2.0 Engineering Costs and Cost Estimating Rev 2

Asset Life Study 28th Sept to 1st Oct 2012
Engineering Costs and Cost Estimating
Module Objectives
By end of this module, participants should be able
to : Explain Engineering cost and LCC terminology
Describe different types of cost estimates
Draw cash flow diagram
2.0 Engineering Costs and Estimating
Agenda Content
Definition of Engineering Cost and cost
terminology
Types of Engineering Cost Estimates
Estimating Models
Basics of cash flow diagram
Interest
The fee that a borrower pays to a lender for the
use of his or her money.
INTEREST RATE
The percentage of money being borrowed that is
paid to the lender on some time basis. The
Compound Interest
Whenever the interest charge for any interest period is based
on the remaining principal amount plus any accumulated
interest charges up to the beginning of that period.
Economic Equivalent
Established when we are indifferent between a future
payment, or a series of future payments, and a present
sum of money .
Considers the comparison of alternative options, or
proposals, by reducing them to an equivalent basis,
depending on:
interest rate;
amounts of money involved;
timing of the affected monetary receipts and/or expenditures;
manner in which the interest , or profit on invested capital is paid
and the initial capital is recovered.
ECONOMIC EQUIVALENCE FOR FOUR

REPAYMENT PLANS OF AN $8,000 LOAN
Plan #1: $2,000 of loan principal plus 10% of BOY principal paid at the
end of year; interest paid at the end of each year is reduced by $200 (i.e.,
10% of remaining principal)

Plan #2: $0 of loan principal paid until end of fourth

year; $800 interest paid at the end of each year
Year
Amount owed at
the beginning of
year
Interest
accrued for
year
Total money
owed at end of
year
1
2
3
4
RM8,000
RM8,000
RM8,000
RM8,000
RM800
RM800
RM800
RM800
RM8,800
RM8,800
RM8,800
RM8,800
Principal Total end of

pmt
year pmt
RM0
RM800
RM0
RM800
RM0
RM800
RM8,000 RM8,800

Plan #3: $2,524 paid at the end of each year; interest paid at the end of
each year is 10% of amount owed at the beginning of the year.
Total interest paid is $2096

Plan #4: No interest and no principal paid for first three years. At the
end of the fourth year, the original principal plus accumulated
(compounded) interest is paid.
10
CASH FLOW DIAGRAMS / TABLE NOTATION

i = effective interest rate per interest period
N = number of compounding periods (e.g., years)
P = present sum of money; the equivalent value of one or
more cash flows at the present time reference point
F = future sum of money; the equivalent value of one or more
cash flows at a future time reference point
A = end-of-period cash flows (or equivalent end-of-period
values ) in a uniform series continuing for a specified
number of periods, starting at the end of the first period
and continuing through the last period
G = uniform gradient amounts -- used if cash flows increase
by a constant amount in each period
11

1
1
5=N
Time scale with progression of time moving from left to right; the
numbers represent time periods (e.g., years, months, quarters,
etc...) and may be presented within a time interval or at the end
of a time interval.
12
CASH FLOW DIAGRAM NOTATION

1
P =$8,000
5=N
etc...) and may be presented within a time interval or at the end of a
time interval.
Present expense (cash outflow) of $8,000 for lender.
13

A = $2,524
1
P =$8,000
1
2
5=N
etc...) and may be presented within a time interval or at the end of a
time interval.
Annual income (cash inflow) of $2,524 for lender.
14

A = $2,524
1
P =$8,000
1
2
4
4
5=N
i = 10% per year
etc...) and may be presented within a time interval or at the end of
a time interval.
Interest rate of loan.
15

