CVE 267: Civil Engineering Cost Analysis

Outline
1. Introduction
100 1.1 Introduction
1.2 Definition
Percent Cost Committed
75

50
1.3 Decision-making Process
DESIGN

1.4 Interest Rate & Rate of Return

OPERATIONS
25

LIFE CYCLE
0
Conceptual Design
Detailed Design &
Development
Production and/or
Construction
Product/System use
Phaseout/Disposal
1.5 Economic Equivalence
Dr. Sami W. Tabsh, P.E. 1.6 Minimum Attractive Rate of Return
Civil Engineering, AUS 1.7 Cash Flow Diagrams
Reference: Engineering Economy, Blank & Tarquin, McGraw-Hill 1 2

1.1 Introduction 1.1 Introduction

Decisions made by engineers, managers, and The issues considered in making the decision
CEOs involve choosing one alternative or have both economic (initial cost, income and
independent project over another, for example: expenses, salvage value, interest rate, inflation,
Construct a long span bridge or under-water tunnel tax, etc.) and non-economic factors (technical,
Invest in a high-rise building or compound of villas convenience, safety, political, environmental, etc.)
Upgrade an existing equipment or replace it with a
new one
In addition to the above, the “do nothing” option
sometimes exists as an additional alternative.
Often the decisions require knowledge related to
investment of funds (or capitals). 3 4
1.1 Introduction 1.1 Introduction
Items which are not easily expressed in terms In engineering, capital investments have lives
of dollars are called intangible costs: of 3-50 years. The life of a private project is
Market pressures, such as need for an increased usually shorter than that of a public project.
international presence.
Availability of certain resources, e.g., skilled labor
Often the choice between alternatives is:
force, water, power, tax incentives. Which one is cheaper?
Government laws that dictate safety, legal, The concept of time value of money is
environmental, or other aspects. fundamental to Engineering Economy.
Corporate management’s interest in a particular The main issue usually is the decision
alternative. between current value and expected future
Goodwill offered by an alternative toward a group:
revenues.
employees, union, county, etc. 5 6

1.1 Introduction 1.2 Definition

Problems encountered by engineers can be Economics is the study of how individuals
loosely divided into 3 groups for the purposes and societies choose to use the scarce
of Engineering Economy: resources that nature and previous
1. Too small to merit any attention, generations have provided.
2. Problems whose solution is determined by Engineering Economics is subset of
Engineering Economy, and (micro)economics. It is not concerned with
3. Problems so big that Engineering Economy general economics situations, but rather with
plays only a supporting role in the final the specific project at hand.
decision.
It is pragmatic by nature, integrating
=> So the principle is to match the scale of the
economic theory with engineering practice. 8
analysis to the scale of the problem. 7
1.2 Definition 1.2 Definition
Analysis is performed by a technical The time value of money was first recognized in
professional, not an economist, because it may the Talmud (~500 BC). In Tractate Makkos page
require some advanced technical knowledge. 3a the Talmud discusses a case where witnesses
Engineering Economy involves formulating, falsely claimed that the term of a loan was 30
days when it was actually 10 years. The false
estimating, and evaluating the economic
witnesses must pay the difference of the value of
outcomes when alternatives are available.
the loan "in a situation where he would be
It includes a collection of mathematical required to give the money back (within) thirty
procedures and formulations that simplify days..., and that same sum in a situation where
economic comparisons between he would be required to give the money back
projects/alternatives. 9 (within) 10 years. 10

1.2 Definition 1.2 Definition

The notion of time value of Arthur Wellington, a civil engineer born in

money was later described Massachusetts, USA, is considered the father
by Martín de Azpilcueta (1491– of engineering economy. In 1877, he
1586), a prominent 16th Century published a book on “The Economic Theory of
economist and religious scholar Location of Railways.”
in the school of Salamanca, Significant contributions were added by Holger
Spain. He argued that money Theusen, who was the world’s first industrial
exchange is not unnatural as it school of Salamanca engineer in 1911 from Penn State. Theusen
puts money on the same level later published a book on Engineering
as any other merchandise. 11 Economy in 1950 (Prentice Hall). 12
 1.2 Definition 1.2 Definition
Typical questions addressed in this course:
E. Paul DeGarmo, founder of the Industrial
 Which investment alternative shall we select?
Engineering department at UC-Berkley, >
-

methe
present worth

 What independent projects should we select?

