LESSON 13. Other+Basic+Economic+Study+Methods

OTHER METHODS
V. PAYBACK ANALYSIS
Payback analysis is another use of the present worth technique. It is used

to determine the amount of time, usually expressed in years, required to recover
the first cost of an asset or project. Payback is allied with breakeven analysis; this
is illustrated later in the section. The payback period, also called payback or
payout period, has the following definition and types.
The payback period 𝒏𝑷 is an estimated time for the revenues, savings, and any
other monetary benefits to completely recover the initial investment plus a
stated rate of return i.
There are two types of payback analysis as determined by the required return.
No return; i = 0%: Also called simple payback, this is the recovery of only the
initial investment.
Discounted payback; i > 0%: The time value of money is considered in that
some return, for example, 10% per year, must be realized in addition to
recovering the initial investment.
𝑡=𝑛
No Return, i=0%; NCF, varies annually: 0 = −𝑃 + ∑𝑡=1 𝑝 𝑁𝐶𝐹𝑡
𝑃
No Return, i=0%; annual uniform NCF: 𝑛𝑝 =
𝑁𝐶𝐹
𝑡=𝑛 𝑃
Discounted, i > 0%; NCF, varies annually: 0 = −𝑃 + ∑𝑡=1 𝑝 𝑁𝐶𝐹𝑡 ( , 𝑖, 𝑡)
𝐴
𝑃
Discounted, i > 0%; annual uniform NCF: 0 = −𝑃 + 𝑁𝐶𝐹( , 𝑖, 𝑛𝑝 )
𝐴
Example 3.10:
Two equivalent pieces of quality inspection equipment are being
considered for purchase by Square D Electric. Machine 2 is expected to be
versatile and technologically advanced enough to provide net income longer
than machine 1.
Machine 1 Machine 2
First Cost, $ 12, 000 8, 000
Annual NCF, $ 3, 000 1, 000 (years 1-5),
3, 000 (years 6-14)
Maximum Life, years 7 14
The quality manager used a return of 15% per year.
Solution:
Machine 1: use equation,

Machine 2: use equation,
𝑃
0 = −𝑃 + 𝑁𝐶𝐹(𝐴 , 𝑖, 𝑛𝑝 ) 𝑃
0 = −𝑃 + 𝑁𝐶𝐹(𝐴 , 𝑖, 𝑛𝑝 )
𝑃
0 = −12, 000 + 3000(𝐴 , 15%, 𝑛𝑝 ) 𝑃
0 = −8, 000 + 1000 ( , 15%, 𝑛𝑝 )
𝐴
𝑃 𝑃
(1+0.15) 𝑛 −1 +3000(𝐴 , 15%, 𝑛𝑝 − 5)(𝐹 , 15%, 5)
0 = −12, 000 + 3, 000 (0.15(1+0.15)𝑛)
12,000
(0.15)(1 + 0.15)𝑛 = (1 + 0.15)𝑛 − 1 𝒏𝒑 = 𝟗. 𝟓𝟐 𝒚𝒆𝒂𝒓𝒔
3,000
0.6(1.15)𝑛 = (1.15)𝑛 − 1
0.6(1.15)𝑛 − 1.15𝑛 = −1
−0.4(1.15)𝑛 = −1
1 Recommendation: Select machine 1,
(1.15)𝑛 = because it has a shorter payback period of
0.4
𝑛 ln(1.15) = ln(2.5) 6.57 years at i =15%.
ln(2.5)
𝑛𝑝 = ln(1.15) = 𝟔. 𝟓𝟕 𝒚𝒆𝒂𝒓𝒔
Vll. Benefit/Cost Analysis
The benefit/cost ratio is relied upon as a fundamental analysis method for

