Engineering Economic Analysis

FOURTEENTH EDITION

Donald G. Newnan
Chapter 9 San Jose State University

Ted G. Eschenbach
Other Analysis University of Alaska Anchorage

Techniques Jerome P. Lavelle

North Carolina State University

Neal A. Lewis
Fairfield University

Copyright Oxford University Press 2020 9-1

 Chapter Outline

◼ Future Worth Analysis

◼ Benefit-Cost Ratio Analysis
◼ Payback Period
◼ Sensitivity & Breakeven Analysis
◼ Graphing with Spreadsheets for Sensitivity &
Breakeven Analysis
◼ Doing What-If Analysis with Spreadsheets

Copyright Oxford University Press 2020 9-2

 Learning Objectives

◼ Apply future worth, benefit-cost ratio, payback

period, & sensitivity analysis methods
◼ Link future worth analysis to present worth &
annual worth methods
◼ Develop the benefit-cost ratio
◼ Understand the concept of “payback period”
◼ Conduct sensitivity & breakeven analyses
◼ Use spreadsheets for sensitivity & breakeven
analyses

Copyright Oxford University Press 2020 9-3

 Vignette:
Clean, Lower Cost Space Travel

◼ >5000 orbital launches since

1960, with debris. NASA
tracks 500,000 pieces of
space debris
24% satellites, 18% spent
rockets
Reusable rockets: SpaceX can land the 1st stage, refurbish
it, and use in another launch
According to SpaceX, can be reused up to 15 times
Reduces cost of launch from $62M to $40M
Lowers cost of production & launch, and improves the
environment – on Earth and in space
Copyright Oxford University Press 2020 9-4
 Vignette:
Clean, Lower Cost Space Travel

1. What has happened recently with reusable launches?

2. What are potential costs & benefits of reusable
rockets?
3. What impact will this technology have on existing
rocket manufacturers?
4. What ethical questions arise from companies who
allow single-use rockets to land in the ocean or
become space debris?

Copyright Oxford University Press 2020 9-5

 Future Worth Analysis

◼ Alternatives compared using future worth at

given time
◼ Emphasizes final outcome
◼ Firm’s final wealth
◼ Retirement savings
◼ Easily converted to/from PW, EAW, & EAC

Copyright Oxford University Press 2020 9-6

 Example 9-1
Future Worth Calculation
A 20-year-old quits $35/week lottery habit. What is in savings
account paying 5% compounded semiannually at age 65?
Work-week habit costs $7/day. What if $2/day alternative
substituted 4 days/week?

Stop: Semiannual saving = $35 𝗑 26 = $910

Habit to treat: $5 saved on 4 days = $20/wk. = $520 every 6 mo.

Copyright Oxford University Press 2020 9-7

 Example 9-2
Future Worth Analysis
New
Plant Year Remodel
$85,000 0 $850,000
200,000 1 250,000
1,200,000 2 250,000
200,000 3 250,000

Copyright Oxford University Press 2020 9-8

 Benefit-Cost Ratio Analysis

At given MARR, an acceptable alternative satisfies

NPW = PW(Benefits) – PW(Costs) ≥ 0
EUAW = EUAB – EUAC ≥ 0

As a ratio:
𝐵 𝑃𝑊(𝐵𝑒𝑛𝑒𝑓𝑖𝑡𝑠) 𝐸𝑈𝐴𝐵
= = ≥1
𝐶 𝑃𝑊(𝐶𝑜𝑠𝑡𝑠) 𝐸𝑈𝐴𝐶

Copyright Oxford University Press 2020 9-9

 Benefit/Cost Ratio Example for Road

◼ Benefits = + outcomes for public

◼ Faster, safer travel
◼ PW = $3.8M
◼ Disbenefits = − outcomes for public
◼ Traffic delays during construction
◼ PW = −$0.9M
◼ Costs = paid by government
◼ Building & maintaining roads
◼ PW = −$2M
◼ B/C ratio = (3.8M − 0.9M)/2M = 1.45
Copyright Oxford University Press 2020 9-10
 Benefit-Cost Ratio Analysis
Situation Criterion
Neither input nor output One alternative: B/C ≥ 1
fixed
Two or more alternatives:
Incremental analysis of B/C ratios
Fixed input; constant C Maximize B/C; highest B

