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May 19, 2017

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introduction to industrial economics

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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

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

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

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.

Factor Find/Gi Standard Equation

Notation Name ven Notation with Factor

Equation Formula

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 (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.

Factor Find/G Standard Equation

Notation Name iven Notation with Factor

Equation Formula

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 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

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

. 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

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

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)

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

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

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

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

= Rs. 8,05,300

62

The cash flow diagram of alternative C

= - 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

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

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.

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

83

Contd

84

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

the bridge across the river is justified.

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Reading Assignment

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Decision Making With Probability

2. Decision trees

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1. Expected Monetary Value

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?

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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.

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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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