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Part -2

Introduction to Engineering Economics

1
Introduction
The technological and social environments
continue to change at a rapid rate.
In recent decades, advances in science and
engineering have
made space travel possible,
transformed our transportation system,
revolutionized the practice of medicine, and
miniaturized electronic circuits.
The utilization of scientific and engineering
knowledge is achieved through the design of
things we use. 2
Contd
However, these achievements dont occur
without a price, monitory.
Therefore, the purpose of this course is to
develop and illustrate the principle and
methodology required to answer the basic
economic question of any design.

3
Important Terms
Economics is the study of how people and
society choose to employ scarce resources.
Engineering is the profession in which a
knowledge of mathematical and natural sciences
is applied with judgment.
Engineering economics
is the systematic evaluation of the economic merits
of proposed solutions to engineering problems. Or
is the application of economic techniques to the
evaluation of design and engineering alternatives or
projects.
4
Contd
The role of engineering
economics is to
Assess the
appropriateness of a
given project
Estimate its value
Justify it
Costing refers to the
technique and process of
ascertaining cost.

5
Time Value of Money
The time value of money explains the change in the
amount of money over time.
This is the most important concept in engineering
economy.
Money has a value
It can be leased or rented same way as apartment
The payment is called interest

6
Interest
is the manifestation of the time value of money.
is the difference between an ending amount of
money and the beginning amount.
There are always two perspectives to an amount of
interest interest paid and interest earned.
Interest = amount owed now principal
interest rate is the interest paid expressed as a
percentage of the principal over a specific time unit.
Interest rate (%) = x 100%
The time unit of the rate is called the interest
period.
7
Example
1
An employee borrows $10,000 on May 1 and must
repay a total of $10,700 exactly 1 year later.
Determine the interest amount and the interest rate
paid.
Solution
The perspective here is that of the borrower since
$10,700 repays a loan. to determine the interest paid.
Interest paid = $10,700 - 10,000 = $700
determines the interest rate paid for 1 year.
Percent interest rate = X 100% = 7 % per year

8

Example 2
(a) Calculate the amount deposited 1 year ago to have $1000 now
at an interest rate of 5% per year.
(b) Calculate the amount of interest earned during this time period.
Solution
(a) The total amount accrued ($1000) is the sum of the original
deposit and the earned interest.
If X is the original deposit,
Total accrued = deposit + deposit(interest rate)
$1000 = X + X(0.05) = X(1 + 0.05) = 1.05X
The original deposit is
X = = $952.38
(b) Interest = $1000 - 952.38 = $47.62

9
Elements of Transactions Involving Interest
P = value or amount of money at a time designated
as the present or time 0.
F = value or amount of money at some future time.
A = series of consecutive, equal, end-of-period
amounts of money.
n = number of interest periods; years, months, days
i = interest rate per time period; percent per year,
percent per month
t = time, stated in periods; years, months, days

10
Cash Flows: Estimation and Diagramming
Cash flows are the amounts of money estimated for
future projects or observed for project events that
have taken place.
All cash flows occur during specific time periods.
Cash inflows are the receipts, revenues, incomes, and
savings generated by project and business activity.
A plus sign indicates a cash inflow.
Cash outflows are costs, disbursements, expenses,
and taxes caused by projects and business Cash flow
activity.
A negative or minus sign indicates a cash outflow.
11
Cash Flow Diagram
A cash flow diagram
(CFD) illustrates the size,
sign, and timing of At each time cash flow
individual cash flows.
will occur, a vertical
It is a segmented time-based
horizontal line, divided into
arrow is added-pointing
appropriate time units. down for costs and up
The time units on the CFD for revenues or
can be years, months, benefits.
quarters.
CFD summarizes The costs
and benefits of engineering
projects.

