1. Engineering Systems Analysis Richard de Neufville © Massachusetts Institute of Technology Economic Evaluation Slide 1 of 22 Economic Evaluation l Objective of Analysis l Criteria – Nature – Peculiarities l Comparison of Criteria l Recommended Approach

2. Engineering Systems Analysis Richard de Neufville © Massachusetts Institute of Technology Economic Evaluation Slide 2 of 22 Objectives of Economic Evaluation Analysis l Is individual project worthwhile? Above minimum standards? –This is a “choice”, is it better or not? –This is easier l Is it best? Is it at top of ranking list? –This is a “judgment” about details –This is more difficult l Note difference between “choice” and “judgement” -- a key consideration in selection of method to be used in real options analysis

3. Engineering Systems Analysis Richard de Neufville © Massachusetts Institute of Technology Economic Evaluation Slide 3 of 22 Principal Evaluation Criteria l Net Present Value l Benefit - Cost Ratio l Internal Rate of Return l Cost-Effectiveness Ratio l Pay-Back Period

4. Engineering Systems Analysis Richard de Neufville © Massachusetts Institute of Technology Economic Evaluation Slide 4 of 22 l NPV = B - C (stated in present values) l Objective: To Maximize l Advantage: Focus on Result l Disadvantages –Interpretation of NPV –No account for scale, thus difficult to use for ranking Net Present Value

5. Engineering Systems Analysis Richard de Neufville © Massachusetts Institute of Technology Economic Evaluation Slide 5 of 22 Present Value and Net Present Value: Example Calculations Note: c9:n9 => range of years 1 to 12; b9 => year 0 Thus formula = NPV of cash flows to start of year 1 + cost investment

6. Engineering Systems Analysis Richard de Neufville © Massachusetts Institute of Technology Economic Evaluation Slide 6 of 22 Difficulty in Interpreting Meaning of NPV l Suppose for example that a project –costs 1000 –sells 4 years later for 1500 l The obvious profit is 500 = 1500 - 1000 l From an NPV perspective, however, we get –NPV = 1500 / (1+r) exp 4 - 1000 –This amount depends on discount rate, r –If r = 10%, NPV ~ 1500 / 1.47 - 1000 ~ 20 –Try telling that to tax authorities -- or others!

7. Engineering Systems Analysis Richard de Neufville © Massachusetts Institute of Technology Economic Evaluation Slide 7 of 22 Evaluation of Projects S and T

8. Engineering Systems Analysis Richard de Neufville © Massachusetts Institute of Technology Economic Evaluation Slide 8 of 22 Benefit - Cost Ratio =  B /  C (Present Values) l Objective: –To Maximize l Advantage: –Common Scale, Useful in Ranking l Disadvantages: –Treatment of Recurring Costs  B /  C or Net Benefits/Investment = > Bias against operating projects –Ranking sensitive to r low r = > higher rank for long-term projects

9. Engineering Systems Analysis Richard de Neufville © Massachusetts Institute of Technology Economic Evaluation Slide 9 of 22 A Comparison of a Capital Intensive and Operations Project (Benefits in Present Values)

10. Engineering Systems Analysis Richard de Neufville © Massachusetts Institute of Technology Economic Evaluation Slide 10 of 22 The Ranking of Projects by Benefit-Cost Criterion Can Depend on DR

11. Engineering Systems Analysis Richard de Neufville © Massachusetts Institute of Technology Economic Evaluation Slide 11 of 22 Internal Rate of Return l IRR = r such that NPV = 0 l Objective: –Maximize IRR l Advantages: –No need to choose r –Manipulation by r impossible l Disadvantages: –Calculations complex -- but easy in spreadsheet –Ambiguous l Note: ranking by IRR and B/C ratio may differ

12. Engineering Systems Analysis Richard de Neufville © Massachusetts Institute of Technology Economic Evaluation Slide 12 of 22 Data for calculation of IRR Repeat of Example in Present Value/DCF lecture Example: Note: b9:k9 => range of years from 2001 to 2010 This NPV calculation assumes cash flows all at end of year

13. Engineering Systems Analysis Richard de Neufville © Massachusetts Institute of Technology Economic Evaluation Slide 13 of 22 Spreadsheet Determination of IRR Note: b9:k9 => range of years from 2001 to 2010 This NPV calculation assumes cash flows all at end of year

14. Engineering Systems Analysis Richard de Neufville © Massachusetts Institute of Technology Economic Evaluation Slide 14 of 22 Graphical Determination of IRR

15. Engineering Systems Analysis Richard de Neufville © Massachusetts Institute of Technology Economic Evaluation Slide 15 of 22 Projects can Lead to Ambiguous Solutions for the Internal Rate of Return 310 NPV DR 5 % 500 200 Cash flow t

16. Engineering Systems Analysis Richard de Neufville © Massachusetts Institute of Technology Economic Evaluation Slide 16 of 22 Ranking of Projects by Internal Rate of Return and Benefit-Cost Ratio Can Differ

17. Engineering Systems Analysis Richard de Neufville © Massachusetts Institute of Technology Economic Evaluation Slide 17 of 22 Pay-Back Period l PBP = Cost/Annual Benefits –Note: undiscounted l Objective: –To minimize l Advantages: –Really simple –No choice of r l Disadvantages –Difficult to rank correctly projects with different useful lives or uneven cash flows

18. Engineering Systems Analysis Richard de Neufville © Massachusetts Institute of Technology Economic Evaluation Slide 18 of 22 Evaluation of Projects V and W

19. Engineering Systems Analysis Richard de Neufville © Massachusetts Institute of Technology Economic Evaluation Slide 19 of 22 Cost- Effectiveness Ratio l Ratio = (Units of Benefit) / Cost –example: “lives saved/million dollars” l Objective: To Maximize l Advantage: Avoids problem of trying to assign $ values to “intangibles” such as a “life”, “ton of pollution”, etc. l Disadvantage: No sense for minimum standard or limits

20. Engineering Systems Analysis Richard de Neufville © Massachusetts Institute of Technology Economic Evaluation Slide 20 of 22 Data for of Cost-Effectiveness Analysis

21. Engineering Systems Analysis Richard de Neufville © Massachusetts Institute of Technology Economic Evaluation Slide 21 of 22 Cost-Effectiveness Analysis

22. Engineering Systems Analysis Richard de Neufville © Massachusetts Institute of Technology Economic Evaluation Slide 22 of 22 Recommended Procedure (if you have discretion to choose) l Examine Nature of projects –Easy to put into $ terms? Steady cash flows? or with closure costs? Or various project lifetimes? –An operating or a straight capital investment? l Choose Method Accordingly l No method is perfect -- ultimately a judgment l Current “best practice” uses several criteria; uses judgment to decide on project

23. Engineering Systems Analysis Richard de Neufville © Massachusetts Institute of Technology Economic Evaluation Slide 23 of 22 A Note for Optimal Plant Exercise Part 1 Average Costs of Production vary