row and proceed to compare with the next alternative. Eventually, one
will exit from the table on the best economic choice.
5.7. PROBLEMS 83
5.7 PROBLEMS
5.1. Projects A and B below are mutually exclusive alternatives. The cash flow diagrams are
given. Determine which project is the best economic choice using NPV, IRR, and ERR
analyses. Use a value of 15% for MARR.
Project A:
0 1 2 3 9 10
Project B:
0 1 2 3 9 10
5.2. Two mutually exclusive, but unequal life, investment projects A and B are shown below.
Project A:
0 1 2 3 4 5
100 40 40 40 40 140
Project B:
0 1 2
120 60 180
84 5. INCOME PRODUCING INVESTMENTS
(a) Determine the best economic choice using NPV, IRR, and ERR analyses. Use an
MARR of 20%.
(b) What value of MARR would reverse the ranking of projects A and B found in part
(a)?
The following projects are utilized in Problems 5.3 and 5.4. Projects A and B are indepen
dent. Projects C and D are mutually exclusive and both are dependent on the acceptance of
B. Project E is dependent on the acceptance of A.
B:
C:
D:

5.7. PROBLEMS 85
E:
5.5. Use NPV and ERR analyses to determine which of the following two mutually exclusive
projects is the best economic choice. Use MARR of 15%.
Project A:
0 1 2 3 4
0 1 2
5.6. Suppose you are considering two independent sets of two mutually exclusive projects each
plus a fifth project. The fifth project is contingent on two of the first four occurring. Make a
table that shows all of the mutually exclusive alternatives that are possible and the projects
that each alternative contains.
5.7. Projects A through E are being considered by an investor. They all are tenyear projects and
the MARR is 10%. Projects A and B are mutually exclusive. Projects C and D are mutually
exclusive and contingent on the acceptance of B. Project E is contingent on the acceptance
of A.
5.8. Use Excel to solve Problem 5.1 for values of MARR of 5%, 15%, 25%, 35%, and 45%.
5.9. Use Excel to solve Problem 5.2 for values of MARR of 10%, 20%, and 30%.
5.10. Use Excel to solve Problem 5.3 for values of MARR of 10%, 20%, 25%, and 30%.
5.11. Use Excel to develop the incremental I RR table for Problem 5.4. Use the table to deter
mine which alternative should be chosen if the MARR equals 10% and one has unlimited
capital.
5.12. Use Excel to solve Problem 5.5 for values of MARR of 5%, 15%, 25%, and 35%.
87
CHAPTER 6
200.0
150.0
CPI
100.0
50.0
0.0
1960 1970 1980 1990 2000 2010
Year
year n will be considered as a future value and the CP I from year m will be considered a present
value. Thus:
For example, the average inflation rate between 1980 and 1990 was:
(130.7/82.4)[1/10] 1 100 = 4.72%
Similarly, the average inflation rate between 2009 and 2010 was:
(218.056/214.537)[1/1] 1 100 = 1.64%
Escalation, on the other hand, refers to the total change in the price of a specific commodity or
service over a period of time. Prices of individual commodities can change due to supply and demand,
as well as many other factors. While the inflation rate is a single numerical value for all commodities,
the escalation rate may be different for each commodity. For example, for 2000 to 2010, the price
of food increased an average of 2.69% per year (similar to inflation), the price of unleaded gasoline
increased an average of 6.32% per year, and the price of computers actually dropped an average of
6.2. ESCALATION AND INFLATION 89
** Star ng in 2007, the Bureau of Labor Sta s cs began publishing the CPI with three
decimal places instead of one
16.4% per year over that same time frame. It should be pointed out that escalation includes the effect
of inflation. Figure 6.2 shows the price of unleaded gasoline ($/U.S. gallon) from 1976 to 2010.
One should notice that the CPI curve in Figure 6.1 is relatively smooth, but the price of any
one commodity may fluctuate significantly over the same time frame as shown in Figure 6.2. This
is due to the fact that the CPI measures the average change in prices paid for a market basket of
goods and services. (U.S. Department of Labor)
The escalated or actual dollar type of analysis referred to above includes both the effect of
inflation and escalation. This type of analysis attempts to predict the future prices of those elements
that are part of the cash flow calculation. One can either let all income and expenses rise at the
average inflation rate or one can attempt to isolate each commodity and use various escalation rates
for each income or expense item.
The constant dollar analysis reflects the purchasing power of money over the life of the project
by factoring out the effect of inflation. For example, in constant dollars, the price of unleaded gasoline
has increased an average of 3.84% per year and the price of food only increased an average 0.29%
per year from 2000 to 2010. This calculation will be shown later in this chapter.
The today dollar analysis simply uses the current prices for the commodities that are part of
the cash flow calculation for the project and maintains them at this level throughout the life of the
project. Thus, there is no consideration of the effects of inflation and escalation.
The authors believe that one should use either an escalated dollar analysis or a constant dollar
analysis when attempting to determine the economic viability of a project. Today dollar analyses
90 6. DETERMINATION OF PROJECT CASH FLOW
Figure 6.2: Price of unleaded gasoline from 1976 to 2010 (Government Accounting Office analysis of
Bureau of Labor Statistics (BLS) data).
should only be used for projects that have short enough lives that the costs of the commodities that
are part of the cash flow calculation do not change substantially.
Two rules should be kept clearly in mind when incorporating the effects of inflation and
escalation. The first is that the dollar types, constant or escalated, should never be mixed within
a single cash flow diagram. The second is that the MARR that is used in the evaluation must be
consistent with the type of dollars used. A rate of return calculated from a set of cash flows that are
based on constant dollars should be compared with an MARR that is also based on constant dollars.
Similarly, consistency between escalated dollar cash flows and an MARR that is based on escalated
dollars is necessary. It should be noted that bank interest rates and investment bond interest rates
are based on escalated dollars. Thus, if an investors MARR is derived from those types of interest
rates, it should also be considered to be an escalated dollar MARR.
The relationship between interest rates in escalated and constant dollars can be obtained by
comparing the corresponding P /F factors:
ii = (1 + i)/(1 + f ) 1 (6.2)
This equation was utilized earlier to factor out the effect of inflation from escalation. For
example, for the period of 20002010, the inflation rate was 2.39% per year and the escalation rate
for unleaded gasoline was 6.32% per year. Using Equation 6.2, the constant dollar growth of this
commodity is:
ii = (1 + 0.0632)/(1 + 0.0239) 1 = 0.0384 = 3.84%
Note that just subtracting the inflation rate from the escalation rate (a difference of 3.93% in this
example) is not the correct way to factor out inflation from escalation.
The relationships between today dollars, escalated dollars, and constant dollars are shown
below:
Example 6.1
Cash flow diagrams for projects A and B are shown below. Assume that the cash flows are
in escalated dollars and that the escalated dollar MARR is 15%. (a) Calculate the NP V of each
project as given and (b) calculate the NP V if one assumes a 5% inflation rate.
0 1 2 3
A:
100 40 60 80
92 6. DETERMINATION OF PROJECT CASH FLOW
(b):
For part (b), one needs to factor out the effect of inflation from the escalated cash flows. In
addition, the MARR will have to be adjusted to a constant dollar basis. The cash flows are adjusted
by using the (P /F ) factor at 5% for the corresponding number of years. For example, the 55 (year 1
cash flow for Project A) is multiplied by (P /F )5,1 to yield 52.38. When this is done, the cash flows
become:
0 1 2 3
A:
Note that within numerical round off, the NP V s are the same for either escalated or constant dollar
analysis. This will always be the case.
6.2. ESCALATION AND INFLATION 93
Example 6.2
A fiveyear life project has an initial capital expenditure of $250,000 and annual operating
costs beginning at the end of the year 1 of $100,000. At the end of the years 3, 4, and 5 the project
receives $500,000 as income. Calculate the I RR for the following cases:
(a) Assume the cash flows given are in escalated dollars and the escalated dollar MARR is 25%.
(b) Assume the cash flows given are in today dollars and that incomes are escalated at 6% and
costs are escalated at 10%.
(c) Assume inflation is 4% and rework part (b) in terms of constant dollars.
(a) (numbers are in $1000):
0 1 2 3 4 5
NP V = 0
= 250 110(P /F )I RR,1 121(P /F )I RR,2 + 463(P /F )I RR,3
+ 485(P /F )I RR,4 + 508(P /F )I RR,5
Trial and error solution yields I RR = 39.9%. This value would be compared to the escalated
MARR of 25% to indicate that its an economically acceptable project.
(c) (numbers are in $1000):
Use Equation 6.4 to convert the today dollars to constant dollars:
NP V = 0
= 250 106(P /F )I RR,1 112(P /F )I RR,2 + 411(P /F )I RR,3
+ 415(P /F )I RR,4 + 418(P /F )I RR,5
Trial and error solution yields I RR = 34.5%. This value would be compared to the constant
dollar MARR that is calculated according to Equation 6.1:
This value would still indicate that its an economically acceptable project.
6.3 DEPRECIATION
Certain capital assets of a company lose their value with use and/or with time. A building or an
item of equipment are examples of such assets. These assets have an initial value that is equal to
the original cost of the asset. However, they may lose value over time due to physical deterioration,
development of improved facilities by technological advances, or different demands of their use. The
reduction in value is called depreciation.
6.3. DEPRECIATION 95
One also needs to recognize that most governments (including the United States) do not
allow companies, for tax purposes, to deduct the entire cost of an asset against their income in
the year that the asset is purchased. Since the asset retains at least some portion of its value over
its life, companies must prorate the deduction of the original asset cost over the usable life of the
asset. Governments will specify particular techniques for this proration. These techniques are called
depreciation methods.
Therefore, there are two interpretations of a depreciation account for a capital asset. Under the
first, a company would set aside actual cash in a depreciation account in order to have the necessary
funds to replace the asset at the end of its useful life. Under the second, rather than setting aside actual
cash in the depreciation account, the company would simply establish depreciation accounts for tax
purposes. That is, the depreciation account represents the allowable annual deduction of the asset
against the projects income. The second interpretation represents reality. Thus, the depreciation
account that is maintained does not involve real dollars and depreciation expenses are known as
paper expenses in that they reduce the tax liability of the project but do not represent actual cash
expenditures. This chapter contains information on how to handle these paper expenses in the
calculation of aftertax cash flows for a project.
The most popular depreciation methods used in the United States are straightline, sum
oftheyearsdigits, decliningbalance, and the acceleratedcostrecoverysystem. All four of these
methods will be discussed in this chapter.
In addition to the depreciation account, one also maintains a book value account that represents
the remaining value of the asset. Book value is simply the initial cost of the asset minus all accumulated
depreciation up to a specific point in time.
Depreciation calculations are based on the initial cost of the asset, P , any salvage value of the
asset at the end of its useful life, L, and the length of its useful life, N. The quantity P L represents
the total allowable depreciation of the asset if it is held for the entire time period N.
It should be evident that the depreciation is constant with time when using the straightline
method.
96 6. DETERMINATION OF PROJECT CASH FLOW
At the end of any given year, the book value of the asset is given by Equation 6.7:
Excel has a builtin function called SLN that computes straightline depreciation:
Dn = f (1 f )n1 P (6.8)
Bn = (1 f )n P (6.9)
It should be noted that while the salvage value, L, is not utilized in the equations, one must
be careful that the total depreciation does not exceed the amount (P L).
Limits have been placed on the value of f that can be used in the decliningbalance method.
The value of f cannot exceed 2/N. When the value of 2/N is used, the method is referred to as the
doubledecliningbalance (DDB) method.
Excel has a builtin function called DDB that computes doubledeclining balance depreci
ation:
where, S = sum of the digits of the useful life of the asset = N(N + 1)/2
Excel has a builtin function called SYD that computes sumoftheyearsdigits deprecia
tion:
When calculating depreciation amounts for the determination of aftertax cash flows, it is
advantageous to use the most accelerated depreciation schedule possible. The sumoftheyears
digits and the decliningbalance methods give larger depreciation amounts in the early years of an
asset. The straightline method may, however, be more advantageous in later years.
Example 6.3
A device costs $5000 and has a salvage value of $800 after its useful life of 7 years. Calculate
the depreciation deduction that can be taken each year and the book value at the end of each year
for the useful life of the asset. Use the following depreciation methods:
98 6. DETERMINATION OF PROJECT CASH FLOW
(a) StraightLine (SL)
(b) DoubleDecliningBalance (DDB)
(c) SumoftheYearsDigits (SYD)
(a) For StraightLine:
Dn = (P L)/N = (5000 800)/7 = $600 which remains constant over the 7 years
Bn = P n(P L)/N = 5000 600 n
0 5000
1 1429 3571
2 1020 2551
3 729 1822
4 521 1301
5 372 929
6 129* 800
7 0** 800
*D6 would have been calculated as $266, but it was limited to $129 because the book value
cannot go below the salvage value.
**D7 would have been calculated as $190, but it was limited to $0 because the book value had
already reached the salvage value at the end of year 6.
6.3. DEPRECIATION 99
(c) For SumoftheYearsDigits:
S = N (N + 1)/2 = (7)(8)/2 = 28
Dn = [N (n 1)](P L)/S = [7 (n 1)](5000 800)/28 = 150(8 n)
n n
Bn = P Dj = 5000 Dj
j =1 j =1
The depreciation and book values are shown in Figures 6.3 and 6.4 below to further demon
strate the differences between these three methods.