12
Computing Cash Flows
Example 1
Draw the CFD for a specific investment
opportunity whose cash flows are described
as follows:

13
CFD

14
Example 2
Assume you borrow $8500 from a bank today
to purchase an $8000 used car for cash next
week, and you plan to spend the remaining
$500 on a new paint job for the car two weeks
from now. Construct the cash flow diagram

Perspective Activity Cash flow with Time, week


Sign, $
You Borrow +8500 0
Buy car -8000 1
Paint job -500 2

15
CFD

16
Methods of Calculating Interest
Simple Interest
Interest paid (earned) on only the original amount, or principal,
borrowed (lent).
the interest earned during each interest period does not earn
additional interest in the remaining periods.
FormulaI = P(i)(n)
I: Simple Interest
P: Deposit today (t=0)
i: Interest Rate per Period
n: Number of Time Periods
The total amount available at the end of N periods, F. thus
would be
F = P + I = P (l + i N )
17
Compound Interest
the interest accrued for each interest period is
calculated on the principal plus the total amount of
interest accumulated in all previous periods.
In general, if you deposited (invested) P dollars at an
interest rate i, you would have
P + iP = P( 1 + i ) dollars at the end of one interest
period.
This interest-earning process repeats, and after N
periods, the total accumulated value (balance) F will
grow to
F = P(1 + i)N
Total interest earned = In = P (1+i)n - P
18
Example 1
Assume that you deposit $1,000 in an
account earning 7% simple interest for 2
years. What is the accumulated interest at
the end of the 2nd year?
I = P(i)(n)
= $1,000(.07)(2) = $140

19
Example 1
Suppose you deposit $1,000 in a bank savings account
that pays interest at a rate of 8% per year. Assume that
you don't withdraw the interest earned at the end of
each period (year), but instead let it accumulate. (a)
How much would you have at the end of year three
with simple interest? (b) How much would you have
at the end of year three with compound interest?
Solution:
Given: P = $1,000. N = 3 years. and i = 8% per year.
(a) Simple interest: We calculate F as
F= $1000[1 + (0.08)3]= $1,240
20
Contd
The interest-accruing process shown as
follows:

21
Contd
(b) Compound interest: Applying the Eq. F = P(1
+ i)N to a three-year, 8% case, we obtain
F= $1000(1 + 0.08)3= $1259.71
The interest-accruing process shown as
follows:

22
Example 2

23
Factors: How Time and Interest Affect Money
Single-Amount Factors (F/P and P/F)
(1 + i)n is called the single-payment compound/
amount factor, or the F/P factor.
(1 + i)-n is known as the single-payment present
worth factor, or the P/F factor.
Summary of the standard notation and equations of the factors
Factor Find/G Standard Equation
Notation Name iven Notation with Factor
Equation Formula

(F/P, i, n) Single-payment F/P F = P(F/P,i,n) F = P( 1 + i )n


compound amount
(P/F, i, n) Single-payment P/F P = F(P/F,i,n) P = F/(l + i)n
present worth
24
Cash flow diagrams for single-payment factors

=?

= =
Given Given
Fig: Cash flow diagram for single payment compound
amount
=
Given

=
=?
Given
Fig: Cash flow diagram single payment present worth
amount
25
Example 1
A manufacturing engineer has just received a
year-end bonus of $10,000 that will be
invested immediately. With the expectation of
earning at the rate of 8% per year, he hopes to
take the entire amount out in exactly 20 years
to pay for a family vacation when the oldest
daughter is due to graduate from college. Find
the amount of funds that will be available in
20 years by using the factor formula and
tabulated value.

26
Solution
The symbols and values are
P = $10,000 F = ? i = 8% per year n = 20 years
(a) Factor formula
F = P(1 + i )n = 10,0000(1.08)20 = 10,000(4.6610)
= $46,610
(b) Standard notation and tabulated value
Notation for the F/P factor is (F/P,i%,n)
F = P(F/P, i%,n) = P(F/P, 8%,20) =
10,000(4.6610)
= $46,610
27
Example 2
A person wishes to have a future sum of Birr. 1 00,000
for his sons education after 10 years from now. What is
the single-payment that he should deposit now so that
he gets the desired amount after 10 years? The bank
gives 15% interest rate compounded annually.
Solution
F= Birr. 100,000 P = ? i = 15%, compounded annually
n= 10 years
P= F/ (1 + i) n = F (P/F, i, n)
= 1, 00,000 (P/F, 15%, 10)
= 1, 00,000 X 0.2472
= Birr. 24,720
28
Meaning Of Equivalence
Consider that a firm received a sum of $10000
at the beginning of year 6
Immediately invested at 8%
By the beginning of year 9,this sum of money
expanded to 10000(F/P,3,8)=$12597.
These two events are equivalent to one another.

