& pic 3 > Engineering Economics Analysis of this topic, you should be able to: 3s the concept of cash flow and the use of cash flow statements ibe the factors of time value of money and accuracy in cost ‘the foundational concepts and formulas for cost analysis g. depreciation and rate of return; ise and describe the 4 methods of evaluation available i.e. net Saline intemal rate of etuin, payback perlod and propiabiity INTRODUCTION ering Economic analysis is the quantitative approach of comparing tives on the basis of their projected cash flows, properly accounting for ime value of money. There are several rules of thumb in accounting that to be introduced first before you can start analysing. Additionally, basic ind definitions also need to be familiarised for better undersianding of Ie concepts,36D TOPIC3 ENGINEERING ECONOMICS ANALYSIS Ge CASH FLOWS Before you go on reading further about cash flow, le’s look at the following Ramet aS S2Y You want to buy a used bicycle that costs you RM200. You borrow RM200 from Zaki (your friend) and promise to pay back atthe ond ofthe Week. In turn, you sell the bicycle to someone else for the price of RM50 and the buyer agreed to pay you in a week. Unfortunately, at the end of the week, your buyer says that he does not have the money as promised and he aslo ene extension of time, to the end of the month. Meanwhile, Zaks desperately needs ‘his RM200 back. (uit seemed like a great opportunity to make an easy RMS profits now a real GAuse for concer. Right now you owe Zaki RM200 and you Feve ne aash, What do you do when Zaki shows up again and demands tobe paid? From the above situation, if you are ina business, this (on the loan and possibly go bankrupt even thou > Loses eeaan 2 Pcie of fd 9 erase in Sock + ieceaseindetios D 5 DrawingsDividends D5 Loan Reps Figure 3.1(a): Schematic cash flow description For any business, itis important to ensure that: Sslfficient profits are made to finance the business activities; and * sufficient cash funds are available as and when needed.TOPIC 3 ENGINEERING ECONOMICS ANALYSIS > 37 ‘The above information can be found in cash flow statements. Besides that, cash flow statements also show: + Net cash flow from operating activities. Dividends from joint ventures and associates. * Returns on investments and servicing of finance. + Taxation. ‘© Capital expenditure and financial investment, + Acquisitions and disposals. * Equity dividends paid. * Management of liquid resources. + Financing, A.sample of cash flow statement can be seen in Figure 3.1 (b).38 Cash flow = the movement of money into and out of an account Dh TOPIC3 ENGINEERING ECONOMICS ANALYSIS erin SEE ERASE enoco 2 uancisooe oe 7 ——— cmt mean Ch scare 0M ness neve Songer se Tu ‘CASH FLOW STATEMENT. FOR THE FINANCIAL YEAR ENDED 31 MARCH 2006 ¢conTINUED) mm 3 (CASHFLOW FROM FRANONG ACTIRTIES Per sata se coe exeat, : et se Dro racing acre eT) eTngmeasmicecneAsey CASH 380 aah COUWALENTS $008.94 aazerasa ‘ASH ANCA eouALENTS AF SEaewNG OF re CAL TEAR nernase | searaeur Caste gna cast couvaneners Ar thO Ge Te ANCL YEAR rast Figure 3.1(bTOPIC 3 ENGINEERING ECONOMICS ANALYSIS pe Example 1 ‘Alia Machineries Sdn. Bhd. wishes to design and market on earth moving machine. During the first year, the company's cash flow reflects the designers’ ‘wages and overheads, say RM20,000. There is a net cash outflow in the first year of -RM20,000. (note that the ~ sign is used to donate a flow out of the system.) During the second year, sales are underway but the full manufacturing effort has not yet been reached. Cash flow -KM100,000. During the fourth year, sales revenue costs offset production costs but spares and servicing network costs still generate a negative cash flow. Overall cash flow +RM50,000. During years 5, 6, 7, sales take their market share and revenue exceeds production and support costs. Net cash flow year 5 = +RM250,000 Net cash flow year 6 = +RM300,000 Net cash flow year 7 = +RM300,000 Sales begin to fall in year 8 as competitors bring out new machines. Manufacturing ceases at the end of year 9. Net cash flow year 8 = +RM150,000 Net cash flow year 9 = +RM 50,000 Instead of putting the data above in cash flow statement form, data can also be represented in diagram as shown in Figure 3.2. Cash Flow Diagram = 5 c 3 é 5 Figure 32: Cash flow diagram for Example 140 > TOPIC} ENGINEERING ECONOMICS ANALYSIS Figure 32 shows cash flow for a 9 year period of a project. Note that the cash flow is shown to take place at a specific time in the year. In reality, the cash is moving continuously throughout the period but it is usual to show it occurring at the end of a‘tax’ year (B22) cost ana ysis It is important for all engineering managers to become well-versed in cost accounting. Engincering firms and companies focus on making profit by way of investing resources (money, equipment, manpower, time, brainpower, business relationships, etc.) and satisfying the needs of its stakeholders (stockholders, customers, employees, suppliers, and community). To do this, cost analysis is the key management concept to be used. Numerous technology-based organisations such as manufacturing, engineering, construction, product development, product design, technology applications and services actively perform cost analysis. In fact, you also perform simple cost analysis in your daily life, for example when you intend to go shopping. ‘Two types of cost analysis can be performed depending, on the two major factors ie. time and accuracy: The characteristics for both types of cost analysis can be seen in Figure 3.3.Multiple Periad Analysis. Sat si osama ad Hae ee eae ~igarsaes tai pesieenae ise Serene, ceuans seg i poet ne eee sara iio coraree ENE cue nn Geaereerees Bo esc Sees er EEE. nasstee comareeee ewan sis formula, ‘instabiity.ete). EEO mone a Saeki’ rsp eee GP = PxN -(FG*VGxN) Product Price (Riven) ‘Numbor ef Products sold daring the period FO = Fined costs (RM) 3.2.1 Time Value of Money Money in hand may earn income through investment as in the case of money: in the bank, which may earn income through interest. Money of the same dollar amount in different time periods have different values. This is called purchasing, power. Value of money changes with time caused by the primary reasons of: + inflation that tends to erode the purchasing power (value) of money; © money in hand that could eam additional interest by depositing in bank accounts; and * money available in a future period that is less valuable because it is not available for use at the present. Since this topic is a little bit different from other engineering technical topics, a few basic terms and definitions are listed in Table 3.1 which you will need to understand and remember. TOPIC3 ENGINEERING ECONOMICS ANALYSIS i42 TOPIC 3 ENGINEERING ECONOMICS ANALYSIS ‘Table 3.1: Table of Terms and Definitions ‘Terms Definitions 1, Interest It represents a fraction of the principal designated as a reward to its owner 2. Compound interest ‘When the interest income earned in one interest period is, added to the principal 3. Nominal Interest ‘The interest rate quoted by banks or lenders on an annual bbasis= Annual Percentage Rate (APR). 4. Effective Interest Rate ‘The interest rate in effect for a given interest period (e-g. 1 month) Nominal Dollar ‘The actual dollar value at a given point in time. Constant Dollar ‘The dollar value thathas a constant purchasing power with respect to a given base year (e.g. Int), ‘Source: Chang, CM. 2005. Engineering Management. Challenges. Three simple cases will bi and as you go along, you will find other new terms and formulas as well. Do take special note of these! the new Millennium. New Jersey: Prentice Hall 1e discussed to show how time value of money works (a) Case 1: Single Payment Compound Amount Factor Consider the case of investing RMI00 in a bank account which produces 12% interest per anni the end of year 3? SOLUTION jum over 3 years. How much money is accumulated at Deposit/ Interest ‘Amount (RM) | Total (RM) Capital 100.00 Ist year interest 12.00 Total atthe endl of yeorL 12.00 2nd year intrest 1a ‘Total at the end of year 2 - 125.44 Sed year interest 1505 Total a the end of year an ‘This process of COMPOUNDING (also signified as $). The total Compound Interest on RM100 at 12% over 3 calculating an accumulated interest is called years is RM40.49. For an interest of 12%, it can also beo) TOPIC 3 ENGINEERING ECONOMICS ANALYSIS said that RM100 today is EQUIVALENT of RM125.44 at the end of year 2, or RM140.49 over 3 years. ‘Thus, this system can be expressed mathematically as: S = Compound Total P = Original Sum i = Interest rate Number of periods The reverse of compounding is called DISCOUNTING. This process is used to determine the original sum, P, which will produce the compound total, §, with a given rate of interest, ‘The Original sum, P, is said to be the “PRESENT WORTH, DISCOUNTED CASH VALUE, or the PRESENT VALUE” of the compound total, S, at an interest rate of, I. for a period of n years. So RM100 is the present value of RM140.49 at 12% interest over a period of 3 years. Case 2: Present Worth Factor A further refinement of the system is often used. The ratio of P/S is usually described as the DISCOUNT FACTOR. This is generally written as: Example 2 