conducted research on the subject and wrote
in 1942 the first book on Engineering  Should we buy or lease equipment?
Economy, still in print (MacMillan).  How long till we get profit back?
Arthur Lesser, Jr., developed the breakeven  Should we replace an old equipment with a
new one or not? and if so, how soon?
analysis techniques and founded the
Engineering Economist Journal in 1955.  What rate of return will we get?
 Shall we expand our existing products or
13 develop new ones? 14

1.2 Definition 1.3 Decision-making Process

Sample Situation: Hydro vs. Thermal power An engineering economic analysis results in
Hydro: Thermal the best estimates of what is expected
- Expensive initially - Less expensive initially to occur.
- Far away from load - Can be near load centers
centers (high These estimates involve:
- Requires fuel
transmission cost)
- Shorter life
- Cash flows Q1 Q2
- No fuel required - Time of occurrence 0
- Can cause pollution 1 2 n-1 n
- Longer life 3
- Interest rates n-2
- No pollution A
- Measure of worth for i%
15
selecting an alternative 16
1.3 Decision-making Process 1.3 Decision-making Process
These estimates are about the future, and The time value of money is the change in
will be somewhat different than what the amount of money over time.
actually occurs because of changing It is the most important concept in engineering
circumstances and unaccounted factors. economic studies.
Sensitivity analysis is usually performed The basic principle of the time value of money:
during the engineering economic study to “Money now is better than money later”
determine how the decision might change It is said that “money makes money.” This is
based on varying estimates of important true because investment of money generates
parameters. more money, and borrowing it accumulates
17 more debt in the future. 18

1.3 Decision-making Process 1.3 Decision-making Process

The steps in engineering economy studies are: Which tunnel boring machine to buy:
1. Recognize the problem and define the goals Machine A, Machine B or Machine C ?
2. Collect all the relevant information
3. Make realistic cash flow estimates
4. Identify an economic measure of worth criterion
for decision making
5. Evaluate each alternative with consideration of
Machine A
economic (and noneconomic) factors
6. Select the best alternative Machine B
7. Implement the solution and monitor the results
19
Machine 20C
 1.3 Decision-making Process 1.3 Decision-making Process
1. Recognize the problem and define the goals
Need a 7-m diameter tunnel boring machine for a metro project
Financial data required to make an economic
2. Collect all the relevant information decision (e.g. for Machine C):
Based on specification, decide on feasible alternatives (A, B & C) Manufacturer’s suggested retail price (e.g. $15
3. Making realistic cash flow estimates million)
Estimate cost of purchase, installation, operation, maintenance,…
4. Identify an economic measure of worth criterion Installation cost (e.g. $1 million)
Select (for example) the Present Worth (PW) method Monthly operating costs (e.g. $4 million)
5. Evaluating each alternative
Annual maintenance cost (e.g. $2 million)
Carry out the engineering economy study (e.g. PWC>PWA>PWB)
6. Selecting the best alternative Supply and feed material (e.g. $10,000 per day)
Outcome of step#5 will lead to the best alternative (Machine C) Removal cost after 5 years (e.g. $1 million)
7. Implementing the solution and monitoring the results
21 Salvage value ($6 million) 22
Buy Machine C and compare actual versus assumed expenses