A B C D
1 P= 5000
2 L= 800
3 N= 7
4
5 Year SL DDB SYD
6 1 $600 $1,429 $1,050
7 2 $600 $1,020 $900
8 3 $600 $729 $750
9 4 $600 $521 $600
10 5 $600 $372 $450
11 6 $600 $130 $300
12 7 $600 $0 $150
100
A B C D
1 P= 5000
2 L= 800
3 N= 7
4
5 Ye a r SL DDB SYD
6 1 =SLN($B$1,$B$2,$B$3) =DDB($B$1,$B$2,$B$3,A6) =SYD($B$1,$B$2,$B$3,A6)
7 2 =SLN($B$1,$B$2,$B$3) =DDB($B$1,$B$2,$B$3,A7) =SYD($B$1,$B$2,$B$3,A7)
6. DETERMINATION OF PROJECT CASH FLOW
Depreciaon Values
1600
1400
1200
1000
D(n) $ 800 SL
600 DDB
400 SYD
200
0
1 2 3 4 5 6 7
Year
Figure 6.3: Comparison of depreciation values for straightline, double declining balance, and sumof
theyearsdigits methods.
Book Values
5000
4500
4000
3500
3000
B(n) $ 2500 SL
2000 DDB
1500
1000 SYD
500
0
0 1 2 3 4 5 6 7
Year
Figure 6.4: Comparison of book values for straightline, double declining balance, and sumofthe
yearsdigits methods.
102 6. DETERMINATION OF PROJECT CASH FLOW
6.3.4 MODIFIED ACCELERATED COST RECOVERY SYSTEM (MACRS)
In 1981, the United States government passed the Economic Recovery Tax Act which made sig
nificant changes in depreciation calculations. The act was further modified in 1986 which led to
the Modified Accelerated Cost Recovery System (MACRS) for assets that were placed after 1980.
MACRS generally simplified the calculation of depreciation by (a) removing any reference to the
salvage value of the asset at the end of its useful life by assuming that L = 0 and (b) using various
combinations of the three previously presented depreciation methods to calculate annual deprecia
tion values that are simply percentages of the original asset cost. As in the other methods, the assets
book value is the original cost minus all accumulated depreciation. That is:
To determine what depreciation rate to use, one must first determine the depreciable life of the
asset. The MACRS method created the following classifications: 3year property, 5year property,
7year property, 10year property, 15year property, 20year property, and 25year property. IRS
publication 946 (http://www.irs.gov/pub/irspdf/p946.pdf) defines the types of assets that
fit in each classification. Table 6.2 shows a summary of this publication. One should note that any
property that doesnt specifically fit in another category is automatically classified as 7year property.
Table 6.3 shows the depreciation rates that are used for various classifications, assuming a
halfyear convention (most common assumption). A halfyear convention simply recognizes that
assets are put into service at various times during any one year. Rather than beginning to depreciate
the asset on the actual day that it is put into service, the U.S. government allows a half year of
depreciation in the first year of use, a full year of depreciation from year two until year N and a half
year of depreciation in year N+1. Thus, depreciation for assets that fit in the 7year depreciation
category, are actually spread over a total of 8 years.
6.3. DEPRECIATION 103
Property
Classification Examples
3year property Tractor units for overtheroad use
Qualified renttoown property
5year property Automobiles, taxis, buses, and trucks
Computer and peripheral equipment
Office machinery
Certain geothermal, solar, and wind energy property
7year property Office furniture and fixtures
Agricultural machinery and equipment
Any property that does not have a class life and has not been designated
by law as being in any other class
Any natural gas gathering line placed in service after April 11, 2005
10year property Vessels, barges, tugs and similar water transportation equipment
Qualified small electric meter and qualified smart electric grid system
placed in service after Oct 3, 2008
15year property Any municipal wastewater treatment plant
Any qualified restaurant property placed in service before Jan 1, 2012
Electric transmission property used in transmission at 69 or more kilovolts
of electricity placed in service after April 11, 2005
Any natural gas distribution line placed in service after April 11, 2005
20year property Farm buildings
Municipal sewers
25year property Water utility property that is not included as 20year property
104 6. DETERMINATION OF PROJECT CASH FLOW
Although Excel does not have a builtin function that can be used to directly compute
MACRS depreciation, one can use the VDB function if one recognizes that MACRS is defined as
DDB depreciation, using 1/2 year convention, and then switching to straightline depreciation:
=VDB(Initial_Cost, Salvage, Life, Start_Period, End_Period, Factor,no_Switch)
{Gross Revenue} = {#of items sold during a period} {price per item} (6.14)
It should be noted that, for economic evaluation purposes, the periods gross revenue will be assumed
to occur at the end of the particular time period in which it is generated.
It should be noted that, for economic evaluation purposes, the periods operating expenses will be
assumed to all occur at the end of the particular time period in which it is spent. The assumption
that all capital investment will occur at the beginning of each year and that the income and operating
expenses will occur at the end of each year is known as endofyear convention.
0 1 2 3 4 5
6.4.6 DEPRECIATION
As mentioned above, depreciation costs are paper expenses that result from the depreciation of a
capital item. That is, there is no actual cash expenditure for this category. The cost does, however,
reduce the companys income tax burden as will be shown. One can pick any of the methods given
above to calculate the depreciation expenses.
6.4. CASH FLOW COMPUTATION 109
6.4.7 TAXABLE INCOME
Taxable income is the income (or sometimes called gross profit) that is subject to taxation by the
United States government:
Table 6.4: United States corporate income tax (FIT) ratesfrom United States Code: Title 26,
Subtitle A, Chapter 1, Part II, 11.
Therefore,
In some circumstances, FIT can be allowed to be a negative value. That is, if the taxable
income is negative (a loss), multiplying any tax rate by that taxable income would yield a negative
value for FIT. This would be the same as the government paying the project for losing money!!
However, this computation can be defensible if the project that is being evaluated is only one of
many for a large company. Since the company only pays taxes on its total taxable income (that is,
from all projects taken together), a loss from one project will reduce the taxes that would be paid by
a profitable project. Thus, the project that generates a negative taxable income does indeed yield a
negative tax. Allowing negative FIT values is known as a corporate analysis.
If the project is a stand alone project (that is, its profit or loss will not be combined with any
other project), then any negative values of FIT must be changed to zero for that year. However, the
loss in that year may be carried forward into the future to reduce taxes from a profitable year that
occurs later. This is an area where consultation with a corporate tax expert would be necessary.
110 6. DETERMINATION OF PROJECT CASH FLOW
6.4.9 NET PROFIT
Net Profit is computed as the taxable income minus the income tax:
As mentioned before, since depreciation is only a paper expense (that is, no actual cash
payment is made for depreciation), it must be added back into the cash flow calculation. Depreciations
only effect, therefore, is to reduce the income tax that is paid.
Any capital investment (cash spent on depreciable assets) made during the particular period
is subtracted after all other cash flow considerations are taken into account.
Example 6.6
Determine the after tax cash flows for the ten years of the following projects life:
Sales Schedule:
For evaluation purposes, assume that the initial capital investment occurs at the beginning of
year 1 (which, by definition, is year 0).
CF0 = 1, 000, 000
Year 1
At a value of MARR of 20%, the NP V of this project can be shown to be $518,000 (after
tax).
One might wish to generate an Excel spreadsheet to allow additional analysis of this problem
if any or all of the given numerical values change. Such a spreadsheet is shown on the next page.
From the formulas it can be seen that key numerical values can be easily changed and the remainder
of the spreadsheet will change accordingly.
The formulas and/or values in each column are shown on the next pages.
112 6. DETERMINATION OF PROJECT CASH FLOW
6.4. CASH FLOW COMPUTATION 113
114 6. DETERMINATION OF PROJECT CASH FLOW
6.5. PROBLEMS 115
6.5 PROBLEMS
6.1. Using the CP I , compute the average inflation rate from 1992 to 2009.
6.2. Cash flow diagrams for projects A and B are shown below. Assume that the cash flows are
in escalated dollars and that the escalated dollar MARR is 10%.
0 1 2 3
80 40 45 50
0 1 2 3
120 100 80 60
6.3. An eightyear life project has an initial capital expenditure of $450,000, annual income of
$300,000 beginning at the end of year 1, and annual operating costs of $80,000 beginning
at the end of year 1. Calculate the I RR for the following cases:
(a) Assume the cash flows given are in escalated dollars and the escalated dollar MARR
is 20%.
(b) Assume the cash flows given are in today dollars and that incomes are escalated at 7%
and costs are escalated at 6%.
(c) Assume inflation is 4% and rework part (b) in terms of constant dollars.
116 6. DETERMINATION OF PROJECT CASH FLOW
6.4. An investment related to developing a new product is estimated to have the following costs
and revenues in today dollars. Do not consider any tax issues.
0 1 2 3 4 5
(a) Evaluate the projects escalated dollar I RR if both capital costs and operating costs
are estimated to escalate at 15% per year from time zero and income is estimated to
escalate at 10% per year from time zero.
(b) Evaluate the projects escalated dollar I RR assuming a washout of escalation of
income and operating costs with a 15% escalation of capital costs per year. Washout
means any operating cost escalation is offset by the same dollar escalation of revenue
(not the same percentage escalation) so that the beforetax profit remains uniform.
(c) Compute the constant dollar I RR of case (b) assuming that the rate of inflation will
be 10% per year.
6.5. Determine the breakeven escalated dollar selling price per unit, X, required in each of years
1 and 2 to achieve a 15% constant dollar project I RR, assuming a 12% per year inflation
rate. All values are given in today dollars.
0 1 2
Investment: 100,000
Income: 1000(X) 1000(X)
Oper Costs: 50,000 50,000
Income escalation = 10% per year from time zero when selling price is $X per unit.
Operating Cost escalation = 15% per year from time zero.
1,000 units are to be produced and sold per year.
6.5. PROBLEMS 117
6.6. Equipment has been purchased for $2,000,000 and put into service with an expected salvage
value at the end of 10 years of $200,000. Calculate the annual depreciation using:
6.7. Consider a mining and processing project for an oil tar sands project. From the data given
below, calculate the aftertax cash flows for a 30year life of the project and the NP V for
an MARR of 15%.
Initial capital expenditures totaled $415.5 million and were distributed over four years
(10% in year 0, 30% in year 1, 40% in year 2, and 20% in year 3).
Beginning in year 4:
6.8. The XYZ oil company owns several natural gas wells and is negotiating a 10year contract
to sell the gas from these wells to another company. They are negotiating on the price of the
gas in the first year, in dollars per thousand cubic feet ($/MCF), including a 4% escalation
clause. XYZ expects the wells to produce 33,000 MCF the first year and to decline at the
rate of 15% every year thereafter. Operating costs are estimated to be $2/MCF and escalate
at 3% per year. XYZ has agreed to spend $500,000 now to lay pipelines from each well to
the second companys processing plant. What should the minimum price be the first year
for this to be acceptable to XYZ? Assume an endofyear convention and an MARR of
15%.
118 6. DETERMINATION OF PROJECT CASH FLOW
6.9. An investment of $80,000 is projected to generate escalated dollar net revenues (income
minus costs) of $10,000 in year 1, $30,000 in year 2, and $40,000 in year 3 with a $40,000
salvage value at the end of year 3.
(a) Calculate the escalated dollar I RR for an escalated dollar MARR of 20%. Is this an
acceptable investment?
(b) Calculate the equivalent constant dollar I RR assuming that inflation will be 8% in
year 1, 10% in year 2, and 12% in year 3. Is this an acceptable investment?
6.10. The projected cost of the Alaskan oil pipeline was $900 million in 1969 dollars. The final
cost estimate was nearly $8.5 billion in 1977. What was the average yearly escalation rate
for the pipeline?
6.11. Bostons Big Dig is one of the most expensive highway projects in the U.S. The projects
original estimated cost was $2.6 billion in 1982 dollars. The costs in 2005 had risen to over
$14.6 billion.
6.12. Using Excel and the CP I values given in Table 6.1, calculate the annual inflation rate for
each year from 1980 to 2010.
6.13. Use Excel to solve Problem 6.2 for all 9 combinations of the following:
6.14. Use Excel to solve the following problem. An eightyear life project has an initial capital
expenditure of $450,000, annual income of $300,000 beginning at the end of year 1, and
annual operating costs of $80,000 beginning at the end of year 1. Calculate the I RR for
the following cases:
(a) Assume the cash flows given are in escalated dollars and the escalated dollar MARR
is 10%, 20%, and 30%.
(b) Assume the cash flows given are in today dollars and pairs of escalation rates are:
a. Incomes are escalated at 7% and costs are escalated at 6%
b. Incomes are escalated at 3% and costs are escalated at 5%
c. Incomes are escalated at 4% and costs are escalated at 4%
(c) Assume inflation is 4% and rework all portions of part (b) in terms of constant dollars.
6.5. PROBLEMS 119
6.15. Use Excel to solve Problem 6.6. Create a line graph that shows the values generated by
all four of the methods.
6.16. Use Excel to solve Problem 6.7. The spreadsheet should allow for the user to easily change
any of the numerical values given.
6.17. Use Excel to solve Problem 6.8. The spreadsheet should allow for the user to easily change
any of the numerical values given.
121
CHAPTER 7
Financial Leverage
7.1 INTRODUCTION
Earlier in this text, a brief description of the financial aspects involved in economic analyses was
presented. It was pointed out that one of the important financial aspects had to do with obtaining
the funds required to initiate the project. These funds are referred to as the investment capital. As
a source for this investment capital, a company could use its own internal funds (what is known as
equity funds), borrow funds from an external source (known as debt funds), or use a combination
of the two. The ratio of total borrowed funds to the total capital investment is called the financial
leverage factor. The ratio of borrowed funds to equity funds is called the debt to equity ratio. The
degree of financial leverage for any given project will affect the economic analysis of the project.
Example 7.1
A company is considering a one year investment which will cost $1000.The companys before
tax MARR is 10%. The $1000 will purchase assets that will be fully depreciated in the one year
of operation. There are three possible economic conditions that the company needs to investigate.
