Analysis of Independent Project

Learning Outcomes

Formulate Alternatives
Present Worth (PW) of equal-life alternatives
Present Worth (PW) of different-life alternatives
Future Worth analysis
Capitalized Cost analysis

Introduction

In the field of engineering economy, a project is defined as an opportunity for investment, which can be categorized as either an investment project or a divestment project. An investment project involves committing funds now with the expectation of gaining financial returns in the future. Conversely, a divestment project generates income prior to needing additional investments.

Opportunity Costs and MARR

This section concentrates on independent projects, where opportunity costs arise from capital rationing. When capital is constrained, competing proposals must be weighed against each other. To be considered viable, any project must yield returns that surpass a threshold known as the Minimum Attractive Rate of Return (MARR).

Minimum Attractive Rate of Return (MARR)

MARR serves as a benchmark for evaluating prospective projects of similar risk, enabling their ranking in order of profitability. Projects that meet or exceed the MARR are prioritized. An organization might define multiple MARR levels corresponding to different risk categories.

Factors Affecting MARR

The amount, source, and cost associated with available funds
The number and type of promising projects
Perceived risk associated with investment opportunities
The organization's structure and objectives

Establishing MARR

The Weighted Average Cost of Capital (WACC) reflects the average cost of all available funding to a firm. A normal risk environment may use the WACC as a baseline MARR, often increasing it to account for higher risk ventures. Decision-makers determine MARR based on factors like preserving capital for future opportunities or promoting new initiatives.

Methods of Evaluation

Several methods for project evaluation include:

Present Worth (PW)
Future Worth (FW)
Annual Worth (AW)
Internal Rate of Return (IRR)
Payback Period (often not primary decision-making tool)

Present Worth Analysis

Present Worth is an analysis technique that consolidates all projected cash flows into a single present value, factoring in an interest rate. It is important to note that due to the time value of money, the present worth will always be less than future cash inflows at any interest rate exceeding zero, hence it is also referred to as discounted cash flows (DCF).

In terms of terminology, present worth is synonymous with present value (PV) or net present value (NPV).

Formulating Alternatives

Economic proposals generally fall into two categories:

Mutually Exclusive (ME) Alternatives: Only one option can be chosen, as they compete directly.
Independent Projects: Multiple options can be selected since they compete solely against a Do Nothing (DN) alternative, which entails maintaining current practices without additional costs, revenues, or savings.

Cash Flow Estimates

Two distinct types of cash flow estimates exist:

Revenue: Accounts for costs (cash outflows) along with revenues (cash inflows).
Cost: Primarily concerns costs, with revenues and savings assumed to be equivalent across alternatives, commonly referred to as service alternatives.

Evaluation of Alternatives Using Present Worth

To assess alternatives using Present Worth, all cash flows are converted to present worth at the established MARR:

Costs are denoted as negative values; revenues are positive.

The evaluation criteria are as follows:

For a single project, if PW > 0, the project is justified.
For mutually exclusive alternatives, select the one with the highest PW.
For independent projects, select all with PW > 0.

Example of Present Worth Analysis

Consider the following project IDs and their respective present worth:

Project ID	Present Worth
A	$30,000
B	$12,500
C	$-4,000
D	$2,000

The selected alternatives would lead us to choose Project A for the greatest absolute value, while projects A, B, and D would be selected among those with a positive PW.

Evaluating Equal-Life ME Alternatives

Examining two alternatives, X and Y, yields:

Alternative X: Initial cost of $20,000, operating cost of $9,000 per year, salvage value of $5,000 after 5 years.
Alternative Y: Initial cost of $35,000, operating cost of $4,000 per year, salvage value of $7,000 after 5 years.

Using a MARR of 12%:

PW of X: PW_X = -$49,606
PW of Y: PW_Y = -$45,447

Thus, Alternative Y is the recommended choice.

Present Worth Comparison for Different Life Alternatives

When life spans differ among alternatives, PW analysis necessitates that they offer equitable service, meaning all considered timeframes should match. This can be achieved through:

Calculating the least common multiple (LCM) of respective lives.
Evaluating a specified study period.

These methodologies ensure fairness when comparing the alternatives and help firms avoid favoring shorter-lived projects that may seem less costly.

Using Study Period for PW Evaluation

After a study period is selected, all cash flows beyond this timeframe are disregarded. Market values at the end of the study are incorporated in evaluations. It is common for short study periods to be defined by management, especially during equipment replacement analyses.

Future Worth Method

The Future Worth method computes the future value of alternative projects, determining the option with the highest net worth or lowest net cost for implementation.

FW computations involve evaluating all cash flows at their future values at the close of the study period.
FW is represented as: FW = PW (F/P,i%,N).
FW ≥ 0 indicates the project is economically sound.

Annual Worth (AW)

AW entails determining an equivalent series of periodic returns and expenses at MARR. The formula considers capital recovery alongside annual revenues and expenses.

Capital Recovery (CR)

CR signifies the annual equivalent of the capital invested, accounting for declines in asset value and interest on the invested capital.

Internal Rate of Return (IRR)

The IRR approach is a prevalent return rate method within engineering economic analysis, also known as the investor's method or profitability index. A project's IRR must exceed the MARR for it to be acceptable.

Challenges of IRR Method

Application challenges of the IRR method include:

Calculation complexity without suitable tools.
Potential for multiple rates of return in unusual cases.

Comparison and Selection Among Alternatives

Key factors in decision-making are the comparisons among viable design alternatives. Projects requiring larger investments should be weighed against the benefits they yield relative to investments made at the same MARR.

Types of Alternatives

Investment Alternatives: These necessitate an initial capital investment producing positive cash flows through generated revenue or cost savings.
Cost Alternatives: Primarily entail expenses that may culminate in a positive cash flow at project end, such as asset disposal.

Examples of Alternatives

The introduction of a consistent MARR aids in assessing these alternatives. For investment alternatives, only those with a positive PW meet attractiveness criteria and the one with the highest PW is selected. In the case of cost alternatives, projects are compared on the basis of their absolute values.

Example: Decision-Making Using a MARR of 10%

Considering two investment alternatives, A and B:

A: Capital investment $100,000, Annual net revenue $34,000
B: Capital investment $125,000, Annual net revenue $41,000

With a MARR of 10%, the selected alternative would be B due to its greater present worth despite both being viable options.

Example: Cost Alternatives

C: Capital investment $80,000, Annual expenses $25,000
D: Capital investment $60,000, Annual expenses $30,000

Using a MARR of 12%, we find that D is the preferred option owing to its lower costs.

Summary of Important Points

Present Worth analysis entails converting cash flows to present value using the MARR.
Alternatives can either be mutually exclusive or independent.
Cash flow estimates must align with the ongoing service considerations through an LCM or predefined study period.

Comprehensive Analysis of Independent Project Management and Evaluation

Comprehensive Analysis of Independent Project Management and Evaluation