29
Meaning Of Equivalence

Example1:If money is worth 10 percent, what single


payment made at the beginning of year 7 is
equivalent to the following set of payments:$600 at
the beginning of year 1, $3200 at the beginning of
year 2, and $4000 at the beginning of year 10.
Solution:
equivalent payment = 600(F/P,6) +3200(F/P,5)+
4000(F/P,3)
= $9222

30
Uniform Series Present Worth and
Capital Recovery Factors (P/A and A/P)
is called uniform series present worth factor or P/A
factor.
is called capital recovery factor or A/P factor.

Summary of the standard notation and equations of the factors


Factor Find/Gi Standard Equation
Notation Name ven Notation with Factor
Equation Formula

(P/A, i, n) Uniform series P/A P = A(P/A,i,n) P=A


present worth
(A/P, i, n) Capital recovery A/P A= A=P
P(A/P,i,n)

31
Cash flow diagrams for Uniform Series Present
Worth and Capital Recovery Factors
=?
=
Given

=
Given
Fig: Cash flow diagram of equal-payment series present
worth amount.
=
Given
=
Given

=?
Fig: Cash flow diagram of equal-payment series capital
recovery amount.
32
Example 3
How much money should you be willing to
pay now for a guaranteed $600 per year for 9
years starting next year, at a rate of return of
16% per year?
Solution
A = $600, i = 16%, and n = 9.
The present worth is
P = A(P/A, i%,n)
P = 600(P/A,16%,9) = 600(4.6065) = $2763.90

33
Example 4
A bank gives a loan to a company to purchase an
equipment worth Birr. 1,000,000 at an interest rate of
18% compounded annually. This amount should be repaid
in 15 yearly equal installments.
Find the installment amount that the company has to pay to
the bank.
Solution
The corresponding cash flow diagram is shown below.

34
Contd
P= Birr. 1,000,000 A= ? i = 18% n= 15 years

= 1,000,000 X (A/P, 18%, 15)


= 1,000,000 X (0.1964)
= Birr. 196,400
The annual equivalent installment to be paid by
the company to the bank is Birr. 196,400.

35
Uniform Series Compound
Amount and Sinking Fund Factors (F/A and A/F)
is called the uniform series compound amount
factor or F/A factor.
is called sinking fund factor of A/F factor.

Summary of the standard notation and equations of the factors


Factor Find/G Standard Equation
Notation Name iven Notation with Factor
Equation Formula

(F/A, i, n) Uniform series F/A F= F=A


compound amount A(F/A,i,n)
(A/F, i, n) Sinking fund A/F A= A= F
F(A/F,i,n)
5/19/17 36
Cash flow diagrams for Uniform Series
Compound Amount and Sinking Fund Factors
=?
=
Given

=
Given
Fig: Cash flow diagram of equal-payment series compound
amount
=
Given

=?
=
Given
Fig: Cash flow diagram of equal-payment series sinking
fund.
37
Example 5
The president of Ford Motor Company wants
to know the equivalent future worth of a
$1,000 capital investment each year for 8
years, starting 1 year from now. Ford capital
earns at a rate of 14% per year.
Solution
In $1000 units, the F value in year 8 is found
by using the F/A factor.
F = 1000(F/A,14%,8) = 1000(13.2328) =
$13,232.80
38
Example 6
A company has to replace a present facility after 15 years at
an outlay of Birr. 500,000. It plans to deposit an equal
amount at the end of every year for the next 15 years at an
interest rate of 18% compounded annually.
Find the equivalent amount that must be deposited at the
end of every year for the next 15 years.
Solution
The corresponding cash flow diagram is shown below.

39
Contd
F= Birr. 500,000 A = ? i = 18% n= 15 years

= 500,000 (A/F, 18%, 15)


= 500,000 X 0.0164
= Birr. 8,200
The annual equal amount which must be
deposited for 15 years is Birr. 8,200.

40
Depreciation
Depreciation is the decrease in value of physical
properties with the passage of time and use.
is a book method (noncash) to represent the
reduction in value of a tangible asset.
The actual amount of depreciation can never be
established until the asset is retired from
service.
Depreciable property is property for which
depreciation is allowed under income tax laws
and regulations.