1
P =$8,000
A = $2,524
4
4
5=N
i = 10% per year
etc...) and may be presented within a time interval or at the end of
a time interval.
Interest rate of loan.
5
16
Dashed-arrow line indicates

amount to be determined.
Break
17
Cost Terminology
Fixed cost is the cost that are unaffected by changes in
activity level. Eg- Insurance, interest, rental
Variable cost is the cost that vary with output or activity
level. Eg- Material cost, labor cost
Sunk Cost- Occurred in the past and has no relation to
the future cost or revenue and normally disregarded from
engineering analysis.
Opportunity Cost-The benefit that are foregone by
engaging a business resource in a chosen activity instead
of engaging that same resource in the foregone activity.
18
Fixed, variable and total

cost
Cost
Variable Cost
Fixed Cost
Volume
Total cost = Total Fixed cost + Total Variable Cost

19
Cost Terminology
Recurring cost- Cost that are repetitive and occurs when
the organization produce similar product or services.EgSpace rental, annual maintenance
Non-recurring cost- Cost that are not repetitive or one
time deal charge. Eg- new machine installation,
emergency maintenance
Direct cost- Cost that can be measured and allocated to
specific activities. Eg- labor cost, material cost
Indirect cost- Cost other than direct cost that related to
the product. eg.- Equipment maintenance cost, building
maintenance
20
LCCs Terminology
Salvage values : the cost of the equipment/asset at
the end of the study period. Values can be positive
or negative (cost)
Study period : Over which the operating expenses
and ownership are evaluated.
Discount rate : Rate of interest reflecting investors
time value of money.
21
Cost Estimating
The basic of engineering economic analysis focuses on
future consequences of current decisions
As the exact future results are not known with certainty,
the consequences must be estimated.
The estimate depends largely on the accuracy of data
input
Examples of estimates normally used in economic
analysis:
Purchase Cost
Annual revenue
Annual Maintenance
Equipment salvage value
22
Types of Estimates
Usage
Accuracy
Rough
estimates
High level planning

Macro feasibility
-30% to
+60%
SemiDetailed
estimates
Budgeting purposes
-15% to
Preliminary design decision +20%
Detailed
estimates
Projects detailed design

Contract bidding
-3% to
+5%
high
Cost of estimates
Types of
Estimates
Low
Low
Medium
Accuracy of estimates
23
high
Estimating Models
Per unit model
Uses per unit factor such as cost per square foot (meter)
No allowance for economies of scale(higher quantity cost less on
per unit basis)
Applicable for order of magnitude type of estimates
Examples:
Service cost per customer
Utility cost per equipment
Segmenting model (bottom up approach)

An estimate is decomposed into individual components
Estimates are then made on those individual components
Those individual estimates are aggregated(added) back together)
24
Cost estimate-bottom up approach

Material cost estimates for a Pump
Cost Items
Unit material cost

estimates
A. Chassis
A.1 Deck
A.2 Wheels
A.3 Axles
Cost Item
Unit material cost

estimates
C. Controls
7.40
C.1 Handle Assembly
3.85
10.20
C.2 Engine linkage
8.55
4.85
C.3 Blade linkage
4.70
22.45
C.4 Speed control
21.50
C.5 Drive control
6.70
C.6 Cutting height
7.40
B. Drive Train
B.1 Engine
38.5
B.2 Starter Assembly
5.90
B.3 Transmission
5.45
D. Cutting system
10.00
D.1 Blade assembly
B.4 Drive disc assembly
52.70
10.80
B5. Clutch Linkage
5.15
D.2 Side Chute
7.05
B6. Belt assembly
7.70
D.3 Grass bag
7.75
72.70
25.60
25
Total Material cost

estimates = $173.45
Estimating Model
Cost Indexes
Dimensionless number to reflect historical change in
costs. Eg CPI or consumer price index.
Indexes can be used to update historical costs with basic
ratio relationship given in the equation below:
Cost at Time A
Cost at Time B
Index value at time A

Index value at time B
The equation states that the ratio of the cost index

numbers at two points in time is equal to the dollar cost
ratio of the item at the same times.
26
Cost indexes -Example

