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6. Economic Evaluation of Facility Investments
6.1 Project Life Cycle and Economic Feasibility
Facility investment decisions represent major commitments of corporate resources and have serious
consequences on the profitability and financial stability of a corporation. In the public sector, such
decisions also affect the viability of facility investment programs and the credibility of the agency in
charge of the programs. It is important to evaluate facilities rationally with regard to both the
economic feasibility of individual projects and the relative net benefits of alternative and mutually
exclusive projects.
This chapter will present an overview of the decision process for economic evaluation of facilities with
regard to the project life cycle. The cycle begins with the initial conception of the project and
continues though planning, design, procurement, construction, start-up, operation and maintenance. It
ends with the disposal of a facility when it is no longer productive or useful. Four major aspects of
economic evaluation will be examined:
1. The basic concepts of facility investment evaluation, including time preference for
consumption, opportunity cost, minimum attractive rate of return, cash flows over the planning
horizon and profit measures.
2. Methods of economic evaluation, including the net present value method, the equivalent
uniform annual value method, the benefit-cost ratio method, and the internal rate of return
method.
3. Factors affecting cash flows, including depreciation and tax effects, price level changes, and
treatment of risk and uncertainty.
4. Effects of different methods of financing on the selection of projects, including types of
financing and risk, public policies on regulation and subsidies, the effects of project financial
planning, and the interaction between operational and financial planning.
In setting out the engineering economic analysis methods for facility investments, it is important to
emphasize that not all facility impacts can be easily estimated in dollar amounts. For example, firms
may choose to minimize environmental impacts of construction or facilities in pursuit of a "triple
bottom line:" economic, environmental and social. By reducing environmental impacts, the firm may
reap benefits from an improved reputation and a more satisfied workforce. Nevertheless, a rigorous
economic evaluation can aid in making decisions for both quantifiable and qualitative facility impacts.

3. Estimate the cash flow profile for each project.
4. Specify the minimum attractive rate of return (MARR).
5. Establish the criterion for accepting or rejecting a proposal, or for selecting the best among a
group of mutually exclusive proposals, on the basis of the objective of the investment.
6. Perform sensitivity or uncertainty analysis.
7. Accept or reject a proposal on the basis of the established criterion.
It is important to emphasize that many assumptions and policies, some implicit and some explicit, are
introduced in economic evaluation by the decision maker. The decision making process will be
influenced by the subjective judgment of the management as much as by the result of systematic
analysis.
The period of time to which the management of a firm or agency wishes to look ahead is referred to as
the planning horizon. Since the future is uncertain, the period of time selected is limited by the ability
to forecast with some degree of accuracy. For capital investment, the selection of the planning horizon
is often influenced by the useful life of facilities, since the disposal of usable assets, once acquired,
generally involves suffering financial losses.
In economic evaluations, project alternatives are represented by their cash flow profiles over the n
years or periods in the planning horizon. Thus, the interest periods are normally assumed to be in years
t = 0,1,2, ...,n with t = 0 representing the present time. Let B
t,x
be the annual benefit at the end of year
178
t for a investment project x where x = 1, 2, ... refer to projects No. 1, No. 2, etc., respectively. Let C
t,x

be the annual cost at the end of year t for the same investment project x. The net annual cash flow is
defined as the annual benefit in excess of the annual cost, and is denoted by A
t,x
at the end of year t for
an investment project x. Then, for t = 0,1, . . . ,n:
(6.1)

The basic principle in assessing the economic costs and benefits of new facility investments is to find
the aggregate of individual changes in the welfare of all parties affected by the proposed projects. The
changes in welfare are generally measured in monetary terms, but there are exceptions, since some
effects cannot be measured directly by cash receipts and disbursements. Examples include the value of
human lives saved through safety improvements or the cost of environmental degradation. The
difficulties in estimating future costs and benefits lie not only in uncertainties and reliability of
measurement, but also on the social costs and benefits generated as side effects. Furthermore, proceeds
and expenditures related to financial transactions, such as interest and subsidies, must also be
considered by private firms and by public agencies.
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To obtain an accurate estimate of costs in the cash flow profile for the acquisition and operation of a
project, it is necessary to specify the resources required to construct and operate the proposed physical
facility, given the available technology and operating policy. Typically, each of the labor and material
resources required by the facility is multiplied by its price, and the products are then summed to obtain
the total costs. Private corporations generally ignore external social costs unless required by law to do
so. In the public sector, externalities often must be properly accounted for. An example is the cost of
property damage caused by air pollution from a new plant. In any case, the measurement of external
costs is extremely difficult and somewhat subjective for lack of a market mechanism to provide even
approximate answers to the appropriate value.
In the private sector, the benefits derived from a facility investment are often measured by the
revenues generated from the operation of the facility. Revenues are estimated by the total of price
times quantity purchased. The depreciation allowances and taxes on revenues must be deducted
according to the prevailing tax laws. In the public sector, income may also be accrued to a public
agency from the operation of the facility. However, several other categories of benefits may also be
included in the evaluation of public projects. First, private benefits can be received by users of a
facility or service in excess of costs such as user charges or price charged. After all, individuals only
use a service or facility if their private benefit exceeds their cost. These private benefits or consumer
surplus represent a direct benefit to members of the public. In many public projects, it is difficult,
impossible or impractical to charge for services received, so direct revenues equal zero and all user
benefits appear as consumers surplus. Examples are a park or roadways for which entrance is free. As