Details of these conditions are shown below. In addition, the company will consider three different
leverage factors: 0.0, 0.4, and 0.7. Interest on any borrowed funds will be 10% over the one year of
operation. Use a 40% corporate tax rate and determine the aftertax I RR on the equity funds for
each combination of the three economic conditions and the three leverage factors. Note that, for
economic condition A, the beforetax IRR on total assets (in this case $1000) is less than the interest
rate that will be charged on the loan. For economic condition B, the beforetax I RR on total assets
is equal to the interest rate to be charged on the loan and, for economic condition C, the beforetax
I RR is greater than the loan interest rate.
Economic Conditions
A B C
Revenue Oper Costs $1050 $1100 $1200
Depreciation 1000 1000 1000
Taxable income without leverage 50 100 200
I RR on total assets before taxes 5% 10% 20%
0 1 0 1 0 1
A: B: C:
Table 7.1 shows the cash flows and the computed aftertax I RRs for the 9 different combi
nations. Figure 7.1 shows the aftertax IRR on equity as a function of the leverage factor for the
three different economic conditions.
7.3. ADJUSTMENT TO CASH FLOW EQUATIONS 123
Table 7.1: Effect of leverage and economic conditions on the aftertax I RR on equity for
Example 7.1
124 7. FINANCIAL LEVERAGE
Economic Condition A
Economic Condition B
Economic Condition C
Figure 7.1: Effect of leverage factor for various economic conditions for Example 7.1.
From the results of Example 7.1, the following observations can be made:
1. Figure 7.1 shows that when the projects beforetax I RR on assets is less than the interest rate
charged on the loan (economic condition A), the aftertax I RR on equity decreases as the
leverage factor increases. This makes sense because the project must pay the lender a higher
rate of interest than it will be able to pay the owner in rate of return.
2. Figure 7.1 shows that when the projects beforetax I RR on assets is equal to the interest rate
charged on the loan (economic condition B), the aftertax I RR on equity is not affected as
the leverage factor increases. This makes sense because the project pays the lender the same
rate of interest as it will be able to pay the owner in rate of return.
3. Figure 7.1 shows that when the projects beforetax I RR on assets is greater than the interest
rate charged on the loan (economic condition C), the aftertax I RR on equity increases as the
leverage factor increases. This makes sense because the project pays the lender a lower rate of
interest than it is able to pay the owner in rate of return.
4. There is more risk to equity capital when projects are leveraged with borrowed money. If the
economic conditions are poorer than originally predicted (such as condition A occurring when
condition C was predicted when the decision to invest was made), the aftertax I RR on equity
will decrease.
5. If enough equity capital exists, companies should not borrow money to fund a project unless
the interest rate paid on the debt is less than the beforetax I RR on the projects total assets.
Leverage factors vary from company to company and even within a company from project
to project. In general, for most companies other than public utilities (who typically have very high
7.3. ADJUSTMENT TO CASH FLOW EQUATIONS 125
leverage factors of 0.6 or greater), leverage factors usually run from 0.3 to 0.5. A highly leveraged
project can do very well in a favorable economic climate, but may run into some hard times as
economic conditions go from good to bad. Many companies have used this principle to expand
rapidly during thriving business conditions.
Example 7.2
Consider the following fiveyear project with different methods of financing. A company has
the opportunity to invest in a fiveyear project that has an initial capital investment of $100,000.
The entire capital investment (total assets) will be depreciated over the fiveyear life of the project
using straightline depreciation. Annual incomes and operating costs are expected to be $50,000
and $10,000, respectively. Interest on borrowed money will be 10% compounded annually. Calculate
the aftertax IRR on equity for the following cases and assuming a corporate tax rate of 40%. Use
an aftertax MARR of 12%.
(b) Leverage factor of 0.4. The principal payments will be constant for each of the five years and
the interest paid each year will be based on the outstanding debt balance.
(c) Leverage factor of 0.7. The principal payments will be constant for each of the five years and
the interest paid each year will be based on the outstanding debt balance.
(d) Leverage factor of 0.4. The principal and interest will be paid with a constant annual payment
as calculated according to: P &I payment = Debt (A/P )10%,5 .
(e) Leverage factor of 0.4. Interest payments are made each year but the principal is paid back
in one lump sum at the end of the project. This is known as yearly interest with a balloon
payment of the principal at the end.
126 7. FINANCIAL LEVERAGE
First, solve for the beforetax I RR on assets. This would be represented by a 0.0 leverage
factor and a 0% FIT rate.
Therefore, the beforetax I RR on assets for this project is 28.6%. Since the interest rate on
borrowed funds is less than this value, leveraging the project should increase the aftertax I RR on
equity.
7.3. ADJUSTMENT TO CASH FLOW EQUATIONS 127
(a) This solution will show the effect of the 40% FIT rate compared to the beforetax solution shown
previously.
The 40% FIT tax rate reduces the aftertax I RR on total assets to 18.0%.
128 7. FINANCIAL LEVERAGE
(b) This solution will show the effect of a leverage factor of 0.4.
0.4
40000
25.1%
18691
The aftertax I RR on an equity investment of $60,000 has increased to 25.1%. This increase
is as expected. Also, the aftertax NP V has increased from a leverage factor of 0.0.
7.3. ADJUSTMENT TO CASH FLOW EQUATIONS 129
(c) This solution will show the effect of a leverage factor of 0.7.
Increasing the leverage factor to 0.7 further increases the aftertax I RR on equity and the
aftertax N P V .
130 7. FINANCIAL LEVERAGE
(d) This solution will show the effect of paying constant annual principal and interest payments.
Using a more conventional method to repay the debt, the aftertax I RR and aftertax NP V
both increase slightly from the first repayment method.
7.3. ADJUSTMENT TO CASH FLOW EQUATIONS 131
(e) This solution will show the effect of paying annual interest and then a balloon payment for the
principal.
From the results of Example 7.2, the following observations can be made:
1. If the results from parts (a), (b), and (c) are compared, it is again found that, under these
economic conditions, when the amount of borrowed funds is increased, a higher rate of return
is obtained on the equity investment. It should be stressed that this higher rate of return is on
a smaller amount of equity dollars compared to financing the project with 100% equity funds.
2. It can also be seen that aftertax NP V increases as the leverage factor is increased. NPV
analysis would further emphasize that, under the economic conditions of the beforetax I RR
on assets being greater than the interest rate paid on the debt, the best option is to maximize
132 7. FINANCIAL LEVERAGE
the amount of leverage. By using maximum leverage on each project, a company can invest in
more projects and grow more rapidly.
3. Parts (b), (d), and (e) compare three different, but acceptable, methods of repaying the debt
portion of the investment. Since the interest on the borrowed money is less than the I RR on
assets, it is better to push the repayment of the principal as far forward in time as possible
in order to increase I RR on equity and NP V . The balloon payment technique provides the
highest I RR and N P V .
(a) Determine the return on equity for each of three different leverage factors of 0, 0.4,
and 0.7. Assume an interest rate on borrowed funds to be 10% compounded annually.
The principal payments will be constant for each of the five years and the interest paid
each year will be based on the outstanding debt balance.
(b) Assume two additional economic conditions: (i) annual income increases to $125,000
and (ii) annual income decreases to $95,000. Repeat part (a) for these two economic
conditions. Prepare a plot of the I RR on equity versus the leverage factor.
7.2. A corporations tax rate is 40%. An outlay of $35,000 is being considered for a new asset.
Estimated annual revenues are $30,000 and estimated annual operating costs are $10,000.
The useful life of the asset is 5 years and has no salvage value. Use the SYD method of
depreciation. A lending institution has offered to loan the corporation 50% of the initial
investment cost at an annual interest rate of 12.5%. The principal and interest will be
paid with a constant annual payment as calculated according to: P &I payment = Debt
(A/P )12.5%,5 . If the corporations aftertax MARR is 15%, should it accept the loan?
7.3. Solve Problem 6.7 using a leverage factor of 0.2.
7.4. Use Excel to solve Problem 6.8 for leverage factors of 0.2 and 0.4.
135
CHAPTER 8
8.2 STATISTICS
8.2.1 MEASURES OF CENTRAL TENDENCY
Averages are often used to represent a set of data. Several different types of averages can be calculated.
These include the arithmetic mean, the median, the mode, and the geometric mean.These are known
as measures of central tendency as they tend to be centrally located within the data.
Arithmetic Mean
The arithmetic mean of a set of data is calculated with Equation 8.1. The arithmetic mean is also
known as the expected value of the data.
N
= xi /N (8.1)
i=1
Median
When a set of data is arranged in order of magnitude, the median of the set is found by taking the
middle value (when there is an odd number of values) or the arithmetic mean of the two middle
values (when there is an even number of values).
Excel has a builtin function to calculate the median:
= MEDIAN(number1, number2,)
Mode
The mode is the value which occurs with the greatest frequency. A set of data can have a single
mode, several modes, or no modes.
Excel has two builtin functions to calculate the mode:
Geometric Mean
The geometric mean of a set of data is calculated with Equation 8.2:
N
G= N
xi (8.2)
i=1
75 67 96 73 78 53 51 47 31 42
76 91 81 87 91 55 88 90 53 74
57 88 94 59 97 81 78 90 83 65
77 38 93 76 35 78 94 88 67 89
54 86 94 60 88 75 86 38 67 99
84 91 67 79 78 73 78 79 39 90
51 77 88 79 46 97 80 90 78 84
94 46 99 85 79 34 85 39 91 82
95 46 48 79 85 87 76 56 48 32
85 87 83 98 74 88 51 57 95 61
First, order the 100 scores from high to low. Since there is an even number of values, the
median is the average of 50th (79) and 51st (78) values, or 78.5.
Again, order the 100 scores from high to low and find the value that occurs most often. In this
case, the value of 78 occurs six times. Therefore, the mode is 78.
100
G= 75 67 96 95 61 = 70.9
138 8. BASIC STATISTICS AND PROBABILITY
Using Excel :
A B C D E F G H I J
1 75 67 96 73 78 53 51 47 31 42
2 76 91 81 87 91 55 88 90 53 74
3 57 88 94 59 97 81 78 90 83 65
4 77 38 93 76 35 78 94 88 67 89
5 54 86 94 60 88 75 86 38 67 99
6 84 91 67 79 78 73 78 79 39 90
7 51 77 88 79 46 97 80 90 78 84
8 94 46 99 85 79 34 85 39 91 82
9 95 46 48 79 85 87 76 56 48 32
10 85 87 83 98 74 88 51 57 95 61
11
12 Average = 73.7
13 Median = 78.5
14 Mode = 78
15 Geo Mean = 70.9
A B C D E F G H I J
1 75 67 96 73 78 53 51 47 31 42
2 76 91 81 87 91 55 88 90 53 74
3 57 88 94 59 97 81 78 90 83 65
4 77 38 93 76 35 78 94 88 67 89
5 54 86 94 60 88 75 86 38 67 99
6 84 91 67 79 78 73 78 79 39 90
7 51 77 88 79 46 97 80 90 78 84
8 94 46 99 85 79 34 85 39 91 82
9 95 46 48 79 85 87 76 56 48 32
10 85 87 83 98 74 88 51 57 95 61
11
12 Average = =AVERAGE(A1:J10)
13 Median = =MEDIAN(A1:J10)
14 Mode = =MODE.SNGL(A1:J10)
15 Geo Mean = =GEOMEAN(A1:J10)
8.2. STATISTICS 139
8.2.2 MEASURES OF DISPERSION
It is frequently desired to determine how a set of data is dispersed or spread about its average.
Measures of dispersion which will be discussed in this chapter include the range, the mean deviation,
the standard deviation, and the variance.
Range
The range of a set of data is simply the difference between the largest and the smallest values of the
data.
In order to compute the range of a set of data with Excel , use the MAX and MIN functions:
=MAX(number1, number2,) MIN(number1, number2,)
Mean Deviation
The mean deviation (or average deviation) is the mean of the distances between each value and the
mean. It is computed with Equation 8.3:
N
M.D. = xi  /N (8.3)
i=1
Excel does not have a builtin function to calculate the mean deviation. To use Excel , do
the following:
1. Place the data in a single column (for example, assume 10 data points in cells A1 through
A10).
2. Use the formula =AVERAGE(A1:A10) in cell A11 to compute the average of this column of
data. This is the mean of the data.
5. Use the formula =AVERAGE(B1:B10) in cell B11 to compute the average of this column of
data. This is the mean deviation of the data.
Standard Deviation
Standard deviation is another measure of the variability of a data set about its mean. Its origins are
associated with the normal distribution that is discussed later in this chapter, but it has meaning
140 8. BASIC STATISTICS AND PROBABILITY
for any set of data. A small value of standard deviation indicates that the data points are clustered
more closely to the mean than a larger value of standard deviation. If the entire population has been
sampled (that is, N equals the total possible number of data points in the population), the standard
deviation is calculated with Equation 8.4:
N
= (x )2 /N
i (8.4)
i=1
where, xi = the i value of the data
th
Example 8.2
Consider 100 exam scores from a collegelevel class as shown below (same as Example 8.1):
75 67 96 73 78 53 51 47 31 42
76 91 81 87 91 55 88 90 53 74
57 88 94 59 97 81 78 90 83 65
77 38 93 76 35 78 94 88 67 89
54 86 94 60 88 75 86 38 67 99
84 91 67 79 78 73 78 79 39 90
51 77 88 79 46 97 80 90 78 84
94 46 99 85 79 34 85 39 91 82
95 46 48 79 85 87 76 56 48 32
85 87 83 98 74 88 51 57 95 61
8.2. STATISTICS 141
(a) Calculate the range:
Order the numbers from high to low. The range is then given by the highest value minus the
lowest value. Range = 9931 = 68.