Estimate the annual labor cost for a new
production facility given the following data:
Labor cost index value was 124 ten years ago
and is 188 today
Annual labor cost for a similar facility were
$575K ten years ago.
Cost at Time A
Cost at Time B
575,000
Cost at Time B

124
188
Cost at Time B = $871,800

27
Estimating Model
Power Sizing Model
Used to estimate the cost of industrial plants
and equipment
The model scale up or scale down of previously
known costs by taking into account the
economies of scale.
The model uses the following equation for the
estimate:Size (Capacity) of equipment A
Cost of equipment A
=
Cost of equipment B
Size (Capacity) of equipment B
Where:
x is the power sizing exponent
Cost of A and B are at the same point in time
Size or capacity of A and B are in the same physical units
28
Power Sizing Exponent

Values
Note : Other values can be obtained from Plant design and economics for chemical engineers,
Chemical Engineering Handbooks, other design handbooks and equipment companies.
29
Power sizing Example

A preliminary estimate is needed for the cost of building a 600MW fossil fuel plant. It is known
that a 200MW plant cost $100 Million 20 year ago when the approximate cost index was 400.
The cost index is now at 1200 and the power sizing exponent value for a fossil fuel plant is
0.79.
1. Use cost index to calculate the current cost of 200MW plant.
Cost at Time A
Cost at Time B
100
Cost at Time B

400
1200
Cost at Time B = $300 Mil

2. Use power sizing exponent equation to calculate the cost for 600MW plant
Cost of equipment A
Cost of equipment B
300
Cost of 600 MW
Size (Capacity) of equipment A
Size (Capacity) of equipment B

200
600
0.79
= Cost of 600MW plant =$714mil

30
Cash Flow Diagram (CFD)

CFD illustrates the size, sign and timing of
individual cash flows
+ve cash
flow
(future
Value)
Beginning End of year 1

of year 1
3
Years
Expense
(-ve) cash
flow
(present
value)
31
5=N
i = interest rate=10%
Cash Flow Categories

The expense and revenue due to engineering
projects can be divided into the following
categories: First Cost Expense to build or to buy and install
Operation and Maintenance (O&M) Annual expense
such as repairs, utilities, labor
Salvage value Receipt at project termination
Revenues Annual receipt due sale of product and
services
Overhaul Major capital expenditure that occurs
during the assets life.
32
Cash Flow Diagram Example

A piece of new equipment has been proposed by engineers to increase the productivity of a
certain manual welding operation. The investment cost is $25000 and the equipment will
have a market value of $5000 at the end 5 years. The annual O&M is $2500 and an overhaul
needs to be done at the end of 3 rd year at a cost of $12000. Draw the cash flow diagram.
Year
Capital
Cost
-25000
O&M
Overhaul
Net Cash
Flow
-25000
-2500
-2500
-2500
-2500
-2500
-2500
-2500
-2500
2500
5000
-12000
2500
0
2500
2500
33
2500
-14500
14500
25000
Cash Flow Diagram Exercise

A rental company spent $2500 on a new air compressor 7 years ago. The annual rental income
from the compressor has been $750. Additionally, the $100 spent on maintenance during the
first year has increased each year by $25. The company plans to sell the compressor at the end
of next year for $150. Construct the cash flow diagram from the companys perspective.
Year
Income
Cost
Net Cash Flow
-7
-2500
-2500
-6
750
-100
650
-5
750
-125
625
-4
750
-150
600
-3
750
-175
575
-2
750
-200
550
-1
750
-225
525
750
-250
500
750 + 150
-275
625
34
MINIMUM ATTRACTIVE RATE OF RETURN
( MARR )
An interest rate used to convert cash flows into equivalent worth

at some point(s) in time
Usually a policy issue based on:
- amount, source and cost of money available for investment
- number and purpose of good projects available for investment
- amount of perceived risk of investment opportunities and
estimated cost of administering
projects over short and long
run
- type of organization involved
MARR is sometimes referred to as hurdle rate
CAPITAL RATIONING
Establishing MARR involves opportunity cost viewpoint results from

