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Chapter 9 - Benefit-Cost Ratio and Other Analysis Methods Click here for Streaming Audio To Accompany Presentation (optional) 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

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EGR 403 - Cal Poly Pomona - SA122 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

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EGR 403 - Cal Poly Pomona - SA123 Chapter 9 - Other Analysis Methods Future worth analysis Benefit-cost ratio analysis Payback period Sensitivity and breakeven analysis

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EGR 403 - Cal Poly Pomona - SA124 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)

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EGR 403 - Cal Poly Pomona - SA125 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.

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EGR 403 - Cal Poly Pomona - SA126 Benefit-Cost Ratio Analysis If the PW of benefits - PW of costs 0. The alternative is considered acceptable. Restated: Benefit-cost ratio B/C =. PW of benefit/PW of cost 1. Fixed input, maximize B/C. Example 9-3

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EGR 403 - Cal Poly Pomona - SA127 Benefit-Cost Ratio Analysis If the EUAB - EUAC 0. The alternative is considered acceptable. Restated: Benefit-cost ratio: B/C = EUAB/EUAC 1 Or, using PW: B/C = PWB/PWC 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

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EGR 403 - Cal Poly Pomona - SA128 Benefit Cost Ratio Analysis Example Reject increment if incremental B/C Ratio is < 1

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EGR 403 - Cal Poly Pomona - SA129 Benefit Cost Ratio Analysis Example First Increment is B-D. Incremental B/C > 1, so choose higher cost alternative

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EGR 403 - Cal Poly Pomona - SA1210 Benefit Cost Ratio Analysis Example Reject increment if incremental B/C Ratio is < 1

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EGR 403 - Cal Poly Pomona - SA1211 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.

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EGR 403 - Cal Poly Pomona - SA1212 Payback Period 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? 9-6

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EGR 403 - Cal Poly Pomona - SA1213 Payback Analysis What is wrong here? Payback and IRR analysis do not agree. 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? 1.Liquidity vs. profitability. 2.Life of project. Example 9-8

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EGR 403 - Cal Poly Pomona - SA1214 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.

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EGR 403 - Cal Poly Pomona - SA1215 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?

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EGR 403 - Cal Poly Pomona - SA1216 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.

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EGR 403 - Cal Poly Pomona - SA1217 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

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