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Chapter 4

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Economic Factors in Design The basis of design decisions will be economics. Designing a technically safe and sound system will be only part of the designer's task. Equally important is the requirement that the system be economical and show an adequate return on investment.

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Economic Factors As in any investment project, the following economic factors should be also considered while making investment decisions Capital cost of technology Long term debt availability Capacity Risks and uncertainties

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Time Rate of inflation Competitors Liquidity Tax Promotions

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Time is money. Cycle time (i.e., construction period) is an important factor. Ensuring revenues (i.e., income) as fast as possible is a priority to investors. Shorter construction periods also mean lower capital cost.

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Economic Analysis There are various methods for economic evaluation of design alternatives. The most commonly used methods are: Investment profitability analysis Annual cost method Present worth method Capitalized cost method

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Profitability analysis is concerned with the assessing feasibility of a new project from the point of view of its financial results. Several methods for investment profitability analysis of design alternatives have been developed. The following profitability analysis methods are commonly used to compare the profitability of alternative designs:

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Internal rate of return (IRR) Return on investment (ROI) Net present value (NPV) Pay-back period Simple rate of return Internal rate of return, return on investment (ROI), and the net present value (NPV) are discounted methods because they take into consideration the entire life of a project and the time factor by discounting the future inflows and outflows to their present values.

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Simple rate of return and the pay-back period, are two other methods used for profitability analysis, and are usually referred to as simple methods since they do not take into consideration the whole life span of the project.

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Annual cost method, present worth method and capitalized cost method are the three methods used to compare lifetime cost of alternative parameters.

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Time Value of Money A sum of money is more valuable the sooner it is received. A dollar today is worth more than the promise of a dollar tomorrow Due to: Inflation and risk Before you invest money in a project you must compare its rate of return against other opportunities (other projects)

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Time Value of Money FV = PV(1 + i) n Where: FV = Future Value of an investment (project) PV = Present Value of that same investment i = Interest rate, discount rate or cost of capital n = Number of years Example: Invest $1000 today (PV) for 1 year(n) at an interest rate of 10% (i), the investment is worth $1000(1+.1) 1 or $1100 at the end of year one What happens when you have two different investments with varying rates of return? You must find a way to put both on equal terms.

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Time Value of Money You put both on equal terms by changing the formula slightly to evaluate all future cash flows at time zero or today PV = FV/(1+i) n Example: You have a project that promises you $1000 of profit at the end of the first year with the discount rate at 10% PV = $1,000 = $909 (1+0.1) 1 The project is worth only $909 today

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Net Present Value Analysis NPV is a method of calculating the expected net monetary gain or loss from an investment (project) by discounting all future costs and benefits to the present time Projects with a positive NPV should be considered if financial value is a key criterion Generally, the higher the NPV, the better

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Net Present Value Analysis NPV is one of the most often used quantitative models for project selection. NPV is a method of calculating the expected net monetary gain or loss from an investment (project) by discounting all future costs and benefits to the present time.

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Net Present Value Analysis If the NPV turns out to be a positive value, the project has surpassed the cost of capital or return available by investing the same money in other ways. All other project characteristics being equal, the project with the highest NPV should be chosen.

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NPV Example NPV is calculated using the following formula: NPV = ∑t=0…n CF/ (1+i) t

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NPV Example Calculations

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Excel worksheet.

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Internal Rate of Return (IRR) IRR is similar to NPV in process but is slightly more difficult to calculate. The IRR is the discount rate at which NPV is zero. Finding an IRR solution involves trial and error: You keep plugging in different discount rates and see which one drives the NPV to zero.

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Internal Rate of Return (IRR) You can compare the IRR value to other projects or to a company standard to see which projects should get priority. If the organization has set a minimum value of 8 percent and the project IRR is 15 percent, you have a positive situation, and you should do the project. If the project IRR turns out to be 6 percent, you should not do the project

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Internal Rate of Return (IRR) One of the more sophisticated capital budgeting techniques and also more difficult to calculate The IRR is the discount rate at which NPV is zero Or the Discount rate where the present value of the cash inflows exactly equals the initial investment. IRR is the discount rate when NPV = 0 Most companies that use this technique have a minimum IRR that you must meet. Basically trial and error changing the discount rate until NPV becomes zero

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Return on Investment (ROI) Return on investment (ROI) is income divided by investment ROI = (total discounted benefits – total discounted costs) / total discounted costs The higher the ROI or higher the ratio of benefits to costs, the better Many organizations have a required rate of return or minimum acceptable rate of return on investment for projects

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ROI Example Step 1: determine discount factor for each year. Step 2: calculate discounted benefits and costs

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ROI Example

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ROI Project 1 = ($436,000 - $367,100) / $367,100 = 19% ROI Project 2 = ($335,000 - $256,000) / $256,000 = 31%

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Payback Period The payback period is the amount of time it will take a project to recover its initial cost. As with the other quantitative models, many organizations have a maximum number in mind that all projects must meet or beat. If an IT project has a payback period of four years but the organization demands two years, then either you won't be allowed to proceed with the project or you must make adjustments to change the equation.

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Payback Period The payback period ignores the time value of money but offers a glimpse at the potential risk associated with each of the projects. A longer payback period generally infers a riskier project. The longer it takes before a project begins to make money for the organization,the greater the chances that things can go wrong on the project

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Payback Analysis The payback period is the amount of time it will take a project before the accrued benefits surpass accrued costs or how much time an investment takes to recover its initial cost track the net cash flow across each year to determine the year that net benefits overtake net costs (not discounted cash flows) Many organizations want IT projects to have a fairly short payback period (< 1 year)

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Payback Example Same numbers as earlier examples. Table shows net cash flows Project 1 payback occurs sometime during year 4 Project 2 payback occurs sometime during year 3

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