phenomena of CAPITAL RATIONING
Exists when management decides to restrict the total amount of
capital invested, by desire or limit of available capital
Select only those projects which provide annual rate of return in
excess of MARR
As amount of investment capital and opportunities available change
over time, a firms MARR will also change
PRESENT WORTH METHOD ( PW )
Based on concept of equivalent worth of all cash flows

relative to the present as a base
All cash inflows and outflows discounted to present at
interest -- generally MARR
PW is a measure of how much money can be afforded for
investment in excess of cost
PW is positive if dollar amount received for investment
exceeds minimum required by investors
FINDING PRESENT WORTH

Discount future amounts to the present by using the interest
N
rate over the appropriate study period
PW = Fk ( 1 + i )
-k
k=0
i = effective interest rate, or MARR per compounding period

k = index for each compounding period
Fk = future cash flow at the end of period k
N = number of compounding periods in study period
interest rate is assumed constant through project
The higher the interest rate and further into future a cash flow
occurs, the lower its PW
FUTURE WORTH METHOD (FW )

FW is based on the equivalent worth of all cash inflows and
outflows at the end of the planning horizon at an interest
rate that is generally MARR
The FW of a project is equivalent to PW
FW = PW ( F / P, i%, N )
If FW > 0, it is economically
N justified
FW ( i % ) = Fk ( 1 + i )
k=0
i = effective interest rate
k = index for each compounding period
Fk = future cash flow at the end of period k
N = number of compounding periods in study period
N-k
ANNUAL WORTH METHOD ( AW )
AW is an equal annual series of dollar amounts, over a stated

period ( N ), equivalent to the cash inflows and outflows at
interest rate that is generally MARR
AW is annual equivalent revenues ( R ) minus annual
equivalent expenses ( E ), less the annual equivalent capital
recovery (CR)
AW ( i % ) = R - E - CR ( i % )
AW = PW ( A / P, i %, N )
AW = FW ( A / F, i %, N )
If AW > 0, project is economically attractive
AW = 0 : annual return = MARR earned
CAPITAL RECOVERY ( CR )
CR is the equivalent uniform annual cost of the capital

invested
CR is an annual amount that covers:
Loss in value of the asset
Interest on invested capital ( i.e., at the MARR )
CR ( i % ) = I ( A / P, i %, N ) - S ( A / F, i %, N )
I = initial investment for the project
S = salvage ( market ) value at the end of the study period
N = project study period
Example of capital recovery calculation

Consider a machine that cost $10,000, last five years, and
have a salvage (market) value $2,000. Thus, the loss in value
of this asset over five years is $8,000. Additionally, the MARR
is 10% per year.
Thus
CR (i%)=I(A/P,i%,N) S(A/F,i%,N)
Solution:
CR (10%) = $10,000(A/P,10%,5) - $2,000(A/F,10%,5)
= $10,000 (0.2638) - $2,000 (0.1638)
= $2,310.40
CAPITAL RECOVERY ( CR)
CR is also calculated by adding sinking fund amount

(i.e., deposit) to interest on original investment
CR ( i % ) = ( I - S ) ( A / F, i %, N ) + I ( i % )
CR is also calculated by adding the equivalent annual
cost of the uniform loss in value of the investment to
the interest on the salvage value
CR ( i % ) = ( I - S ) ( A / P, i %, N ) + S ( i % )
Example of Annual Worth Method:

