Chapter 3

Economic Analysis
Learning Outcomes

Purpose: Utilize different economic worth techniques to evaluate and select alternatives.
Understand public sector projects and select the best alternative on the basis of incremental
benefit /cost analysis

 Identify mutually exclusive and independent projects; define revenue and cost
alternatives.
 Select the best of equal-life alternatives using present worth analysis
 Select the best of different-life alternatives using present worth analysis
 Select the best alternative using future worth analysis
 Select the best alternative using an annual worth analysis.
 Select the best alternative using capitalized cost (CC) analysis.
 Explain some of the fundamental differences between private and public sector projects.
 Calculate the benefit/cost ratio and use it to evaluate a single project

Introduction

Future amount of money converted to its equivalent value now has a present worth (PW) that is
always less than that of the future cash flow, because all P/F factors have a value less than 1.0
for any interest rate greater than zero. For this reason, present worth values are often referred to
as discounted cash flows (DCF) , and the interest rate is referred to as the discount rate. Besides
PW, two other terms frequently used are present value ( PV ) and net present value ( NPV ). Up
to this point, present worth computations have been made for one project or alternative. In this
chapter, techniques for comparing two or more mutually exclusive alternatives by the present
worth method are treated. Two additional applications are covered here—future worth and
capitalized cost. Capitalized costs are used for projects with very long expected lives or long
planning horizons.

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To understand how to organize an economic analysis, this chapter begins with a description of
independent and mutually exclusive projects as well as revenue and cost alternatives.

3.1 Formulating Alternatives

The evaluation and selection of economic proposals require cash flow estimates over a stated
period of time, mathematical techniques to calculate the measure of worth (review Examples in
chapter 2 for possible measures), and a guideline for selecting the best proposal. From all the
proposals that may accomplish a stated purpose, the alternatives are formulated. This progression
is detailed in Figure 3–1. Up front, some proposals are viable from technological, economic, and
or legal perspectives; others are not viable. Once the obviously nonviable ideas are eliminated,
the remaining viable proposals are fleshed out to form the alternatives to be evaluated. Economic
evaluation is one of the primary means used to select the best alternative(s) for implementation.
The nature of the economic proposals is always one of two types:

Mutually exclusive alternatives: Only one of the proposals can be selected. For terminology
purposes, each viable proposal is called an alternative.
Independent projects: More than one proposal can be selected. Each viable proposal is called a
project.
The do-nothing (DN) proposal is usually understood to be an option when the evaluation is
performed.

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 Figure 3–1 Progression from proposals to economic evaluation to selection.

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Mutually exclusive alternatives and independent projects are selected in completely different
ways. A mutually exclusive selection takes place, if for example, when an engineer must select
the best diesel-powered engine from several available models. Only one is chosen, and the rest
are rejected.
If none of the alternatives are economically justified, then all can be rejected and, by default, the
DN alternative is selected. For independent projects one, two or more, in fact, all of the projects
that are economically justified can be accepted, provided capital funds are available. This leads
to the two following fundamentally different evaluation bases:
Mutually exclusive alternatives compete with one another and are compared pairwise.
Independent projects are evaluated one at a time and compete only with the DN project.

A parallel can be developed between independent and mutually exclusive evaluation. Assume
there are m independent projects. Zero, one, two, or more may be selected. Since each project
may be in or out of the selected group of projects, there are a total of 2m mutually exclusive
alternatives.
This number includes the DN alternative, as shown in Figure 3–1. For example, if the engineer
has three diesel engine models (A, B, and C) and may select any number of them, there are
23 = 8 alternatives: DN, A, B, C, AB, AC, BC, ABC. Commonly, in real-world applications,
there are restrictions, such as an upper budgetary limit, that eliminate many of the 2 m
alternatives.

Finally, it is important to recognize the nature of the cash flow estimates before starting the
computation of a measure of worth that leads to the final selection. Cash flow estimates
determine whether the alternatives are revenue - or cost-based. All the alternatives or projects
must be of the same type when the economic study is performed. Definitions for these types
follow:

Revenue: Each alternative generates cost (cash outflow) and revenue (cash inflow) estimates,
and possibly savings, also considered cash inflows. Revenues can vary for each alternative.

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Cost: Each alternative has only cost cash flow estimates. Revenues or savings are assumed equal
for all alternatives; thus they are not dependent upon the alternative selected. These are also
referred to as service alternatives.

