Engineering Economic Analysis

Arif S. Malik
Department of Electrical & Computer
Engineering
College of Engineering

Table of Contents

Time Value of Money

Interest Formulas
Discount Rate
Escalation and Inflation
Depreciation
Classification of Costs
Measure of Price
Criteria used for Project Evaluation

Time Value of Money

Money of the same dollar amount in different time
periods have different values (purchasing power)
Primary Reasons:
(1) Inflation tends to erode the purchasing power
(value) of money, (2) Money can be invested for
intervals of time to earn a real return (i.e.
independent of inflation or deflation), (3) Money
available in a future period is less valuable
because it is not available for use at the present.
3

Fundamental concept (return on

investment)
The mathematical process by which different
monetary amounts are moved either forward or
backward in time to a common point in time is
called present value or present worth analysis.
The process of converting monetary values
forward in time to an equivalent amount is called
compounding.
The process of converting monetary values
backward in time to an equivalent amount is called
discounting

Interest Formulas

Single Compound Amount Formula

Single Present Worth Formula
Uniform Sinking Fund Formula
Uniform Series compound amount formula
Uniform Series Present Worth Formula
Uniform Capital Recovery Formula

The following notation is used in

developing the formulas:
i is an interest or discount rate
N is the number of interest or discounting
periods
P is a present sum of money
F is a future sum of money at the end of N
periods
A is an end-of-period payment (or receipt) in a
uniform series of payments (or receipts) over
N periods at i interest or discount rate.

Single Compound Amount

Formula
P dollars deposited in an account at a
specific rate i grow to P(1+i) by the end of
the first period and to P(1+i)(1+i) by the
end of the second period. In general at the
end of N periods
F=P(1+i)N

(1)

Single Compound Amount Formula

(Contd)
Example 1: Jack deposits $200 in a saving
account that has an interest rate of 8%, then in
4 years time he will have
F = $200*(1+0.08)4
= $200*1.36
= $272
and the FVF is $272/$200 = 1.36

Single Present Worth Formula

The present worth P of a sum N periods in
the future, F, is determined by rearranging
Eq.(1)
(2)

Single Present Worth Formula

(Contd)
1/(1+i)N called the single payment present worth
factor or Present Value Factor (PVF)
i is usually called the discount rate(the discount
rate may be significantly different from the
interest rate). This factor is used whenever a
monetary amount is moved backward in time, i.e.,
it is used to determine the present value of money
N periods in the future

Single Present Worth Formula

(Contd)
Example 2: An expenditure of $5000 will be required at the
end of 2005, and some money must be put aside at the start of
2001 to cover this future expense. If the interest rate is 12%
per year, the present value of that future expense at the start
of 2001 is
P = F/(1+i)N
= $5000/(1.12)5
= $5000/1.7623
= $2837
PVF = P/F = $2837/$5000 = 0.5674

Uniform Sinking Fund Formula

A fund established to accumulate a desired
future amount of money at the end of given
length of time through collection of uniform
series of payments
Each payment called an annuity A, made at the
end of each of N interest periods
The total amount F at the end of each of N
interest periods is the sum of the compound
amounts of the individual payments.

Uniform Sinking Fund Formula

(Contd)
F=A(1+i)N-1 + A(1+i)N-2+. . .+A
(3)
Multiplying the above equation by (1+i) on both sides
(4)
F(1+i)=A(1+i)N+A(1+i)N-1+. . . +A(1+i)
Subtracting (3) from (4), we get
Fi = A(1+i)N-A
or
(5)
The expression i/[(1+i)N-1] is called the sinking fund
factor, SFF.

Uniform Sinking Fund Formula

(Contd)
Example 3: Mortgage bonds with a face value of
$1000 must be saved in 20 years. How much
money should be put into a saving account at the
end of each year (annuity) to meet that bond
commitment if the saving accounts pays 7%? The
answer is
A = (0.02439) $1000 = $24.39

Uniform Series Compound

Amount Formula
A future sum F equivalent to a uniform series of
end-of-period sums A can be determined by
rearranging Eq. (5)
(6)
Where the term in brackets is called the uniform
series Compound Amount Factor (CAF).