A piece of new equipment has been proposed by engineers to
increase the productivity of a certain manual welding operation.
The investment cost $25,000, and the equipment will have a
market value $5,000 at the end of a study period of five years.
Increased productivity attributable to this equipment will
amount to $8,000 per year after extra operating costs have
been subtracted from the revenue generated by the additional
production.
If the firm MARR is 20% per year, is this proposal a sound one?
Use the AW method.
Solution:
AW (i%) = R - E CR (i%)
AW (20%) = $8,000 [$25,000(A/P,20%,5) $5,000(A/F,20%,5)]
= $8,000 [$8360 - $672]
= $312
Conclusion: because AW (20%) is positive, the equipment more
than pays for itself over the planning horizon.
Problem
A certain service can be performed satisfactorily by process X,
which has a capital investment cost of $8,000, an estimated life of
10 years, no salvage value, an annual net receipts (revenue
expenses) of $2,400. Assuming a MARR of 18% before income
taxes, find the AW of this process and specify whether you would
recommend it.
Solution:
AW (i%) = R - E CR (i%)
AW (18%) = $2,400 [$8,000(A/P,18%,10) - $0(A/F,18%,10)]
= $2,400 [$1,780 - $0]
= $620
Conclusion: because AW (18%) is positive, the process X is
recommended.
INTERNAL RATE OF RETURN METHOD ( IRR )

IRR solves for the interest rate that equates the equivalent
worth of an alternatives cash inflows (receipts or savings) to
the equivalent worth of cash outflows (expenditures)
Also referred to as:
investors method
discounted cash flow method
profitability index
IRR is positive for a single alternative only if:
both receipts and expenses are present in the cash flow
pattern
the sum of receipts exceeds sum of cash outflows
INTERNAL RATE OF RETURN METHOD ( IRR )
IRR is i %, using the following PW formula:

N
( P / F, i %, k ) =
k=0
( P / F, i %, k )
k=0
R k = net revenues or savings for the kth year

E k = net expenditures including investment costs for the kth
year
N = project life ( or study period )
If i > MARR, the alternative is acceptable
To compute IRR for alternative, set net PW = 0
N
PW = Rk =k 0( P / F, i %, k ) - k=E0 k ( P / F, i %, k ) = 0
i is calculated on the beginning-of-year unrecovered
INTERNAL RATE OF RETURN PROBLEMS
The IRR method assumes recovered funds, if not

consumed each time period, are reinvested at i %,
rather than at MARR
The computation of IRR may be unmanageable
Multiple IRRs may be calculated for the same
problem
The IRR method must be carefully applied and
interpreted in the analysis of two or more
alternatives, where only one is acceptable
Example of Internal Rate of Return method

A capital investment of $10,000 can be made in a project that will
produce a uniform annual income revenue of $5,310 for five years and
then have a salvage value of $2,000.
Annual expenses will be $ 3,000.
The company is willing to accept any project that will earn at least 10%
per year on all invested capital. Determine whether it is acceptable by
using IRR method.
Solution:
Set net PW = 0
PW = 0 = -$10,000 + ($5,310 $3,000)(P/A,i%,5)
+ $2,000(P/F,i%,5) ; i% = ?
By trial-and-error process; at i = 5%; PW = $1,568
at i = 15%; PW = -$1,262
By linear interpolation; i = 10.5%.
Therefore, the project is minimally acceptable (i% > MARR)
Problem
Determine the IRR of the following engineering project when the
MARR is 15% per year.
Investment cost
$10,000
Expected life
5 years
Salvage value
-$ 1,000
Annual receipts
$ 8,000
Annual expenses
$ 4,000
Solution:
PW = 0 = -$10,000 $1,000(P/F,i%,5) + (8,000-$4,000)(P/A,i%,5)
By trial and error process, at i = 20%, PW = $1560.50
at i = 25%, PW = $ 429.50
By linear extrapolation, i = 27%, hence the project is acceptable;
> MARR
Example of IRR Method:

A piece of new equipment has been proposed by engineers to
increase the productivity of a certain manual welding operation.
The investment cost $25,000, and the equipment will have a market
value $5,000 at the end of a study period of five years.
Increased productivity attributable to this equipment will amount to
$8,000 per year after extra operating costs have been subtracted
from the revenue generated by the additional production.
If the firm MARR is 20% per year, is this proposal a sound one? Use
the IRR method.
Solution:
PW = 0 = -$25,000 + $8,000(P/A,i%,5) + $5,000(P/F,i%,5)
By trial and error process, at i = 20%, PW = $ 934.30
at i = 25%, PW = -$1847.10
By linear interpolation, i = 22 %.
Therefore, the project is acceptable (i% > MARR)
Example of IRR method

Barron Chemical uses a thermoplastic polymer to enhance the
appearance of certain RV panels.
The first cost of one process was $126,000 with annual costs of
$49,000 and revenues of $88,000.
A salvage value of $33,000 was realized when the process was
discontinued after 8 years.
What rate of return did the company make on the process ?
Solution:
Set FW = 0
FW = 0 = -$126,000 (F/P,i%,8) + ($88,000 - 49,000)
(F/A,i%,8) + $33,000
By trial and error process, at i = 25%, FW = -$55,811
at i = 30%, FW = $64,370
By linear interpolation, i = 27.3%
LCC Selection of HVAC System

Location: X
Discount Factor: 10% real for constant dollar analysis
Energy prices: Fuel type: Electricity at 30 sen /kWh
Useful life of systems: 20 years
Study period: 20 years
Base Date: Jan 2010.
Base Case is a constant volume HVAC system with a reciprocal
chiller , without night-time setback and economiser cycle. Relevant
cash flow:
Initial investment: RM400,000, assumed to occur in a lump sump.
Replacement cost for fan at the end of year 12: RM36,000
Salvage value at the end of 20-year period: RM14,000
Annual electricity cost (250,000 kWh at 30 sen/kWh): RM75,000
Annual OM&R costs: RM30,000
Cash flow Diagram:
Total LCC:
LCC Selection of HVAC System

Location: X
Base Date: Jan 2010.
Alternative: Energy Saving Design
Relevant Cash Flow:
Initial investment: RM440,000, assumed to occur in a lump sump.
Replacement cost for fan at the end of year 12: RM38,000
Salvage value at the end of 20-year period: RM15,000
Annual electricity cost (162,500 kWh at 30 sen/kWh): RM48,750
Annual OM&R costs: RM32,000
Cash flow Diagram:
Total LCC:
LCC Conventional HVAC System

Location: X
2010.
Cost ItemsBase Date: Jan
Base
date
Year
Discount factor
Present value
Cost (RM)
of
occurrence
206,000
206,000
1
2
Capital replacement
(fan)
48,000
14
Capital replacement
(Plant)
240,000
17
Salvage value
80,000
22
Electricity
125,000 kWh at
0.3/kWh
37500
annual
Natural gas
1700 GJ at RM24/GJ
40800
annual
OM&R
28000
annual
Initial investment cost

1st installment
2nd installment
@ i=10%
Total LCC
LCC Energy saving HVAC System
Location: X
Base Date: Jan Base
2010.date
Cost Items
Year
Discount factor
Cost (RM)
of
occurrence
220,000
220,000
1
2
Capital replacement
(fan)
50,000
14
Salvage value
80,000
22
Electricity
100,000 kWh at
0.3/kWh
37500
annual
Natural gas
1180 GJ at RM24/GJ
40800
annual
OM&R
32000
annual
Initial investment cost

1st installment
2nd installment
@ i=10%
Total LCC
Present value
Back Up
57
THE EXTERNAL RATE OF RETURN METHOD ( ERR )
ERR directly takes into account the interest rate ( )

external to a project at which net cash flows generated
over the project life can be reinvested (or borrowed ).
If the external reinvestment rate, usually the firms
MARR, equals the IRR, then ERR method produces same
results as IRR method
CALCULATING EXTERNAL RATE OF RETURN ( ERR )
1. All net cash outflows are discounted to the present (time 0) at %

per compounding period.
2. All net cash inflows are discounted to period N at %.
3. ERR -- the equivalence between the discounted cash inflows and
cash outflows -- is determined.
The absolute value of the present equivalent worth of the net cash
outflows at % is used in step 3.
A project is acceptable when i % of the ERR method is greater
than or equal to the firms MARR
CALCULATING EXTERNAL RATE OF RETURN ( ERR )