1.3 Decision-making Process 1.3 Decision-making Process

The following definitions are relevant: Cash Flows:
Alternative Description: They are the estimated inflows and outflows of
Alternatives are stand-alone options that money.
involve best estimates of first cost, useful life, Cash inflows (indicated as positive) are all types of
annual income and expenses, salvage value, receipts, including sales, revenues, income, money
interest rate, inflation and income tax. For from loans when received from lender, and savings
example, investment in a ready-mix concrete generated by business activity.
plant (initial cost=50 million AED, useful Cash outflows (indicated as negative) are all types
life=30 years, salvage value = 10 million AED, of costs, including disbursements, expenses,
deposits into retirement or saving accounts, loan
annual revenues = 10 million AED, annual repayments, and taxes caused by business activity.
expenses = 5 million AED, etc.) 23 24
1.3 Decision-making Process 1.3 Decision-making Process
Examples of cash inflows: Expenses can be divided into “direct” and
Income: +$75,000 from sales of water pumps “indirect” costs.
Savings: +25,500 AED saved by installing an Direct costs are related to direct operation of
efficient air conditioning equipment the business. They cover materials, supplies,
Receipt: +$19,000/year interest received on saving labor, cost of land, transportation, etc.
Revenue: +150,000 AED on sales of old trucks Indirect costs, or overhead, are usually
Examples of cash outflows: allocated to a company’s products by an arbitrary
method (e.g. $ per floor area of occupancy or as
Operating costs: -$2,500,000/year for running a percentage of direct costs). They cover cost of
precast concrete plant management, financing, taxes, employee benefits,
First cost: -$50,000 to buy a forklift next year insurance, office equipment & supplies, travel,
Expense: -99,000 AED/year for interest on a loan 25 marketing, research, legal services and accounting.
26

1.3 Decision-making Process 1.3 Decision-making Process

“Interest” is the difference between an The criterion used to select an alternative in

ending amount of money and the beginning engineering economy for a set of estimates is
amount of money over time. If the difference called a “measure of worth.”
is negative, there is no interest The measures of worth developed and used
Simply put, the interest is the rental fee you in this course are:
pay for the money used -Present worth -Future worth -Annual worth
Interest is paid when money is borrowed, and -Rate of return -Benefit/cost
interest (or return) is earned when money is All of the above measures account for the
invested time value of money.
27 28
 1.3 Decision-making Process 1.3 Decision-making Process
Example 1.1 If in the past 5 years, the cost of repairing
Geotechnico is a company flaws in shafts has costed the company $7.5M,
specialized in constructing determine if it is economically
drilled shafts for building feasible for Geotechnico to
and bridge structures. It is subcontract the NDT
considering subcontracting
company? Assume the NDT
an NDT company that
allows for detection of flaws technology can only detect
in concrete at a cost of 50% of the flaws with
$0.5M/year. negligible repair costs. Ignore
29 the time value of money. 30

1.3 Decision-making Process 1.4 Interest Rate & Rate of Return

Solution: There are always two perspectives to an
From the previous 5 years data, the total annual amount of interest—interest paid and interest
cost of repairing shafts due to undetected earned.
flaws is: 7.5/5 = $1.5M. Interest is paid when a person or organization
If the NDT company is contracted, Geotechnico borrows money (obtained a loan) and repays
will pay the annual cost of hiring the NDT a larger amount over time.
company plus the cost of repairing flaws that
cannot be detected by the NDT company:
(a) Interest paid
$0.5M + (50%)x1.5 = $1.25M (< $1.5M) over time to lender
Based on the above, it is economically feasible
to subcontract the NDT company. 31 32
 1.4 Interest Rate & Rate of Return 1.4 Interest Rate & Rate of Return
On the other hand, interest is earned when a The interest paid on borrowed funds is:
person or organization invests money and Interest = (future amount owed) - (original amount)*
gets a return of a larger amount over time. The “interest rate” (i%) on borrowed
funds over a specific time unit is:
F - P *
Interest Rate (%) = interest accrued per unit time x 100%
original amount
(b) Interest earned
over time by investor ------------(1.1)
The most common interest period used to
state an interest rate is 1 year.
profit
33 34
Return is

intract lost

1.4 Interest Rate & Rate of Return 1.4 Interest Rate & Rate of Return
The return is the interest earned on invested Example 1.2
funds: The ABC corporation borrowed ~ $50,000 from
Return = (total future amount) - (original amount) * a bank and must repay it -- $56,000 after 1
From the perspective of an investor, the year. Determine the interest amount and the
~
“Rate of Return” (ROR%) is the interest interest rate. Famount F- P
=
=% (EP) x00 =

earned over a specific period of time, Solution:

= 56 000-50,000
,

(0x00 % = = 12

expressed as % of original amount:

=
G, 000

* Interest amount = 56,000 – 50,000 = $6,000

Rate of Return(%) = return accrued per unit time x 100% Interest rate = (interest/original amount)x100
original amount
= (6,000/50,000)x100 = 12%
------------- (1.2)
35 36
1.4 Interest Rate & Rate of Return 1.4 Interest Rate & Rate of Return
Example 1.3 P ! =
Solution:
A steel fabricator company ~ invested a sum (a) Let X = original amount
of money in the stock market and - collected Total accrued = original + return
>
-
$85,600 a year later. F 85 =
,
600
= original + (original)(ROR)
(a) Determine the original amount invested if Hence, $85,600 = X + X (0.07)
the rate of return was 7% per year.
-
=> X = 85,600/(1 + 0.07) = $80,000
(b) What is the return (or amount of interest (b) Return = total – original
earned)? b) Returne
F- =
= 85,600 – 80,000
(f) x100
= $5,600
85 600 P
- %
= ,
-

a)
=

37 38
7 %
(18600p) x100
= - -

P =

1.4 Interest Rate & Rate of Return 1.4 Interest Rate & Rate of Return
Example 1.4 Solution:
The world bank loans money to governments 1. Total accrued = original + interest
for environmental projects at 8% interest = original + (original)(interest rate)
rate per year. Determine the followings: = $2.0 M + ($2.0 M)(0.08) = $2.16 M
1. What is the worth of a $2.0 million loan, 1 2. Total accrued = original + (original)(interest rate)
year from now?  Original amount = (Total accrued)/(1+ interest rate)
2. What was the original worth of a $5.5 million $5.5 M
= = $5.09 M
loan that was initiated 1 year ago? (1+0.08)
3. What is the charge accumulated in 1 year on 3. Interest = (original) (interest rate)
$3.5 million loan? 39 = ($3.5 M)(0.08) = $0.28 M or $280,00040
1.4 Interest Rate & Rate of Return 1.4 Interest Rate & Rate of Return

Example 1.5 Proposal A: Give me $100,000 and I will bring it

You are on a deserted back $500,000 a year from now.
island living comfortably Proposal B: Give me the whole $1,000,000 and
with $1,000,000 in your I will bring it back $1,500,000 a year from now.
pocket and no expenses.
One day a person shows Which proposal you should choose? (1 1)

up on a boat with two

0

P(1 + i) o
-
.

f =

Ii
A) 0 . 97
proposals. A) 0 S = 0 .
1 (1 + i) =
0 .
1" + o .
1 :

+
.

i = 4 = 4
decial

B) 1 S .
= 1 .
0 (1 + i) = 1 + 10i

41 0 5
.
= i 42
i =
0. S
x

1.4 Interest Rate & Rate of Return 1.4 Interest Rate & Rate of Return
Solution: Solution (Cont’d):
Return = (future amount) - (original amount) Although the rate of return on proposal A
Proposal A: (400,000/100,000 x 100 = 400%) is much
Return = (900,000+500,000) – 1,000,000 higher than the rate of return on proposal B
= $400,000 (500,000/1,000,000 x 100 = 50%), you
(after 1 year you will have $1,400,000) should choose proposal B because it yields a
Proposal B: larger return.
Return = 1,500,000 – 1,000,000 Morale: the alternative with highest profitability
= $500,000 is the one to choose if the invested money is
(after 1 year you will have $1,500,000) 43 different in the various proposals. 44
1.4 Interest Rate & Rate of Return 1.4 Interest Rate & Rate of Return
There are two different types of interests: (a)
For compound interest, the interest accrued
Simple interest, and (b) Compound interest.
for each interest period is calculated on the
Simple interest is calculated using the principal plus the total amount of interest
principal only, ignoring any interest accrued in accumulated in all previous periods (interest
preceding interest periods. The total simple on top of interest). The interest for one
interest over several periods is computed as period is
Interest = (principal)(No. of periods)(interest rate) Interest = (principal+all accrued interest)(interest rate)
----------- (1.3) ------------- (1.4)
where the interest is expressed in decimals.45 46