3.2 Present Worth Analysis of Equal-Life Alternatives

The PW comparison of alternatives with equal lives is straightforward. The present worth P is
renamed PW of the alternative. The present worth method is quite popular in industry because all
future costs and revenues are transformed to equivalent monetary units NOW; that is, all
future cash flows are converted (discounted) to present amounts (e.g., dollars) at a specific rate
of return, which is the MARR. This makes it very simple to determine which alternative has the
best economic advantage. The required conditions and evaluation procedure are as follows:

If the alternatives have the same capacities for the same time period (life), the equal-service
requirement is met. Calculate the PW value at the stated MARR for each alternative.
For mutually exclusive (ME) alternatives, whether they are revenue or cost alternatives, the
following guidelines are applied to justify a single project or to select one from several
alternatives.
One alternative: If PW ≥0, the requested MARR is met or exceeded and the alternative is
economically justified.
Two or more alternatives: Select the alternative with the PW that is numerically largest, that
is, less negative or more positive. This indicates a lower PW of cost for cost alternatives or a
larger PW of net cash flows for revenue alternatives.
Note that the guideline to select one alternative with the lowest cost or highest revenue uses the
criterion of numerically largest. This is not the absolute value of the PW amount, because the
sign matters. The selections below correctly apply the guideline for two alternatives A and B.

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For independent projects, each PW is considered separately, that is, compared with the DN
project, which always has PW ≥ 0. The selection guideline is as follows:
One or more independent projects: Select all projects with PW ≥0 at the MARR.

The independent projects must have positive and negative cash flows to obtain a PW value that
can exceed zero; that is, they must be revenue projects.
All PW analyses require a MARR for use as the i value in the PW relations.

Example: Refer to the examples given in class.

3.3 Present Worth Analysis of Different-Life Alternatives

The PW of the alternatives must be compared over the same number of years and must end at
the same time to satisfy the equal-service requirement.
This is necessary, since the present worth comparison involves calculating the equivalent PW of
all future cash flows for each alternative. A fair comparison requires that PW values represent
cash flows associated with equal service. For cost alternatives, failure to compare equal service
will always favor the shorter-lived mutually exclusive alternative, even if it is not the more
economical choice, because fewer periods of costs are involved. The equal-service requirement
is satisfied by using either of two approaches:

LCM: Compare the PW of alternatives over a period of time equal to the least common
multiple (LCM) of their estimated lives.
Study period: Compare the PW of alternatives using a specified study period of n years.
This approach does not necessarily consider the useful life of an alternative. The study period is
also called the planning horizon.

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For either approach, calculate the PW at the MARR and use the same selection guideline as that
for equal-life alternatives. The LCM approach makes the cash flow estimates extend to the same
period, as required. For example, lives of 3 and 4 years are compared over a 12-year period.
The first cost of an alternative is reinvested at the beginning of each life cycle, and the estimated
salvage value is accounted for at the end of each life cycle when calculating the PW values over
the LCM period. Additionally, the LCM approach requires that some assumptions be made about
subsequent life cycles.

The assumptions when using the LCM approach are that

1. The service provided will be needed over the entire LCM years or more.
2. The selected alternative can be repeated over each life cycle of the LCM in exactly the same
manner.
3. Cash flow estimates are the same for each life cycle
The third assumption is valid only when the cash flows are expected to change by exactly the
inflation (or deflation) rate that is applicable through the LCM time period. If the cash flows are
expected to change by any other rate, then the PW analysis must be conducted using constant-
value dollars, which considers inflation.

❶A study period analysis is necessary if the first assumption about the length of time the
alternatives are needed cannot be made. For the study period approach, a time horizon is chosen
over which the economic analysis is conducted, and only those cash flows which occur during
that time period are considered relevant to the analysis. All cash flows occurring beyond the
study period are ignored. An estimated market value at the end of the study period must be made.
The time horizon chosen might be relatively short, especially when short-term business goals are
very important.
❷ It is also useful when the LCM of alternatives yields an unrealistic evaluation period, for
example, 5 and 9 years.

For independent projects , use of the LCM approach is unnecessary since each project is
compared to the do-nothing alternative, not to each other, and satisfying the equal-service

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requirement is not a problem. Simply use the MARR to determine the PW over the respective
life of each project, and select all projects with a PW ≥ 0.