N
E
k=0
( P / F,
%, k )( F / P, i %, N )
=
%, N - k )
( F / P,
k=0
Rk = excess of receipts over expenses in period k
Ek = excess of expenses over receipts in period k
N = project life or period of study
= external reinvestment rate per period
N
R ( F / P, %, N - k )
i %= ?
Time
Ek ( P / F, %, k )( F / P, i %, N )
k=0
k = 0k
ERR ADVANTAGES
ERR has two advantages over IRR:

1. It can usually be solved for directly, rather than by trial and
error.
2. It is not subject to multiple rates of return.
Example of ERR Method:

A piece of new equipment has been proposed by
engineers to increase the productivity of a certain
manual welding operation. The investment cost
$25,000, and the equipment will have a market value
$5,000 at the end of a study period of five years.
Increased productivity attributable to this equipment
will amount to $8,000 per year after extra operating
costs have been subtracted from the revenue
generated by the additional production. If the external
investment rate = MARR = 20% per year, what is the
alternatives ERR, and is this proposal a sound one?
Solution:
$25,000(F/P,i%,5) = $8,000(F/A,20%,5) + $5,000
(F/P,i%,5) = $64,532.80/$25,000 = 2.5813
i = 20.88%
Since i > MARR, the alternative is minimally
justified.
Problem 4.32
Summary of the projected costs and annual receipts for a
new product line is presented as follows:
End of Year
Net Cash Flow
0
- $450,000
1
42,500
2
92,800
3
386,000
4
614,600
5
- 202,200
The companys external reinvestment rate per year = MARR
= 10% per year
Solution:
[$450,000 + $42,500(P/F,10%,1) + $202,200(P/F,10%,5)]
(F/P,i%,5)
= $92,800(F/P,10%,3) + $386,000(F/P,10%,2) +
$614,600(F/P,10%,1)
$614,182.73(F/P,i%,5) = $1,265,544
(F/P,i%,5) = 2.0622
By interpolation, i% , ERR = 15.6%
Problem 4.34
Given a cash flow as stated below:

End of Year
Net Cash Flow
0
- $10,000
17
1,400
7
10,000
The external rate of reinvestment for the company =
8% per year.
Solution:
$10,000(F/P.i%,7) = $1,400(F/A,8%,7) + $10,000
(F/P,i%,7) = $22,491.92 / 10,000 = 2.2492
By interpolation, ERR = i% = 12.3%
Problem
A certain project has a net receipts equaling $1,000
now, has costs of $5,000 at the end of the first year, and
earns $6,000 at the end of the second year.
If the external reinvestment rate of 10% is available,
what is the rate of return for this project using the ERR
method ?
Solution:
$5,000(P/F,10%,1)(F/P,i%,2) = $1,000(F/P,10%,2) +
$6,000
(F/P,i%,2) = $7,210 / $4,545.50
= 1.5862
By interpolation, ERR = i% = 25.9%
PAYBACK PERIOD METHOD
Sometimes referred to as simple payout method