M.D. = (75 73.7 + 67 73.7 + 96 73.7 + + 95 73.7 + 61 73.7) /100
= 15.4
(75 73.7)2 + (67 73.7)2 + + (95 73.7)2 + (61 73.7)2
=
100
= 18.5
Using Excel :
A B C D E F G H I J
1 75 67 96 73 78 53 51 47 31 42
2 76 91 81 87 91 55 88 90 53 74
3 57 88 94 59 97 81 78 90 83 65
4 77 38 93 76 35 78 94 88 67 89
5 54 86 94 60 88 75 86 38 67 99
6 84 91 67 79 78 73 78 79 39 90
7 51 77 88 79 46 97 80 90 78 84
8 94 46 99 85 79 34 85 39 91 82
9 95 46 48 79 85 87 76 56 48 32
10 85 87 83 98 74 88 51 57 95 61
11
12 Average = 73.7
13 Median = 78.5
14 Mode = 78
15 Geo Mean = 70.9
16 Range = 68
17 Mean Dev = 15.4
18 StdDev = 18.5
142 8. BASIC STATISTICS AND PROBABILITY
A B C D E F G H I J
1 75 67 96 73 78 53 51 47 31 42
2 76 91 81 87 91 55 88 90 53 74
3 57 88 94 59 97 81 78 90 83 65
4 77 38 93 76 35 78 94 88 67 89
5 54 86 94 60 88 75 86 38 67 99
6 84 91 67 79 78 73 78 79 39 90
7 51 77 88 79 46 97 80 90 78 84
8 94 46 99 85 79 34 85 39 91 82
9 95 46 48 79 85 87 76 56 48 32
10 85 87 83 98 74 88 51 57 95 61
11
12 Average = =AVERAGE(A1:J10)
13 Median = =MEDIAN(A1:J10)
14 Mode = =MODE.SNGL(A1:J10)
15 Geo Mean = =GEOMEAN(A1:J10)
16 Range = =MAX(A1:J10)MIN(A1:J10)
17 Mean Dev = =B121**
18 StdDev = =STDEV.P(A1:J10)
**This assumes that the 100 data points are copied to cells A21:A120 and the procedure listed
above under Mean Deviation is followed.
Using ten classes from 0100, develop the frequency distribution for the data.
Solution:
Within the frequency distribution, the range of numbers that is used to define the class is
called a class interval. The smaller number is the lower class limit and the larger number is the upper
class limit. Note that in Example 8.3, the upper class limit of one class is the same as the lower class
limit of the next class. If a value is exactly equal to one of the class limits, one needs to decide in
which class it belongs. It doesnt matter if it is placed in the higher range or the lower range as long
as the evaluator remains consistent. In Example 8.3, any value that is equal to a class limit is placed
in the lower range (e.g., a value of 90 is placed in the 8090 class). If this convention is used, then
one can define true class limits for a range. In this case, the true class limits would be 90.5100.5,
80.590.5, 70.580.5, etc. Excel utilizes this convention as well.
There are two other terms that need to be defined for frequency distributions. The class size
is the difference between the upper true class limit and the lower true class limit. The true class mark
144 8. BASIC STATISTICS AND PROBABILITY
is the midpoint of each true class interval or the average between the upper true class limit and the
lower true class limit. In Example 8.3, the class size is ten for all ten classes and the true class marks
are 95.5, 85.5, 75.5, etc.
Histogram
30
25
20
Freq 15
10
0
5.5 15.5 25.5 35.5 45.5 55.5 65.5 75.5 85.5 95.5
Exam Scores
Frequency Polygon
30
25
20
Freq 15
10
0
4.5 5.5 15.5 25.5 35.5 45.5 55.5 65.5 75.5 85.5 95.5 105.5
Exam Scores
0.25
0.2
0.1
0.05
0
4.5 5.5 15.5 25.5 35.5 45.5 55.5 65.5 75.5 85.5 95.5 105.5
Exam Scores
If the data are presented in frequency distribution form, items such as the mean, mean devi
ation, and standard deviation can be determined from the following equations, respectively.
M
= fj xj (8.5)
j =1
M
M.D. = fj xj (8.6)
j =1
M
2
=
fj xj (8.7)
j =1
Mean:
This value compares favorably to 73.7 computed with all 100 data points.
Mean Deviation:
This value compares favorably to 15.4 computed with all 100 data points.
Standard Deviation:
0.00 (5.5 73.3)2 + 0.00 (15.5 73.3)2 + +
=
0.27 (85.5 73.3)2 + 0.00 (95.5 73.3)2
= 18.3
This value compares favorably to 18.5 computed with all 100 data points.
8.3. PROBABILITY 149
8.3 PROBABILITY
8.3.1 CLASSICAL DEFINITION
The classical definition of probability involves an event occurring from a group or a set of equally
likely outcomes. That is, when a fair coin is tossed, the specific outcome of that event is either a
heads or a tails with each outcome equally likely to occur. Suppose that a particular event occurs
a certain number of times out of a total possible number of other events. The probability that the
desired event will occur is given by Equation 8.8:
P (A) = nA /n (8.8)
Example 8.5
Consider the probability of drawing an ace from a fair deck of cards. Since there are four aces
in a total of 52 cards and the chances of drawing any specific card is the same, the probability of
drawing an ace would be:
P (Ace) = 4/52 = 1/13 = 0.0769 = 7.69%
Note that in the above example, the probability of 4/52 is only correct for any given attempt
to draw an ace if, when an undesired card is drawn (not an ace), it is returned to the deck before
the next card is drawn. This is referred to as sampling with replacement. If the undesired card is not
returned to the deck, known as sampling without replacement, the probability changes to 4/51, then
4/50, etc.
Example 8.6
Consider the probability of rolling two fair die and getting a total of 8. When rolling two fair
die, the possible outcomes are:
As shown in the table, there are 36 possible outcomes of the dice rolls, five of which have a
value of 8. Therefore, the probability of getting exactly 8 is:
Example 8.7
Consider the flipping of a fair coin (50% probability of a head and 50% probability of a tail).
The coin will be flipped three times. What is the probability that 0, 1, 2, and 3 heads occurred in
the three flips?
As shown in the table, there are eight possible outcomes of the three flips. Therefore,
Example 8.8
Consider the tossing of a coin. One would normally assume that the probability of getting a
head on any one toss is 50%. However, consider an experiment where a coin is tossed 100 times and
heads occurs 52 times and tails 48 times. For this case, the probability of getting a head would be
predicted to be 52%. If the coin is a fair one, as the number of experimental data points gets larger
and larger, the probability of getting a head will approach 50%.
In most cases throughout engineering, one does not have the luxury of performing an infinite
number of experiments in order to determine the true probability of an event occurring. For example,
if an engineer is doing failure tests on a particular manufactured component, one can only do a limited
number of failure experiments in order to determine the probability of failure.
Discrete Distribution
A discrete distribution is one which involves an experiment with a finite number of possibilities.
For example, as described earlier, when a fair die is thrown, a 1, 2, 3, 4, 5, or 6 will occur. Thus,
the outcome of a throw is a discrete value. Using the classical probability definition, each possible
outcome would have a probability of 1/6. Note that the sum of the probabilities of all possible
outcomes will always equal 1.0.
Example 8.9
Consider that a certain discrete random variable, x, has a discrete probability distribution as
follows:
0.25
0.2
P(x) 0.15
0.1
0.05
0
3 1 0 1 2 3 5 8
x
Figure 8.5: Probability distribution for the random discrete variable x in Example 8.9.
8.3. PROBABILITY 153
For this distribution, it would be useful to calculate the mean and standard deviation using
Equations 8.5 and 8.7:
(b) = 0.1 (3) + 0.2 (1) + 0.15 (0) + 0.25 (1) + 0.1 (2) + 0.1 (3)
+ 0.05 (5) + 0.05 (8) = 0.90
0.1 (3 0.9)2 + 0.2 (1 0.9)2 + 0.15 (0 0.9)2 + 0.25 (1 0.9)2
(c) =
+ 0.1 (2 0.9)2 + 0.1 (3 0.9)2 + 0.05 (5 0.9)2 + 0.05 (8 0.9)2
= 2.51
A B C D E
1 x P(x) x*P(x) (xmu)^2 P(x)*(xmu)^2
2 3 0.1 0.3 15.2 1.521
3 1 0.2 0.2 3.6 0.722
4 0 0.15 0 0.8 0.122
5 1 0.25 0.25 0.0 0.003
6 2 0.1 0.2 1.2 0.121
7 3 0.1 0.3 4.4 0.441
8 5 0.05 0.25 16.8 0.841
9 8 0.05 0.4 50.4 2.521
10
11 Total = 1.00
12 Mean = 0.90
13 StdDev = 2.51
154 8. BASIC STATISTICS AND PROBABILITY
A B C D E
1 x P(x) x*P(x) (xmu)^2 P(x)*(xmu)^2
2 3 0.1 =A2*B2 =(A2B$12)^2 =B2*D2
3 1 0.2 =A3*B3 =(A3B$12)^2 =B3*D3
4 0 0.15 =A4*B4 =(A4B$12)^2 =B4*D4
5 1 0.25 =A5*B5 =(A5B$12)^2 =B5*D5
6 2 0.1 =A6*B6 =(A6B$12)^2 =B6*D6
7 3 0.1 =A7*B7 =(A7B$12)^2 =B7*D7
8 5 0.05 =A8*B8 =(A8B$12)^2 =B8*D8
9 8 0.05 =A9*B9 =(A9B$12)^2 =B9*D9
10
11 Total = =SUM(B2:B9)
12 Mean = =SUM(C2:C9)
13 StdDev = =SQRT(SUM(E2:E9))
Binomial Distribution
The binomial distribution is a standard discrete distribution that accounts for the case where there
are two possible events and the probabilities of each event are not the same. Given a number of
independent trials, n, of an experiment that has two possible outcomes (call them success and failure),
the probability of a certain number of successes occurring in those n trials is given by Equation 8.10:
Example 8.10
The probability that a fuse will be defective when first installed is 0.08. If six fuses are selected
at random, find each of the following:
(a) The probability that less than two fuses are defective
(b) The probability that four or more fuses are defective
(c) The probability that at least one is defective
Solution:
Define a success as a fuse that is defective. Therefore, p = 0.08 and q = 0.92.
6!
P6 (0) = C60 (0.08)0 (0.92)6 = (0.08)0 (0.92)6
0!6!
= 0.606
6!
P6 (1) = C61 (0.08)1 (0.92)5 = (0.08)1 (0.92)5
1!5!
= 0.316
6!
P6 (2) = C62 (0.08)2 (0.92)4 = (0.08)2 (0.92)4
2!4!
= 0.0688
156 8. BASIC STATISTICS AND PROBABILITY
6!
P6 (3) = C63 (0.08)3 (0.92)3 = (0.08)3 (0.92)3
3!3!
= 0.00797
6!
P6 (4) = C64 (0.08)4 (0.92)2 = (0.08)4 (0.92)2
4!2!
= 0.000520
6!
P6 (5) = C65 (0.08)5 (0.92)1 = (0.08)5 (0.92)1
5!1!
= 0.0000181
6!
P6 (6) = C66 (0.08)6 (0.92)0 = (0.08)6 (0.92)0
6!0!
= 0.000000262
(a) P6 (x < 2) = P6 (0) + P6 (1) = 0.606 + 0.316 = 0.922
(b) P6 (x 4) = P6 (4) + P6 (5) + P6 (6) = 5.20 104 + 1.81 105 + 2.62 107 =
5.38 104
(c) P6 (x > 0) = P6 (1) + P6 (2) + P6 (3) + P6 (4) + P6 (5) + P6 (6) = 0.394
Alternatively, P6 (x > 0) = 1 P6 (0) = 1 0.606 = 0.394
Using Excel :
8.3. PROBABILITY 157
In graphical form, the discrete distribution for Example 8.10 can be shown as:
Binomial Distribuon
0.7 6.06E01
0.6
0.5
0.4 3.16E01
P(x)
0.3
0.2
6.88E02
0.1 7.97E03 5.20E04 1.81E05 2.62E07
0
0 1 2 3 4 5 6
# of Successes
Continuous Distributions
When the value of the event, x, can take on a continuous set of probability values, rather than
a set of specific values, then a probability density function, p(x), exists. While there are a wide
variety of continuous distributions possible, the authors have chosen to present three continuous
distributions: the uniform distribution, the triangular distribution, and the normal or Gaussian
distribution. Figure 8.6 is a representation of a continuous distribution.
For continuous probability distributions, the following statements and equations are pertinent:
1. For a given x, p(x) is not the probability of that exact value occurring. Since there are an
infinite number of values for x, the probability of any one specific value of x would be zero.
2. The total area under the curve will equal the value of unity.
Connuous Distribuon
0.25
0.2
0.15
p(x)
0.1
0.05
0
0 2 4 6 8 10 12 14 16
x
6. F (x1 ) represents the probability that the value of x is less than or equal to x1 .
7. The quantity (1 F (x1 )) represents the probability that the value of x is greater than or equal
to x1 .
h = 1/(b a) (8.17)
8.3. PROBABILITY 159
p(x) = h for a x b
p(x) = 0 for all other values of x
= (a + b)/2 (8.18)
= (b a)/ 12 (8.19)
F (x) = (x a)/(b a) (8.20)
Triangular Distribution
The triangular distribution is represented in Figure 8.8.
Let a be the minimum value of x, c be the maximum value of x, and b be the mode. P1 and P2
represent the areas from a to b and b to c, respectively. The triangular distribution has the following
properties:
h = 2/(c a) (8.21)
P1 = (b a)/(c a) (8.22)
P2 = (c b)/(c a) (8.23)
160 8. BASIC STATISTICS AND PROBABILITY
= (a + b + c)/3 (8.24)
= (c a) (1 P1 P2 )/18 (8.25)
F (x) = P1 [(x a)/(b a)]2 for a x b (8.26)
F (x) = 1 P2 [(c x)/(c b)]2 for b x c (8.27)
Normal Distribution
The Normal or Gaussian distribution is a continuous probability function that takes on the common
bellshaped curve as represented in Figure 8.9.