3.4 Future Worth Analysis

The future worth (FW) of an alternative may be determined directly from the cash flows, or by
multiplying the PW value by the F/P factor, at the established MARR. The n value in the F/P
factor is either the LCM value or a specified study period. Analysis of alternatives using FW
values is especially applicable to large capital investment decisions when a prime goal is to
maximize the future wealth of a corporation’s stockholders.
Future worth analysis over a specified study period is often utilized if the asset (equipment, a
building, etc.) might be sold or traded at some time before the expected life is reached. Suppose
an entrepreneur is planning to buy a company and expects to trade it within 3 years. FW analysis
is the best method to help with the decision to sell or keep it 3 years hence. Another excellent
application of FW analysis is for projects that will come online at the end of a multiyear
investment period, such as electric generation facilities, toll roads, airports, and the like. They are
analyzed using the FW value of investment commitments made during construction.
The selection guidelines for FW analysis are the same as for PW analysis; FW ≥ 0 means the
MARR is met or exceeded. For two or more mutually exclusive alternatives, select the one with
the numerically largest FW value.

Example: The Examples given in the class illustrates the use of FW analysis.

3.5 Annual Worth Analysis

In this section, we add to our repertoire (range) of alternative comparison tools. Here we learn
the equivalent annual worth, or AW, method. AW analysis is commonly considered the more
desirable of the two methods because the AW value is easy to calculate; the measure of worth—
AW in monetary units per year—is understood by most individuals; and its assumptions are
essentially identical to those of the PW method.
Annual worth is also known by other titles. Some are equivalent annual worth (EAW),
equivalent annual cost (EAC), annual equivalent (AE), and equivalent uniform annual cost
(EUAC). The alternative selected by the AW method will always be the same as that selected by

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the PW method, and all other alternative evaluation methods, provided they are performed
correctly.

3.5.1 Advantages and Uses of Annual Worth Analysis

For many engineering economic studies, the AW method is the best to use, when compared to
PW, FW, and rate of return. Since the AW value is the equivalent uniform annual worth of all
estimated receipts and disbursements during the life cycle of the project or alternative, AW is
easy to understand by any individual acquainted with annual amounts, for example, Birrs per
year. The AW value, which has the same interpretation as A used thus far, is the economic
equivalent of the PW and FW values at the MARR for n years. All three can be easily
determined from each other by the relation
AW = PW(A/P,i,n ) = FW(A/F,i,n )
The n in the factors is the number of years for equal-service comparison. This is the LCM or the
stated study period of the PW or FW analysis.

When all cash fl ow estimates are converted to an AW value, this value applies for every year of
the life cycle and for each additional life cycle.

The annual worth method offers a prime computational and interpretation advantage because the
AW value needs to be calculated for only one life cycle. The AW value determined over one life
cycle is the AW for all future life cycles. Therefore, it is not necessary to use the LCM of lives
to satisfy the equal-service requirement.
As with the PW method, there are three fundamental assumptions of the AW method that should
be understood. When alternatives being compared have different lives, the AW method makes
the assumptions that
1. The services provided are needed for at least the LCM of the lives of the alternatives.
2. The selected alternative will be repeated for succeeding life cycles in exactly the same manner
as for the first life cycle.
3. All cash flows will have the same estimated values in every life cycle.

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In practice, no assumption is precisely correct. If, in a particular evaluation, the first two
assumptions are not reasonable, a study period must be established for the analysis. Note that for
assumption
1, the length of time may be the indefinite future (forever). In the third assumption, all cash flows
are expected to change exactly with the inflation (or deflation) rate. If this is not a reasonable
assumption, new cash flow estimates must be made for each life cycle, and again a study period
must be used.
Not only is annual worth an excellent method for performing engineering economy studies, but
also it is applicable in any situation where PW (and FW and benefi t/cost) analysis can be
utilized.

3.5.2 Evaluating Alternatives by Annual Worth Analysis

The annual worth method is typically the easiest to apply of the evaluation techniques when the
MARR is specified. The AW is calculated over the respective life of each alternative, and the
selection guidelines are the same as those used for the PW method. For mutually exclusive
alternatives, whether cost- or revenue-based, the guidelines are as follows:

One alternative: If AW ≥ 0, the requested MARR is met or exceeded and the alternative is
economically justified.
Two or more alternatives: Select the alternative with the AW that is numerically largest, that
is, less negative or more positive. This indicates a lower AW of cost for cost alternatives or a
larger AW of net cash flows for revenue alternatives.
If any of the three assumptions in Section 3.3 is not acceptable for an alternative, a study period
analysis must be used. Then the cash flow estimates over the study period are converted to AW
amounts.

If the projects are independent, the AW at the MARR is calculated. All projects with AW≥0 are
acceptable.

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Example: Refer to the examples given in class.

Evaluation of public sector projects, such as flood control dams, irrigation canals, bridges, or
other large-scale projects, requires the comparison of alternatives that have such long lives that
they may be considered infinite in economic analysis terms. For this type of analysis, the annual
worth (and capital recovery amount) of the initial investment is the perpetual annual interest on
the initial investment, that is, A = Pi = (CC) i.
Cash flows recurring at regular or irregular intervals are handled exactly as in conventional AW
computations; convert them to equivalent uniform annual amounts A for one cycle. This
automatically annualizes them for each succeeding life cycle.