Indicates liquidity (riskiness) rather than
profitability
Calculates smallest number of years ( )
needed for cash inflows to equal cash outflows
-- break-even life
ignores the time value of money and all cash

flows which occur
k = 1 after
( R
-Ek) - I > 0
If is calculated to include some fraction of a

year, it is rounded to the next highest year
PAYBACK PERIOD METHOD
The payback period can produce misleading results,

and should only be used with one of the other
methods of determining profitability
A discounted payback period ( where < N ) may
be calculated so that the time value of money is
considered
( Rk - Ek) ( P / F, i %, k ) - I > 0
k=1
i is the MARR
I is the capital investment made at the present time
( k = 0 ) is the present time
is the smallest value that satisfies the equation
Simple Payback Period vs. Discounted Payback Period
EOY
Net c / flow
@ MARR 20%
Cum PW @ i=0%
0
- $25,000
- $25,0000
$25,000
1
8,000
17,000
18,333
2
8,000
9,000
12,777
3
8,000
1,000
8,147
period is at7,000
4th
4 The payback
8,000
years, because the
4,289
balance turns
5 cumulative
13,000
20,000
positive at EOY 4
934
[time value of money is not
considered]
PW @ i=20%
Cum PW
- $25,000
6,667
5,556
4,630
3,858
The payback
period is at 5th year, because the cumulative
discounted5,223
balance turns
positive at EOY 5
[time value of money is
considered]

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Asset Life Study 28th Sept to 1st Oct 2012

Engineering Costs and Cost Estimating

Asset Life Study 28th Sept to 1st Oct 2012

2.0 Engineering Costs and Estimating

Asset Life Study 28th Sept to 1st Oct 2012

2.0 Engineering Costs and Estimating

Asset Life Study 28th Sept to 1st Oct 2012

2.0 Engineering Costs and Estimating

Asset Life Study 28th Sept to 1st Oct 2012

2.0 Engineering Costs and Estimating

Asset Life Study 28th Sept to 1st Oct 2012

2.0 Engineering Costs and Estimating

Asset Life Study 28th Sept to 1st Oct 2012

ECONOMIC EQUIVALENCE FOR FOUR

2.0 Engineering Costs and Estimating

Asset Life Study 28th Sept to 1st Oct 2012

ECONOMIC EQUIVALENCE FOR FOUR

Plan #2: $0 of loan principal paid until end of fourth

2.0 Engineering Costs and Estimating

Principal Total end of

Asset Life Study 28th Sept to 1st Oct 2012

ECONOMIC EQUIVALENCE FOR FOUR

2.0 Engineering Costs and Estimating

Asset Life Study 28th Sept to 1st Oct 2012

ECONOMIC EQUIVALENCE FOR FOUR

2.0 Engineering Costs and Estimating

Asset Life Study 28th Sept to 1st Oct 2012

CASH FLOW DIAGRAMS / TABLE NOTATION

2.0 Engineering Costs and Estimating

ECONOMIC EQUIVALENCE FOR FOUR

2.0 Engineering Costs and Estimating

CASH FLOW DIAGRAM NOTATION

Present expense (cash outflow) of $8,000 for lender.

2.0 Engineering Costs and Estimating

CASH FLOW DIAGRAM NOTATION

Annual income (cash inflow) of $2,524 for lender.

2.0 Engineering Costs and Estimating

CASH FLOW DIAGRAM NOTATION

i = 10% per year

Present expense (cash outflow) of $8,000 for lender.

Annual income (cash inflow) of $2,524 for lender.

Interest rate of loan.

2.0 Engineering Costs and Estimating

CASH FLOW DIAGRAM NOTATION

i = 10% per year

Present expense (cash outflow) of $8,000 for lender.

Annual income (cash inflow) of $2,524 for lender.

Interest rate of loan.

2.0 Engineering Costs and Estimating

Dashed-arrow line indicates

Asset Life Study 28th Sept to 1st Oct 2012

Asset Life Study 28th Sept to 1st Oct 2012

2.0 Engineering Costs and Estimating

Asset Life Study 28th Sept to 1st Oct 2012

Fixed, variable and total

Total cost = Total Fixed cost + Total Variable Cost

Asset Life Study 28th Sept to 1st Oct 2012

2.0 Engineering Costs and Estimating

Asset Life Study 28th Sept to 1st Oct 2012