Uniform Series Compound

Amount Formula (Contd)
Example 4: A deposit of $100 is placed in a savings
account at the end of each years from 1990 to 1999.
This savings account earns 8% annual interest. The
future value of this account at the end of 1999 will be
F = $100*[(1.08)10 - 1]/0.08
= $100 * 14.487
= $1,448.70

Uniform Series Present Worth

Formula
The present value of annuity P of the future sum at
the start of year 1 to N, discounted at the rate i is
(7)

P = A*PWF(N yr,i%)
(8)
Where PWF is (uniform series) Present Worth Factor
Also, PWF = CAF*PVF
The present value of an above example 4 is $671.

Uniform Series Present Worth Formula (Contd)

Example 5: Present Value of Delayed Annuity. This
examples deals with the present value at the start of 2000 of
an annuity of $1000 per year extending from the end of 2005
until the year 2025, with 10% interest. Payments occur at the
end of each year, including 2025. This would be a 21-year
annuity, with a present value at the start of 2005 of
P2005 = A * PWF(21 yr, 10%)
= $1000 * 8.649
= $8,649
The discounted value at the start of 2000 can be computed
now by discounting P2005 by 5 more years
P2000 = P2005 * PVF(5 yr, 10%)
= $8,649 * 0.6209 = $5,370

Uniform Capital Recovery Formula

The capital recovery factor is used to compute the uniform
annual payment A (i.e. the annuity) the annuity required at
the end of the each year for N years such that the total
discounted value at the start of Year 1, discounted at i%, will
equal the present amount P. By rearranging Eq. (7) we get
(9)
or

A = P * CRF(N yr, i%)

Note that capital recovery factor; (CRF) = 1/ (PWF)

The capital recovery factor is useful for converting an initial
capital cost into an equivalent levelized annual cost of capital
over the lifetime of the capital investment.

Uniform Capital Recovery Formula

(Contd)
Example 6: A plant of capital cost of $50,000 and an expected
lifetime of 20 years has an annuity at 10%
A = P*CRF(20 yrs, 10%)
A = $50,000 * 0.1175
= $5,837
If the present worth of this equivalent annuity is computed, it
will again equal the initial capital cost, as it should be.
P = A * PWF(20 yrs, 10%)
= $5,837 * 8.514
= $50,000

10

Application Exercise
Mr. Jones wishes to establish a fund for his
newborn childs education. The fund pays $60,000
on the childs 18th, 19th, 20th, and 21st birthdays.
The fund will be set up by the deposit of a fixed
sum on the childs 1st through 17th birthdays. The
fund earns 6 percent annual interest. What is the
required annual deposit.
What would the annual payments be, if the tuition
fees in Example 6.2 are $60,000, $67,000,
$75,000 and $83,000, respectively, for the four
years involved?

Escalation and Inflation

Inflation refers to a rise in price levels caused by a decline in
the purchasing power of a currency
Escalation, also refers to a rise in prices, usually classified as
either real or apparent.
Real escalation defined as price rise over and above the
general rate of inflation such as fuel prices and may result
from factors such as resource depletion, new regulations and
increased demand with limited supply.
Apparent escalation rate defined as the total annual rate of
increase in a cost including the effects of both inflation and
real escalation.
The relationship for apparent escalation is as follows:
(1+e) = (1+e/)(1+f)
Where e is the apparent escalation rate, e/ is the real
escalation rate, and f is the inflation rate.

