IOE 201 Notes 8 - IOE 201 Lecture Notes 8 Project Evaluation Methods In the analyses so far the focus has been on earning interest from investments

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1 Project Evaluation Methods In the analyses so far, the focus has been on earning interest from investments, rather than generating revenue or new wealth. In commercial projects, investments are made and expenses incurred in order to generate revenue. For a project to be considered, the total revenue over the life of the project must outweigh the investment and any other expenses. The timing of the revenue is also important. IOE 201 Lecture Notes 8
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2 Project Evaluation Methods Example: A project requires an initial investment of $100,000 and is expected to generate $40,000 per year for the next 5 years (the life of the project). 0 1 2 3 4 5 years $100,000 $40,000 $40,000 $40,000 $40,000 $40,000
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3 Project Evaluation Methods Payback Period Present Worth Future Worth Capitalized Equivalent Worth Annual Equivalent worth
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0 1 2 3 4 5 Years 4 Payback period 2.5 years - $ 100,000 - $ 50,000 $ 50,000 $1 50,000 $ 100,000 $ 0 Cumulative cash flow Payback Period A simple way to evaluate the project is to determine how long it takes to recoup the initial investment (payback period): In our example: 3 years for discrete cash flow 2.5 years for continuous cash flow $40,000 $40,000
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5 Project Evaluation Methods The payback period method provides a quick and simple evaluation of a project, using minimal information. It is a convenient method for quickly rejecting proposed projects with a payback period that is too long. In practice, for comparing several different projects, the time value of money needs also to be taken into account.
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Discounted Payback Period 0 1 2 3 4 5 years $100,000 $40,000 $40,000 $40,000 $40,000 $40,000 For discounted payback, each year’s revenue is discounted by the interest rate i Discounted revenues are: Year 1 Year 2 Year 3 Year 4 Year 5 5 4 3 2 ) 1 ( 000 , 40 $ ) 1 ( 000 , 40 $ ) 1 ( 000 , 40 $ ) 1 ( 000 , 40 $ ) 1 ( 000 , 40 $ i i i i i + + + + + Results in longer payback period, depending on size of rate i
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Project Evaluation Methods Evaluation of commercial projects requires analyzing a firm’s cash flow for each project, based on the earning power of money. In our previous cash flow analyses, the interest rate used would be the earning power of money as specified by a bank. For cash flow analyses of a commercial firm, this rate is called the Minimum Attractive Rate of Return (MARR) . MARR is the interest rate at which a firm can always earn or borrow money. It is generally specified by the firm’s management, and is the rate used for a firm’s cash flow analyses. Minimum Attractive Rate of Return (MARR)
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This note was uploaded on 03/17/2010 for the course IOE 201 taught by Professor Dennisblumenfield during the Fall '09 term at University of Michigan-Dearborn.

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IOE 201 Notes 8 - IOE 201 Lecture Notes 8 Project Evaluation Methods In the analyses so far the focus has been on earning interest from investments

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