The shape of this distribution is calculated with Equation 8.28:
1 x 2
1
p(x) = e 2
(8.28)
2
When = 0 and = 1, the distribution is called a unit normal distribution and Equation 8.28
simplifies to Equation 8.29:
1 x2
p(x) = e 2 (8.29)
2
One can convert any set of normally distributed data to a unit normal distribution through
the substitution of the variable Z, defined as:
Z = (x )/ (8.30)
This allows one to then use Table 8.1 to determine values of p(Z) and F (Z) as defined above.
Since the unit normal distribution is symmetrical about Z = 0, one only needs the positive
portion of the table. If Z < 0, then use the following equations for p(Z) and F (z):
p(Z) = p(Z) (8.31)
F (Z) = 1 F (Z) (8.32)
Excel has a builtin function that calculates p(x) and F (x) given x, the mean, and the
standard deviation:
=NORM.DIST(x,Mean,Std_Dev,Cumulative)
Table 8.1: Values of p(Z) and F (Z) for the unit normal distribution
Z p(Z) F(Z) Z p(Z) F(Z)
0.00 0.39894 0.50000 1.55 0.12001 0.93943
0.05 0.39844 0.51994 1.60 0.11092 0.94520
0.10 0.39695 0.53983 1.65 0.10226 0.95053
0.15 0.39448 0.55962 1.70 0.09405 0.95543
0.20 0.39104 0.57926 1.75 0.08628 0.95994
0.25 0.38667 0.59871 1.80 0.07895 0.96407
0.30 0.38139 0.61791 1.85 0.07206 0.96784
0.35 0.37524 0.63683 1.90 0.06562 0.97128
0.40 0.36827 0.65542 1.95 0.05959 0.97441
0.45 0.36053 0.67364 2.00 0.05399 0.97725
0.50 0.35207 0.69146 2.05 0.04879 0.97982
0.55 0.34294 0.70884 2.10 0.04398 0.98214
0.60 0.33322 0.72575 2.15 0.03955 0.98422
0.65 0.32297 0.74215 2.20 0.03547 0.98610
0.70 0.31225 0.75804 2.25 0.03174 0.98778
0.75 0.30114 0.77337 2.30 0.02833 0.98928
0.80 0.28969 0.78814 2.35 0.02522 0.99061
0.85 0.27798 0.80234 2.40 0.02239 0.99180
0.90 0.26609 0.81594 2.45 0.01984 0.99286
0.95 0.25406 0.82894 2.50 0.01753 0.99379
1.00 0.24197 0.84134 2.55 0.01545 0.99461
1.05 0.22988 0.85314 2.60 0.01358 0.99534
1.10 0.21785 0.86433 2.65 0.01191 0.99598
1.15 0.20594 0.87493 2.70 0.01042 0.99653
1.20 0.19419 0.88493 2.75 0.00909 0.99702
1.25 0.18265 0.89435 2.80 0.00792 0.99744
1.30 0.17137 0.90320 2.85 0.00687 0.99781
1.35 0.16038 0.91149 2.90 0.00595 0.99813
1.40 0.14973 0.91924 2.95 0.00514 0.99841
1.45 0.13943 0.92647 3.00 0.00443 0.99865
1.50 0.12952 0.93319
8.3. PROBABILITY 163
There is also a builtin function that calculates x given F (x), the mean, and the standard
deviation:
=NORM.INV(F(x),Mean,Std_Dev)
where, F(x) = value of the cumulative distribution at which to find the value of x
Example 8.11
An engineer estimates that the selling price of a particular commodity will range from a low
of $5.00 per item to a high of $10.00 per item.
(a) If the distribution is assumed to be uniform, calculate the mean (or expected) value and the
standard deviation for the price of this commodity. Also, calculate the probability that the
price will be greater than $9.00.
(b) If the distribution is assumed to be triangular with a most likely value (mode) of $7.00 per
item, calculate the mean (or expected) value and the standard deviation for the price of this
commodity. Also, calculate the probability that the price will be greater than $9.00.
Solution (a):
The distribution would be:
Example 8.12
300 ball bearings are tested for their diameters. The mean diameter was determined to be
0.452 cm and the standard deviation was determined to be 0.010 cm. Assume that the diameters
are normally distributed.
(a) How many ball bearings would be expected to be smaller than 0.4425 cm?
(b) Seventy percent of the ball bearings would be expected to have a diameter greater than what
value?
8.3. PROBABILITY 165
The distribution would be:
A B A B
1 Mean = 0.452 1 Mean = 0.452
2 StdDev = 0.010 2 St d D e v = 0.010
3 x= 0.4425 3 x= 0.4425
4 F(x) = 0.17106 4 F(x) = =NORM.DIST(B3,B1,B2,TRUE)
5 # bearings < x = 51 5 # bearings < x = =300*B4
A B A B
1 Mean = 0.452 1 Mean = 0.452
2 StdDev = 0.010 2 StdDev = 0.010
3 F(x) = 0.3 3 F(x) = 0.3
4 x= 0.44676 4 x = =NORM.INV(B3,B1,B2)
Combined Distributions
In some applications, it will be necessary to work with more than one distribution to describe a
particular variable. In order to find the mean and standard deviation for the combined distributions,
the mean and standard deviation for each separate distribution are first determined. Equations 8.33
and 8.34 are then used to calculate the overall average and standard deviation:
c = Ai i (8.33)
c = Ai i2 + (i c )2 (8.34)
Example 8.13
An oil well has a 25% chance of being a dry hole (no oil found) and a 75% chance of finding
an oil reservoir that contains between 10,000 and 60,000 barrels as shown in the distribution below.
(a) Calculate the mean and standard deviation of the combined distributions.
(b) What is the probability that the reservoir will contain less than 40,000 barrels?
(c) What is the probability that the reservoir will contain at least 50,000 barrels?
0.25
p(x)
0 10,000 60,000
barrels
Cumulave Probability
1
0.9
0.8
0.7
0.6
F(x) 0.5
0.4
0.3
0.2
0.1
0
10000 0 10000 20000 30000 40000 50000 60000 70000
Barrels
8.4 PROBLEMS
8.1. The following values of Youngs Modulus for a rubber compound (in 1000 lb/in 2 ) have
been measured. Determine the following:
(a) The frequency distribution using class boundaries of 46, 68, etc
(b) True class boundaries and true class marks
(c) The histogram and cumulative frequency diagrams
8 5 12 14 13 10 9
11 6 11 9 8 15 8
5 6 8 11 4 8 10
13 12 6 10 9 8 13
8.4. PROBLEMS 169
8.2. For the data in Problem 8.1, calculate the mean, median, mode, and standard deviation.
Recalculate the mean and standard deviation using the frequency distribution determined
in Problem 8.1.
8.3. A particular event has two possible outcomes of true and false. There is a 50% probability of
getting a true outcome. The event is repeated four times. Construct a table that contains all
possible combinations of results and determine the probabilities of getting 0 true outcomes,
1 true outcome, 2 true outcomes, 3 true outcomes, and 4 true outcomes.
8.4. Fifteen castings of a certain type are produced per day in a foundry. The finished castings
are inspected and classified as defective or nondefective. Records indicate that of the last
500 castings inspected, 16 were defective. Based on this information, find the following:
(b) The probability of having at least two defective castings in a days production
8.5. The height of trucks on an interstate highway is approximately normally distributed with
mean of 10 ft and standard deviation of 1.5 ft. What is the height of an overpass if the
probability that a truck will clear it is 0.999?
8.6. The average life of a certain type of compressor is 10 years with a standard deviation of 1
year. The lives of the compressors follow a normal distribution. The manufacturer replaces,
at no cost, all compressors that fail while under the guarantee. If the manufacturer is willing
to replace only 3% of all compressors sold, how long of a guarantee should they offer?
8.7. A discrete distribution is given in the table below. Calculate the mean and standard deviation
of the distribution.
x 1 2 3 4
p(x) 0.2 0.3 0.1 0.4
170 8. BASIC STATISTICS AND PROBABILITY
8.8. Determine the mean and standard deviation of the following combined distribution.
8.9. A company is desirous of purchasing a service. The service will cost $10,000 and have a
probability of its life that can be described by a triangular distribution with values of a, b,
and c equal to 1, 3, and 6 years, respectively.
(a) Calculate the mean and the standard deviation of the life of the service
(b) What is the probability that the service will last at least 2 years?
(c) What is the probability that the service will last at least 5 years?
171
CHAPTER 9
Sensitivity Analysis
9.1 INTRODUCTION
A simple way of incorporating the elements of uncertainty into an economic analysis is to use
sensitivity analysis. As described earlier, an evaluator will normally need to include a measure of the
uncertainty pertaining to one or more variables in the analysis. This uncertainty may, in turn, add
significant uncertainty about the profitability of an investment. This range of uncertainty about the
projects profitability is one way to define the risk in a project.
Uncertainty in any particular variable can occur for a number of reasons. For example, the
method of measuring a parameter may have a certain amount of inaccuracy, the parameter may have
to be predicted into the future, or there may be a limited amount of data for a certain parameter. In
any case, the best that can be done for a variable with an uncertain value is to choose a reasonable
range over which it may vary and, perhaps, the type of distribution that the variable might take on
over that range.
Two types of sensitivity analysis will be considered in this chapter. The first is called the
range approach and involves the systematic variation of key variables to determine their overall
effect on the profitability of the investment. The second approach uses the concepts of probability
and statistics and is referred to as Monte Carlo Simulation (MCS). MCS has also been called
probabilistic sensitivity analysis.
Variable A
Ev
Criteria Variable B
Variable C
X% 0 +X%
Example 9.1
A tenyear life project has an initial investment of $87,500, annual operating expenses of
$7,500, and annual incomes of $30,000. It is desired to conduct a range approach sensitivity analysis
by the two methods described earlier:
9.1. INTRODUCTION 173
(a) Determine the most likely, the most optimistic, and the most pessimistic values for the I RR
by assuming the values given are the mean values for each parameter and that each parameter
has a range of 20% from the mean value.
(b) Vary each parameter independently by 20% from the mean values while holding the other
two constant at their mean values and develop a spider plot for the calculated I RR values.
The cash flow diagram for the most likely (or base case) is as follows:
0 1 2 3 8 9 10
Spider Plot
35
30
25
20
IRR Inial Investment
15
Operang Expenses
10
Annual Income
5
0
25 15 5 5 15 25
% son from Base Case
From the spider plot, it can be readily seen that the parameter which has the greatest effect on the
I RR is the annual income. A larger change in I RR is observed for the same percentage change in the
annual income than for initial investment or operating expenses. Changes in the operating expenses
have the least effect on the I RR. To minimize the risk that would be created by a 20% uncertainty
in the annual income, it would be beneficial for the evaluator to do additional research into this
portion of the cash flow calculation and determine if the range in uncertainty can be reduced.
In the example problem, only two values for each variable have been used.To be more complete,
several values between 20% and +20% could have been used to generate additional values of I RR.
9.1. INTRODUCTION 175
The primary drawback on the spider plot approach is that it ignores the interactions that occur
when more than one variable is allowed to change at a time. Not only does one have to define many
more cases to account for all possible interactions, but it is also difficult to tabulate these results in a
meaningful way. Often, the results simply become a tabulated list of I RRs for each case evaluated.
For example, consider a problem that has four variables that have uncertain values and that three
numerical values for each of the variables are chosen in the range approach. This will result in 81
(3x3x3x3) individual solutions to the problem that must be presented to evaluate the effect of all
four variables. It may be very difficult for the evaluator to draw any conclusions from a long tabular
list of 81 results.
3. Estimate the minimum and maximum values for the dependent variable and set up class
intervals in that range such that a probability distribution can be generated.
4. Select a probability distribution that best describes the behavior of each independent variable
between its minimum and maximum values.
5. Set up equations which will allow for the calculation of each of the independent variables.
This is done by determining expressions for the cumulative probability distributions, F (x),
for each independent variable and then solving this expression for the variable, x.
6. Generate a random number for each independent variable. A different random number is
determined for each independent variable. Random numbers are available from scientific
calculators, Excel , or by using Table 9.1. One can enter this table at any random point and
then proceed through the table either by rows or columns. Excel uses the =RAND() function
to generate a uniformly distributed random number between zero and one.
7. Use the random numbers to calculate the values for the independent variables using the
equations developed in step 5.
8. Calculate the dependent variable (or variables if necessary) for this set of independent variables
and increment a counter in the respective class interval.
9. Return to step 6 and repeat steps 6 through 8 a relatively large number of times. A large
number of trials might be 100, 1000, or 10,000 depending on the sensitivity of the dependent
variable to the independent variables.
10. Construct the cumulative probability distribution for the dependent variable.
177
9.1. INTRODUCTION
Initial Investment:
/al Investment
0.00003
0.000025
0.00002
p(x) 0.000015
0.00001
0.000005
0
60000 70000 80000 90000 100000 110000
Dollars
Operating Expenses:
Operng Expenses
0.0007
0.0006
0.0005
0.0004
p(x)
0.0003
0.0002
0.0001
0
5000 6000 7000 8000 9000 10000
Dollars/Year
9.1. INTRODUCTION 179
Annual Income:
Annual Income
0.00009
0.00008
0.00007
0.00006
0.00005
p(x)
0.00004
0.00003
0.00002
0.00001
0
23000 25000 27000 29000 31000 33000 35000 37000
Dollars/Year
Solution:
Let x2 be the value for the operating expenses. Since it has a triangular distribution, its
cumulative probability (F2 ) is given by
Let x3 be the value for the annual income. Since it has a uniform distribution, its cumulative
probability (F3 ) is given by
F3 = (x3 a)/(b a) = (x3 24000)/(36000 24000) = (x3 24000)/12000
First iteration:
Choose the first random number from the table. This will be the value for F1 . (F1 = 0.90535).