41
Contd
Depreciable property is classified as either tangible
or intangible.
Tangible property can be seen or touched, and it
includes two main types called personal property and
real property.
Personal property includes asset such as machinery,
vehicles, equipment, furniture, and similar items.
In contrast, real property is land and generally
anything that is erected on, growing on, attached to
land.
Intangible property is personal property such as a
copyright, patent, or franchise.
42
Contd

A company can begin to depreciate property it


owns when the property is placed in service
for use in the business.
Deprecation stops when the cost of placing an
asset in service has been recovered.

43
Depreciation Calculation Fundamentals
The first step is to examine the
fundamentals of depreciation calculations.
Figure 1 illustrates the general
depreciation problem.
The vertical axis is labeled book value.
Book value = Asset cost - Depreciation
charges made to date.
Book value is the asset's remaining
unallocated cost.
44
In
Figure 1, book value goes from a value of B at time zero
in the recovery period to a value of S at the end of Year 5.
is a dynamic variable that changes over an asset's recovery
period.
The equation used to calculate an asset's book value
overtime is:

where
BVt = book value of the depreciated asset at the end of time t
Cost basis = B = amount that is being depreciated.
= sum of depreciation deductions taken from time 0 to time t
and dj is the depreciation deduction in Year j.

45
Figure 1: General Depreciation Problem

46
Depreciation Methods

1. Straight-Line (SL) Depreciation


. Is the simplest and best known method.
. To calculate the constant annual depreciation charge, the total
'amount to be depreciated, B - S, is divided by the depreciable
life, in years, N.

Where;
. dt = depreciation charge in any year t
. N =number of years in depreciable life
. B = cost of the asset made ready for use
. S =estimated salvage value after depreciable life
47

Example 1
If an asset has a first cost of $50,000 with a $10,000 estimated
salvage value after 5 years,
(a) calculate the annual depreciation and
(b) calculate the book value of the asset after each year, using
straight line depreciation.
Solution
(a) The depreciation each year for 5 years can be found by D t
=.
Dt = = 8,000
(b) The book values after each year t are: for example, For
years 1 and 5,
BV1= 50,000 - 1(8000) = $42,000
BV5 = 50,000 - 5(8000) = $10,000 = S

48
Example 2
By Considering the values given in the table below.
Compute the straight-line depreciation schedule.
Cost of the asset, B $900
Depreciable life, in years, N 5
Salvage value, S $70
Solution

49
2. Declining Balance (DB) Depreciation
Is also known as the fixed percentage or
uniform percentage method.
Is a more realistic approach.
It applies a constant depreciation rate to the
property's declining book value.
The two rates that are commonly used are 150
and 200% of the straight-line.

50
Since 200% is twice the straight straight-line rate, it is
called double declining balance (DDB).

51
Example 3
Compute the DDB depreciation schedule for the
situations given in the table below.
Cost of the asset, B $900
Depreciable life, in years, N 5
Salvage value, S $70
Solution

52
Basic Analysis Tools

In all engineering problems the engineers encounter


one important question, i.e., which project to select.
To select among the different alternatives,
different methods have been evolved.
There are several bases for comparing the
worthiness of the projects. These are
1. Present worth method
2. Future worth method
3. Annual equivalent method
4. Rate of return method
5. Pay back period

53
1. Present worth method

Conditions for Present worth Comparison


1. Estimate the interest rate that the firm wishes
to earn on its investment.
2. Determine the service life of the project.
3. Determine the cash inflows over each service
life.
4. Determine the cash overflows over each
service period.
5. Estimate the net cash flows (inflows
outflows).
54
If there is single investment proposal, whether
a project will be selected or rejected that can be
made accordingly.
If PW > 0, it is a positive NPW, the project
makes profit, so select the proposal.
If PW < 0, it is a negative NPW, so reject the
investment project.
If PW = 0, remain indifferent to the investment.
Present worth cash flows can be calculated by
two prominent methods. These are:
1. Revenue based present worth
2. Cost based present worth
55
1. Revenue based present worth

56
Contd
Where P is the initial investment
Rn is the net revenue at the end of nth year.
i is the interest rate compounded annually
S is the salvage value at the end of the nth year.
PW(i) = -P + R1(P/F,i,1) + R2(P/F, i, 2) + .+
Rn(P/F, i,n) + S(P/F, i,n)

If it is a uniform series or equal payment series then


the formula will be
PW(i) = -P + R (P/A, i, n) + S (P/F, i, n)
57
2. Cost based present worth.