3.6 Capitalized Cost Analysis

Many public sector projects such as bridges, dams, highways and toll roads, railroads, and
hydroelectric and other power generation facilities have very long expected useful lives. A
perpetual or infinite life is the effective planning horizon. Permanent endowments for
charitable organizations and universities also have perpetual lives.
The economic worth of these types of projects or endowments is evaluated using the present
worth of the cash flows
Capitalized Cost (CC) is the present worth of a project that has a very long life (more than, say,
35 or 40 years) or when the planning horizon is considered very long or infinite.

The formula to calculate CC is derived from the PW relation P=A ( P/A , i %, n ), where n = ∞
time periods. Take the equation for P using the P/A factor and divide the numerator and
denominator by (1 / i )n to obtain

As n approaches ∞, the bracketed term becomes 1/i . We replace the symbols P and PW with CC
as a reminder that this is capitalized cost equivalence. Since the A value can also be termed AW
for annual worth, the capitalized cost formula is simply

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 𝐴 𝐴𝑤
CC = 𝑜𝑟 𝐶𝐶 = Equation 3.1
𝑖 𝑖

Solving for A or AW, the amount of new money that is generated each year by a capitalization of
an amount CC is
AW = CC (i) Equation 3.2

This is the same as the calculation A=P ( i) for an infinite number of time periods. Equation [3.2]
can be explained by considering the time value of money. If $20,000 is invested now (this is the
capitalization) at 10% per year, the maximum amount of money that can be withdrawn at the end
of every year for eternity is $2000, which is the interest accumulated each year. This leaves the
original $20,000 to earn interest so that another $2000 will be accumulated the next year.

The cash flows (costs, revenues, and savings) in a capitalized cost calculation are usually of two
types: recurring, also called periodic, and nonrecurring. An annual operating cost of $50,000
and a rework cost estimated at $40,000 every 12 years are examples of recurring cash flows.
Examples of nonrecurring cash flows are the initial investment amount in year 0 and one-time
cash flow estimates at future times, for example, $500,000 in fees 2 years hence.

The procedure to determine the CC for an infinite sequence of cash flows is as follows:
1. Draw a cash flow diagram showing all nonrecurring (one-time) cash flows and at least two
cycles of all recurring (periodic) cash flows.
2. Find the present worth of all nonrecurring amounts. This is their CC value.
3. Find the A value through one life cycle of all recurring amounts. (This is the same value in all
succeeding life cycles. Add this to all other uniform amounts (A) occurring in years 1 through
infinity. The result is the total equivalent uniform annual worth (AW).
4. Divide the AW obtained in step 3 by the interest rate i to obtain a CC value. This is an
application of Equation [3.1].
5. Add the CC values obtained in steps 2 and 4.

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Drawing the cash flow diagram (step 1) is more important in CC calculations than elsewhere,
because it helps separate nonrecurring and recurring amounts. In step 5 the present worths of all
component cash flows have been obtained; the total capitalized cost is simply their sum.
Examples: Refer to the examples given in class.
If a finite-life alternative (for example, 5 years) is compared to one with an indefinite or very
long life, capitalized costs can be used. To determine capitalized cost for the finite life
alternative, calculate the equivalent A value for one life cycle and divide by the interest rate
(Equation [3.1]). This procedure is illustrated in Example 3.8 using a spreadsheet.

3.7. Benefit /cost analysis

The evaluation methods of previous lessons are usually applied to alternatives in the private
sector, that is, for-profit and not-for-profit corporations and businesses.
This portion introduces public sector and service sector alternatives and their economic
consideration. In the case of public projects, the owners and users (beneficiaries) are the citizens
and residents of a government unit—city, county, state, province, or nation. Government units
provide the mechanisms to raise capital and operating funds. Public-private partnerships have
become increasingly common, especially for large infrastructure projects such as major
highways, power generation plants, water resource developments, and the like.
The benefit/cost (B/C) ratio introduces objectivity into the economic analysis of public sector
evaluation, thus reducing the effects of politics and special interests. The different formats of
B/C analysis, and associated disbenefits of an alternative, are discussed here. The B/C analysis
can use equivalency computations based on PW, AW, or FW values. Performed correctly, the
benefit/cost method will always select the same alternative as PW, AW, and ROR analyses.
This section also introduces service sector projects and discusses how their economic
evaluation is different from that for other projects. Finally, there is a discussion on professional
ethics and ethical dilemmas in the public sector.
3.7.1 Public Sector Projects
Here we will explore projects that concentrate on government units and the citizens they serve.
These are called public sector projects.