Use this number in Equation 9.1 to determine the value to be used for the initial investment:
x1 = 35000(0.90535) + 70000 = 101, 700
Choose the second random number from the table. This will be the value for F2 . (F2 =
0.86245). Since F2 0.5, use this number in Equation 9.3 to determine the value to be used
for the operating expense:
x2 = 9000 1500 2(1 0.86245) = 8, 200
Choose the third random number from the table.This will be the value for F3 . (F3 = 0.32775).
Use this number in Equation 9.4 to determine the value to be used for the annual income:
x3 = 12000(0.32775) + 24000 = 27, 900
These values for initial investment, operating expense, and annual income yield the following
cash flow diagram for the project:
0 1 2 3 8 9 10
I RR analysis yields a value of 14.3%. This value is tabulated in a list for further processing.
Second and successive iterations:
Follow the same procedure as listed for the first iteration. Three new random numbers are
used during each iteration. The results of the first ten iterations are shown in the table below.
9.1. INTRODUCTION 181
The cumulative probability distribution for I RR can be developed from information in the
following table:
182 9. SENSITIVITY ANALYSIS
With only ten iterations, this graph is too jagged to interpret correctly. The figure below
shows the same analysis after 100 iterations. One can see that the curve is much smoother. If even
more iterations are added, the curve will become smoother yet. However, the usefulness of the curve
may not increase proportionally to the number of iterations. One should only complete enough
iterations to get a reasonably smooth curve. Generally, this takes about 100 iterations, but this may
be a function of the actual problem being solved.This number of calculations can be easily completed
with Excel .
9.1. INTRODUCTION 183
As discussed in Chapter 8, the use of this graph is as follows. The value of F (x) at any I RR
is the probability that the project will attain that I RR or less. For example, there is approximately
an 18% probability that the project will earn an I RR value of less than 15%. Thus, if one uses
the investors MARR, F (x) provides the probability that the project will earn less than that value.
The quantity (100 F (x)) would provide the probability that the project earns greater than that
MARR. For example, if the investors MARR is 20%, one would enter the horizontal axis at 20%
and read a cumulative probability of about 44%. The interpretation would be that there is a 56%
probability that the project will yield a 20% I RR or greater. This probability is then a direct measure
of risk associated with the project. If an evaluator feels that a 44% probability that the project will
not be economically viable is an unacceptable level of risk, then the project should be eliminated
from further consideration. However, if, in this example, the investors MARR is only 15%, there is
only a 18% probability that the project will not be economically viable. This investor would have a
more acceptable level of risk.
Example 9.3
A particular investment has three uncertain variables of initial cost, future value, and the
investment life.
The initial cost can be described by a uniform distribution from $100 to $200.
The future value can be described by a normal distribution with = $300 and = $30.
The investment life can be described by a discrete probability distribution with 40% probability
that n = 5 years, 30% probability that n = 6 years, 20% probability that n = 7 years, and 10%
probability that n = 8 years.
184 9. SENSITIVITY ANALYSIS
Based on this information,
(a) Calculate the minimum rate of return that can be earned, the maximum rate of return that
can be earned and the mean rate of return that will be earned. For the normal distribution,
assume that the minimum and maximum values of future value will be 3 from the mean
($210 and $390, respectively).
(b) Complete a Monte Carlo Simulation for this project to determine the probability that the
ROR will be at least 15%.
The rate of return, ROR, can be calculated using the relationship, F = P (1 + i)n or
i = (F /P )1/n 1
Let x1 be the value for the initial investment. Since it has a uniform distribution, its cumulative
probability (F1 ) is given by
x1 = 100F1 + 100
Let x2 be the value for the future value. Since it has a normal distribution, its cumulative
probability (F2 ) is given by the values in Table 8.1. Once F2 (Z) is randomly chosen, the
appropriate value of Z is determined from Table 8.1 and then x2 = Z + .
Let x3 be the value for the project life. Since it has a discrete distribution, its cumulative
probability (F3 ) is given by
F3 0.4 x3 =5
0.4 < F3 0.7 x3 =6
0.7 < F3 0.9 x3 =7
0.9 < F3 1.0 x3 =8
186 9. SENSITIVITY ANALYSIS
The dependent variable is ROR which is calculated by using: ROR = (x2 /x1 )1/x3 1.
Each iteration can be calculated using the following Excel spreadsheet:
If one tabulates the result in cell B9 into another column of results (for example start in cell
A20), the spreadsheet will automatically select three new random numbers and a new result of
ROR will be calculated. This result would then be tabulated in cell A21. In order to generate
the histogram, this process is repeated manually 100 times (which would result in a column
of data from A20 to A119).
The results would be as follows:
At ROR of 15%, F (x) is approximately 74%. This means that there is a 74% probability that
the ROR will be less than 15% or a 26% probability that the ROR will be at least 15%.
9.2. PROBLEMS 187
9.2 PROBLEMS
9.1. You are to conduct an extensive sensitivity analysis on the problem described below. The
sensitivity analysis will consist of three parts:
(a) A range approach where the most optimistic, most likely, and most pessimistic values
of the dependent variables NP V and I RR are determined.
(b) A range approach where the mean value is determined for each independent variable
and then each variable is allowed to vary 20% about that mean while all other
independent variables are held constant. Create spider plots for NP V and I RR using
the results.
(c) A probabilistic approach using Monte Carlo Simulation. Complete 10 iterations and
create cumulative probability curves for NP V and I RR.
0 1 2 3 6 7
9.2. Complete Problem 9.1 using an Excel spreadsheet to calculate 100 iterations. Create
cumulative probability curves for NP V and I RR.
9.3. The following distributions are given for three independent variables, x1 , x2 , and x3 and the
relationship for the dependent variable, y. Calculate the largest, smallest, and mean values
of the dependent variable, y.
y = (x1 )(x2 ) + x3
9.4. Using the information given in Problem 9.3, use Monte Carlo Simulation to calculate 10
iterations of the dependent variable and create the cumulative probability diagram for the
dependent variable y.
9.5. Complete Problem 9.4 using an Excel spreadsheet and 100 iterations.
9.6. Complete Problem 9.4 using an Excel spreadsheet and assuming that independent variable
x2 has a normal distribution with a mean of 30 and a standard deviation of 3. Compute 100
iterations and create the cumulative probability diagram for the dependent variable y.
189
APPENDIX A
i= 1%
n F/P P/F F/A A/F P/A A/P A/G
1 1.01000 0.99010 1.0000 1.00000 0.9901 1.01000 0.00000
2 1.02010 0.98030 2.0100 0.49751 1.9704 0.50751 0.49751
3 1.03030 0.97059 3.0301 0.33002 2.9410 0.34002 0.99337
4 1.04060 0.96098 4.0604 0.24628 3.9020 0.25628 1.48756
5 1.05101 0.95147 5.1010 0.19604 4.8534 0.20604 1.98010
6 1.06152 0.94205 6.1520 0.16255 5.7955 0.17255 2.47098
7 1.07214 0.93272 7.2135 0.13863 6.7282 0.14863 2.96020
8 1.08286 0.92348 8.2857 0.12069 7.6517 0.13069 3.44777
9 1.09369 0.91434 9.3685 0.10674 8.5660 0.11674 3.93367
10 1.10462 0.90529 10.4622 0.09558 9.4713 0.10558 4.41792
11 1.11567 0.89632 11.5668 0.08645 10.3676 0.09645 4.90052
12 1.12683 0.88745 12.6825 0.07885 11.2551 0.08885 5.38145
13 1.13809 0.87866 13.8093 0.07241 12.1337 0.08241 5.86073
14 1.14947 0.86996 14.9474 0.06690 13.0037 0.07690 6.33836
15 1.16097 0.86135 16.0969 0.06212 13.8651 0.07212 6.81433
16 1.17258 0.85282 17.2579 0.05794 14.7179 0.06794 7.28865
17 1.18430 0.84438 18.4304 0.05426 15.5623 0.06426 7.76131
18 1.19615 0.83602 19.6147 0.05098 16.3983 0.06098 8.23231
19 1.20811 0.82774 20.8109 0.04805 17.2260 0.05805 8.70167
20 1.22019 0.81954 22.0190 0.04542 18.0456 0.05542 9.16937
25 1.28243 0.77977 28.2432 0.03541 22.0232 0.04541 11.48312
30 1.34785 0.74192 34.7849 0.02875 25.8077 0.03875 13.75566
35 1.41660 0.70591 41.6603 0.02400 29.4086 0.03400 15.98711
40 1.48886 0.67165 48.8864 0.02046 32.8347 0.03046 18.17761
45 1.56481 0.63905 56.4811 0.01771 36.0945 0.02771 20.32730
50 1.64463 0.60804 64.4632 0.01551 39.1961 0.02551 22.43635
55 1.72852 0.57853 72.8525 0.01373 42.1472 0.02373 24.50495
60 1.81670 0.55045 81.6697 0.01224 44.9550 0.02224 26.53331
65 1.90937 0.52373 90.9366 0.01100 47.6266 0.02100 28.52167
70 2.00676 0.49831 100.6763 0.00993 50.1685 0.01993 30.47026
75 2.10913 0.47413 110.9128 0.00902 52.5871 0.01902 32.37934
80 2.21672 0.45112 121.6715 0.00822 54.8882 0.01822 34.24920
85 2.32979 0.42922 132.9790 0.00752 57.0777 0.01752 36.08013
90 2.44863 0.40839 144.8633 0.00690 59.1609 0.01690 37.87245
95 2.57354 0.38857 157.3538 0.00636 61.1430 0.01636 39.62648
100 2.70481 0.36971 170.4814 0.00587 63.0289 0.01587 41.34257
COMPOUND INTEREST FACTORS 191
i= 2%
i= 3%
n F/P P/F F/A A/F P/A A/P A/G
1 1.03000 0.97087 1.0000 1.00000 0.9709 1.03000 0.00000
2 1.06090 0.94260 2.0300 0.49261 1.9135 0.52261 0.49261
3 1.09273 0.91514 3.0909 0.32353 2.8286 0.35353 0.98030
4 1.12551 0.88849 4.1836 0.23903 3.7171 0.26903 1.46306
5 1.15927 0.86261 5.3091 0.18835 4.5797 0.21835 1.94090
6 1.19405 0.83748 6.4684 0.15460 5.4172 0.18460 2.41383
7 1.22987 0.81309 7.6625 0.13051 6.2303 0.16051 2.88185
8 1.26677 0.78941 8.8923 0.11246 7.0197 0.14246 3.34496
9 1.30477 0.76642 10.1591 0.09843 7.7861 0.12843 3.80318
10 1.34392 0.74409 11.4639 0.08723 8.5302 0.11723 4.25650
11 1.38423 0.72242 12.8078 0.07808 9.2526 0.10808 4.70494
12 1.42576 0.70138 14.1920 0.07046 9.9540 0.10046 5.14850