1.4 Interest Rate & Rate of Return 1.4 Interest Rate & Rate of Return
Interest calculations involve consideration of: P is the amount received or incurred in Year 0.
- interest rate per compounding period = i Typically a large amount, e.g., initial
- number of periods during the term = n construction cost, money collected for loan,...
- present amount of money = P F is the future amount that is equivalent to a
- future amount of money at end of term = F given present amount and/or annual amounts
- amount received or incurred every period = A (received or incurred).
P A is the amount received/incurred every
1 2 3 n-2 n-1 n
period, such as operating and maintenance
0
A costs. It is typically uniform but not always
Interest rate = i F 47 (when O&M costs increase with system age)48
 1.4 Interest Rate & Rate of
1.4 Interest Rate & Rate of Return Return
From Eq. (1.3) for simple interest:
Interest = (principal)(No. of periods)(interest rate) Note that over a one period of time (n = 1
Interest = (P)(n)(i) year), the interest earned on a sum of money
and future payment after n-periods is: is the same, irrespective if the interest rate is
simple or compound:
F = P + Interest = P(1+ni) ------(1.5)
From Eq. (1.4) for compound interest: (a) Simple
Interest = (principal+all accrued interest)(interest rate) F = P(1 + nxi) = P(1 + i) => (F – P) = Pi
Interest = P[(1+i)n – 1] To be derived in chapter 2 (b) Compound
and future payment after n-periods is: F = P(1 + i)n = P(1 + i)1 = P(1 + i) => (F – P) = Pi
F = P + Interest = P(1+i)n ------(1.6) 49 50

1.4 Interest Rate & Rate of Return 1.4 Interest Rate & Rate of Return
• Using the formulas for simple and compound Example 1.6
interest, one can determine the future value of
A person financed a new car worth 40,000
$100 at an interest rate of 10%.
800
Dirhams at an interest rate of 9% per year.
Interest is 10% per annum
700 He is required to pay the loan back in a lump
Total $ at Year end

600
500
Compound interest sum after a period of 4 years.
400 (a) How much will the person repay at the end
300
200
of the 4 years if the interest is simple?
Simple interest
100
(b) What would he repay if the interest was
0 01/
compounded? 140
0974) s
, 00
f= 40,000 (1
+ o
.

(1 +
5 10 15 20
0
= 70 , 000 S646AED
.
= =

F SY 40
51 52
=

AED
Years Simple o Hit
,

i 9%
=
1.4 Interest Rate & Rate of Return 1.4 Interest Rate & Rate of Return
Solution Calculation Summary for Simple Interest
(a) The interest for each of the 4 years is: (40,000 End of Amount Interest Amount Amount
dirhams)(0.09) = 3,600 dirhams year Borrowed Owed Paid
The total interest for 4 years from Eq. (1.3) is (dirhams) (dirhams) (dirhams) (dirhams)
Total Interest = (40,000 dirhams)(4 years)(0.09) 0 40,000 40,000

= 14,400 dirhams 1 ---- 3,600 43,600 0

Therefore, the amount due after 4 years is: 2 ---- 3,600 47,200 0
= (40,000 dirhams) + (14,400 dirhams) 3 ---- 3,600 50,800 0
= 54,400 dirhams 4 ---- 3,600 54,400 54,400
Note: this could have been obtained from Eq. 1.5 53 54

