ENGINEERING ECONOMICS –ASSIGNMENT 4

Name : Dhiraj Nayak

RollNo: 074BME615

Q5.2 Refer to Problem 5.1, and answer the following questions: (a) How long does it take to
recover the investment? (b) If the firm’s interest rate is 15% after taxes, what would be the
discounted payback period for this project?

Answer:

Period Inflow Outflow Net Cumulative cash flow

0 $0 $30,000 ($30,000) ($30,000)
1 $45,000 $5,000 $40,000 $10,000
2 $45,000 $5,000 $40,000 $50,000
3 $45,000 $5,000 $40,000 $90,000
4 $45,000 $5,000 $40,000 $130,000
5 $48,000 $5,000 $43,000 $173,000

(a)

Cumulative cash flow is positive in period 1.

So, the recovery period is 1 year.

(b)

Period Cash Flow cost of funds Cumulative cash

(15%) flow
interest rate
0 (-$30,000) 0 (-$30,000)
1 40,000 -4500 $5,500
2 40,000 $825.00 $46,325.00
3 40,000 $6,948.75 $93,273.75
4 40,000 $13,991.06 $147,264.81
5 40,000 $22,089.72 $209,354.53
Cumulative cash flow is positive in period 1.

So, the recovery period is 1 year.

Q5.3 Consider the following cash flows:

(a) Calculate the payback period for each project.

(b) Determine whether it is meaningful to calculate a payback period for project D.

(c) Assuming that i = 10% ,calculate the discounted payback period for each project.

Answer:

For A for B For C For D

Cumulative Cumulative Cumulative Cumulative
Period Cash Flow cash flow Cash Flow cash flow Cash Flow cash flow Cash Flow cash flow
0 ($2,500) ($2,500) ($3,000) ($3,000) ($5,500) ($5,500) ($4,000) ($4,000)
1 300 ($2,200) 2,000 ($1,000) 2000 ($3,500) 5000 $1,000
2 300 ($1,900) 1500 $500 2000 ($1,500) -3000 ($2,000)
3 300 ($1,600) 1500 $2,000 2000 $500 2500 $500
4 300 ($1,300) 500 $2,500 5000 $5,500 1000 $1,500
5 300 ($1,000) 500 $3,000 5000 $10,500 1000 $2,500
6 300 ($700) 1500 $4,500 2000 $4,500
7 300 ($400) 3000 $7,500
8 300 ($100)

For A , there is no payback period as the initial investment is not recovered in given time span of
8 years.

For B, the payback period is 2 years.

For C, the payback period is 3 years.

For D , the payback period is 1 year, and again for the next investment the payback period is 1
year .

(b). It is meaningful to determine the payback period for project D.

For Project A
Period Cash Flow cost of funds Cumulative cash flow Payback period
(10%)
interest rate
0 (-$2,500) $0.0 (-$2,500.0) No payback period
1 300 (-$250.0) (-$2,450.0)
2 300 (-$245.0) (-$2,395.0)
3 300 (-$239.5) (-$2,334.5)
4 300 (-$233.5) (-$2,268.0)
5 300 (-$226.8) (-$2,194.7)
6 300 (-$219.5) (-$2,114.2)
7 300 (-$211.4) (-$2,025.6)
8 300 (-$202.6) (-$1,928.2)

For Project B
Period Cash Flow cost of funds Cumulative cash flow Payback period
(10%)
interest rate
0 (-$3,000) 0 -($3,000) 2 years
1 2,000 (-$300.0) (-$1,300.0)
2 1500 (-$130.0) $70.0
3 1500 $7.0 $1,577.0
4 500 $157.7 $2,234.7
5 500 $223.5 $2,958.2
6 1500 $295.8 $4,754.0

For Project C
Period Cash Flow cost of funds Cumulative cash flow Payback period
(10%)
interest rate
0 (-$5,500) 0 (-$5,500) 4 years
1 2000 (-$550.0) (-$4,050)
2 2000 (-$405.0) (-$2,455)
3 2000 (-$245.5) (-$701)
4 5000 (-$70.1) $4,229
5 5000 $422.9 $9,652

For Project D
Period Cash Flow cost of funds Cumulative cash flow Payback period
(10%)
interest rate
0 (-$4,000) 0 (-$4,000)
1 5000 (-$400.0) $600.0 1 years
2 -3000 $60.0 (-$2,340.0)
3 2500 (-$234.0) ($74.0)
4 1000 (-$7.4) $918.6 2 years
5 1000 $91.9 $2,010.5
6 2000 $201.0 $4,211.5
7 3000 $421.2 $7,632.7

Q5.4 Consider the following sets of investment projects, all of which have a three-year
investment life.

(a) Compute the net present worth of each project at i = 10%

(b) Plot the present worth as a function of the interest rate (from 0% to 30%) for project B.

Answer:

Project Cash Flows at 10%

n A B C D
0 ($1,500) ($1,200) ($1,600) ($3,100)
1 0 600 -1800 800
2 0 800 800 1900
3 3000 1500 2500 2300
NPW $753.94 $1,133.58 ($696.92) $925.54

Q5.5 You need to know whether the building of a new warehouse is justified under the following
conditions: The proposal is for a warehouse costing $200,000. The warehouse has an expected
useful life of 35 years and a net salvage value (net proceeds from sale after tax adjustments) of
$35,000. Annual receipts of $37,000 are expected, annual maintenance and administrative costs
will be $8,000/year, and annual income taxes are $5,000. Given the foregoing data, which of the
following statements are correct?

