MSci261-2007-Ch_4

# MSci261-2007-Ch_4 - Chapter 4 Comparison method 1 MSci 261...

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Chapter 4 1 Chapter 4 Chapter 4 MSci 261: Managerial and Engineering Economics Spring 2007 Instructor: Bon Koo Comparison method 1 Comparison method 1

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Chapter 4 2 Overview Overview Managers often need to choose one among multiple investment projects. Which one to choose? Compare the expected benefit and cost, and choose the one in which the benefit exceeds cost (or net benefit is positive). What if several projects have positive net benefits? Choose the one with the largest net benefit. The evaluation of benefits and costs should be done in a consistent way (refer to chapter 3 on various conversion factors) We will learn several methods of comparing projects in chapters 4 and 5.
Chapter 4 3 1. Types of comparison methods 1. Types of comparison methods Types of comparison methods Present worth (PW) method: Covert to the present worth (\$) Annual worth (AW) method: Convert to an annuity (\$) Payback period method: Calculate the period of payback (yr) Internal rate of return (IRR): Calculate the breakeven rate (%) Basic assumptions Costs and benefits are quantifiable in money (ch. 13). No uncertainty (ch. 11 and 12) No inflation or deflation (ch. 9) No capital constraints (appendix 4A) No taxes (ch. 8)

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Chapter 4 4 2. Basic concepts (1) 2. Basic concepts (1) Three types of relation among projects Independent projects : The cash flows of each project are not related (e.g., buying a vacuum and computer). Consider each project one at a time. Make a decision on the merits of its own project Mutually exclusive projects : Choosing one project excludes other projects (e.g., renting a high-rise building or a townhouse). Rank all the projects and pick the best one. Related but not mutually exclusive projects
Chapter 4 5 Example 2-1: Relation among projects (1) Example 2-1: Relation among projects (1) WatCar is considering to open three new plants, in Waterloo (W), Kitchener (K), and Cambridge (C), and the investment costs for each plant are as follows. 1. What mutually exclusive alternatives are feasible with no budget constraint? 8 different options (= 2 3 ) are feasible. Project First cost W plant K plant C plant \$0.6 million \$0.9 million \$1.2 million

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Chapter 4 6 Example 2-1: Relation among projects (2) Example 2-1: Relation among projects (2) 1. If the total budget is limited to \$2 million. What mutually exclusive alternatives are feasible? Six different options are feasible No. W plant K plant C plant Options Total cost 1. 2. 3. 4. 5. 6. 7. 8. x x x x x x x x x x x x Nothing W K C WK WC KC WKC \$0 \$0.6 million \$0.9 million \$1.2 million \$1.5 million \$1.8 million \$2.1 million \$2.7 million
Chapter 4 7 2. Basic concepts (2) 2. Basic concepts (2) Minimum acceptable rate of return (MARR) A lower limit of interest rate that can be acceptable by a firm.

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