1.4 Interest Rate & Rate of Return 1.4 Interest Rate & Rate of Return
Solution (Cont’d) Calculation Summary for Compound Interest
(b) The interest and total amount for each of the 4 End of Amount Interest Amount Amount
years are: year Borrowed Owed Paid
Year 1 interest=(40,000 dirhams)(0.09)=3,600 dirhams (dirhams) (dirhams) (dirhams) (dirhams)
Total due after year 1=40,000+3,600=43,600 dirhams 0 40,000 40,000
Year 2 interest=(43,600 dirhams)(0.09)=3,924 dirhams
1 ---- 3,600 43,600 0
Total due after year 2=43,600+3,924=47,524 dirhams
Year 3 interest=(47,524 dirhams)(0.09)=4,277 dirhams 2 ---- 3,924 47,524 0
Total due after year 3=47,524+4,277=51,801 dirhams 3 ---- 4,277 51,801 0
Year 4 interest=(51,801 dirhams)(0.09)=4,662 dirhams 4 ---- 4,662 56,463 56,463
Total due after year 4=51,801+4,662=56,463 dirhams
55
Note: this could have been obtained from Eq. 1.656
1.4 Interest Rate & Rate of Return 1.4 Interest Rate & Rate of Return
Example 1.7 Solution:
An Engineer needs a 50,000 AED loan for (i) Duration of loan is n=3 years:
home improvements now and is willing to Bank A (from Eq. 1.5):
return the principal plus the interest after a F = P(1+i*n) = 50,000(1+0.12x3) = 68,000 AED
number of years. He has two alternatives: Bank B (from Eq. 1.6):
-Bank A offers loan at 12% simple interest F = P(1+i)n = 50,000(1+0.10)3 = 66,550 AED
-Bank B offers loan at 10% compound interest Conclusion:
Which option is best economically for him if the Bank B offers a better deal (saving=1,450 AED).
duration of the loan is 3 years? 6 years?
57 58

F = p (1 in)
Simple
+
recall
=
=
"

F P (1 + i)
Compound
=
=

1.4 Interest Rate & Rate of Return 1.4 Interest Rate & Rate of Return
(ii) Duration of loan is n=6 years: Example 1.8
Bank A: Determine the time required for money to
F = P(1+i*n) = 50,000(1+0.12x6) = 86,000 AED double if the annual interest rate is:
Bank B: 10% simple
F = P(1+i)n = 50,000(1+0.10)6 = 88,578 AED 10% compounded

I
i) "
Conclusion: o F = p (1+

in 2
=
(1 +o 1)
Bank A offers a better deal (saving=2,578 AED).
.

F = 2p
2 = 1 .
14
T
2p =
p(1 +0 .
1 + n) Log 2= n loght
0 In

losh
1
= .

n = =
7 25 m
59 60
.

--10
h
1.4 Interest Rate & Rate of Return 1.5 Economic Equivalence
Solution: Economic equivalence means that different
sums of money at different times are equal in
Simple Interest (from Eq. 1.5):
economic term.
F = P(1+i*n) in which F = 2P
For example, if the interest rate is 10% per
or 2 = (1+0.1xn) => n = 10 years year, $100 today is equivalent to $110 one
Compounded Interest (from Eq. 1.6): year from today.
F = P(1+i)n in which F = 2P Amount accrued = 100 +100(0.10) = $110
Similarly, $100 today is equivalent to
or 2 = (1+0.1)n = 1.1n
$100/1.1=$90.91 one year ago at an interest
log 2 = n log1.1 => n = 7.27 years rate of 10%.
61 62

1.5 Economic Equivalence 1.5 Economic Equivalence

Hence, $90.91 last year, $100 today and $110 Economic equivalence considerations can have
one year from today are equivalent at an different forms:
interest rate of 10% per year. Case 1: Finding the future amount (F) to be
yielded by an initial amount (P) at the end of a
Past $90.91 $9.09 $10.0 given period and interest rate.
Example: Jim takes $20,000 now from the bank and
Present $100 $10.0 agrees to pay nothing until five years from now
when he pays everything in a lump sum. How much
Future $110 he needs to pay then if the interest rate is 5%?
1 yr Now 1 yr from
ago now63 64
1.5 Economic Equivalence 1.5 Economic Equivalence
Case 2: Finding the initial amount (P) that would Case 4: Finding the final compounded amount (F)
yield a future amount (F) at the end of a given at the end of a given period and interest rate due
period and interest rate. to uniform annual payments (A).
Example: How much should Jim deposit now in his Example: How much should Jim will have in his bank
bank account in order to collect $50,000 five years account five years from now if he deposits $10,000
from now if the interest rate is 5%? annually for 5 years at an interest rate of 5%?
Case 3: Finding the uniform annual payments (A) Case 5: Finding the initial amount (P) that would
that would yield a certain future amount (F) at the yield specified uniform future amounts (A) over a
end of a given period and interest rate. given period and interest rate.
Example: How much should Jim deposit annually in Example: How much should Jim deposit now in his
his bank account in order to collect $50,000 five bank account in order to collect annually $10,000 for
years from now if the interest rate is 5%? 65
a period of five years if the interest rate is 5%? 66