(a) The proposal is justified for a MARR of 9%.

(b) The proposal has a net present worth of $152,512 when 6% is used as the interest rate.

(c) The proposal is acceptable, as long as MARR< 11.81%.

(d) All of the preceding are correct.

Answer:

(a)

PV of investment = $200,000
Annual income = $37,000-$8,000-$5,000

= $24,000

PV of $24,000 earned for next 35 years anuually =PV = $24,000(P/A,9%,35)

= $253,603.72

A net salvage of $35,000 is received at end of 35 years .

So , PV = $35,000(P/F,9%,35)

= $1,714.51

Now,

NPW = cash inflow – cash outflow

=$253,603.72 +$1,714.51 -$200,000

= $55,318.23

Since , we have a positive NPW , so the given proposal is justified.

(b)

PV of $24,000 earned for next 35 years anuually =PV = $24,000(P/A,6%,35)

= $347,957.91
A net salvage of $35,000 is received at end of 35 years .

So , PV = $35,000(P/F,6%,35)

= $4,553.68

Now,

NPW = cash inflow – cash outflow

= $347,957.91+$4,553.68 -$200,000

= $152,511.60

(c)

PV of $24,000 earned for next 35 years anuually =PV = $24,000(P/A,11.81%,35)

= $199,133.11
A net salvage of $35,000 is received at end of 35 years .

So , PV = $35,000(P/F,11.81%,35)

=$703.47

NPW = cash inflow – cash outflow

= $199,133.11 + $703.47 - $200,000

= - $163.42

Since the NPW is nearly equal to zero , the statement is true.

Hence , all the options are true.

Q5.6 Your firm is considering purchasing an old office building with an estimated remaining
service life of 25 years. Recently, the tenants signed long-term leases, which leads you to believe
that the current rental income of $150,000 per year will remain constant for the first 5 years.
Then the rental income will increase by 10% for every 5-year interval over the remaining life of
the asset. For example, the annual rental income would be $165,000 for years 6 through 10,
$181,500 for years 11 through 15, $199,650 for years 16 through 20, and $219,615 for years 21
through 25. You estimate that operating expenses, including income taxes, will be $45,000 for
the first year and that they will increase by $3,000 each year thereafter. You also estimate that
razing the building and selling the lot on which it stands will realize a net amount of $50,000 at
the end of the 25-year period. If you had the opportunity to invest your money elsewhere and
thereby earn interest at the rate of 12% per annum, what would be the maximum amount you
would be willing to pay for the building and lot at the present time?

Answer:

Annual operating costs is $45,000 for year 1 and increasing by $3,000. So we can divide this into
a constant A and a gradient G. for the next 25 years.

PV = $45,000(P/A,12%,25) +$3,000(P/G,12%,25)

=$45,000*7.8431 +$3,000*53.1046

= $352,941.26 + $159313.8

= $512,255.06

Net salvage at end of year 25 is $50,000

PV = $50,000(P/F,12%,25)
= $2,941.17

For 1st 5 years for 6-10 years for 11-15 for 16- for 21-25 years
years 20years
A= $150,000 $165,000 $181,500 $199,650.0 $219,615.0
Rate 12% 12% 12% 12% 12%
NPW at year NPW at year NPW at NPW at year
5= 10= year 15 20=
$594,788.07 $654,266.88 $719,693.5 $791,662.93
7

NPW at $540,716.43 $337,498.73 $210,656.43 $131,485.3 $82,069.13

n=0 2
Total PV = $761,709.61

Now , NPW = Cash inflow –cash outflow

=$761,709.61 +$2,941.17 -$512,255.06

= $252,395.72

So the maximum amount that should be paid is $252,395.72.

Q5.7.Suppose the company’s reinvestment opportunities change over the life of the project as
shown in the preceding table (i.e., the firm’s MARR changes over the life of the project). For
example, the company can invest funds available now at 10% for the first year, 11% for the
second year, and so forth. Calculate the net present worth of this investment and determine the
acceptability of the investment.

Answer:

n An i PV
0 ($42,000) 10% ($42,000)
1 $32,400 11% $29,189.19
2 $33,400 13% $26,157.10
3 $32,500 15% $21,369.28
4 $32,500 12% $20,654.34
5 $33,000 10% $20,490.40
NPV $75,860.31
Since the NPV is positive , so the project is acceptable.
Q.5.9 A large food-processing corporation is considering using laser technology to speed up and
eliminate waste in the potato-peeling process. To implement the system, the company anticipates
needing $3.5 million to purchase the industrial strength lasers. The system will save $1,550,000
per year in labor and materials. However, it will require an additional operating and maintenance
cost of $350,000. Annual income taxes will also increase by $150,000. The system is expected to
have a 10-year service life and will have a salvage value of about $200,000. If the company’s
MARR is 18%, use the NPW method to justify the economics of the project.

Answer:

Items value PV
Initial ($3,500,000) ($3,500,000)
investment
Net income $1,050,000 $4,718,790.61
/year
Net Salvage $200,000 $38,212.89
NPV $1,257,004

NPV is positive. Hence the project is justified.