L14: Evaluating Business and Engineering Assets – Part II

1. L14: Evaluating Business and Engineering Assets – Part II ECON 320 Engineering Economics Mahmut Ali GOKCE Industrial Systems Engineering Computer Sciences

2. Payback Period Lecture No.14

3. Chapter 5Present-Worth Analysis • Loan versus Project Cash Flows • Initial Project Screening Methods • Present-Worth Analysis • Methods to Compare Mutually Exclusive Alternatives

4. Chapter Opening Story – Federal Express Nature of Project: • Equip 40,000 couriers with PowerPads • Save 10 seconds per pickup stop • Investment cost: $150 million • Expected savings: $20 million per year Federal Express

5. Ultimate Questions • Is it worth investing $150 million to save $20 million per year, say over 10 years? • How long does it take to recover the initial investment? • What kind of interest rate should be used in evaluating business investment opportunities?

6. Mr. Bracewell’s Investment Problem • Built a hydroelectric plant using his personal savings of $800,000 • Power generating capacity of 6 million kwhs • Estimated annual power sales after taxes - $120,000 • Expected service life of 50 years • Was Bracewell's $800,000 investment a wise one? • How long does he have to wait to recover his initial investment, and will he ever make a profit?

7. Mr. Brcewell’s Hydro Project

8. Loan Customer Bank Repayment Bank Loan vs. Investment Project • Bank Loan • Investment Project Investment Project Company Return

9. Describing Project Cash Flows

10. Payback Period • Principle: • How fast can I recover my initial investment? • Method: • Based on cumulative cash flow (or accounting profit) • Screening Guideline: • If the payback period is less than or equal to some specified payback period, the project would be considered for further analysis. • Weakness: • Does not consider the time value of money

11. Fails to measure profitability. Assumes no profit made during payback period. • Does not consider the timing of the cashflows • What if –10000, 9000, 500, 500 vs. –10000, 500, 500, 9000 • Same payback, very different situation

12. Example 5.1 Payback Period N Cash Flow Cum. Flow 0 1 2 3 4 5 6 -$85,000 -$50,000 -$5,000 $45,000 $95,000 $140,000 $175,000 -$105,000+$20,000 $35,000 $45,000 $50,000 $50,000 $45,000 $35,000 Payback period should occurs somewhere between N = 2 and N = 3.

13. $45,000 $45,000 $35,000 $35,000 $25,000 $15,000 Annual cash flow 0 1 2 3 4 5 6 Years $85,000 150,000 3.2 years Payback period 100,000 50,000 Cumulative cash flow ($) 0 -50,000 -100,000 0 1 2 4 5 6 3 Years (n)

14. Practice Problem • How long does it take to recover the initial investment for Federal Express? • How long does it take to recover the investments made by Mr. Bracewell from his hydroelectric project?

15. Discounted Payback Period • Principle: • How fast can I recover my initial investment plus interest? • Method: • Based on cumulative discounted cash flow • Screening Guideline: • If the discounted payback period (DPP) is less than or equal to some specified payback period, the project would be considered for further analysis. • Weakness: • Cash flows occurring after DPP are ignored

16. Example 5.2 Discounted Payback Period Calculation * Cost of funds = (Unrecovered beginning balance) X (interest rate)

17. Summary Payback periods can be used as a screening tool for liquidity, but we need a measure of investment worth for profitability.