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Unformatted text preview: 15 Engineering Economic Analysis - Newnan, Lavelle, and Eschenbach Chapter 8
Incremental Analysis of Multiple Alternatives A. Choices Involving Multiple Alternatives 1. Mutually exclusive: At most, one project out of a group of alternatives may be chosen 2. Independent: The choice of any one project is independent of the choice of any other project
in the group of alternatives. Any number of projects may be chosen as long as sufﬁcient capital
is available. 3. Contingent: The choice of a particular project is conditional on the choice of one or more of
the other projects. Incremental Analysis of Mutually Exclusive Alternatives with Equal Analysis Periods
The examination of the differences between mutually exclusive alternatives is based on incremental
ﬁrst costs, incremental beneﬁts and other yearly cash ﬂows, and incremental salvage values.
Complex cash ﬂows complicate incremental rate of return (AROR) methods and are best done on
Graphical Methods (Chapters 8, 9)
Graphical Methods such as those illustrated in Chapter 8 and the accompanying spreadsheet
analyses are generally not used to solve problems, but serve to illustrate the interrelationships
between the various analysis methods. Graphical methods show how the conclusion concerning
the best alternative is the same, regardless of the analysis method used.
IfPW of Beneﬁts is plotted against PW of Cost for all alternatives using the MARR. as the interest
rate, the 45 degree line where PWB = PWC at an interest rate equal to the MARR represents the
NPW = 0 condition. Alternatives which plot in the lower quadrant of the graph are undesirable
since they have an IRR less than the MARR. The vertical distance from the NPW = 0 line to an
alternative (either positive or negative) indicates the NPW of the Alternative.
If several alternatives have IRR's greater than the MARR (i.e. they plot in the upper quadrant of
the graph), then the best alternative is the one with the highest NPW, which is the vertical distance
from the NPW = 0 line. In terms of AROR‘s, this corresponds to going along the decision tree
until the highest initial cost with an incremental slope greater than unity is found. A n y
incremental slope less than unity indicates an alternative which, by itself, satisﬁes the IRR > MARR
or B/C > 1 criteria, but whose incremental cost does not justify the incremental beneﬁt.
Analytical Methods for Increments of Investment (Chapters 7, 8, 9, and 20)
Be sure all the alternatives and their beneﬁts and costs are identiﬁed. Net the annual cash ﬂows
as explained in the spreadsheet material.
Compute the IRR for each alternative and reject any which are less than the MARR. Alternatively,
a Beneﬁt/Cost ratio > 1.0 is required to be eligible for ”the ﬁnal tournament". For cost only
situations, this step is skipped.
Arrange the remaining alternatives in ascending order of initial investment for AROR analysis
(which should correspond to ascending order of PW of cost for Beneﬁt/ Cost ratio analysis if net
annual cash ﬂows are used.)
Make a two alternative AROR analysis or AB/ AC analysis If AROR 2 MARR, or AB/ AC 2 1.0, retain the higher cost alternative If AROR < MARR, or AB/AC < 1.0, retain the lower cost alternative
Continue along the decision tree until the best of the mutually exclusive multiple alternatives has
been selected. 16 Engineering Economic Analysis — Newnan, Lavelle, and Eschenbach Chapter 9 Other Analysis
Techniques A. Future Worth Analysis Future Worth analysis arrives at the same conclusion as net present worth analysis in
comparing alternatives except the results are given in terms of ﬁiture values. This may be useﬁil
in setting up savings goals and ﬁnding the future value of a long lead time plant construction
project at the time it goes into operation. Benefit-Cost Ratio Analysis requires a meaningful MARR and dollar values for the beneﬁts.
(Intangible beneﬁts are a problem to analyze in cost eﬂectiveness studies.) Beneﬁt/Cost Ratio, B/C = PW of Beneﬁts/PW of Costs
For a project to be considered acceptable, B/C 2 1.0 For mutually exclusive multiple investment alternatives, incremental analysis is required; i.e.,
each increment of additional cost for more expensive solutions must produce additional beneﬁts
in excess of the additional costs. One then chooses the highest cost alternative with AB/AC 2 1.0 Incremental Beneﬁt/Cost Ratio analysis is easier to analyze on a hand calculator than the
Incremental Rate of Return method discussed in Chapter 7. It gives the same results and uses a
decision tree arranged in order of increasing present worth of costs. The absolute magnitudes of
the ratio depend on whether gross or net beneﬁts and costs are used. There is no general
agreement that the "Net Annual Cash Flow" is the best method of analysis except that it must be
used for "cost only" analysis and is the only way to avoid conﬂicting results in some situations. . Payback Period Payback period is the period of time required for the proﬁt or other beneﬁts from an investment
to equal the cost of the investment, i.e., how quickly capital will be recovered. Payback period ignores useful life, salvage value and the time value of money. It should be avoided
in comparing alternatives since the results of this analysis can be misleading. It can be found from the cumulative cash ﬂow vs. year graph in a spreadsheet analysis. Sensitivity and Breakeven Analysis These techniques are used to see how sensitive a decision is to estimates for the various
parameters. Breakeven analysis is done to locate conditions under which various alternatives are equally
desirable. Examples include single vs. multi-stage construction, hours of equipment utilization,
production volume required, equipment replacement analysis (Chapter 12.) Sensitivity analysis is an examination of a range of values for some parameter to determine their
effect on a particular decision. This is illustrated in a number of graphs which accompany the
spreadsheets in the spreadsheet supplements. 17 Engineering Economic Analysis - Newnan, Lavelle, and Eschenbach Chapter 10 Depreciation Depreciation is a decline in market or asset value of physical properties caused by deterioration or
obsolescence. It represents a legal loss of value for tax purposes. Depreciation involves a
systematic allocation of the cost of an asset over its depreciable life. The annual depreciation expense
is deductible for income tax calculations. However, if the asset is sold for more than its book value,
the recovered depreciation is taxed as ordinary income. Depreciation thus represents tax deferral, not
tax avoidance. (Note: Land is a non-depreciable asset.) A. Definitions of Value 1. 2.