1.6 Minimum Attractive Rate of

1.5 Economic Equivalence Return
Case 6: Finding the amount of uniform annual Engineering alternatives are evaluated based
payments (A) over a given period and interest rate, on a “reasonable” or “fair” Rate of Return
that would recover an initial amount (P). (ROR), referred to as the Minimum Attractive
Example: How much should Jim pay back the bank Rate of Return (MARR).
annually for a period of 5 years if takes now $50,000 A project is not economically viable or feasible
loan at an interest rate of 5%?
for a company to invest in unless it is
Case 7: Finding the time needed for an initial
amount (P) to yield a future amount (F) at a given
expected to return at least the MARR on the
interest rate. investment.
Example: How many years will it take for a $50,000 MARR is also referred to as the hurdle rate,
investment to become $75,000 if the interest rate is cutoff rate, benchmark rate, and minimum
5%? 67
acceptable rate of return. 68
1.6 Minimum Attractive Rate of 1.6 Minimum Attractive Rate of
Return Return
MARR is established by (financial) managers A friend wants to borrow from you the
and is used as a criterion against which an $10,000 today with the promise to return it
alternative’s ROR is measured, when making $12,000 after a year (i=20%). His track
the accept/reject investment decision. record shows that he keeps his promises 90%
of the time. Do you accept?
MARR is usually higher than the rate expected
If the answer is yes, then how about if he
from a bank (investment with minimal risk).
returns it $11,800 (i=18%)? If yes, then how
To understand the concept of MARR, we about if he returns it $11,500 (i=15%)? Its
assume the bank can give you a guaranteed becoming difficult decision now. If the least
5% interest on a $10,000 deposit (i.e. you you demand is $11,100 (i=11%) and you
receive $10,500 after 1 year). 69
don’t accept $11,000, then 11% is your MARR.70

1.6 Minimum Attractive Rate of 1.6 Minimum Attractive Rate of

Return Return

A capital of a company is developed in one Cash from savings, stock sales, or investment
of three ways: used to finance projects is called “equity
1) Equity financing, E, financing.”
2) Debt financing, D, and Cash borrowed from outside sources (bonds,
3) Combination of debt bank loans, mortgages, credit cards, etc.) to
and equity financing, finance projects is considered “debt financing.”
D-E. Most projects are funded with combination of
debt and equity capital (e.g. 25-75, D-E mix).
71 72
1.6 Minimum Attractive Rate of 1.6 Minimum Attractive Rate of
Return Return

Combination of debt-equity (D-E) financing Example 1.9

mean that a Weighted Average Cost of Capital A developer is considering investment in the
(WACC) results, calculated based on: construction of a hotel project at a cost of 110
million AED. He plans to use 77 million AED
WACC = (%Debt financing)x(interest on debt)
from his savings and borrow the remaining 33
+ (%equity financing)x(return on equity)
million AED from the bank. Compute the
WACC = (%D)(iD) + (%E)(iE)----------(1.7) weighted average cost of capital if his equity is
currently earning 6% and the cost of borrowing
MARR is always higher than the WACC: money is 11%.
ROR ≥ MARR > WACC ----------(1.8)
73 74