58
Where P is the initial investment
Cn is the net cost of operation and maintenance at the
end of the nth year
S is the salvage value at the end of the nth year
Ci is the discounted rate of interest
and for it the present worth expression is

PW(i) = -P + C1(P/F,i,1) + C2(P/F, i, 2) + .+ Cn(P/F,


i,n) - S(P/F, i,n)
It is a uniform series or equal payment series then the
formula will be
PW(i) = P + C (P/A, i, n) - S (P/F, i, n)
59
Example 1
Given the following information, suggest the
best alternative which is to be implemented
based on the present worth method, assuming
20% interest rate compounded annually.
Alternative Initial Cost Annual Revenue Life
A Rs.15,00,000 Rs. 8,00,000 15 years
B Rs. 20,00,000 Rs. 6,00,000 15 years
C Rs. 16,00,000 Rs. 4,00,000 15 years

60
Solution : The cash flow diagram for alternative A

The present worth for this cash flow is


PW(20%)A = - Rs. 1,500,000 + Rs. 800,000
(P/A,20%,15)
= - Rs. 1,500,000 + Rs. 800,000 (4.6755)
= Rs. 22,40,400
61
The cash flow diagram for alternative B

PW(20%)B = - Rs. 20,00,000 + Rs. 6,00,000 (P/A,20%,15)


= - Rs. 20,00,000 + Rs. 6,00,000 (4.6755)
= Rs. 8,05,300

62
The cash flow diagram of alternative C

PW(20%)C = - Rs. 16,00,000 + Rs. 4,00,000 (P/A,20%,15)


= - Rs. 16,00,000 + Rs. 4,00,000 (4.6755)
= Rs. 2,70,200
Alternative A is suggested to select, because it is present
worth is the highest among all the alternatives.
63
Exercise
Given the following information, suggest
which technology should be selected based on
present worth method, assuming 15% interest
rate compounded annually.

64
2. Future Worth Method
Conditions for computing Future Worth Method
1. Determine the interest rate.
2. Estimate the service life of the project.
3. Estimate the cash inflows for each period over
the service life.
4. Estimate the cash outflows over each service
period.
5. Determine the net cash flows (inflows
outflows).

65
Contd
For a single project evaluation
If FW > 0, project is accepted.
If FW < 0, reject the investment proposal.
If FW = 0, remain indifferent to the
investment.
Future worth cash flows can be calculated by
1. Revenue based future worth.
2. Cost based future worth.

66
1. Revenue based future worth.
The formula for the future worth i is
FW(i) = - P(1 + i)n + R1(1 + i)n-1 + R2(1 + i)n-2
+ ..+ Rn + S
Or FW(i) = - P(F/P, i,n) + R1(F/P, i, n-1) +
R2(F/P, i, n-2) + .+ Rn + S
The alternative with maximum future worth
amount will be selected.
If it is equal payment series, then the formula
will be
FW(i) = - P(F/P, i,n) + R (F/A, i, n) + S
5/19/17 Prepared by: Sharmarke A. 67
2. Cost based future worth
In this case the alternative with the least
future worth amount will be accepted.
If the cash flow stream is cost-based, then the
future worth is given by
= P(1 + i)n + C1(1 + i)n-1 + C2(1 + i)n-2 +
..+ Cn S
FW(i) = P(F/P,i, N)+C(F/A, i, N)-S

68
Example 1
Consider the following two mutually exclusive
alternatives:
At i= 18%, select the best alternative based on
future worth method of comparison.