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Escalation and Inflation (Contd)

Example 7: Suppose the price of the coal in 2000 is $1.00/109J,
and the annual inflation rate over the period 2000-2010 is 6%.
Assume that the price of the coal will escalate over the period
at an average annual rate of 1.5%. The price of coal in the year
2010, expressed in 2000 dollars, can then be
Coal price in year 2010 = (coal price in 2000)*(1+e/)10
(year 2000 dollars)
= $1.00/109J x (1.015)10
= $1.16/109J.
If the effects of inflation are included, then the coal price in the
year 2010 dollars, can be determined:
Coal price in year 2010 = (coal price in 2000)*(1+e)10
(year 2010 dollars)
= $1.00/109J x (1.015x1.06)10
= $2.08/109J

Escalation and Inflation (Contd)

Long-range planning studies can be
performed by either including or excluding
inflationary effects. In both cases, however,
it is essential that all cost and economic
parameters used in a study (e.g. the discount
rate and escalation rates) be treated
consistently.

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Concept of Opportunity Cost

Opportunity cost is the cost of doing something as
measured by the loss of the opportunity to do
something else, with the same amount of time and
resources.
Example 8: Suppose you are a lawyer whose
salary is $100 per hour. You spend 2 hours in
typing and organizing material per day, which you
could have spent doing more law work. If you hire
a secretary to do all the typing and organizing you
will have to pay the secretary $10 per hour, then
the opportunity cost incurred by not hiring a
secretary is $90 per hour.

Discount Rate
Critical economic parameter
Theoretically it reflects the opportunity cost of
money to a particular investor (or in broad terms,
in a particular country)
Since the opportunity cost is linked to the
prevailing conditions within a given country, the
discount rate, like the inflation rate, tends to vary,
often significantly, from country to country

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Effect of Discount Rate on project

selection
Project A

Project B

Costs ($)

Revenue($)

Cost ($)

Revenue ($)

15,000

10,000

5,000

5000

6000

4000

6000

3000

6000

2000

6000

1000

6000

Effect of Discount Rate

$12,000

NetPresentValue

$10,000

ProjectA
ProjectB

$8,000
$6,000
$4,000
$2,000
$0
0%

5%

10%

15%

20%

DiscountRate

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Depreciation
Decrease in worth
Cost accounting viewpoint (Annual charge
against revenues used to repay the original
amount of capital borrowed from investors)
Expansion planning studies depreciation is used
for calculating salvage value for equipment that
have expected lifetimes extending beyond the
end of study period.

Depreciation (Contd)
Four commonly used depreciation methods are:
Straight-line
Sum-of-the-year digits
Declining balance
Sinking fund

15

Comparison of depreciation methods

Accumulated Depreciation (per unit)

1.0
Sum-of-the
year digits
DoubleDeclining
balance
Straight
line
Sinking Fund

Time

End of plant life

Depreciation (Contd)
Sum-of-the-year digits and Declining balance
methods are designed to increase cash flow in the
early years of investment
In straight-line depreciation method the
depreciation charged each year constant
In sinking fund the depreciation is lowest at the
beginning of life and increase with time
Whatever the method used, however, the sum of
all annual depreciation charges over the life of the
alternative must equal initial investment in the
alternative less the salvage value

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Classification of Costs
Basic Cost Concept
Cheap to build or buy (First cost)
Produce goods and services at the lowest
possible cost
Two distinct merit of figures are therefore
1. Capital Investment Cost
2. Variable Cost

Capital Investment Costs

Capital outlay necessary to build a plant or purchase
an equipment and bring it into operation. For
example, hydroelectric, coal and nuclear power
plants, the fixed investment charges are the largest
contributor to power generation cost.
Total capital investment costs include construction
or overnight costs of building the facility,
commonly known as fore costs and costs related to
escalation and inflation charges accrued during the
project.

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Fixed Costs
Fixed Costs:
Fixed Cost can be further subdivided:
i)
Fixed Investment Charges
ii) Fixed O&M costs
iii) Taxes and Insurance

Fixed Cost (Contd)

i) Fixed Investment Charges: Fixed
Investment
Charges are a function of Capital Investment costs
and include
Depreciation (i.e. the annual charge for recovering
the initial capital investment in equipment or asset).
Return on Investment (for private organizations for
example, this includes interest paid to bondholders
and return to stockholders.