13 1.46853 0.68095 15.6178 0.06403 10.6350 0.09403 5.58720
14 1.51259 0.66112 17.0863 0.05853 11.2961 0.08853 6.02104
15 1.55797 0.64186 18.5989 0.05377 11.9379 0.08377 6.45004
16 1.60471 0.62317 20.1569 0.04961 12.5611 0.07961 6.87421
17 1.65285 0.60502 21.7616 0.04595 13.1661 0.07595 7.29357
18 1.70243 0.58739 23.4144 0.04271 13.7535 0.07271 7.70812
19 1.75351 0.57029 25.1169 0.03981 14.3238 0.06981 8.11788
20 1.80611 0.55368 26.8704 0.03722 14.8775 0.06722 8.52286
25 2.09378 0.47761 36.4593 0.02743 17.4131 0.05743 10.47677
30 2.42726 0.41199 47.5754 0.02102 19.6004 0.05102 12.31407
35 2.81386 0.35538 60.4621 0.01654 21.4872 0.04654 14.03749
40 3.26204 0.30656 75.4013 0.01326 23.1148 0.04326 15.65016
45 3.78160 0.26444 92.7199 0.01079 24.5187 0.04079 17.15557
50 4.38391 0.22811 112.7969 0.00887 25.7298 0.03887 18.55751
55 5.08215 0.19677 136.0716 0.00735 26.7744 0.03735 19.86004
60 5.89160 0.16973 163.0534 0.00613 27.6756 0.03613 21.06742
65 6.82998 0.14641 194.3328 0.00515 28.4529 0.03515 22.18407
70 7.91782 0.12630 230.5941 0.00434 29.1234 0.03434 23.21454
75 9.17893 0.10895 272.6309 0.00367 29.7018 0.03367 24.16342
80 10.64089 0.09398 321.3630 0.00311 30.2008 0.03311 25.03534
85 12.33571 0.08107 377.8570 0.00265 30.6312 0.03265 25.83490
90 14.30047 0.06993 443.3489 0.00226 31.0024 0.03226 26.56665
95 16.57816 0.06032 519.2720 0.00193 31.3227 0.03193 27.23505
100 19.21863 0.05203 607.2877 0.00165 31.5989 0.03165 27.84445
COMPOUND INTEREST FACTORS 193
i= 4%
n F/P P/F F/A A/F P/A A/P A/G
1 1.04000 0.96154 1.0000 1.00000 0.9615 1.04000 0.00000
2 1.08160 0.92456 2.0400 0.49020 1.8861 0.53020 0.49020
3 1.12486 0.88900 3.1216 0.32035 2.7751 0.36035 0.97386
4 1.16986 0.85480 4.2465 0.23549 3.6299 0.27549 1.45100
5 1.21665 0.82193 5.4163 0.18463 4.4518 0.22463 1.92161
6 1.26532 0.79031 6.6330 0.15076 5.2421 0.19076 2.38571
7 1.31593 0.75992 7.8983 0.12661 6.0021 0.16661 2.84332
8 1.36857 0.73069 9.2142 0.10853 6.7327 0.14853 3.29443
9 1.42331 0.70259 10.5828 0.09449 7.4353 0.13449 3.73908
10 1.48024 0.67556 12.0061 0.08329 8.1109 0.12329 4.17726
11 1.53945 0.64958 13.4864 0.07415 8.7605 0.11415 4.60901
12 1.60103 0.62460 15.0258 0.06655 9.3851 0.10655 5.03435
13 1.66507 0.60057 16.6268 0.06014 9.9856 0.10014 5.45329
14 1.73168 0.57748 18.2919 0.05467 10.5631 0.09467 5.86586
15 1.80094 0.55526 20.0236 0.04994 11.1184 0.08994 6.27209
16 1.87298 0.53391 21.8245 0.04582 11.6523 0.08582 6.67200
17 1.94790 0.51337 23.6975 0.04220 12.1657 0.08220 7.06563
18 2.02582 0.49363 25.6454 0.03899 12.6593 0.07899 7.45300
19 2.10685 0.47464 27.6712 0.03614 13.1339 0.07614 7.83416
20 2.19112 0.45639 29.7781 0.03358 13.5903 0.07358 8.20912
25 2.66584 0.37512 41.6459 0.02401 15.6221 0.06401 9.99252
30 3.24340 0.30832 56.0849 0.01783 17.2920 0.05783 11.62743
35 3.94609 0.25342 73.6522 0.01358 18.6646 0.05358 13.11984
40 4.80102 0.20829 95.0255 0.01052 19.7928 0.05052 14.47651
45 5.84118 0.17120 121.0294 0.00826 20.7200 0.04826 15.70474
50 7.10668 0.14071 152.6671 0.00655 21.4822 0.04655 16.81225
55 8.64637 0.11566 191.1592 0.00523 22.1086 0.04523 17.80704
60 10.51963 0.09506 237.9907 0.00420 22.6235 0.04420 18.69723
65 12.79874 0.07813 294.9684 0.00339 23.0467 0.04339 19.49093
70 15.57162 0.06422 364.2905 0.00275 23.3945 0.04275 20.19614
75 18.94525 0.05278 448.6314 0.00223 23.6804 0.04223 20.82062
80 23.04980 0.04338 551.2450 0.00181 23.9154 0.04181 21.37185
85 28.04360 0.03566 676.0901 0.00148 24.1085 0.04148 21.85693
90 34.11933 0.02931 827.9833 0.00121 24.2673 0.04121 22.28255
95 41.51139 0.02409 1012.7846 0.00099 24.3978 0.04099 22.65498
100 50.50495 0.01980 1237.6237 0.00081 24.5050 0.04081 22.98000
194 APPENDIX A
i= 5%
n F/P P/F F/A A/F P/A A/P A/G
1 1.05000 0.95238 1.0000 1.00000 0.9524 1.05000 0.00000
2 1.10250 0.90703 2.0500 0.48780 1.8594 0.53780 0.48780
3 1.15763 0.86384 3.1525 0.31721 2.7232 0.36721 0.96749
4 1.21551 0.82270 4.3101 0.23201 3.5460 0.28201 1.43905
5 1.27628 0.78353 5.5256 0.18097 4.3295 0.23097 1.90252
6 1.34010 0.74622 6.8019 0.14702 5.0757 0.19702 2.35790
7 1.40710 0.71068 8.1420 0.12282 5.7864 0.17282 2.80523
8 1.47746 0.67684 9.5491 0.10472 6.4632 0.15472 3.24451
9 1.55133 0.64461 11.0266 0.09069 7.1078 0.14069 3.67579
10 1.62889 0.61391 12.5779 0.07950 7.7217 0.12950 4.09909
11 1.71034 0.58468 14.2068 0.07039 8.3064 0.12039 4.51444
12 1.79586 0.55684 15.9171 0.06283 8.8633 0.11283 4.92190
13 1.88565 0.53032 17.7130 0.05646 9.3936 0.10646 5.32150
14 1.97993 0.50507 19.5986 0.05102 9.8986 0.10102 5.71329
15 2.07893 0.48102 21.5786 0.04634 10.3797 0.09634 6.09731
16 2.18287 0.45811 23.6575 0.04227 10.8378 0.09227 6.47363
17 2.29202 0.43630 25.8404 0.03870 11.2741 0.08870 6.84229
18 2.40662 0.41552 28.1324 0.03555 11.6896 0.08555 7.20336
19 2.52695 0.39573 30.5390 0.03275 12.0853 0.08275 7.55690
20 2.65330 0.37689 33.0660 0.03024 12.4622 0.08024 7.90297
25 3.38635 0.29530 47.7271 0.02095 14.0939 0.07095 9.52377
30 4.32194 0.23138 66.4388 0.01505 15.3725 0.06505 10.96914
35 5.51602 0.18129 90.3203 0.01107 16.3742 0.06107 12.24980
40 7.03999 0.14205 120.7998 0.00828 17.1591 0.05828 13.37747
45 8.98501 0.11130 159.7002 0.00626 17.7741 0.05626 14.36444
50 11.46740 0.08720 209.3480 0.00478 18.2559 0.05478 15.22326
55 14.63563 0.06833 272.7126 0.00367 18.6335 0.05367 15.96645
60 18.67919 0.05354 353.5837 0.00283 18.9293 0.05283 16.60618
65 23.83990 0.04195 456.7980 0.00219 19.1611 0.05219 17.15410
70 30.42643 0.03287 588.5285 0.00170 19.3427 0.05170 17.62119
75 38.83269 0.02575 756.6537 0.00132 19.4850 0.05132 18.01759
80 49.56144 0.02018 971.2288 0.00103 19.5965 0.05103 18.35260
85 63.25435 0.01581 1245.0871 0.00080 19.6838 0.05080 18.63463
90 80.73037 0.01239 1594.6073 0.00063 19.7523 0.05063 18.87120
95 103.03468 0.00971 2040.6935 0.00049 19.8059 0.05049 19.06894
100 131.50126 0.00760 2610.0252 0.00038 19.8479 0.05038 19.23372
COMPOUND INTEREST FACTORS 195
i= 6%
n F/P P/F F/A A/F P/A A/P A/G
1 1.06000 0.94340 1.0000 1.00000 0.9434 1.06000 0.00000
2 1.12360 0.89000 2.0600 0.48544 1.8334 0.54544 0.48544
3 1.19102 0.83962 3.1836 0.31411 2.6730 0.37411 0.96118
4 1.26248 0.79209 4.3746 0.22859 3.4651 0.28859 1.42723
5 1.33823 0.74726 5.6371 0.17740 4.2124 0.23740 1.88363
6 1.41852 0.70496 6.9753 0.14336 4.9173 0.20336 2.33040
7 1.50363 0.66506 8.3938 0.11914 5.5824 0.17914 2.76758
8 1.59385 0.62741 9.8975 0.10104 6.2098 0.16104 3.19521
9 1.68948 0.59190 11.4913 0.08702 6.8017 0.14702 3.61333
10 1.79085 0.55839 13.1808 0.07587 7.3601 0.13587 4.02201
11 1.89830 0.52679 14.9716 0.06679 7.8869 0.12679 4.42129
12 2.01220 0.49697 16.8699 0.05928 8.3838 0.11928 4.81126
13 2.13293 0.46884 18.8821 0.05296 8.8527 0.11296 5.19198
14 2.26090 0.44230 21.0151 0.04758 9.2950 0.10758 5.56352
15 2.39656 0.41727 23.2760 0.04296 9.7122 0.10296 5.92598
16 2.54035 0.39365 25.6725 0.03895 10.1059 0.09895 6.27943
17 2.69277 0.37136 28.2129 0.03544 10.4773 0.09544 6.62397
18 2.85434 0.35034 30.9057 0.03236 10.8276 0.09236 6.95970
19 3.02560 0.33051 33.7600 0.02962 11.1581 0.08962 7.28673
20 3.20714 0.31180 36.7856 0.02718 11.4699 0.08718 7.60515
25 4.29187 0.23300 54.8645 0.01823 12.7834 0.07823 9.07220
30 5.74349 0.17411 79.0582 0.01265 13.7648 0.07265 10.34221
35 7.68609 0.13011 111.4348 0.00897 14.4982 0.06897 11.43192
40 10.28572 0.09722 154.7620 0.00646 15.0463 0.06646 12.35898
45 13.76461 0.07265 212.7435 0.00470 15.4558 0.06470 13.14129
50 18.42015 0.05429 290.3359 0.00344 15.7619 0.06344 13.79643
55 24.65032 0.04057 394.1720 0.00254 15.9905 0.06254 14.34112
60 32.98769 0.03031 533.1282 0.00188 16.1614 0.06188 14.79095
65 44.14497 0.02265 719.0829 0.00139 16.2891 0.06139 15.16012
70 59.07593 0.01693 967.9322 0.00103 16.3845 0.06103 15.46135
75 79.05692 0.01265 1300.9487 0.00077 16.4558 0.06077 15.70583
80 105.79599 0.00945 1746.5999 0.00057 16.5091 0.06057 15.90328
85 141.57890 0.00706 2342.9817 0.00043 16.5489 0.06043 16.06202
90 189.46451 0.00528 3141.0752 0.00032 16.5787 0.06032 16.18912
95 253.54625 0.00394 4209.1042 0.00024 16.6009 0.06024 16.29050
100 339.30208 0.00295 5638.3681 0.00018 16.6175 0.06018 16.37107
196 APPENDIX A
i= 7%
n F/P P/F F/A A/F P/A A/P A/G
1 1.07000 0.93458 1.0000 1.00000 0.9346 1.07000 0.00000
2 1.14490 0.87344 2.0700 0.48309 1.8080 0.55309 0.48309
3 1.22504 0.81630 3.2149 0.31105 2.6243 0.38105 0.95493
4 1.31080 0.76290 4.4399 0.22523 3.3872 0.29523 1.41554
5 1.40255 0.71299 5.7507 0.17389 4.1002 0.24389 1.86495
6 1.50073 0.66634 7.1533 0.13980 4.7665 0.20980 2.30322
7 1.60578 0.62275 8.6540 0.11555 5.3893 0.18555 2.73039
8 1.71819 0.58201 10.2598 0.09747 5.9713 0.16747 3.14654
9 1.83846 0.54393 11.9780 0.08349 6.5152 0.15349 3.55174
10 1.96715 0.50835 13.8164 0.07238 7.0236 0.14238 3.94607
11 2.10485 0.47509 15.7836 0.06336 7.4987 0.13336 4.32963
12 2.25219 0.44401 17.8885 0.05590 7.9427 0.12590 4.70252
13 2.40985 0.41496 20.1406 0.04965 8.3577 0.11965 5.06484
14 2.57853 0.38782 22.5505 0.04434 8.7455 0.11434 5.41673
15 2.75903 0.36245 25.1290 0.03979 9.1079 0.10979 5.75829
16 2.95216 0.33873 27.8881 0.03586 9.4466 0.10586 6.08968
17 3.15882 0.31657 30.8402 0.03243 9.7632 0.10243 6.41102
18 3.37993 0.29586 33.9990 0.02941 10.0591 0.09941 6.72247
19 3.61653 0.27651 37.3790 0.02675 10.3356 0.09675 7.02418
20 3.86968 0.25842 40.9955 0.02439 10.5940 0.09439 7.31631
25 5.42743 0.18425 63.2490 0.01581 11.6536 0.08581 8.63910
30 7.61226 0.13137 94.4608 0.01059 12.4090 0.08059 9.74868
35 10.67658 0.09366 138.2369 0.00723 12.9477 0.07723 10.66873
40 14.97446 0.06678 199.6351 0.00501 13.3317 0.07501 11.42335
45 21.00245 0.04761 285.7493 0.00350 13.6055 0.07350 12.03599
50 29.45703 0.03395 406.5289 0.00246 13.8007 0.07246 12.52868
55 41.31500 0.02420 575.9286 0.00174 13.9399 0.07174 12.92146
60 57.94643 0.01726 813.5204 0.00123 14.0392 0.07123 13.23209
65 81.27286 0.01230 1146.7552 0.00087 14.1099 0.07087 13.47598
70 113.98939 0.00877 1614.1342 0.00062 14.1604 0.07062 13.66619
75 159.87602 0.00625 2269.6574 0.00044 14.1964 0.07044 13.81365
80 224.23439 0.00446 3189.0627 0.00031 14.2220 0.07031 13.92735
85 314.50033 0.00318 4478.5761 0.00022 14.2403 0.07022 14.01458
90 441.10298 0.00227 6287.1854 0.00016 14.2533 0.07016 14.08122
95 618.66975 0.00162 8823.8535 0.00011 14.2626 0.07011 14.13191