69
Solution : The cash flow diagram for alternative A

The future worth amount of alternative A is computed


as
FWA (18%) = 50,00,000(F/P, 18%, 4) +
20,00,000(F/A, 18%, 4)
= 50,00,000(1.939) + 20,00,000(5.215)
= Rs. 7,35,000
70
The cash flow diagram for alternative B

The future worth amount of alternative B is computed as


FWB (18%) = 45,00,000(F/P, 18%, 4) + 18,00,000 (F/A,
18%, 4)
= 45,00,000(1.939) + 18,00,000(5.215)
= Rs. 6,61,500
The future worth of alternative A is greater than that of
alternative B. Thus, alternative A should be selected.
71
3. Equivalent Annual Worth Method (EAW)
Conditions for Computing EAW
1. Estimate the cash flows (inflows, outflows) over each
service period.
2. Estimate the service life of the project.
3. Determine the interest rate.
4. Comparisons are made with before-tax cash flows.
5. EAW comparisons dont include intangible
considerations.

72
For single alternatives if
EAW > 0, Accept the investment proposal
EAW < 0, Reject the investment proposal
EAW = 0, Remain indifferent to the
investment.
For multiple alternatives
If all the alternatives are revenue dominated,
the alternative with higher EAW will be
selected.
If all the alternatives are cost based, the
alternatives with least EAW will be accepted.
73
EAW Consists Of Following Steps
i. Complete the net present worth (NPW)
ii. Multiply the amount of present worth by the
capital recovery factor. i.e. EAW = PW(i) (A/P,
i, n) where (A/P, i, n) is called equal-payment
series capital recovery factor .

74
Example 2
Consider a machine that costs Rs.40,000 and a 10 year
useful life. At the end of 10 year, it can be sold for
Rs.5,000 after tax adjustment. If the firm could earn an
after-tax revenue of Rs.10,000 per year with this
machine, should it be purchased at an interest rate of
15%, compounded annually.
Solution
Initial cost (P) = Rs.40,000
Useful life (n) = 10 years
Salvage value = Rs. 5,000
Revenue = Rs.10,000
i = 15%, compound annually
75
The cash flow diagram for the given project is

76
Contd
Step I
To find out NPW (15%)
PW (15%) = -P+R(P/A,i,n)+S(P/F,i,n)
= - 40,000+10,000 (P/A, 15%,10) + 5,000 (P/F, 15%, 10)
= -40,000+10,000 (5.0188) +5000 (0.2472)
= Rs. 11,424
Step II
EAW (15%) = PW(i) (A/P, i,n)
= Rs.11424 (A/p, 15%, 10)
= Rs.11424 (0.1993)
= Rs. 2276.80
Since EAW (15%) > 0, so the project is accepted.
There will be an equivalent profit of Rs.2276.8 per year over the
machine life.
77
4. Rate Of Return Method
The rate of return of a cash flow pattern is the
interest rate at which the present worth of that
cash flow pattern reduces to zero.
In this method of comparison, the rate of
return for each alternative is computed.
Then the alternative which has the highest
rate of return is selected as the best
alternative.

78
EXAMPLE
A person is planning a new business. The initial outlay
and cash flow pattern for the new business are as listed
below. The expected life of the business is five years.
Find the rate of return for the new business.

79
Solution
Initial investment = Rs. 1,00,000
Annual equal revenue = Rs. 30,000
Life = 5 years
The cash flow diagram for this situation is illustrated
below.

80
Contd
PW(i) = 1,00,000 + 30,000(P/A, i, 5)
PW(10%) = 1,00,000 + 30,000(P/A, 10%, 5)
= 1,00,000 + 30,000(3.7908) = Rs. 13,724.
When i= 15%,
PW(15%) = 1,00,000 + 30,000(P/A, 15%, 5)
= 1,00,000 + 30,000(3.3522) = Rs. 566.
When i= 18%,
PW(18%) = 1,00,000 + 30,000(P/A, 18%, 5)
= 1,00,000 + 30,000(3.1272) = Rs. 6,184

81
Cost Benefit Analysis
The ratio between the equivalent benefits and
equivalent costs is known as the Benefit-
Cost ratio.