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Fixed Cost (Contd)

ii) Fixed O&M Costs: Include staff salaries,
consumables supplies and equipment,
miscellaneous costs etc.
iii) Taxes and Insurance: These are also
kind of fixed costs.

Variable Cost
Variable Costs
Depends directly on the amount of units produced
for example electricity generated (they are expressed
in terms of a monetary amount per kWh of
production). The variable costs can be further
subdivided:
i)
Variable O&M costs:
could be consumable
items which need to be replaced after certain number
of hours of service.
ii)
Variable Fuel costs:
The cost related to
fuel actually spent and used in energy production.

19

Sunk Costs
It is already incurred cost or committed cost.
Such treatment of costs may results in high
investment returns. For example, a dam has
already been built for a hydro-electric project.
Now if a generating unit is added, the dam
cost will be considered as sunk cost and an
additional unit cost will only be considered in
testing the economy.

Life Cycle Cost

LCC is :
Total Initial cost + the running costs associated
with operating the system throughout its lifetime.
LCC include:
1. Initial cost of installing the project
2. Replacement of components when they wear out
3. Regular maintenance
4. System overhauls costs
5. Operating costs
6. Administrative and overhead costs

20

Measure of Price
Public Versus Private Perspective
Objective: Both want to maximize the income level and
minimize the risk of losses.
Price distortion caused by taxes, duties or subsidies distorts
the consumption of various goods and services. When prices
become misleading they produce wastage and provide little or
no incentive for conservation. Because of price distortions, a
conservation measure may be highly desirable from the
national (social) point of view, but quite unattractive as seen
by the private industrialist.

Shadow Pricing

1.
2.
3.
4.

Prices and costs in economic terms - measured from

public point of view.
Adjustments to prices made to reflect more closely the
true social cost or the opportunity cost to the society, the
new value assigned becomes the shadow price
Four major categories where shadow adjustment must
be estimated
Miscellaneous social-cost/private cost discrepancies
especially in public provided services
Labour and wages
Capital charges and discount rates
Fiscal distortions, including sales taxes, duties, and
subsidies.

21

Miscellaneous SocialCost/Private-Cost Discrepancies

For example, in terms of failure to account for
pollution or environmental degradation in the
calculation of a coal-fired power plant or the high
subsidies and/or cross subsides in residential sectors
of electricity tariff. Such examples represent very
large deviations between public and private costs.
Subsidies are transfer payments used by
governments to redistribute income or achieve some
other social objective. They do not represent the use
of resources and hence are not a cost to economy.

Labour and Wages

Prices of labour should reflect the opportunity cost of its use.
In developing countries the opportunity cost of labours is
normally less than what the governments have fixed because
of high unemployment rate.
Example: Suppose in a country X, the monthly salary of a
professor is the same as that of a janitor. The opportunity
cost of both men to the economy is not the same, one should
apply a shadow wage rate to reflect the real opportunity cost
of labour in economic analysis.

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Capital Charge and Discount Rates

The opportunity cost of capital is defined as discount
rate, which is equal to the rate of return earned by
the marginal project in an investment portfolio. In
the case of national economic development, the
investment portfolio would consist of all projects to
be carried out within the capital budget constraint as
determined by the availability of the foreign
exchange and local currency. Economic analyst
suggests that true value of discount rate for society to
use.

Fiscal Distortions, including Sales

taxes, duties and Subsidies
Price distortions by governments do not represent a
resource cost and thus should be omitted from the
calculation of both benefits and costs.
Border prices represents the economic costs and
gains in terms of foreign exchange. Therefore, CIF
(cost, insurance, freight) price for imports and FOB
(free on board) price for exports - paid directly in
foreign exchange should be used. A good example
is petroleum. Duties must be removed from
domestic prices, i.e., prices of goods on the local
market, to determine the economic cost.