of the cost of capital over the period of investment. If the benefits and costs over time are expressed in
constant dollars, the constant value for MARR represents the average real interest rate anticipated over
the planning horizon; if the benefits and costs over time are expressed in then-current dollars, the
constant value for MARR reflects the average market interest rate anticipated over the planning
horizon.
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181
6.5 Investment Profit Measures
A profit measure is defined as an indicator of the desirability of a project from the standpoint of a
decision maker. A profit measure may or may not be used as the basis for project selection. Since
various profit measures are used by decision makers for different purposes, the advantages and
restrictions for using these profit measures should be fully understood.
There are several profit measures that are commonly used by decision makers in both private
corporations and public agencies. Each of these measures is intended to be an indicator of profit or net
benefit for a project under consideration. Some of these measures indicate the size of the profit at a
specific point in time; others give the rate of return per period when the capital is in use or when
reinvestments of the early profits are also included. If a decision maker understands clearly the
meaning of the various profit measures for a given project, there is no reason why one cannot use all
of them for the restrictive purposes for which they are appropriate. With the availability of computer
based analysis and commercial software, it takes only a few seconds to compute these profit measures.
However, it is important to define these measures precisely:
1. Net Future Value and Net Present Value. When an organization makes an investment, the
decision maker looks forward to the gain over a planning horizon, against what might be gained if the
money were invested elsewhere. A minimum attractive rate of return (MARR) is adopted to reflect
this opportunity cost of capital. The MARR is used for compounding the estimated cash flows to the
end of the planning horizon, or for discounting the cash flow to the present. The profitability is
measured by the net future value (NFV) which is the net return at the end of the planning horizon
above what might have been gained by investing elsewhere at the MARR. The net present value (NPV)
of the estimated cash flows over the planning horizon is the discounted value of the NFV to the
present. A positive NPV for a project indicates the present value of the net gain corresponding to the

the evaluation of a project, an adjusted internal rate of return (AIRR) which reflects such policies may
be a useful indicator of profitability under restricted circumstances. Because of the complexity of
financing and reinvestment policies used by an organization over the life of a project, the AIRR
seldom can reflect the reality of actual cash flows. However, it offers an approximate value of the
yield on an investment for which two or more sign reversals in the cash flows would result in multiple
values of IRR. The adjusted internal rate of return is usually calculated as the internal rate of return on
the project cash flow modified so that all costs are discounted to the present and all benefits are
compounded to the end of the planning horizon.
6. Return on Investment. When an accountant reports income in each year of a multi-year project,
the stream of cash flows must be broken up into annual rates of return for those years. The return on
investment (ROI) as used by accountants usually means the accountant's rate of return for each year of
the project duration based on the ratio of the income (revenue less depreciation) for each year and the
undepreciated asset value (investment) for that same year. Hence, the ROI is different from year to
year, with a very low value at the early years and a high value in the later years of the project.
7. Payback Period. The payback period (PBP) refers to the length of time within which the benefits
received from an investment can repay the costs incurred during the time in question while ignoring
the remaining time periods in the planning horizon. Even the discounted payback period indicating the
"capital recovery period" does not reflect the magnitude or direction of the cash flows in the remaining
periods. However, if a project is found to be profitable by other measures, the payback period can be
used as a secondary measure of the financing requirements for a project.
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6.6 Methods of Economic Evaluation
The objective of facility investment in the private sector is generally understood to be profit
maximization within a specific time frame. Similarly, the objective in the public sector is the
maximization of net social benefit which is analogous to profit maximization in private organizations.
Given this objective, a method of economic analysis will be judged by the reliability and ease with
which a correct conclusion may be reached in project selection.
183
The basic principle underlying the decision for accepting and selecting investment projects is that if an

equal to zero are acceptable. That is, project x is acceptable as long as
184
(6.6)