Fixed output; constant B Maximize B/C; lowest C

Copyright Oxford University Press 2020 9-11

 Example 9-3
Benefit-Cost Ratio Analysis
i = 7%

Copyright Oxford University Press 2020 9-12

 Example 9-4
Benefit-Cost Ratio Analysis
A B C D E F
Initial Cost $4000 $2000 $6000 $1000 $9000 $10,000
PW of Benefit 7330 4700 8730 1340 9000 9,500
B/C 1.83 2.35 1.46 1.34 1.00 0.95
Rearrange the alternatives in order of increasing investment
D B A C E
Initial Cost $1000 $2000 $4000 $6000 $9000
PW of Benefit 1340 4700 7330 8730 9000
B/C 1.34 2.35 1.83 1.46 1.00

Calculate ΔB/ΔC of the incremental investments, if ΔB/ΔC≥1,

choose the higher-cost alternative ➔ do A
B-D A-B C-A E-A
Initial Cost $2000 – 1000 $4000 – 2000 $6000 – 4000 $9000 – 4000
PW Benefit 4700 – 1340 7330 – 4700 8730 – 7330 9000 – 7330
ΔB/ ΔC 3.36 1.32 0.70 0.33
B wins A wins A wins A wins

Copyright Oxford University Press 2020 9-13

 New Public Swimming Pool

Pool costs $1.2M to build & $200K/year to operate.

Benefit is $450K/year. Using equivalent annual values
at i =6% & n =25 years, what is B/C ratio?
1. 1.53
2. 1.81
3. 2.25
4. 4.79
5. I don’t know

Copyright Oxford University Press 2020 9-14

 New Public Swimming Pool

Pool costs $1.2M to build & $200K/year to operate.

Benefit is $450K/year. Using equivalent annual values
at i =6% & n =25 years, what is B/C ratio?
1. 1.53
2. 1.81
3. 2.25
4. 4.79
5. I don’t know

Copyright Oxford University Press 2020 9-15

 Graphical Representation of
Benefit-Cost Ratio Analysis
◼ Incremental B/C = 1
is 45⁰ line
◼ Do A since
◼ B/CD > 1
◼ B/CB – D > 1
◼ B/CA – B > 1
◼ B/CC – A & B/CE – A < 1
◼ Not B largest B/C
◼ Not E largest project
with B/C > 1

Copyright Oxford University Press 2020 9-16

 Variations on Benefit-Cost Ratio

Government B/C ratio in Public Sector:

Present Worth Index in Private Sector:

All B/C ratios use same criterion: B/C ≥ 1

Various B/C ratios may differ in value, but they provide
consistent recommendations

Copyright Oxford University Press 2020 9-17

 Example 9-5
Government B/C Ratio Analysis
Right turn Left turn
i = 10%
lanes lanes Incremental
Initial cost $8.9M $3M
Annual maintenance 150K 75K
Uniform annual benefit 1.6M $2.2M
Construction disbenefit 900K 2.1M
Useful life, in years 15 15

Copyright Oxford University Press 2020 9-18

 Example 9-6
Present Worth Index
i = 10% Minimal Total Incremental
Initial cost $8.9M $3M
Annual maintenance 150K 75K
Uniform annual benefit 1.6M $2.2M
Disbenefit 900K 2.1M
Useful life, in years 15 15

Ratios differ from Exp. 9-5 because maintenance cost in numerator.

Copyright Oxford University Press 2020 9-19

 Payback Period
year in which the TC = Total Benefit

accumulated- accumulated
fely fuly)

◼ Time required for project’s profit & benefits to

equal project’s cost
◼ Approximate economic analysis method
◼ Ignores time value of money
◼ Ignores all cash flows after payback
◼ May not be consistent with equivalent worth & rate
of return methods

Copyright Oxford University Press 2020 9-20

 When Payback Can Be Used

◼ If payback time measured in months &

benefits continue for years
◼ Most common in start-up enterprises which
are VERY short of capital
◼ To communicate when other measures may
cause confusion
◼ Most projects with good payback periods look
good on other measures
◼ Not always, so payback is unreliable