23

Fiscal Distortions, including Sales

taxes, duties and Subsidies (Contd)
The distortions can be removed by simple
conversion factor used in border pricing called
Standard Conversion Factor (SCF) which is an
estimate of the average distortions between border
and local prices as measured by the ratio of total
trade excluding all duties, taxes and subsidies to the
actual recorded value of trade.

Other Price Adjustments

Apart from the above mentioned categories for
shadow adjustments, there is another category
called Shadow Exchange Rate. In some countries
government artificially adjust their currency rate
with dollars. Getting foreign exchange legally there
is difficult because the value is set artificially.
Whereas foreign exchange available in black
market is much higher in price. In such countries
for foreign exchange component of the costs, the
shadow exchange rate should be used.

24

Current Vs Constant Prices

It is important that the analysts understand the origin of any
price figures used in analytical work. Price deflators
(inflators) must be used to convert earlier cost estimates to
present-day prices or current costs to future prices. A most
common indicator used is the Consumer price index.
Consumer Price Index: Measure changes in price of a given
basket of market goods

Criteria for Evaluation of Projects

There are three commonly used criteria for
evaluating projects:
1. Present Worth Values
2. Yield
3. Payback or Capital Recovery Time
In the discussion that follows:
Rt denotes revenues (or benefits) in year t.
Ct denotes costs in year t
N expected project life N time periods

25

Criteria Based on Present Worth

Values
Four present worth criteria
i. Maximum net present worth
ii. Minimum present worth of costs
iii. Minimum present worth of unit costs
iv. Benefit-to-cost ratio

Maximum net present worth

All present worth criteria involves ranking

alternatives according to their net discounted
profits according to the difference between the
present value of benefits and the present value
of costs.

26

Minimum Present Worth of Costs

With appropriate assumptions or corrections
for equality of service expected from each
alternative considered, the criterion of
minimum present worth of costs can be used.

Minimum Present Worth of Unit

Costs
It is almost same as above but it does, however, automatically
corrects for inequalities such as differences of size and
estimated operating lives. The unit generating cost of a
station whose construction, fueling and operation involve a
cost stream Ct, and whose energy output over time is
expected to be Et, is defined as:

27

Benefit-to-Cost Ratio
This criterion sometime is used in large power and water
projects by the ratios of the present worth values of revenues
to the present worth values of costs.

This formulation gives a measure of the discounted benefits

per dollar of discounted costs.

Criteria Based on Yield

Internal Rate of Return
It is defined as the rate of discount at which the net present
worth of the operation becomes zero. To distinguish the
internal rate of return from the conventional discount rate, the
symbol r is used in the formulation.

Its advantage is, it is not using any discount rate. The project
can be considered economical if internal rate of return is more
than acceptable discount rate.

28

Criteria Based on Payback or Capital

Recovery Time
Criteria based on payback time have often been applied to
plant selection both in planned economies and in private
enterprise. In general, the payback time T/ is defined by
equation:

Short payback is preferable over longer payback period.

Ranking based on this criterion ignore the benefits and costs
that extend beyond the payback period and are often criticized
as being nearsighted.

Criteria Based on Payback or Capital

Recovery Time (Contd)
If the cost stream Ct is broken down into an investment (I)
that is made at one point in time, and variable costs (Ft)
covering, for instance fuel, O&M costs in the case of a power
plant, the above equation can be written in the following
form.

In this form, time T/ clearly appears as the time required for

net operational revenues to payback the capital investment.