100 867.71633 0.00115 12381.6618 0.00008 14.2693 0.07008 14.17034
COMPOUND INTEREST FACTORS 197
i= 8%
n F/P P/F F/A A/F P/A A/P A/G
1 1.08000 0.92593 1.0000 1.00000 0.9259 1.08000 0.00000
2 1.16640 0.85734 2.0800 0.48077 1.7833 0.56077 0.48077
3 1.25971 0.79383 3.2464 0.30803 2.5771 0.38803 0.94874
4 1.36049 0.73503 4.5061 0.22192 3.3121 0.30192 1.40396
5 1.46933 0.68058 5.8666 0.17046 3.9927 0.25046 1.84647
6 1.58687 0.63017 7.3359 0.13632 4.6229 0.21632 2.27635
7 1.71382 0.58349 8.9228 0.11207 5.2064 0.19207 2.69366
8 1.85093 0.54027 10.6366 0.09401 5.7466 0.17401 3.09852
9 1.99900 0.50025 12.4876 0.08008 6.2469 0.16008 3.49103
10 2.15892 0.46319 14.4866 0.06903 6.7101 0.14903 3.87131
11 2.33164 0.42888 16.6455 0.06008 7.1390 0.14008 4.23950
12 2.51817 0.39711 18.9771 0.05270 7.5361 0.13270 4.59575
13 2.71962 0.36770 21.4953 0.04652 7.9038 0.12652 4.94021
14 2.93719 0.34046 24.2149 0.04130 8.2442 0.12130 5.27305
15 3.17217 0.31524 27.1521 0.03683 8.5595 0.11683 5.59446
16 3.42594 0.29189 30.3243 0.03298 8.8514 0.11298 5.90463
17 3.70002 0.27027 33.7502 0.02963 9.1216 0.10963 6.20375
18 3.99602 0.25025 37.4502 0.02670 9.3719 0.10670 6.49203
19 4.31570 0.23171 41.4463 0.02413 9.6036 0.10413 6.76969
20 4.66096 0.21455 45.7620 0.02185 9.8181 0.10185 7.03695
25 6.84848 0.14602 73.1059 0.01368 10.6748 0.09368 8.22538
30 10.06266 0.09938 113.2832 0.00883 11.2578 0.08883 9.18971
35 14.78534 0.06763 172.3168 0.00580 11.6546 0.08580 9.96107
40 21.72452 0.04603 259.0565 0.00386 11.9246 0.08386 10.56992
45 31.92045 0.03133 386.5056 0.00259 12.1084 0.08259 11.04465
50 46.90161 0.02132 573.7702 0.00174 12.2335 0.08174 11.41071
55 68.91386 0.01451 848.9232 0.00118 12.3186 0.08118 11.69015
60 101.25706 0.00988 1253.2133 0.00080 12.3766 0.08080 11.90154
65 148.77985 0.00672 1847.2481 0.00054 12.4160 0.08054 12.06016
70 218.60641 0.00457 2720.0801 0.00037 12.4428 0.08037 12.17832
75 321.20453 0.00311 4002.5566 0.00025 12.4611 0.08025 12.26577
80 471.95483 0.00212 5886.9354 0.00017 12.4735 0.08017 12.33013
85 693.45649 0.00144 8655.7061 0.00012 12.4820 0.08012 12.37725
90 1018.91509 0.00098 12723.9386 0.00008 12.4877 0.08008 12.41158
95 1497.12055 0.00067 18701.5069 0.00005 12.4917 0.08005 12.43650
100 2199.76126 0.00045 27484.5157 0.00004 12.4943 0.08004 12.45452
198 APPENDIX A
i= 9%
n F/P P/F F/A A/F P/A A/P A/G
1 1.09000 0.91743 1.0000 1.00000 0.9174 1.09000 0.00000
2 1.18810 0.84168 2.0900 0.47847 1.7591 0.56847 0.47847
3 1.29503 0.77218 3.2781 0.30505 2.5313 0.39505 0.94262
4 1.41158 0.70843 4.5731 0.21867 3.2397 0.30867 1.39250
5 1.53862 0.64993 5.9847 0.16709 3.8897 0.25709 1.82820
6 1.67710 0.59627 7.5233 0.13292 4.4859 0.22292 2.24979
7 1.82804 0.54703 9.2004 0.10869 5.0330 0.19869 2.65740
8 1.99256 0.50187 11.0285 0.09067 5.5348 0.18067 3.05117
9 2.17189 0.46043 13.0210 0.07680 5.9952 0.16680 3.43123
10 2.36736 0.42241 15.1929 0.06582 6.4177 0.15582 3.79777
11 2.58043 0.38753 17.5603 0.05695 6.8052 0.14695 4.15096
12 2.81266 0.35553 20.1407 0.04965 7.1607 0.13965 4.49102
13 3.06580 0.32618 22.9534 0.04357 7.4869 0.13357 4.81816
14 3.34173 0.29925 26.0192 0.03843 7.7862 0.12843 5.13262
15 3.64248 0.27454 29.3609 0.03406 8.0607 0.12406 5.43463
16 3.97031 0.25187 33.0034 0.03030 8.3126 0.12030 5.72446
17 4.32763 0.23107 36.9737 0.02705 8.5436 0.11705 6.00238
18 4.71712 0.21199 41.3013 0.02421 8.7556 0.11421 6.26865
19 5.14166 0.19449 46.0185 0.02173 8.9501 0.11173 6.52358
20 5.60441 0.17843 51.1601 0.01955 9.1285 0.10955 6.76745
25 8.62308 0.11597 84.7009 0.01181 9.8226 0.10181 7.83160
30 13.26768 0.07537 136.3075 0.00734 10.2737 0.09734 8.66566
35 20.41397 0.04899 215.7108 0.00464 10.5668 0.09464 9.30829
40 31.40942 0.03184 337.8824 0.00296 10.7574 0.09296 9.79573
45 48.32729 0.02069 525.8587 0.00190 10.8812 0.09190 10.16029
50 74.35752 0.01345 815.0836 0.00123 10.9617 0.09123 10.42952
55 114.40826 0.00874 1260.0918 0.00079 11.0140 0.09079 10.62614
60 176.03129 0.00568 1944.7921 0.00051 11.0480 0.09051 10.76832
65 270.84596 0.00369 2998.2885 0.00033 11.0701 0.09033 10.87023
70 416.73009 0.00240 4619.2232 0.00022 11.0844 0.09022 10.94273
75 641.19089 0.00156 7113.2321 0.00014 11.0938 0.09014 10.99396
80 986.55167 0.00101 10950.5741 0.00009 11.0998 0.09009 11.02994
85 1517.93203 0.00066 16854.8003 0.00006 11.1038 0.09006 11.05508
90 2335.52658 0.00043 25939.1842 0.00004 11.1064 0.09004 11.07256
95 3593.49715 0.00028 39916.6350 0.00003 11.1080 0.09003 11.08467
100 5529.04079 0.00018 61422.6755 0.00002 11.1091 0.09002 11.09302
COMPOUND INTEREST FACTORS 199
i= 10%
i= 12%
n F/P P/F F/A A/F P/A A/P A/G
1 1.12000 0.89286 1.0000 1.00000 0.8929 1.12000 0.00000
2 1.25440 0.79719 2.1200 0.47170 1.6901 0.59170 0.47170
3 1.40493 0.71178 3.3744 0.29635 2.4018 0.41635 0.92461
4 1.57352 0.63552 4.7793 0.20923 3.0373 0.32923 1.35885
5 1.76234 0.56743 6.3528 0.15741 3.6048 0.27741 1.77459
6 1.97382 0.50663 8.1152 0.12323 4.1114 0.24323 2.17205
7 2.21068 0.45235 10.0890 0.09912 4.5638 0.21912 2.55147
8 2.47596 0.40388 12.2997 0.08130 4.9676 0.20130 2.91314
9 2.77308 0.36061 14.7757 0.06768 5.3282 0.18768 3.25742
10 3.10585 0.32197 17.5487 0.05698 5.6502 0.17698 3.58465
11 3.47855 0.28748 20.6546 0.04842 5.9377 0.16842 3.89525
12 3.89598 0.25668 24.1331 0.04144 6.1944 0.16144 4.18965
13 4.36349 0.22917 28.0291 0.03568 6.4235 0.15568 4.46830
14 4.88711 0.20462 32.3926 0.03087 6.6282 0.15087 4.73169
15 5.47357 0.18270 37.2797 0.02682 6.8109 0.14682 4.98030
16 6.13039 0.16312 42.7533 0.02339 6.9740 0.14339 5.21466
17 6.86604 0.14564 48.8837 0.02046 7.1196 0.14046 5.43530
18 7.68997 0.13004 55.7497 0.01794 7.2497 0.13794 5.64274
19 8.61276 0.11611 63.4397 0.01576 7.3658 0.13576 5.83752
20 9.64629 0.10367 72.0524 0.01388 7.4694 0.13388 6.02020
25 17.0001 0.05882 133.334 0.00750 7.8431 0.12750 6.77084
30 29.9599 0.03338 241.333 0.00414 8.0552 0.12414 7.29742
35 52.7996 0.01894 431.663 0.00232 8.1755 0.12232 7.65765
40 93.0510 0.01075 767.091 0.00130 8.2438 0.12130 7.89879
45 163.988 0.00610 1358.23 0.00074 8.2825 0.12074 8.05724
50 289.002 0.00346 2400.02 0.00042 8.3045 0.12042 8.15972
55 509.321 0.00196 4236.01 0.00024 8.3170 0.12024 8.22513
60 897.597 0.00111 7471.64 0.00013 8.3240 0.12013 8.26641
65 1581.87 0.00063 13173.9 0.00008 8.3281 0.12008 8.29222
70 2787.80 0.00036 23223.3 0.00004 8.3303 0.12004 8.30821
COMPOUND INTEREST FACTORS 201
i= 15%
i= 20%
i= 25%
n F/P P/F F/A A/F P/A A/P A/G
1 1.25000 0.80000 1.0000 1.00000 0.8000 1.25000 0.00000
2 1.56250 0.64000 2.2500 0.44444 1.4400 0.69444 0.44444
3 1.95313 0.51200 3.8125 0.26230 1.9520 0.51230 0.85246
4 2.44141 0.40960 5.7656 0.17344 2.3616 0.42344 1.22493
5 3.05176 0.32768 8.2070 0.12185 2.6893 0.37185 1.56307
6 3.81470 0.26214 11.2588 0.08882 2.9514 0.33882 1.86833
7 4.76837 0.20972 15.0735 0.06634 3.1611 0.31634 2.14243
8 5.96046 0.16777 19.8419 0.05040 3.3289 0.30040 2.38725
9 7.45058 0.13422 25.8023 0.03876 3.4631 0.28876 2.60478
10 9.31323 0.10737 33.2529 0.03007 3.5705 0.28007 2.79710
11 11.6415 0.08590 42.5661 0.02349 3.6564 0.27349 2.96631
12 14.5519 0.06872 54.2077 0.01845 3.7251 0.26845 3.11452
13 18.1899 0.05498 68.7596 0.01454 3.7801 0.26454 3.24374
14 22.7374 0.04398 86.9495 0.01150 3.8241 0.26150 3.35595
15 28.4217 0.03518 109.687 0.00912 3.8593 0.25912 3.45299
16 35.5271 0.02815 138.109 0.00724 3.8874 0.25724 3.53660
17 44.4089 0.02252 173.636 0.00576 3.9099 0.25576 3.60838
18 55.5112 0.01801 218.045 0.00459 3.9279 0.25459 3.66979
19 69.3889 0.01441 273.556 0.00366 3.9424 0.25366 3.72218
20 86.7362 0.01153 342.945 0.00292 3.9539 0.25292 3.76673
25 264.698 0.00378 1054.79 0.00095 3.9849 0.25095 3.90519
30 807.794 0.00124 3227.17 0.00031 3.9950 0.25031 3.96282
35 2465.19 0.00041 9856.76 0.00010 3.9984 0.25010 3.98580
40 7523.16 0.00013 30088.7 0.00003 3.9995 0.25003 3.99468
45 22958.87 0.00004 91831.5 0.00001 3.9998 0.25001 3.99804
50 70064.92 0.00001 280256 0.00000 3.9999 0.25000 3.99929
55 213821.2 0.00000 855281 0.00000 4.0000 0.25000 3.99974
60 652530.4 0.00000 2610118 0.00000 4.0000 0.25000 3.99991
205
Authors Biographies
DAVID L. WHITMAN
David L. Whitman, P.E., Ph.D. received a B.S. degree (1975) in Electrical Engineering from the
University of Wyoming (UW). He also received a Ph.D. degree (1978) in Mineral Engineering
from the University of Wyoming. He worked in the synthetic fuels arena prior to becoming a faculty
member in Petroleum Engineering at the University of Wyoming in 1981. From 1989 to 2005,
he was the Associate Dean of Academics and since 2005 has been a professor of Electrical and
Computer Engineering. He received UWs Ellbogen Outstanding Teacher Award in 1985, UWs
College of Engineering Outstanding Undergraduate Teaching Award in 1990 and 2004 and the
ASEE Rocky Mountain Section Outstanding Teaching Award in 2001. He is a Past President
of the National Council of Examiners for Engineers and Surveyors (NCEES), chairman of the
IEEEUSA Licensure & Registration Committee, and an active member of ASEE.
RONALD E. TERRY
Ronald E. Terry, Ph.D. received a B.S. in Chemical Engineering from Oregon State University
(1971) and a Ph.D. from Brigham Young University (BYU) (1976). He worked for Phillips Petroleum
Company after graduate school and began his academic career in 1977 at the University of Kansas
in the Chemical and Petroleum Engineering Department. He taught in the Petroleum Engineering
Department at the University of Wyoming (19811987) and at BYU in the Chemical Engineering
Department (19872007) and in the Technology and Engineering Education Department (2007
present). He has received teaching awards at the University of Kansas, University of Wyoming, and
at Brigham Young University.
Early in his career, his scholarship efforts involved researching methods to enhance the pro
duction of oil and gas. After joining BYU, his scholarship centered on pedagogy, student learning,
and engineering ethics. He has served as acting department chair, associate dean, and in BYUs
central administration as an Associate in the Office of Planning and Assessment for five years
(20032008). He is past president of the Rocky Mountain Section of the American Society for
Engineering Education.