1.6 Minimum Attractive Rate of

Return 1.7 Cash Flow Diagrams
Solution As stated earlier, cash flows are described as
either inflows or outflows of money.
WACC is calculated based on the following
formula (Eq. 1.7): Examples of cash inflows include: (a)
revenues, (b) operating cost reductions, (c)
WACC = (%Debt fin.)x(interest on debt) income, (d) asset salvage value, and (e)
+ (%equity fin.)x(interest on equity) income tax savings.
in which the %Debt financing = 33/110 = 0.3 Examples of cash outflows include: (a) first
cost of assets, (b) engineering design costs,
and the %equity financing = 77/110 = 0.7
(c) operating costs, (d) maintenance, (e)
=> WACC = 0.3x11% + 0.7x6% = 7.5% upgrade, (f) income tax, and (g) loan.
75 76
 1.7 Cash Flow Diagrams 1.7 Cash Flow Diagrams
Example 1.10
An equipment with a useful life of 5 years has
just been purchased for 60,000 dirhams now
and 40,000 dirhams after 1 year. It requires
annual maintenance of 5,000 dirhams the 1st
year, increasing by 20% from the previous
year in each of the subsequent years. The
benefits obtained from using the machine are
equivalent to 30,000 dirhams/year over its life.
Draw the cash flow diagram if the salvage
81
value after 5 years is 10,000 dirhams. 82

1.7 Cash Flow Diagrams 1.7 Cash Flow Diagrams

Solution:
A part of the purchase price is paid now (t=0): The net cash flow (in AED) diagram is shown
=> -60,000 AED below:
The Net Cash Flow after 1 year (@ t=1) is: 29,632
24,000 22,800
(NCF)1=-40,000+30,000–5,000=-15,000 AED 21,360
@ t=2 => (NCF)2=+30,000–1.2x5,000=24,000 AED 0 1
@ t=3 => (NCF)3=+30,000–1.22x5,000=22,800 AED 2 3 4 5 Time (yrs)
15,000
@ t=4 => (NCF)4=+30,000–1.23x5,000=21,360 AED
@ t=5 => (NCF)5=+30,000–1.24x5,000+10,000
= 29,632 AED 83 60,000 84
Salvage Value
1.7 Cash Flow Diagrams 1.7 Cash Flow Diagrams
Example 1.11 Solution:
A ready-mix concrete company has purchased - The purchase price @ t=0 is: -$250,000
a large equipment for $250,000. The annual - The Net Cash Flow after 1 year (@ t=1) is:
income from using the equipment for the next (NCF)1 = +75,000 – 25,000 = +$50,000
10 years is $75,000. Annual operation and @ t=2: (NCF)2 = +75,000 –27,500 = +$47,500
maintenance costs are expected to be @ t=3: (NCF)3 = +75,000 – 30,000 = +$45,000
$25,000 in the first year, rising by $2,500 in and so on…
each of the subsequent years. The salvage @ t=9: (NCF)9 = +75,000 – 45,000 = +$30,000
value of the equipment after 10 years is @ t=10: (NCF)10 = +75,000 – 47,500 + 50,000
$50,000. Draw the cash flow diagram. 85 = +$77,500 86

1.7 Cash Flow Diagrams

The net cash flow (in $) diagram is shown
below:
77,500
50,000 2,500
30,000
0
1 2 3 4 5 6 7 8 9 10
Time (years)

250,000 87
1.7 Cash Flow Diagrams 1.7 Cash Flow Diagrams
Example 1.11 Solution:
A ready-mix concrete company has purchased - The purchase price @ t=0 is: -$250,000
a large equipment for $250,000. The annual - The Net Cash Flow after 1 year (@ t=1) is:
income from using the equipment for the next (NCF)1 = +75,000 – 25,000 = +$50,000
10 years is $75,000. Annual operation and @ t=2: (NCF)2 = +75,000 –27,500 = +$47,500
maintenance costs are expected to be @ t=3: (NCF)3 = +75,000 – 30,000 = +$45,000
$25,000 in the first year, rising by $2,500 in and so on…
each of the subsequent years. The salvage @ t=9: (NCF)9 = +75,000 – 45,000 = +$30,000
value of the equipment after 10 years is @ t=10: (NCF)10 = +75,000 – 47,500 + 50,000
$50,000. Draw the cash flow diagram. 85 = +$77,500 86

1.7 Cash Flow Diagrams

The net cash flow (in $) diagram is shown
below:
77,500
50,000 2,500
30,000
0
1 2 3 4 5 6 7 8 9 10
Time (years)

250,000 87