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A public sector project is a product, service, or system used, financed, and owned by the
citizens of any government level. The primary purpose is to provide service to the citizenry for
the public good at no profit. Areas such as public health, criminal justice, safety, transportation,
welfare, and utilities are publically owned and require economic evaluation.
Upon reflection, it is surprising how much of what we use on a daily or as-needed basis is
publicly owned and financed to serve us—the citizenry. These are some public sector examples:
 Hospitals and clinics  Economic development projects
 Parks and recreation  Convention centers
 Utilities: water, electricity, gas, sewer,  Sports arenas
sanitation  Transportation: highways, bridges,
 Schools: primary, secondary, waterways
community colleges, universities  Public housing
 Police and fire protection  Emergency relief
 Courts and prisons  Codes and standards
 Food stamp and rent relief programs
 Job training
There are significant differences in the characteristics of private and public sector alternatives.
They are summarized here.
Characteristic Public sector Private sector
Size of investment Large Some large; more medium to small
Life estimates Longer (30–50+ years) Shorter (2–25 years)
Annual cash flow No profit; costs, benefits, & Revenues contribute to
estimates disbenefits are estimated profits; costs are estimated
Funding Taxes, fees, bonds, Stocks, bonds, loans,
private funds individual owners
Interest rate Lower Higher, based on cost of capital
Alternative selection Multiple criteria Primarily based on rate of return
criteria
Environment of the Politically inclined Primarily economic
evaluation

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Often alternatives developed to serve public needs require large initial investments, possibly
distributed over several years. Modern highways, public transportation systems, universities,
airports, and flood control systems are examples.

The long lives of public projects often prompt the use of the capitalized cost method, where
infinity is used for n and annual costs are calculated as A = P ( i ). As n gets larger, especially
over 30 years, the differences in calculated A values become small.
Public sector projects (also called publicly owned) do not have profits; they do have costs that
are paid by the appropriate government unit; and they benefit the citizenry. Public sector projects
often have undesirable consequences, as interpreted by some sectors of the public. It is these
consequences that can cause public controversy about the projects. The economic analysis
should consider these consequences in monetary terms to the degree estimable. (Often in private
sector analysis, undesirable consequences are not considered, or they may be directly addressed
as costs.) To perform a benefit/cost economic analysis of public alternatives, the costs (initial and
annual), the benefits, and the disbenefits, if considered, must be estimated as accurately as
possible in monetary units.
Costs—estimated expenditures to the government entity for construction, operation, and
maintenance of the project, less any expected salvage value.
Benefits—advantages to be experienced by the owners, the public
Disbenefits—expected undesirable or negative consequences to the owners if the alternative is
implemented. Disbenefits may be indirect economic disadvantages of the alternative.
The bases and standards for benefits estimation are always difficult to establish and verify.
Relative to revenue cash flow estimates in the private sector, benefit estimates are much harder
to make, and vary more widely around uncertain averages. And the disbenefits that accrue from
an alternative are even harder to estimate. In fact, the disbenefit itself may not be known at the
time the evaluation is performed.

3.7.2 Benefit/Cost Analysis of a Single Project

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

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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:
𝑷𝑾 𝒐𝒇 𝒃𝒆𝒏𝒆𝒇𝒊𝒕𝒔 𝐴𝑤 𝑜𝑓 𝑏𝑒𝑛𝑒𝑓𝑖𝑡𝑠 𝐹𝑤 𝑜𝑓 𝑏𝑒𝑛𝑒𝑓𝑖𝑡𝑠
𝐵/𝐶 = = =
𝑃𝑤 𝑜𝑓 𝐶𝑜𝑠𝑡𝑠 𝐴𝑤 𝑜𝑓 𝑐𝑜𝑠𝑡 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 𝐸𝑞𝑢𝑎𝑡𝑖𝑜𝑛 3.4

𝐶 𝐶𝑜𝑠𝑡𝑠 𝐶
In Equation [3.4] disbenefits are subtracted from benefits, not added to costs. The B/C value
could change considerably if disbenefits are regarded as costs. For example, if the numbers 10, 8,
and 5 are used to represent the PW of benefits, disbenefits, and costs, respectively, the correct
procedure results in B/C = (10 - 8)/5 = 0.40. The incorrect placement of disbenefits in the
denominator results in B/C = 10/(8 +5) =0.77, which is approximately twice the correct B/C
value of 0.40. Clearly, then, the method by which disbenefits are handled affects the magnitude
of the B/C ratio. However, regardless of whether disbenefits are (correctly) subtracted from the
numerator or (incorrectly) added to costs in the denominator, a B/C ratio of less than 1.0 by the
first method will always yield a B/C ratio less than 1.0 by the second method, and vice versa.