public sector projects. The B/C analysis was developed to introduce greater
objectivity into public sector economics. There are several variations of the B/C
ratio; however, the fundamental approach is the same. All cost and benefit
estimates must be converted to a common equivalent monetary unit (PW, AW,
or FW) at the discount rate (interest rate). The B/C ratio is then calculated using
one of these relations:
𝐵 𝑃𝑊 𝑜𝑓 𝑏𝑒𝑛𝑒𝑓𝑖𝑡𝑠 𝐴𝑊 𝑜𝑓 𝑏𝑒𝑛𝑒𝑓𝑖𝑡𝑠 𝐹𝑊 𝑜𝑓 𝑏𝑒𝑛𝑒𝑓𝑖𝑡𝑠
= = =
𝐶 𝑃𝑊 𝑜𝑓 𝑐𝑜𝑠𝑡𝑠 𝐴𝑊 𝑜𝑓 𝑐𝑜𝑠𝑡𝑠 𝐹𝑊 𝑜𝑓 𝑐𝑜𝑠𝑡𝑠
Present worth and annual worth equivalencies are preferred to future worth
values. The sign convention for B/C analysis is positive signs; costs are preceded
by a sign. Salvage values and additional revenues to the government, when they
are estimated, are subtracted from costs in the denominator. Disbenefits are
considered in different ways depending upon the model used. Most commonly,
disbenefits are subtracted from benefits and placed in the numerator. The
different formats are discussed below.
The decision guideline is simple:
If B/C ≥1.0, accept the project as economically justified for the estimates and
discount rate applied.
If B/C < 1.0, the project is not economically acceptable.
If the B/C value is exactly or very near 1.0, noneconomic factors will help make
the decision. The conventional B/C ratio, probably the most widely used, is
calculated as follows:
𝐵 𝑏𝑒𝑛𝑒𝑓𝑖𝑡𝑠 − 𝑑𝑖𝑠𝑏𝑒𝑛𝑒𝑓𝑖𝑡𝑠 𝐵 − 𝐷
= =
𝐶 𝑐𝑜𝑠𝑡𝑠 𝐶
The modified B/C ratio includes all the estimates associated with the project, once
operational. Maintenance and operation (M&O) costs are placed in the
numerator and treated in a manner similar to disbenefits. The denominator
includes only the initial investment. Once all amounts are expressed in PW, AW, or
FW terms, the modified B/C ratio is calculated as;
𝐵 𝑏𝑒𝑛𝑒𝑓𝑖𝑡𝑠 − 𝑑𝑖𝑠𝑏𝑒𝑛𝑒𝑓𝑖𝑡𝑠 − 𝑀&𝑂 𝑐𝑜𝑠𝑡𝑠

𝑀𝑜𝑑𝑖𝑓𝑖𝑒𝑠 =
𝐶 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑒𝑚𝑒𝑛𝑡
Example 3.11:
In the past, the Afram Foundation has awarded many grants to improve
the living and medical conditions of people in war-torn and poverty-stricken
countries throughout the world. In a proposal for the foundation’s board of
directors to construct a new hospital and medical clinic complex in a deprived
central African country, the project manager has developed some estimates.
These are developed, so she states, in a manner that does not have a major
negative effect on prime agricultural land or living areas for citizens.
Award amount: $20 million (end of) first year, decreasing by $5 million per
year for 3
additional years; local government will fund during the
first year
only
Annual costs: $2 million per year for 10 years, as proposed
Benefits: Reduction of $8 million per year in health-related
expenses for
citizens
Disbenefits: $0.1 to $0.6 million per year for removal of arable land
and
commercial districts
Use the conventional and modified B/C methods to determine if this grant
proposal is economically justified over a 10-year study period. The foundation’s
discount rate is 6% per year.
Solution:
Initially, determine the AW for each parameter over 10 years. In $1 million units,
Award: 20 − 5(A/G,6%,4) = $12.864 per year

Annual costs: $2 per year
Benefits: $8 per year
Disbenefits: Use $0.6 for the first analysis
The conventional B/C analysis

𝐵 𝑏𝑒𝑛𝑒𝑓𝑖𝑡𝑠 − 𝑑𝑖𝑠𝑏𝑒𝑛𝑒𝑓𝑖𝑡𝑠 8.0 − 0.6
= = = 0.50
𝐶 𝑐𝑜𝑠𝑡𝑠 12.864 + 2.0
The modified B/C analysis

𝐵 𝑏𝑒𝑛𝑒𝑓𝑖𝑡𝑠 − 𝑑𝑖𝑠𝑏𝑒𝑛𝑒𝑓𝑖𝑡𝑠 − 𝑀&𝑂 𝑐𝑜𝑠𝑡𝑠 8.0 − 0.6 − 2.0
𝑀𝑜𝑑𝑖𝑓𝑖𝑒𝑑 = = = 0.42
𝐶 𝑐𝑜𝑠𝑡𝑠 12.864
The proposal is not justified economically since both measures are less than
1.0. If the low disbenefits estimate of $0.1 million per year is used, the
measures increase slightly, but not enough to justify the proposal.

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OTHER METHODS

Payback analysis is another use of the present worth technique. It is used

First Cost, $ 12, 000 8, 000

Annual NCF, $ 3, 000 1, 000 (years 1-5),

3, 000 (years 6-14)

Maximum Life, years 7 14

The quality manager used a return of 15% per year.

Machine 1: use equation,

The benefit/cost ratio is relied upon as a fundamental analysis method for

The decision guideline is simple:

If B/C < 1.0, the project is not economically acceptable.

𝐵 𝑏𝑒𝑛𝑒𝑓𝑖𝑡𝑠 − 𝑑𝑖𝑠𝑏𝑒𝑛𝑒𝑓𝑖𝑡𝑠 − 𝑀&𝑂 𝑐𝑜𝑠𝑡𝑠

Award: 20 − 5(A/G,6%,4) = $12.864 per year

The conventional B/C analysis

The modified B/C analysis

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