Compare the two cash plans shown. Equipment is to be purchased. Two identical models are available. B has higher initial outlay but lower long term operational costs. A is initially cheaper but more expensive to run. Cash flow for purchase and operation of machines A and B are calculated as follows: ‘Year | Cash Flow A | Cash Flow B 0 400 00, 1 200 100 2 200 100 3 200 100 4 200 100 5 200 10044° TOPIC3 _ ENGINEERING ECONOMICS ANALYSIS If the interest rate is 10%, which is the best option to choose? SOLUTION ; : vear| coh, | ct, | sown | isn ‘Cask low . ‘ena | “wens ~ To | 40 00) 1.000) 40000 900.00 [ome pm | 250 vei | 9081 ee ven | mes 3 |_200 7100 o7st 150.26 75:3 4 200 100, 0.683, C 136.60 68.30 if. 200 100 0.621 124.18 | 62.09 om wasaxe | 7308 * Where, Discount factor = 1/ (1+i)" CONCLUSION Buy machine A, it has the lower equivalent cost at year zero. Option A ts better and cheaper. (©) Case 3: Uniform Series Compound Amount Factor Defines the total future value of dn account (e.g. retirement college education) at the end of 1 periods, if a known annuity A is deposited into the account at the end of every period. ‘This is generally written as: Ss S/A Ala sty Wi {(asip- ai (S/A.in) ‘Example3 Mr. Kamarul wishes to have an educational plan for his 5 year old son. He allocates RM100 every month for this plan. Please help Mr. Kamarul to calculate how much he will get when his son reaches 21 years old. Assume the annual interest for the planis 8.5%. SOLUTION n= 21 years ~ 5 years = 16 years; i = 0085; A= 100 x 1 deposit) = 1200 (annual Ss = Alsi ai 1200 [(1+0.085)'*—1] / 0.085 RM 37, 958.41TOPIC 3 ENGINEERING ECONOMICS ANALYSIS 45 3.2.2 Rate of Return (RoR) Rate of return describes the interest you will receive by investing capital. The term can also be used to describe the value of investments made on projects, plants and equipment. RoR is a very important tool to evaluate the potential of a project. If the acceptable RoR is not realised, then it is not worth making the investment The formula used for RoR is: Uniform series present worth factor / Rate of Return (ROR) P=AlL +i)n-11/fi (1+ dn} P/A = [(sip-1/Li iy) = @/Ain) Where: P = Present value i Effective interest rate n= number of interest periods A. = Annuity (RM) periodical payments at the end of periods If the problem is more complex or an accurate RoR is required, a graphical solution is applied as shown in Example 4. Example 4 The following table shows the cash flow for a contracting company. What is its RoR? voiod | Plant | Working [Running | Reverse [Net Cach NIK | Capital RNDK | Costs (RMDK | MOK —_ | Flow (RMD nd year | 280 =0 0 = 290 1] 50 —185 “579 00 204 2] -10 =185 =| 88 ~ af 0 “5 —az7k 1500 15 [0 5i a2 1300 239 5| 0 82 “B10 1000 zm 6| 50 270 69 300 | 38h As first attempt, try interest rates of 16% and 20%46 > TOPIC3 _ ENGINEERING ECONOMICS ANALYSIS [ered tw | teres | overs | yuenm | ream o 290 1.000 - -20 1.000 290 1 24 0.362 =193 oss | ass | 2 2 ws [7 694 | 3 75 oat m2 0579 101 L- 4 | 239 0.552 132 0.482 m5 5 272 0.476 130 0.402 1 6 351 aio a 0335 8 E a) [=o] The tables show that the NPV for which the interest rate will be Zero is between {6% and 20%, The calculation can be repeated to refine the solution or a graphical method can be used. The true RaR is defined as the inibrest ratg¥or which NPV is Zero. This is 18% for this particular example 3.2.3 Depreciation Most assets decrease in value with use and time. This is referred to as depreciation. Fr describes the decrease in capital value of an asset ard is generally fixed at given yates or times by the taxing body: Take the simple example of buying a car and running it, Purchase price RM 60,000; sold after 1 year at RM 35,000. ‘Three methods can be used to calculate depreciation, namely: + Staight Line.EET TOPIC 3 ENGINEERING ECONOMICS ANALYSIS» 42 + Declining Balance —a common depreciation-calculation system that involves applying the depreciation rate against the non-depreciated balance. Instead of spreading the cost of the asset evenly over its life, this system expenses the asset at a constant rate, which results in declining depreciation charges each successive period. For example, if an asset that costs $1,000 is depreciated at 25% each year, the deduction is $250.00 in the first year and $187.50 in the second year, and so forth. (Source: hitp://www.investopedia.com/ terms /d /decliningbalancemethod asp) + Unitof Production. Depreciation ~ under the Units-of Production method, useful life of the asset is expressed in terms of the total number of units expected to be produced. Annual depreciation is computed in three steps. (Source: http / /en.wikipedia