The modified B/C ratio includes all the estimates associated with the project, once operational.

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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

𝐵𝑒𝑛𝑒𝑓𝑖𝑡𝑠 − 𝐷𝑖𝑠𝑏𝑒𝑛𝑒𝑓𝑖𝑡𝑠 − 𝑀&𝑂 𝐶𝑜𝑠𝑡𝑠

𝑀𝑜𝑑𝑖𝑓𝑖𝑒𝑑 𝐵⁄𝐶 =
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

Salvage value is usually included in the denominator as a negative cost. The modified B/C ratio
will obviously yield a different value than the conventional B/C method. However, as with
disbenefits, the modified procedure can change the magnitude of the ratio but not the decision to
accept or reject the project.

The benefit and cost difference measure of worth, which does not involve a ratio, is based on the
difference between the PW, AW, or FW of benefits and costs, that is, B − C . If (B − C ) ≥ 0, the
project is acceptable. This method has the advantage of eliminating the discrepancies noted
above when disbenefits are regarded as costs, because B represents net benefits. Thus, for the
numbers 10, 8, and 5, the same result is obtained regardless of how disbenefits are treated.

Subtracting disbenefits from benefits: B –C= (10 - 8) – 5= -3

Adding disbenefits to costs: B –C= 10 – (8 + 5)= -3

Before calculating the B/C ratio by any formula, check whether the alternative with the larger

AW or PW of costs also yields a larger AW or PW of benefits. It is possible for one alternative

with larger costs to generate lower benefits than other alternatives, thus making it unnecessary to
further consider the larger-cost alternative.

By the very nature of benefits and especially disbenefits, monetary estimates are difficult to
make and will vary over a wide range. The extensive use of sensitivity analysis on the more
questionable parameters helps determine how sensitive the economic decision is to estimate
variation.

Examples: Refer to the examples given in class.

Exercise: The cash flow details of a public project is as follows Initial cost = Br. 21000000
Annual operating cost = Br. 1600000 Worth of annual benefits = Br. 5000000 Worth of annual

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disbenefits = Br. 1100000 Salvage value = Br. 4000000 Interest rate per year = 8% and useful lie
= 30 Years. Using benefit-cost ratio method (both conventional and modified), find out the
economical acceptability of the public project. (Use PW, AW and FW methods to find out the
equivalent worth of costs, benefits and disbenefits, for both conventional and modified B/C
methods.)

3.8 Sensitivity Analysis

In all our preceding discussions we had arrived at a particular decision (in the form of acceptance
or rejection of a proposal, and the selection of one alternative among different possible
alternatives) in a given situation assuming that the estimates or the expected value for different
variables such as initial cost, receipts, disbursements, interest rate, life of the assets, salvage
value etc. were accurate and constant. Unfortunately in real life situation it is not the case.
Barring few variable, such as initial cost of the asset, rest all the variables are all our estimates or
forecasts which may prove to be wrong on most of the occasions. The life of the asset could be
longer or shorter than our estimate; the interest rate could be higher or lower than the assumed
value and so on. The salvage value may be more or less than the assumed value.

We may like to know what will happen to the net present worth associated with a particular
investment alternative when some variables like incomings (receipts) value or outgoings
(disbursement) value vary from its expected value. Sensitivity analysis thus is aimed to study the
impact of change in the value of variable(s) on the economic decision in a particular situation.

In a sense it aims to answer “what if”. For example what will happen if the annual disbursement
value increases by 10% or 20% from the current value? Will it turn the positive present worth
into negative? Will it change the earlier decision?

The changes (increase or decrease in the assumed values) in the variable values may or may not
lead to reversal of our earlier decision. If even a slight change in one variable makes the reversal
of decision from let’s say acceptance of one alternative to the rejection we say that the variable is
highly sensitive. Whereas, even if a large change in one variable does not change the decision we
say that the variable is not sensitive or insensitive.

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The sensitivity analysis is also aimed at identifying the sensitivity of a particular variable. Once
the identification has been made of variables in categories such as highly sensitive, less sensitive
or insensitive the management can focus their attention to the highly sensitive variables. That is
for such variables they can put more energy and effort in preparing their estimate. In some
situations, external help in the form of engagement of consultants can also be thought of.

