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EGR 403 Capital Allocation Theory Dr. Phillip R. Rosenkrantz

Chapter 9 - Benefit-Cost Ratio and Other Analysis Methods Click here for Streaming Audio To Accompany Presentation (optional). EGR 403 Capital Allocation Theory Dr. Phillip R. Rosenkrantz Industrial & Manufacturing Engineering Department Cal Poly Pomona. EGR 403 - The Big Picture.

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EGR 403 Capital Allocation Theory Dr. Phillip R. Rosenkrantz

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  1. Chapter 9 - Benefit-Cost Ratio and Other Analysis MethodsClick here for Streaming Audio To Accompany Presentation (optional) EGR 403 Capital Allocation Theory Dr. Phillip R. Rosenkrantz Industrial & Manufacturing Engineering Department Cal Poly Pomona

  2. EGR 403 - The Big Picture • Framework:Accounting& Breakeven Analysis • “Time-value of money” concepts - Ch. 3, 4 • Analysis methods • Ch. 5 - Present Worth • Ch. 6 - Annual Worth • Ch. 7,7A,8 - Rate of Return (incremental analysis) • Ch. 9 - Benefit Cost Ratio & other methods • Refining the analysis • Ch. 10, 11 - Depreciation & Taxes • Ch. 12 - Replacement Analysis EGR 403 - Cal Poly Pomona - SA12

  3. Chapter 9 - Other Analysis Methods • Future worth analysis • Benefit-cost ratio analysis • Payback period • Sensitivity and breakeven analysis EGR 403 - Cal Poly Pomona - SA12

  4. Future Worth Analysis • Answers the question, what will the future situation be, if we take some particular course of action now? • Example 9.1, FW = P(F/P,i , n), FW = A(F/A, i, n) EGR 403 - Cal Poly Pomona - SA12

  5. Future Worth Analysis • When constructing a building, the issue is: • not the dollars out of pocket, • but the invested cost at start- up. • Example 9-2: The remodel project costs less out of pocket, but has a higher “up front” cost. That makes it less desirable. EGR 403 - Cal Poly Pomona - SA12

  6. Benefit-Cost Ratio Analysis Example 9-3 • If the PW of benefits - PW of costs ³ 0. The alternative is considered acceptable. • Restated: Benefit-cost ratio B/C =. PW of benefit/PW of cost ³ 1. • Fixed input, maximize B/C. EGR 403 - Cal Poly Pomona - SA12

  7. Benefit-Cost Ratio Analysis • If the EUAB - EUAC ³ 0. The alternative is considered acceptable. • Restated: Benefit-cost ratio: B/C = EUAB/EUAC ³ 1 Or, using PW: B/C = PWB/PWC ³ 1 • Neither input or output fixed - use incremental B/C. • Note: Salvage Value is considered a “negative cost”, not a benefit • B/C Ratio Analysis is popular in government • Very easy to use with databases and spreadsheets EGR 403 - Cal Poly Pomona - SA12

  8. Benefit Cost Ratio Analysis ExampleReject increment if incremental B/C Ratio is < 1 EGR 403 - Cal Poly Pomona - SA12

  9. Benefit Cost Ratio Analysis ExampleFirst Increment is B-D. Incremental B/C > 1, so choose higher cost alternative EGR 403 - Cal Poly Pomona - SA12

  10. Benefit Cost Ratio Analysis ExampleReject increment if incremental B/C Ratio is < 1 EGR 403 - Cal Poly Pomona - SA12

  11. Payback Period: Important Points • Approximate economic analysis method. • Prior to payback the effect of timing is ignored. • After payback all economic consequences are ignored. • Will not necessarily produce a recommended alternative consistent with equivalent worth and rate of return methods. EGR 403 - Cal Poly Pomona - SA12

  12. Payback Period 9-6 • The period of time required for the profit or other benefits of an investment to equal the cost of the investment. • How many years are required to get my money back? EGR 403 - Cal Poly Pomona - SA12

  13. What is wrong here? • Payback and IRR analysis do not agree. Payback Analysis Example 9-8 With alternative A we get our money back in 4 years but never make a return on the investment. With alternative B we get our money back in 5 years and make a return on the investment of 19%. • How should we make a decision? • Liquidity vs. profitability. • Life of project. EGR 403 - Cal Poly Pomona - SA12

  14. Sensitivity and Break-even Analysis • Economic data represent projections of expenditures and returns. • These projections ultimately affect our decisions. • To more fully consider our choice of a decision, we should play a “what if” game to determine the amount of change in a data point that might change the decision. EGR 403 - Cal Poly Pomona - SA12

  15. Consider Problem 6-21 • Diesel engine is preferred based on values assumed. • How much would changes in assumptions have to be in order to change the preferred alternative? EGR 403 - Cal Poly Pomona - SA12

  16. How much would price of diesel fuel need to go up before Gas would be the preferred alternative? Price of Diesel would have to go up to $.75 to change decision. EGR 403 - Cal Poly Pomona - SA12

  17. What is the impact of the variability of resale value on the analysis? By varying the resale value, we find that at about $4200 resale value for the gasoline powered vehicle the EUAC is almost equal EGR 403 - Cal Poly Pomona - SA12

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