Module15 - Making the Decision for a Single Project...

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Making the Decision for a Single Project Deterministic Evaluation Part I
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Key Concepts Last Module: After-Tax Cash Flow Estimation This Module: Deterministic Evaluation of a Single Project Define absolute and relative measures of worth for a single project to determine whether acceptable or not.
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1 Problem (need or opportunity) Recognition and Definition 2 Generation of Solution Alternatives 3 Development of Feasible Solution Alternative Cash Flows 4 Economic Evaluation of Alternatives, including cases under uncertainty and risk 5 Selection and Implementation of Best Alternative 6 Post-implementation Analysis and Evaluation Economic Decision Analysis
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Assumptions Cash flow magnitudes and timing are known with certainty Interest rate (the MARR) is known and constant for the length of decision horizon The decision is to accept or reject the project
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Decision Accept the project : Implies that the project can generate acceptable amount of wealth for the company or, for public entity, the benefits outweigh the cost. If acted upon, funds should be released to begin the project Reject the project : Implies that there are better options available for investment than the one currently being analyzed. Rejecting is equivalent to accepting the “do-nothing” alternative which assumes the funds can be invested at MARR
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Absolute vs. Relative Worth Absolute worth defines the amount of wealth that a project generates for a company Relative worth defines the worth of a project relative to its level of investment
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Absolute Measure: Present Worth This value is commonly referred to as present value, net present value, or NPV Decision is made according to the following (where i is MARR): PW Value Decision PW(i) > 0 Accept PW(i) = 0 Indifferent PW(i) < 0 Reject PW ( i ) = A n (1 + i ) n n = 0 N
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Example: Present Worth Norwegian electric-car manufacturer Think will invest $43.5 million in facilities and equipment in Indiana to produce its City car (for two adults and two children) starting in early 2011. Production will start in the low thousands and build to a capacity of 20,000 cars per year which is expected to sell for urce: Dolan, M., “WSJ: Scandinavian Electric Car Maker To Build Vehicles In Indiana,” Dow Jones News Service, January 4, 2010.
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Example: Present Worth Assume first year sales of 4000 cars increasing by 2000 cars each year until reaching capacity. Revenues total $34,000 per car with per-unit costs of $31,000. Fixed O&M costs for the plant are estimated at $20 million per year. The plant is estimated to have a 10-year life and salvage value of $3 million. Is this a good investment? Use present worth with an interest rate of 15% per year to make your
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Solution Draw the cash flow diagram:
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Present Worth Discounting “removes” a baseline value Cost of capital Money expected to be earned Present worth is the amount of money remaining after removal: wealth remaining after cost of capital is paid Often referred to as “discounted profit” Note: it is not profit!
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Present Worth For investment: as cost of capital increases, PW of investment decreases
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This note was uploaded on 01/11/2012 for the course EIN 4354 taught by Professor Tufecki during the Fall '08 term at University of Florida.

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Module15 - Making the Decision for a Single Project...

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