Lecture No.15Chapter 5

Contemporary Engineering EconomicsCopyright © 2010

Contemporary Engineering Economics, 5th edition, © 2010

Chapter Opening Story – GE’s Healthymagination ProjectGE Unveils $6 Billion Health-Unit Plan:• Goal: Increase the market share in the healthcare sector.• Strategies: Develop products that will lower costs, increase access and improve health-care quality.• Investment required: $6 billion over six years• Desired project outcome: Would help GE’s health-care unit grow at least twice as fast as the broader economy.

Contemporary Engineering Economics, 5th edition, © 2010

Ultimate QuestionsGE’ s Point of View:

Would there be enough demand for their products to justify the investment required in new facilities and marketing?

What would be the potential financial risk if the actual demand is far less than its forecast or adoption of technology is too slow?

If everything goes as planned, how long does it take to recover the initial investment?

Contemporary Engineering Economics, 5th edition, © 2010

Bank Loan vs. Project Cash Flows

Contemporary Engineering Economics, 5th edition, © 2010

Contemporary Engineering Economics, 5th edition, © 2010

Example 5.1 Describing Project Cash Flows – A Computer-Process Control Project

Year(n)

Cash Inflows(Benefits)

Cash Outflows(Costs)

NetCash Flows

0 0 $650,000 -$650,000

1 215,500 53,000 162,500

2 215,500 53,000 162,500

… … … …

8 215,500 53,000 162,500

Cash Flow Diagram for the Computer Process Control Project

Contemporary Engineering Economics, 5th edition, © 2010

Contemporary Engineering Economics, 5th edition, © 2010

Principle: How fast can I recover my initial investment?

Method: Based on the cumulative cash flow (or accounting profit)

Screening Guideline: If the payback period is less than or equal to some specified bench-mark period, the project would be considered for further analysis.

Weakness: Does not consider the time value of money

Contemporary Engineering Economics, 5th edition, © 2010

N Cash Flow Cum. Flow

0123456

-$105,000+$20,000$15,000$25,000$35,000$45,000$45,000$35,000

-$85,000-$70,000-$45,000-$10,000$35,000$80,000

$115,000

Payback period should occurs somewherebetween N = 3 and N = 4.

Contemporary Engineering Economics, 5th edition, © 2010

$85,000

$15,000$25,000

$35,000$45,000 $45,000

$35,000

0

1 2 3 4 5 6Years

Ann

ual c

ash

flow

-100,000

-50,000

0

50,000

100,000

150,000

0 1 2 3 4 5 6Years (n)

3.2 years Payback period

Cum

ulat

ive

cash

flo

w (

$)

Practice ProblemHow long does it take to recover the initial

investment for the computer process control system project in Example 5.1?

Contemporary Engineering Economics, 5th edition, © 2010

Contemporary Engineering Economics, 5th edition, © 2010

Discounted Payback Period Principle:

How fast can I recover my initial investment plus interest?

Method: Based on the cumulative discounted cash flow

Screening Guideline: If the discounted payback period (DPP) is less than or equal to some specified bench-mark period, the project could be considered for further analysis.

Weakness: Cash flows occurring after DPP are ignored

Contemporary Engineering Economics, 5th edition, © 2010

Discounted Payback Period Calculation

Period (n)

Cash Flow (An)

Cost of Funds(15%)*

Ending Cash Balance

0 -$85,000 0 -$85,000

1 15,000 -$85,000(0.15) = -$12,750 -82,750

2 25,000 -$82,750(0.15) = -12,413 -70,163

3 35,000 -$70,163(0.15) = -10,524 -45,687

4 45,000 -$45,687(0.15) =-6,853 -7,540

5 45,000 -$7,540(0.15) = -1,131 36,329

6 35,000 $36,329(0.15) = 5,449 76,778

* Cost of funds = (Unrecovered beginning balance) X (interest rate)

Illustration of Discounted Payback Period

Contemporary Engineering Economics, 5th edition, © 2010

Payback periods can be used as a screening tool for liquidity, but we need a measure of investment

worth for profitability.

Contemporary Engineering Economics, 5th edition, © 2010