If this ratio is at least one, the public activity


is justified; otherwise, it is not justified
82
Contd
Let
BP = present worth of the total benefits
BF = future worth of the total benefits
BA = annual equivalent of the total benefits
P = initial investment
PF = future worth of the initial investment
PA = annual equivalent of the initial investment
C = yearly cost of operation and maintenance
CP = present worth of yearly cost of operation and
maintenance
CF - future worth of yearly cost of operation and
maintenance
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Contd

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Example-1
In a particular locality of a state, the vehicle users take a
roundabout route to reach certain places because of the
presence of a river. This results in excessive travel time
and increased fuel cost. So, the state government is
planning to construct a bridge across the river. The
estimated initial investment for constructing the bridge is
Rs. 40,00,000. The estimated life of the bridge is 15
years. The annual operation and maintenance cost is Rs.
1,50,000. The value of fuel savings due to the
construction of the bridge is Rs. 6,00,000 in the first year
and it increases by Rs. 50,000 every year thereafter till
the end of the life of the bridge. Check whether the
project is justified based on BC ratio by assuming an
interest rate of 12%, compounded annually.
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Solution
Initial investment = Rs. 40,00,000
Annual operation and maintenance = Rs. 1,50,000
Annual fuel savings during the first year = Rs.
6,00,000
Equal increment in fuel savings in the following years
= Rs. 50,000
Life of the project = 15 years
Interest rate = 12%
6,00,000 + 7,00,000

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The cash flow diagram of the project for
constructing bridge.

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Total present worth of costs = Initial investment (P) +
Present worth of annual operating and maintenance
cost (CP) = P + CP
= Rs. 40,00,000 + 1,50,000 x (P/A, 12%, 15)
= Rs. 40,00,000 + 1,50,000 x 6.8109
= Rs. 50,21,635
Total present worth of fuel savings (BP):
A1 = Rs. 6,00,000
G = Rs. 50,000
n =15 years
i = 12%

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Annual equivalent fuel savings (A) = A1 + G(A/G, 12%,
15)
= 6,00,000 + 50,000 (4.9803)
= Rs. 8,49,015
Present worth of the fuel savings (BP) = A(P/A, 12%, 15)
= 8,49,015 (6.8109)
= Rs. 57,82,556

Since the BC ratio is more than 1, the construction of


the bridge across the river is justified.

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Reading Assignment

Pay Back Period Method

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Decision Making With Probability

1. Expected Monetary Value


2. Decision trees

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1. Expected Monetary Value

Expected Monetary Value (EMV ) of a single event


is simply the probability of that event multiplied by
the monetary value of that outcome.
In general, the expected monetary value of a project
(or bet) is given by the formula
EMV =P(Event) Monetary value of Event
where the sum is over all possible events that make
up the project.
The EMV of a project can be used as a decision
criterion for choosing between different projects and
has applications in a large number of situations.
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Example
A small technology company with a new and
innovative product that they wish to launch on to the
market. It could go for a direct approach, launching
onto the whole of the domestic market through
traditional distribution channels, or it could launch
only on the internet. A third option exists where the
product is licensed to a larger company through the
payment of a license fee irrespective of the success of
the product. How should the company launch the
product?

93
Contd
The company has done some initial market research
and the managing director, Jack Holmes, believes the
demand for the product can be classed into three
categories: high, medium or low. Jack thinks that
these categories will occur with probabilities 0.2, 0.35
and 0.45 respectively and his thoughts on the likely
profits (in K) to be earned in each plan are

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Solution
The EMV of each plan can be calculated as follows:
EMV (Direct) = 0.2 100 + 0.35 55 + 0.45
(25) = 28K
EMV (Internet) = 0.2 46 + 0.35 25 + 0.45 15 =
24.7K
EMV (Licence) = 0.2 20 + 0.35 20 + 0.45 20 =
20K.
On the basis of expected monetary value, the best
choice is the Direct approach as this maximizes his
EMV.

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The decision tree for the above example would look like this:

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2. Decision trees
In the above example we had to make a
decision.
When we include a decision in a tree diagram
we use a rectangular node, called a decision
node to represent the decision.
The diagram is then called a decision tree.
There are no probabilities at a decision node
but we evaluate the expected monetary values
of the options.

97
Contd
In a decision tree the first node is always a
decision node.
There may also be other decision nodes.
If there is another decision node then we
evaluate the options there and choose the best
one, and the expected value of this option
becomes the expected value of the branch
leading to the decision node.

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The end .

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