Engineering Economics, Costing, Estimation, and
Tendering
Prof. Rishman Jot Kaur Chahal
Indian Institute of Technology Roorkee
Part 3 - Methods of Performance Evaluation
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Overview
1 Time Value of Money
2 Various Techniques to select among different alternatives
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Time Value of Money
How do you determine the monetary value of cash transactions that
are expected in the future?
This is just like deciding whether to invest now or to wait for future?
Time value of money refers that money in the hand today is worth
more than the same amount promised at the same time in future.
Example: Remember your old days when you prefer even Rs.100 at
the time but now you would tempt towards Rs. 500.
Time allows you to postpone the current consumption to earn
interest.
1
Remember Simple interest is A = PxRxT
100
and Compound Interest is A = P(1 + nr )nt
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Time Value of Money
Cash Flow
Cash flow is the sum of money recorded as receipts or disbursements
in a project’s financial records.
Example: A mechanical device will cost $20,000 when purchased.
Maintenance will cost $1000 per year. The device will generate
revenues of $5000 per year for 5 years. The salvage value is $7000.
Figure: Incorporated from FERC Publication
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Time Value of Money
Cash Flow
Cash flow is the sum of money recorded as receipts or disbursements
in a project’s financial records.
A cash flow diagram presents the flow of cash as arrows on a time line
scaled to the magnitude of the cash flow, where expenses are down
arrows and receipts are up arrows.
Figure: Incorporated from Prof Faisal Hassan’s Engineering Economics 5 / 19
Time Value of Money
Terminology
Present worth P is the present amount at the time t=0.
Future worth F is the equivalent future amount at t = n of any
present amount at t = 0.
Annual Amount A is the uniform amount that repeats at the end of
each year for n years.
N: Total number of interest period which could be years, months or
days.
i: Interest rate per time-period; percent per year.
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Time Value of Money
Discounting Factor and Equivalence
Figure: Factor table provided in the NCEES FE Handbook.
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Time Value of Money
Economic Equivalence of Cash Flow
Economic equivalence is a combination of the interest rate and the
time value of money to determine the different amounts of money at
different points of time that are equal in economic value.
Numerical discussed in class.
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Time Value of Money
Problem
Sanya wishes to have $12000 in her savings account at the end of 5
years and a 5% interest is paid annually. How much should she put in
the account today?
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Various Techniques to select among different alternatives
Present Worth Analysis
Equivalent Annual Worth Method
Future Worth Method/Analysis
Rate of Return
Benefit-Cost Analysis
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Present Worth (PW) Analysis
When alternatives do the same job and have the same lifetimes,
compare them by converting each to its cash value today. The
superior alternative will have the highest present worth.
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Present Worth (PW) Analysis
Decision Rule
Accept the alternative with the highest PW value (if PW is positive)
i.e. Maximum Profit or Return.
Accept the alternative with the lowest PW value (if PW is negative)
i.e. Minimum loss.
However the comparison of alternatives can have equal or unequal
lives. For example Asset A and B has an economic life of 7 years but
of Asset C is of 4 years. How to compare them?
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Present Worth (PW) Analysis
Problem 1
Investment A costs $10000 today and payback $11,500 two years
from now. Investment B costs $8000 today and pays back $4500 each
year for two years. If an interest rate of 5% is used, which alternative
is superior?
2
Problem is an Example 13.11 from FERC publications
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Present Worth (PW) Analysis
Problem 2
Autocon company is evaluating three robots for possible use in its
assembly operations. (Only one robot is to be placed). Data
associated with these robots are as follows:
Figure: Problem 3.26, Riggs
Assuming the technological life of 3 years and a desired interest rate
of 12% which robot seems to be preferred? Use a net PW analysis.
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Present Worth (PW) Analysis
Repeatability Assumption
For the same example above, consider the economic life of Robot A
as 2 years, Robot B as 4 years and Robot C as 8 years, keeping
everything else as constant.
Possibilities: We can purchase Robot A four times, Robot B two
times and Robot C just once.
This is what we call as Repeatability Assumption. It means that
the cash flow will repeat again and again if we are making purchases
over and above their economic life.
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Annual Worth (AW) Method
The main idea is to transfer all the cash flows to a series of EUAW
(equivalent uniform annual worth).
So, in PW analysis we were converting all the cash flows in the
present point of time but here we are converting the complete cash
flow diagram into annuities.
So, the method is used to determine Annual value of all receipts and
disbursements occurring in a cash flow.
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Annual Worth (AW) Method
For a given i, calculate the Net EUAW (EUAWBenefit − EUAWCost ).
Decision: Either accept the alternative with the highest Net
EUAWBenefits (if Net EUAW is positive) or with lowest EUAWloss (if
Net EUAW is negative).
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Numerical Question
Consider two types of batteries, A and B, are under consideration for
a specific application in an electric car. Thus the company has to
make an economic comparison to be made at an interest rate of 10%
and following estimates have been obtained:
Battery A Battery B
Purchase Price (Rs.) 10000 25000
Annual Operating cost (Rs.) 2500 1200
Salvage Value (Rs.) 0 5000
Estimated Service Life 5 years 9 years
Estimate the preferred Battery using Equivalent Annual Cost (EAC)
method.
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Thank you for your attention.
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