Sensitivity analysis is basically a non- probabilistic technique as it does not consider the
probability of occurrence associated with the variation in variables. There could be different
forms of sensitivity analysis. These are depicted in Figure 3–2.

Figure 3–2 Different forms of Sensitivity Analysis

There are different forms of sensitivity analysis. In its simplest form, sensitivity analysis for a
single alternative can be performed and the impact (on decision) of change in single variable can
be studied. Then there could be simultaneous changes in two variables corresponding to a single
alternative can be studied. Or for a single alternative one can study the changes in more than two
variables at a time.

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Sensitivity analysis can be performed for more than one alternative. Here also you can see the
impact of variation of one variable on the decision. There can be cases in which we would like to
change two variables at a time or more than two variables at a time and see their impact on the
decision arrived earlier by assuming all the variables as fixed or constant.

Sensitivity analysis can be performed with any method of evaluation of alternatives for example,
present worth analysis, annual cost or worth analysis or internal rate of return method of
analysis. Also the analysis can be performed at different stages of project either with the pre-tax
cash flow or post-tax cash flows. However, it is preferable to perform sensitivity analysis with
post-tax cash flow. It is customary to show the results of sensitivity analysis in the form of
sensitivity graphs.

Examples: Refer to the examples given in class.

3.8.1 Benefits of performing sensitivity analysis

i. It shows how robust or vulnerable a particular alternative is to changes in the value of

different variables,
ii. It enables the decision maker to distinguish the sensitive variables from insensitive
variables thus the decision maker can focus its attention in making the estimate of
sensitive variables

3.8.2 Limitation of sensitivity analysis

i. It is non-probabilistic in nature. One may recollect that for none of the cases we
considered the likelihood of occurrence of a particular variable value. It merely shows us
what happens to the net present worth, or annual worth or rate of return when there is a
change in some variable(s), without providing any information on the likelihood of the
changes.
ii. Commonly, in sensitivity analysis only one variable is changed at a time which may not
reflect the real world situation as variables tend to move together.
iii. There is subjectivity involved in the sensitivity analysis. Thus the sensitivity analysis
may lead one decision maker to accept the proposal while other may reject it.

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3.8.4 Break-even analysis

It is another way of performing sensitivity analysis. Here we are more concerned about finding
the value (called the break-even point) at which the reversal of decision takes place. In the
sensitivity analysis not much emphasis was given on finding this break even value. In sensitivity
analysis we ask what will happen to the project if the invoice or billing declines or costs increase
or something else happens. We will also be interested in knowing how much should be produced
and sold at a minimum to ensure that the project does not 'lose money'. Such an exercise is called
break-even analysis and the minimum quantity at which loss is avoided is called the break- even
point. The break even analysis is also referred to as cost-volume-profit analysis.

Examples: Refer to the examples given in class.

3.9 Inflation Effects

This portion concentrates upon understanding and calculating the effects of inflation in time
value of money computations. Inflation is a reality that we deal with nearly every day in our
professional and personal lives. The annual inflation rate is closely watched and historically
analyzed by government units, businesses, and industrial corporations. An engineering economy
study can have different outcomes in an environment in which inflation is a serious concern
compared to one in which it is of minor consideration. In the first decade of the 21st century,
inflation has not been a major concern in the developed countries or most industrialized nations.
But the inflation rate is sensitive to real, as well as perceived, factors of the economy. Factors
such as the cost of energy, interest rates, availability and cost of skilled people, scarcity of
materials, political stability, and other, less tangible factors have short-term and long-term
impacts on the inflation rate. In some industries, it is vital that the effects of inflation be
integrated into an economic analysis. The basic techniques to do so are covered here.

3.9.1 Understanding the Impact of Inflation

We are all very well aware that $20 now does not purchase the same amount as $20 did in 2005
and purchases significantly less than in 2000. Why? Primarily this is due to inflation and the
purchasing power of money.
Inflation is an increase in the amount of money necessary to obtain the same amount of goods or
services before the inflated price was present.

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Purchasing power, or buying power , measures the value of a currency in terms of the quantity
and quality of goods or services that one unit of money will purchase. Infl ation decreases the
purchasing ability of money in that less goods or services can be purchased for the same one unit
of money.
Money in one period of time t1 can be brought to the same value as money in another period of
time t2 by using the equation
amount in period t
Amount in period t1 = inflation rate between t 2and t (4.1)
1 2

Using dollars as the currency, dollars in period t1 are called constant-value dollars or today’s
dollars. Dollars in period t2 are called future dollars or then-current dollars and have inflation
taken into account. If f represents the inflation rate per period (year) and n is the number of time
periods (years) between t1 and t2, above equation becomes
future dollars
Constant − value dollars = (1+f)n
(4.2)