org /wiki /Depreciation) Straight line is the simplest way to calculate depreciation. It is a system which calculates depreciation on the basis of a fall in value from purchase to scrap (see Figure 3.4). Pan bought for FM 20ck fasting for 10 yrs (2 Stsightdine An equal orton of fhe doprecabie Base Ps stocaed ch pesos ‘Age (Yours) Figure 3.4:Straight Line Depreciation (BB) wuice To cHoose? Before making a decision, prioritising, comparing and analysing alternatives are some éxamples of activities that you should do. Although there are many criteria for selecting a project, selection criteria are typically divided into two. They are Financial and Non-financial. Based on the criteria, some questions in Table 3.2 may help in the selection process. However in this topic, we only focus on the economical aspects48 & TOPIC3 ENGINEERING ECONOMICS ANALYSIS Table 32: Example of Economic and Financial Questions Financial/economic Questions Non-financial Questions Will the investment pay? Are the alternatives technically feasible? Will return on the investment be adequate? Does the law constrain the choice of alternatives? Should the present consumption of capital be | Do political aspects influence the sactificed for the prospect of future benefits? _| cheice of alternatives? Bte. Is there sufficient capital available? Are health or safety at risk in any of the alternatives? Ete. However, answering questions only is not enough for project managers to make a decision. Several standard methods are used in industry to evaluate a project. These include net present value (NPV), internal rate of return (IRR), payback and profitability index: 3.3.1 Net Present Value (NPV) In this method, the discount factor is of prime importance as it significantly affects the results. The main use of this method is to measure profitability of a Project. Basic information needed to’calculate NPV are: + Length of the project- years. * Value of eash flow — years * Discount factor/ cost of capital to the company. There are two ways in calculating NPV. It is either to use table or formula. The formula for NPV is: NPV NCE, CR (vie * @sip foT tan) fe Where: P Present investment NCIF (mm) = Net cash in-flow (RM) in the period of m, which represents revenue eared — cost i = cost of capital rate CR capital recovery (RM), which is the amount regained at the end of the project though resale or other methods of dispositionsTOPIC3 ENGINEERING ECONOMICS ANALYSIS «49 r -_ ‘Once the calculation has been performed, projects with the largest NPV are to be preferred. « Example 5 ‘A company is considering the purchase of earth moving plant for RM10,000 which is expected to work for 4 years. The terminal value will be RM1,000. Net cash inflows are expected to be RM3,000. The discount factor used for the investment appraisal is 15%. SOLUTION (Using table: Years, Items Gash Flows | DF (5%) DCF 0 | Purchase =10000 i.0000 | —10000 t__[Netinflow 3000 08696 | 2609 2 [Net inflow’ 3000) 07561 | 2268 3 | Net inflow 3000) 0.6575 | 1973 4 | Netinflow 3000 oss | 1715 5 | Saleof machine 1000 0.4972, 4197 NPV 338 (i) Using formula: -p+ J NCIEim , CR Gee G+ Saad to0) NPv=-1000 + -0001_ , (3000), (3000), _(3000)_,. _(1000)_ (1+ 0.15) 7 +015 "+015" © + 0.15) + 0,15" =938 ‘Therefore, the project option of purchasing the particular earth moving plant is not preferred, 3.3.2 Internal Rate of Return (IRR) ‘The IRK is the average annual rate of return (usually annual) realised by an investment with a zero NPV at the end of its project life cycle. In other words, initial investment is fully compensated by the earnings and capital recovery of the project50 TOPIC 3_ ENGINEERING ECONOMICS ANALYSIS ‘Therefore the formula for IRR is NPV =0 In NPV calculations and other similar techniques, it is necessary to know’ the: appropriate interest rate before calculations are made. Often however, the decision 10 invest may change with interest rate! On the other hand, this method calculates an actual “internal rate of return” for a series of cash flows rather than applying a set rate of return and interpreting the results obtained. Projects with high IRR are preferable. 