For mutually exclusive proposals (x = 1,2,...,m), a proposal j should be selected if it has the maximum
nonnegative net present value among all m proposals, i.e.
(6.7)

provided that NPV
j
0.
Net Future Value Method
Since the cash flow profile of an investment can be represented by its equivalent value at any specified
reference point in time, the net future value (NFV
x
) of a series of cash flows A
t,x
(for t=0,1,2,...,n) for
project x is as good a measure of economic potential as the net present value. Equivalent future values
are obtained by multiplying a present value by the compound interest factor (F|P,i,n) which is (1+i)
n
.
Specifically,
(6.8)

Consequently, if NPV
x
0, it follows that NFV
x
0, and vice versa.

proposals generally does not necessarily lead to the maximum net benefit. Consequently, it is
necessary to perform incremental analysis through pairwise comparisons of such proposals in selecting
the best in the group. In effect, pairwise comparisons are used to determine if incremental increases in
costs between projects yields larger incremental increases in benefits. This approach is not
recommended for use in selecting the best among mutually exclusive proposals.
Internal Rate of Return Method
The term internal rate of return method has been used by different analysts to mean somewhat
different procedures for economic evaluation. The method is often misunderstood and misused, and its
popularity among analysts in the private sector is undeserved even when the method is defined and
interpreted in the most favorable light. The method is usually applied by comparing the MARR to the
internal rate of return value(s) for a project or a set of projects.
A major difficulty in applying the internal rate of return method to economic evaluation is the possible
existence of multiple values of IRR when there are two or more changes of sign in the cash flow
profile A
t,x
(for t=0,1,2,...,n). When that happens, the method is generally not applicable either in
determining the acceptance of independent projects or for selection of the best among a group of
mutually exclusive proposals unless a set of well defined decision rules are introduced for incremental
analysis. In any case, no advantage is gained by using this method since the procedure is cumbersome
even if the method is correctly applied. This method is not recommended for use either in accepting
independent projects or in selecting the best among mutually exclusive proposals.
Example 6-1: Evaluation of Four Independent Projects
The cash flow profiles of four independent projects are shown in Table 6-1. Using a MARR of 20%,
determine the acceptability of each of the projects on the basis of the net present value criterion for
accepting independent projects.
TABLE 6-1 Cash Flow Profiles of Four Independent Projects (in $ million)
t A
t,1
A
t,2

30.0
50.0
Using i = 20%, we can compute NPV for x = 1, 2, 3, and 4 from Eq. (6.5). Then, the acceptability of
each project can be determined from Eq. (6.6). Thus,
[NPV
1
]
20%
= -77 + (235)(P|F, 20%, 5) = -77 + 94.4 = 17.4
[NPV
2
]
20%
= -75.3 + (28)(P|U, 20%, 5) = -75.3 + 83.7 = 8.4
[NPV
3
]
20%
= -39.9 + (28)(P|U, 20%, 4) - (80)(P|F, 20%, 5)
= -39.9 + 72.5 - 32.2 = 0.4
[NPV
4
]
20%
= 18 + (10)(P|F, 20%, 1) - (40)(P|F, 20%, 2)
- (60)(P|F, 20%, 3) + (30)(P|F, 20%, 4) + (50)(P|F, 20%, 5)
= 18 + 8.3 - 27.8 - 34.7 + 14.5 + 20.1 = -1.6
Hence, the first three independent projects are acceptable, but the last project should be rejected.
It is interesting to note that if the four projects are mutually exclusive, the net present value method
can still be used to evaluate the projects and, according to Eq. (6.7), the project (x = 1) which has the

or n refers to the particular year under consideration. Then,
(6.11)

and
(6.12)

The depreciation methods most commonly used to compute D
t
and B
t
are the straight line method,
sum-of-the-years'-digits methods, and the double declining balanced method. The U.S. Internal
Revenue Service provides tables of acceptable depreciable schedules using these methods. Under
straight line depreciation, the net depreciable value resulting from the cost of the facility less salvage
value is allocated uniformly to each year of the estimated useful life. Under the sum-of-the-year's-
digits (SOYD) method, the annual depreciation allowance is obtained by multiplying the net
depreciable value multiplied by a fraction, which has as its numerator the number of years of
remaining useful life and its denominator the sum of all the digits from 1 to n. The annual depreciation
allowance under the double declining balance method is obtained by multiplying the book value of the
previous year by a constant depreciation rate 2/n.
To consider tax effects in project evaluation, the most direct approach is to estimate the after-tax cash
flow and then apply an evaluation method such as the net present value method. Since projects are
often financed by internal funds representing the overall equity-debt mix of the entire corporation, the
deductibility of interest on debt may be considered on a corporate-wide basis. For specific project
financing from internal funds, let after-tax cash flow in year t be Y
t
. Then, for t=0,1,2,...,n,
(6.13)

where A

Depreciation
D
t

Taxable
Income
A
t
-D
t

Income
Tax
X
t
(A
t
-D
t
)
After-Tax Cash-
Flow
Y
t

0
1-5
each
5 only
- $55,000