Copyright Oxford University Press 2020 9-21

 Example 9-7 Payback Period
Year 0 1 2 3 4 5
A −$1000 +200 +200 +1200 +1200 +1200
B −$2783 +1200 +1200 +1200 +1200 +1200
$3,000 $3,000

$2,500 $2,500
Accumulative Benefits

Accumulative Benefits
$2,000 $2,000

$1,500 $1,500

$1,000 $1,000
Payback Period
$500 Payback Period =2.33 years
$500
=2.5 years
$0 $0
0 1 2 3 4 5 0 1 2 3 4 5
Year Year
Alternative A Alternative B

Copyright Oxford University Press 2020 9-22

 Example 9-8 Payback Period

Product: n = 5, A = −4000
Machine A: P = −$10,000 S = $0
Machine B: P = −$15,000 S = $9000

◼ Payback A = $10,000/($4000/yr) = 2.5 years

◼ Payback B = $15,000/($4000/yr) = 3.75 years
◼ Minimizing payback Machine A

Copyright Oxford University Press 2020 9-23

 Example 9-8 TVM solution

Incremental IRR = 12.5% ➔ B better at rates below 12.5%

Above i = 12.5%: A is better

At 15%, incremental PW = −$525 ➔ A better

Copyright Oxford University Press 2020 9-24

 Payback: A new computer systems
costs $20,000

Savings each year: Payback period is:

Year Savings A. 2.6 years

1 $8,000 B. 3.0 years

2 $6,000 C. 3.5 years
3 $4,000
D. 3.6 years
4 $4,000
E. 4.0 years
5 $3,000

Copyright Oxford University Press 2020 9-25

 Payback: A new computer systems
costs $20,000

Savings each year: Payback period is:

Year Savings A. 2.6 years

1 $8,000 B. 3.0 years

2 $6,000 C. 3.5 years
3 $4,000
D. 3.6 years
4 $4,000
E. 4.0 years
5 $3,000

Copyright Oxford University Press 2020 9-26

 Discounted Payback Period

◼ Adds time value of money to payback

◼ Computes interest on cumulative investment or
project balance
◼ Still ignores cash flows after payback

Copyright Oxford University Press 2020 9-27

 Example 9-9
Discounted Payback Period
Alternatives Cost Uniform Annual Benefit
i = 10% A $10,000 $3000
B $12,000 $3500

A preferred because shorter discounted payback

period
1, 000 (F/p 10 %, n) n)
, = 3000 (F/A ,
10 %,

Copyright Oxford University Press 2020 9-28

 Sensitivity & Breakeven Analysis

◼ Sensitivity Analysis:
◼ Projected expenditures & returns ➔ which decision
◼ To what extent do uncertainties/variations in data affect
decision?
◼ Breakeven Analysis
◼ Form of sensitivity analysis changing 1 variable
◼ When are 2 alternatives economically equivalent?
◼ Common example is project life since often one of most
uncertain values

Copyright Oxford University Press 2020 9-29

 Example 9-10 Breakeven Analysis
Construction Cost
Full-
$140,000
capacity
$100,000 now +
Two-stage $120,000 n years
from now

▪ 𝑃𝑊(𝑐𝑜𝑠𝑡𝑠) = 140,000
▪ 𝑃𝑊(𝑐𝑜𝑠𝑡𝑠) = 100,000 +
120,000(𝑃⁄𝐹, 8%, 𝑛)

Breakeven n = 14.27 years

Copyright Oxford University Press 2020 9-30
 Example 9-11 Breakeven Analysis
Right turn Left turn
i = 10% lanes lanes Incremental
Initial cost $8.9M $3M
Uniform annual benefit 1.6M $2.2M
Annual maintenance $150K 75K
Disbenefit $900K 2.1M
Useful life, in years 15 15

Copyright Oxford University Press 2020 9-31

 Example
9-12
Construction Cost
Full-
$140,000
capacity
$100,000 now +
Two-stage $120,000 n years
from now

Copyright Oxford University Press 2020 9-32

 Example 9-13 What-if Analysis
Can Change Multiple Variables
Initial
Adjustment
Estimate
First cost $70,000 +10%
Units / year 1200 −20%
Net unit
$25 −15%
revenue
Life, in years 8 −3
Interest rate 12% None

Initial B/C = 2.13

but only 0.96 with adjustments

Copyright Oxford University Press 2020 9-33