3.3.3 Payback Payback period is defined as the number of years in which the initial investment will be paid back by the annual earnings generated by the project. Basically this, is to answer the question of “How quickly do I get my money back?” To calculate payback period, remember this simple formula: + PB=P/CF =(capital investment/ Average Annual Cash Flow) Projects with least PB are preferred. Example 6 Calculate the payback period for the following cash flows. Initial cash outflow Yearly Net cash flow [1 6000 | 2 3000 | 3 1000 4 1000 5 1000 6 2000 7 - 2000 8 2000 9 = 2000 10 = 2000 L 4.165667 ay PAYBACK 4YEARS | 5 YEARS Using the payback criteria, A is selected but B is better because it has RM20,000 total cash inflow compared with RM12,000 total cash inflow for Project A. So, here is the weakness of the system. It ignores cash flows after the cash flow period. It also ignores the effects of the type of cash flow, meaning that we would ideally like a large cash inflow early in the project's life but this system ignores that, Thus, is not recommended to be used as the sole project ranking tool. SeeTOPIC3 ENGINEERING ECONOMICS ANALYSIS. 51. 3.3.4 Profitability Index Profitability Index is applicable for projects with low Capital Recovery values. Profitability index is defined by a ratio: Imagine that your brother's company is currently pursuing three cost reduction projects at the same time. + Project ‘ANTARTICA’ requires an investment of RM10 million. It is expected to yield a cost savings of RM30 million in the first year and another RM10 million in the second year. ‘+ Project ‘BULAN’ demands an investment of RM 5 million. It is expected to produce a cost savings of RM 5 million in the first year and another RM 2) million in the second year. ‘© Project ‘COMET’ needs an investment of RM 5 million. It is expected to bring about a cost savings of RM 5 million in the first year and another RM 15 million in the second year After the second year, there will be no receivable benefit or capital recovery from any of these projects. Take the cost of capital (interest rate) as 10%. Help your brother to determine the ranking of these projects on the basis of the evaluation criteria of NPV, IRR, payback and profitability index. 2. Based on the following cash flow given and by using payback method, choose which one that you prefer, Project C or Project D? Please state seasons why. Year | Project | Project D Initial cash outflow = 6000 = 6000 Yearly Net cash flowr 1 1000 3000 2 ‘2000 2000 3 3000 000 4 2000 2000 5 2000 200052 > _TOPIC3 ENGINEERING ECONOMICS ANALYSIS. Cash flow simply describes the movement of money coming into and going out of the business, company or accounts. It can be presented as cash flow statement and cash flow diagram form Two types of cost analysis can be performed depending on two major factors (time and accuracy). They are Single-Period Analysis and Multiple-Period Analysis. In cost analysis, value of money changes with time. Responding to the context of time value of money, several formulas depending on the specific cases are available as shown in Table 3.3: ‘Table 33: Table of Formula Cases Formula Definitions Single Payment S=Pl+ ‘The total value of an investment Compound S, with periodical returns added Amount Factor to the principles to eam more money at the end of n periods. Present Worth Defines the present value of a Factor sum that will be available in the future. Uniform Series S=A [G+in—1i | Defines the (otal future value ‘Compound ‘of an account (eg, retirement Amount Factor college education) at the end of n periods, if a known annuity Ais deposited into the account a¢ the end of every period, Uniform Series P=ALd+i)—1)/fi | Defines the total present value of Present Worth aro an account to which an annuity Factor/ Rate of Ais deposited at the end of each Ketura (ROR) period Depreciation must be identified and considered in analysing cost The four standard methods used in industry to evaluate projects are listed in Table 34 Table 3.4: Methods of Evaluation Method Definition Preferable Result Net Present ‘The main use of this Value method is to measure NPV = -P Profitability of a project. 4 Largest NPV are to be preferred.TOPIC 3 ENGINEERING ECONOMICS ANALYSIS p53 i ‘The IRR is the average annual rate of retum (usually annual) realised by an investment with a zero NPV at the end of its project lifecycle. 4 High IRR are Preferable. Payback Payback period is defined as the number i of years in which the Average Annual Cash Flow | ss Roce willbe paid ba annu: earnings generated by the project. 4 Least PB are preferred. Profitability Profitability Index is snore Index py. Present value ofall future benefits| applicable. for prejecis FF ene? | with low ‘Capital — Recovery values tthe 4 Large Pl values are preferable. ake nent ofa Ais eS as the | Cash flow |Costanalysis | Depreciation _} Net Present Value (NPV) Chang, C. M. (2005). Engineering management challenges in the new millennium. New Jersey: Prentice Hall. Frank Wood's. (2005). Business Accounting 1. (10th ed.). New Jersey: Prentice Hall Internal Rate of Retum (IRR) Payback Profitability Index