Future dollars = constant − value dollars(1 + f)n (4.3)

Present Worth Calculations Adjusted for Inflation

When the dollar amounts in different time periods are to be expressed in constant-value dollars,
the equivalent present and future amounts must be determined using the real interest rate i .
The calculations involved in this procedure are illustrated in below, where the inflation rate is
4% per year. Column 2 shows the inflation-driven increase for each of the next 4 years for an
item that has a cost of $5000 today. Column 3 shows the cost in future dollars, and column 4
verifies the cost in constant-value dollars via Equation [4.2]. When the future dollars of column 3
are converted to constant-value dollars (column 4), the cost is always $5000, the same as the cost
at the start. This is predictably true when the costs are increasing by an amount exactly equal to
the inflation rate. The actual cost (in inflated dollars) of the item 4 years from now will be $5849,
but in constant-value dollars the cost in 4 years will still amount to $5000. Column 5 shows the
present worth of future amounts of $5000 at a real interest rate of i = 10% per year.

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Two conclusions can be drawn. At f _ 4%, $5000 today infl ates to $5849 in 4 years. And $5000
four years in the future has a PW of only $3415 now in constant-value dollars at a real interest
rate of 10% per year.

Future worth Calculations Adjusted for Inflation

In future worth calculations, a future amount F can have any one of four different interpretations:
Case1. The actual amount of money that will be accumulated at time n .
Case2. The purchasing power of the actual amount accumulated at time n , but stated in today’s
(constant-value) dollars.
Case3. The number of future dollars required at time n to maintain the same purchasing power
as today; that is, inflation is considered, but interest is not.
Case4. The amount of money required at time n to maintain purchasing power and earn a stated
real interest rate.
Depending upon which interpretation is intended, the F value is calculated differently, as
described below. Each case is illustrated.

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Case 1: Actual Amount Accumulated. It should be clear that F, the actual amount of money
accumulated, is obtained using the inflation-adjusted (market) interest rate.
F
F = P(1 + if )n = P (P , if , n)

For example, when we quote a market rate of 10%, the inflation rate is included. Over a 7-year
period, $1000 invested at 10% per year will accumulate to
F
F = 1000 (P , 10%, 7) = $19448

Case 2: Constant-Value Dollars with Purchasing Power.

The purchasing power of future dollars is determined by first using the market rate if to calculate F and then
deflating the future amount through division by(1 + 𝑓)𝑛 .
F
P(1+if )n P( ,if ,n)
P
F= (1+if )n
= (1+f)n

This relation, in effect, recognizes the fact that inflated prices mean $1 in the future purchases
less than $1 now. The percentage loss in purchasing power is a measure of how much less. As an
illustration, consider the same $1000 now, and a 10% per year market rate, which includes an
inflation rate of 4% per year. In 7 years, the purchasing power has risen, but only to $1481.
𝐹
P1000( ,10%.7) $1948
𝑃
F= (1.04)7
= 1.3159 = $1481

This is $467 (or 24%) less than the $1948 actually accumulated at 10% (case 1). Therefore, we
conclude that 4% inflation over 7 years reduces the purchasing power of money by 24%.
Case 3: Future Amount Required, No Interest.
This case recognizes that prices increase when inflation is present. Simply put, future dollars are
worth less, so more are needed. No interest rate is considered in this case—only inflation. This is
the situation if someone asks, “How much will a car cost in 5 years if its current cost is $20,000
and its price will increase by the inflation rate of 6% per year?” (The answer is $26,765.) No
interest rate—only inflation—is involved. To find the future cost, substitute f for the interest rate
in the F /P factor.
F
F = P(1 + f)n = P (P , f, n)

Reconsider the $1000 used previously. If it is escalating at exactly the inflation rate of 4% per
year, the amount 7 years from now will be
F
F = 1000 (P , 4%, 7) = $1316

Case 4: Inflation and Real Interest

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This is the case applied when a market MARR is established.
Maintaining purchasing power and earning interest must account for both increasing prices (case
3) and the time value of money. If the growth of capital is to keep up, funds must grow at a rate
equal to or above the real interest rate i plus the inflation rate f. Thus, to make a real rate of
return of 5.77% when the inflation rate is 4%, i f is the market (inflation-adjusted) rate that must
be used. For the same $1000 amount,
if = 0.0577 + 0.04 + 0.0577(0.04) = 0.10
F
F = 1000 (P , 10%, 7) = $1948

This calculation shows that $1948 seven years in the future will be equivalent to $1000 now with
a real return of i = 5.77% per year and inflation of f = 4% per year.

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