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Discounted Payback period

Discounted payback :
Some firm employ the discounted payback period, rather than the simple
payback period.
Ex : Our initial investment is $200
1
2
3
4

Year

Cash flow
$100.00
100.00
81.70
100.00

np = 2 years

Discounted cash flow at a 20% discount rate are:

1
2
3
4

Year

Cash flow
$83.30
69.94
47.30
48.20

np = 3 years

Example 1
Suppose a new restaurant that just opened up had incurred
an initial cost of $5000 and is expected to stay open for the
next 3 years. The net benefit for the next 3 years is expected
to be $3000 per year. What is the net present worth of the
investment? Should the investment have to be invested?
The discount rate is 9%.
Solution: Apply the equation for net present worth (NPV)
C0 = $ -5,000
R1 = R2 = R3 = $3,000
then
NPV=-5000+3000*(1/1.09)+3000*(1/1.09)2+3000*(1/1.09)3
NPV = $2593.88
Therefore, the project should be accepted, since NPV>0

30

Example 2
Find the internal rate of return (IRR) for the above
example.
0 = -5,000 + 3000{1/(1+r%) + 1/(1+r%)2
+1/(1+r%)3}
Solving this equation gives an IRR of 36.31%
which is much higher than the opportunity cost of
capital (9% in this example).

Example 3
Project C0
A
-100
B -10,000

R1
+200
+15,000

IRR,%
100
50

NPV@10%
82
3,636

Both are good project, but B has the higher NPV and is,
therefore, better. However, the IRR rule seems to indicate
that if you have to choose, you should go for A since it has
the higher IRR. If you follow the IRR rule, you have the
satisfaction of earning a 100% rate of return; if you follow
the NPV rule, you are 3,636 richer.

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Example 4
Cash Flow($)

Projects
A
-2000
+1000
+1000
+5000

B
-2000
0
+2000
+5000

C
-2000
+1000
+1000
+100,000

NPV@10%
+3,492
Payback Period (yrs) 2

+3,409
2

+74,867
2

C0
R1
R2
R3

The payback rule says that they all are equally attractive.
But according to NPV the project C is the best project.

Example 5
Project
A
B

C0
-100
-10,000

R1
+220
+14,000

NPV@10
100
2,727

B/C ratio
2
1.27

Both are acceptable projects, since the benefit-to-cost ratio

in both cases are greater than 1.0. Using the benefit-cost
ratio as tool of evaluation, we ought to choose project A.
However, project B has a much higher NPV.

32

Conclusions
In case where a discount rate is reasonably
established, present worth analysis is certainly the
most comprehensive approach.
When discount rate is unknown or fixed at
artificial level, the rate of return provide more
useful information.
Payback criterion is useful for quick preliminary
assessments.

Example 6
Consider a hydroelectric project with a capacity of
120MW, average annual energy generation of 600
GWh/yr, a total cost of $150 million a construction
period of 5 years with cost disbursements of 20%
each year, and a useful economic lifetime of 50 years
after the start of operation. The annual operation and
maintenance costs will be $1,500,000/yr and the
interest rate is 12%. There is no inflation. Find the
average unit cost of energy.

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Example 6 (Contd)
Solution: The future value of construction costs, which is
equal to the construction cost plus accumulated Interest
During Construction, (IDC), called Capitalized cost is
calculated at the end of year 5, which is the project
commissioning date.
Construction
year

Construction
Cost

Future value
Factor @12%

Original Cost
and IDC

30,000,000

1.574

47,220,000

30,000,000

1.405

42,150,000

30,000,000

1.254

37,620,000

30,000,000

1.120

33,600,000

30,000,000

1.000

30,000,000

Total

190,590,000

Example 6 (Contd)
It is assumed that all construction costs are paid at the end of each year,
and also that all O&M costs and annual benefits occur at the end of each
year.
The levelized annual capital cost or annual fixed investment charge is
CRF(50 yr, 12%)*Capitalized Cost
12.04% * $190,590,000
Add annual O&M costs
Total uniform annual cost

= $22,947,000/yr
= $ 1,500,000/yr
= $24,447,000/yr

Now divide by annual benefits to calculate the average unit cost of energy.

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