3. .U‘ 1. Market Value: Cost of a property when both buyer and seller have equal advantage and are
under no compulsion to buy or sell. Use Value: Worth of a property to its present owner because of its current use. Esteem Value: Worth of a property to its present owner because of its qualities that make
people want to possess the product. Fair Value: Worth of a property determined by a disinterested party as fair to both buyer and
seller. Salvage (resale) Value (S): Price that can be obtained from the sale of the property Book Value: Original cost (P) of a property less the amounts that have been charged as
depreciation expense. Adjusted Basis Value: Book value plus the cost of improvements, additions, and other
capital costs, commissions, legal fees, etc. minus certain credits. This value is essential in
calculating the taxable proﬁt or loss from the sale of property. Pre—ACRS./MACRS Methods of Depreciation Asset Life: In 1971 the US. Treasury Department published guidelines for about 100
classiﬁcations of depreciable asset including the concept of an Asset Depreciation Range
(ADR) whose midpoint lives were somewhat shorter than the actual average useﬁil lives.
Depreciation Methods: Although most business depreciation uses either MACRS or straight
line depreciation, the other methods may still be found on the EIT examination. Straight line (S.L.) Depreciation:
Annual depreciation charge = (P-S)/N where N = Depreciable life
Book value at end of year n = P - n(P-S)/N n = 1 ...... N Sum-of—Years Digits (SOYD) Depreciation
Sum—of—Years Digits = N(N+1)/2
SOYD depreciation for year n = (P—S)[2(N-n+1)/(N(N+1))]
= (P— S)(Remaining useﬁrl life at beginning of year n)/SOYD Declining Balance Depreciation:
Double Declining Balance depreciation in any year = 2(Book Value)/N = 2(Cost - Depreciation charges to date)/N
Book value at end of year n = P(1-2/N)
Implied Salvage value at the end of N years = P(l-2/N)
(see discussion pp. 37 8-3 79) Declining Balance Depreciation with Conversion to Straight Line Dep.
Rule: Switch from declining balance to S.L. whenever S.L. results in a larger depreciation charge. (Table 10-1). This is handled automatically in the spreadsheet program MACRS as
illustrated in Tables 108-1 and 10S—2. 18 0 Unit of Production Depreciation, Cost and Percentage Depletion
Depletion allowances on oil, gas, mineral, and timber properties may be based on the units of
production relative to the total expected production over the lifetime of the resource or may
be based on percent of gross income (up to 50% of taxable income). . The Economic Recovery Tax Act of 1981 (ERTA) and the Tax Reform Act of 1986 - These acts introduced the Accelerated Cost Recovery System (ACRS) as the standard
depreciation method for assets placed in service after 31 December, 1980. It did not
retroactively affect depreciation practices for assets placed in service prior to 1 January, 1981.
ACRS allowed some of the older methods to be used in special circumstances, so these
methods are still covered in the course. The Tax Reform Act of 1986 replaced the more liberal
ACRS. depreciation schedules with the MACRS (Modiﬁed Accelerated Cost Recovery
System) which is currently in effect as modiﬁed yearly by the Congress. Principal features of the 1981 Act - Depreciable life was considerably less than the useful life for most classes of assets. Real estate
could be ﬁilly depreciated in 15 years. - Salvage value was assumed to be zero . Half year ownership was assumed for non real estate property regardless of when the property
is placed in service. . An investment tax credit of up to 10% of the value of the asset was allowed. The Tax Reform Acts of 1986 and 1988 0 To decrease the number of “tax shelters" generated by features of the 1981 act, the depreciable lives were
lengthened and the half-year convention was introduced. That is, three year property is depreciated over
three and one half years and so forth as illustrated in Table 10-4. 0 Automobiles used for business were changed from three year property to ﬁve year property. Real estate
was changed from 15 year property to 18 year property and then to 27.5 and 31.5 year property.
Commercial real estate has recently been changed to 39 year property. 0 “Passive losses” generated by leveraged depreciation charges were outlawed for passive investors who
did not have an active management role in running a limited partnership tax shelter. This combined with
the lower depreciation charges for real estate essentially caused the collapse of the tax shelter business
for passive investors and was a contributing factor in the collapse of many savings and loan
organizations. - The mid-quarter convention was introduced for personal property. 0 The investment tax credit was repealed. 0 Table 10-3, lists the MACRS property classes and 0 Tables 10-4 and 10-5, list the MACRS depreciation percentages for the various classes of depreciable property. ...
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- Fall '09