b2cb53 - Lecture 06 EE

Lecture 06
Engineering Economics
Methods of Evaluating a
Single Project
Capital Budgeting
 Capital Budgeting refers to the process of planning expenditures
that give rise to revenues or returns over a number of years.
 Capital Budgeting is of crucial importance to a firm.
 Capital budgeting is the process a business undertakes to
evaluate potential major projects or investments.
 Construction of a new plant or a big investment in an outside
venture are examples of projects that would require capital
budgeting before they are approved or rejected.
 As part of capital budgeting, a company might assess a

prospective project's lifetime cash inflows and outflows to
determine whether the potential returns that would be generated
meet a sufficient target benchmark.
 The process is also known as investment appraisal.

 Capital budgeting is the process that a business uses to
determine which proposed fixed asset purchases it should
accept, and which should be declined.
 This process is used to create a quantitative view of each
proposed fixed asset investment, thereby giving a rational
basis for making a judgment.
 In other words Capital budgeting is a method of analyzing
and comparing substantial future investments and
expenditures to determine which ones are most worthwhile.
 In other words, it’s a process that company management
uses to identify what capital projects will create the biggest
return compared with the funds invested in the project.
 Each project is ranked by its potential future return, so the
company management can choose which one to invest in
first.
1. Present Value
2. Future Value
3. Net Present Value
4. Internal Rate of Return
5. Pay Back Period
6. Benefit Cost Ratio

1. NET PRESENT VALUE
 The Net Present Value or Net Present Worth (NPW) is one of the most important
decisions making criteria under certainty.
 When the costs and expected benefits are of a project are certain (Known), then
the NPV criteria may be used for the acceptance or rejection of a project.
 A project is acceptable if NPV is positive.
 NPV is computed by finding the difference between the discounted benefits and
discounted costs streams. Arithmetically
NPV= ∑
(1+r)t
 The major problem associated with using the NPV method is the appropriate
discount rate.
 It is always discounted at the opportunity cost of capital.
 The NPV method reduces a stream of costs and benefits to a single number in
which future costs and benefits are discounted.
 Of course the higher the NPV, the better is a project.
Example 1. Find the NPV of the following by 14%
discount rate, given the costs and benefits.
Years Gross costs Gross Net Benefits Discount
(Ct) Benefits (Bt) (Bt – Ct) Factor (1+r)t
1 / (1+r)t
2001 (0) 2000 0 -2000 1 -2000

2002 (1) 8000 0 -8000 0.877 -7016
2003 (2) 7000 6000 -1000 0.769 769
2004 (3) 5000 10000 5000 0.675 3375
2005 (4) 5000 10000 5000 0.592 2960
2006 (5) 5000 10000 5000 0.519 2595
2007 (6) 5000 10000 5000 0.456 2280
1425
Example 2
For a project, the Receipts and costs streams are

enumerated as below
Initial cost= Rs. 1000
Investment after one year= Rs.15000
Annual expenditure after two years= Rs.5000
Annual receipts after 2nd year-= rs.9000
Workout NPV at 15% if the project life is ten years
Salvage value = 4000
Years Initial Annual Gross Gross Net Discount
Cost expenditur Costs (Ct) Benefits benefits Factor (1+r)t
e (Bt) (Bt-Ct) 1 / (1+r)t
0 1000 - 1000 -
1 15000 - 15000 -
2 - 5000 5000 9000
3 - 5000 5000 9000
4 - 5000 5000 9000
5 - 5000 5000 9000
6 - 5000 5000 9000
7 - 5000 5000 9000
8 - 5000 5000 9000
9 -- 5000 5000 9000
10 - 5000 5000 9000
Salvage - 4000
Value
NPV= 3534
Example 3
Find NPV at 12% if the costs and benefits are given
below
Years Initial Costs Misc.Cost
Gross Benefits
0 12000 - -
1 - 5000 5000
2-3 - 4000 8000
4-7 - 3000 10000
8 - 4000 11000
9-11 - 2000 7000
Years Initial Misc. Cost Gross Gross Net Discount
Cost Costs (Ct) Benfits benfits Factor (1+r)
(Bt) (Bt-Ct) 1 / (1+r)t
0 12000 - 12000 -
1 - 5000 5000 5000
2 - 4000 4000 8000
3 - 4000 4000 8000
4 - 3000 3000 10000
5 - 3000 3000 10000
6 - 3000 3000 10000
7 - 3000 3000 10000
8 - 4000 4000 11000
9 -- 2000 2000 7000
10 - 2000 2000 7000
11 - 2000 2000 7000
Salvage - 15000
Value
NPV 18276
Example 4.
Find NPV at 8% if the costs and benefits are given below
Year Initial Operatin Gross Gross Net Discoun

cost g Cost Benefits Costs benefits t Factor (1+r)
(Bt-Ct) 1 / (1+r)t
0 10000 - - 1000
1 - 300 1500 300
2 - 300 2000 300
3 - 300 2500 300
4 - 300 3000 300
5 - 300 3500 300
6 300 4000 300
7 - 300 4500 300
8 - 300 5000 300
9 - 300 5500 300
S.Value - 6000
NPV= 10933
For details
https://onlinelibrary.wiley.com/doi/pdf/10.1002/9780470404324.hof003055
https://www.csie.ntu.edu.tw/~lyuu/Capitals/lessons_tvm.pdf

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Lecture 06

 As part of capital budgeting, a company might assess a

 The process is also known as investment appraisal.

3. Net Present Value

4. Internal Rate of Return

5. Pay Back Period

6. Benefit Cost Ratio

2001 (0) 2000 0 -2000 1 -2000

For a project, the Receipts and costs streams are

Year Initial Operatin Gross Gross Net Discoun

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