07 Lecture 07 - Evaluation Techniques This lesson will...

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Evaluation Techniques This lesson will focus on two important areas: 1. Evaluation techniques for common operating issues that arise in facilities 2. Firm-wide capital budgeting Most engineers who are associated with operating facilities are faced with decisions about replacement of equipment or abandonment of equipment from time to time. Replacement decisions are called defender/challenger studies where the existing unit is the defender and the proposed (or new) unit is the challenger. Evaluation Techniques: Delay of Projects We know that the Present Worth of a project is the cashflow value of the excess return over the MARR at a point in time. A typical question for project managers is what is the effect of acceleration or delay in the project schedule? What happens if the project does not start until, say, one year later? The answer to these types of questions is usually formed by calculating the change in Present Worth over the time interval of the delay. For instance, accelerating a project by one year permits us to generate revenues one year earlier and therefore generate positive cashflows one year sooner which increases the present worth of the project. Conversely, delay of one year would cause a decrease in present worth by deferring positive cashflows by one year. The difference in present worth’s over the period is the effect of the delay or acceleration. A significant assumption is the issue of whether the project life will shift intact based on the delay or whether there is reason to believe that a truncation of cashflows would occur at the end of the project life. In my experience, when using a 15 or 20 year project life, the analyst will assume a shift of cashflows with an intact project life instead of assuming a truncation. It would be unusual if a "hard" termination date was known so far in advance. On the
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other hand, if a project life is three years and the revenues are controlled by a contractual obligation, then truncation would be a possible outcome and should be considered. Example: A manufacturing plant is under construction in Nebraska and its benefits are expected to be worth $15,000,000 when complete. It is expected to have a 20 year economic life. Question: If the owner uses MARR of 15%, what is it worth to speed up the construction so that it can open at the beginning of the next canning season rather than a year later? Answer: A set of cash flows equivalent to $15,000,000 at time zero (beginning of the next canning season) would undergo a one year shift delay unless the speedup occurs. From Figure 5.4 in the text, given P=$15,000,000, the present worth of avoiding the delay is: P(1 - b ) = $15,000,000 [1- (1 / 1.15) ] = $1,960,000 It is worth nearly $2 million to speed up the construction.
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This note was uploaded on 05/12/2010 for the course BUSINESS BS515 taught by Professor Johnson during the Fall '09 term at Drexel.

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07 Lecture 07 - Evaluation Techniques This lesson will...

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