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Engineering Economy

Capital Budgeting Overview

o Investment capital represents a scarce resource;

o Generally more projects for funding consideration

than there are funds available to fund.

o Some projects may be funded and some may not!

o We have, then, the independent project selection

problem.

Independent Projects

o Independent Projects:

n A set of projects ( two or more) are independent if:

o The cash flows of one project do not in anyway impact

the cash flows of any other project in the set.

o Selection of one project in the set does not

impact to accept or reject any other project in

the set.

Project Bundles

o A bundle is a collection of independent projects.

o Independent-type projects tend to be quite different

from each other.

o The candidate set of projects is all projects under

consideration for funding from a given budget

amount.

o Not all projects can be selected budget constraints

may exist.

Capital Budgeting Characteristics

o Identify independent projects and their

estimated cash flows;

o Each project is selected entirely, or it is not

selected at all;

o Partial projects are not permitted;

o A given budget constraint restricts the total

amount available for investment;

o Objective: maximize the return on

investment using a measure of worth.

Selection Guidelines

o Accept projects with the best PW values

determined at the MARR;

o Over the project life;

o Provided the investment capital limit is not

exceeded.

The Capital Budgeting Problem

(A) $$ Cash Flow Profile

$$

(B) $$ Cash Flow Profile

Budget

Max Present Worth

o Previous Assumption:

o Equal Life for the alternatives;

o No longer valid for capital budgeting;

o No life cycle beyond the estimated life of each

bundle;

o PW over the respective life of each independent

project;

o Implicit Reinvestment Assumption is in place.

Reinvestment Assumption

o The following is assumed for the capital budgeting

problem

(bundle) are reinvested at the MARR from

the time they are realized until the END of

the LONGEST-LIVED project!

With this assumption, projects (bundles) with

unequal lives can be accommodated in the

analysis.

Use of ROR To Select

o ROR can be used to select projects;

o However must apply the incremental ROR method

(cumbersome);

o Recall, ROR and NPV may not rank (select) projects

the same;

o Different reinvestment assumptions within the two

methods;

o Use incremental ROR to select!

Suggested Objective Function

o It is suggested that PV be used as the criteria in the

associated objective function as opposed to ROR.

o Probably best to not use the incremental ROR

ranking;

o Easier to apply PV at the MARR to all of the

projects.

Rationing for Equal-Life Projects

o Given a set of candidate projects whose lives are all

equal;

o Calculate the PV(MARR) for each project;

o Formulate all of the mutually exclusive bundles from

the set;

Mutually Exclusive Bundles

o Assume you have 4 projects having equal lives;

o Candidate set = { A, B, C, D};

o The Do-Nothing (DN) alternative is also an option:

Set = { DN, A, B, C, D };

o Given 4 projects, how many mutually exclusive

bundles can be formed?

Number of Bundles

o Given m projects (independent), how many

possible bundles are there?

o Rule: Total no. of bundles = 2m;

o 2m 1 bundles if you cut out the DN option;

o If m = 4 then 24 1 = 15 bundles (excluding the DN

option).

Number of Bundles

o Manual approaches are not well suited for

large numbers of candidate projects.

o If m = 6 then 26 = 64 bundles to evaluate;

o If m = 30 then 230 bundles to evaluate;

o Equal 1,073,741,824 bundles!

o Require a more sophisticated approach other than

a manual analysis.

Example of Bundling: m =4

Assume:

Project Investment $

A $10,000

B 5,000

C 8,000

D 15,000

$38,000 Total

Assume a b = $25,000 (The budget max.)

What, then, is the optimal combination of projects?

Example of Bundling: m =4

Assume:

Project Investment $

A $10,000

B 5,000

C 8,000

D 15,000

$38,000 Total

Assume a b = $25,000 (The budget max.)

projects will maximize the present worth of the selected bundle?

Example of Bundling: m =4

Assume:

Project Investment $

A $10,000

B Feasible bundles must have 5,000

Positive PV and a total

C Budget that does not 8,000

D Exceed $25,000/ 15,000

$38,000 Total

Assume a b = $25,000 (The budget max.)

Steps for a Manual Analysis

1. Identify the investments and cash flows for all

feasible combinations of the projects where each

combination represents an economically mutually

exclusive bundle.

Consider all possible combinations by taking the

projects one at a time, two at a time, etc., and

listing.

Possible Combinations Where m = 4

1. Do Nothing; 14. BCD

2. A 15. CD

3. B 16. ACD

4. C

5. D

6. AB TOTAL ENUMERATION OF

7. AC ALL 16 POSSIBLE

8. AD MUTUALLY EXCLUSIVE

9. ABC COMBINATIONS

10. ABCD

11. BC

12. BD

13. ABD

Ordering the Combinations

o Order the bundles from low to high based upon the

total budget requirement of the combination.

Rank-Ordered Bundles: Total Investment

PROJECT ID INVESTMENT

1 DN $0

2 B $5,000

3 C $8,000

4 A $10,000

5 BC $13,000 Eliminate Those

6 D $15,000 Mutually Exclusive

7 AB $15,000 Bundles That

8 AC $18,000 Exceed the $25,000

9 BD $20,000

10 ABC $23,000 Budget Limitation.

11 CD $23,000

12 AD $25,000

13 BCD $28,000

14 ABD $30,000

15 ACD $33,000

16 ABCD $38,000

Reduced Budget Feasible Set

PROJECT ID INVESTMENT

1 DN $0 Four bundles

2 B $5,000 are

3 C $8,000

infeasible: they

4 A $10,000

5 BC $13,000 exceed the

6 D $15,000 budget amt.

7 AB $15,000 dropped from

8 AC $18,000

9 BD $20,000

further

10 ABC $23,000 consideration.

11 CD $23,000

12 AD $25,000

13 BCD $28,000

14 ABD $30,000

15 ACD $33,000

16 ABCD $38,000

The Feasible Set

PROJECT ID INVESTMENT

1 DN $0

2 B $5,000

3 C $8,000

4 A $10,000 The feasible set

5 BC $13,000 of mutually

6 D $15,000 exclusive bundles.

7 AB $15,000

8 AC $18,000

9 BD $20,000

10 ABC $23,000

11 CD $23,000

12 AD $25,000

Bundle Selection

o The previous slide shows the feasible set;

o None of the combinations exceed the budget

limitation;

o If one has the PV of each bundle, then pick the

bundle with the maximum present value.

General Solution Technique

1. Develop all mutually exclusive bundles.

2. Eliminate those bundles whose total investment

requirement exceeds the budget amount.

3. Within each bundle, sum the NCFs for all

projects in that bundle and compute the PV of

the bundle at the MARR.

General Solution Technique

o Let j equal the bundle number;

o PWj = PW of bundles net cash flows the initial

investment.

nj

t =1

Example 1

o Assume b = 20 million;

o Number of candidate projects = 5

o Set = {DN, A,B,C,D,E}

o No. of bundles = 25 = 32 possible combinations.

Example for m = 5 Projects

Amounts are in units of $1,000.

Project Investment Cash Flow Years

A -$10,000 $2,870 9

B $15,000 $2,930 9

C -$8,000 $2,680 9

D -$6,000 $2,540 9

E -$21,000 $9,500 9

25 Possible Bundles:E is removed $21 Million > 20 Million

Example 1: Feasible Bundles

o Max Bundle is { CD };

o Left over budget = 6 million assumed to be invested at

the MARR

Unequal-Life Projects

o It is assumed that reinvestment of positive net cash flows

occurs at the MARR from the time they are realized until

the end of the longest-lived project.

o Use of the LCM of lives is not necessary for the capital

budgeting model.

Example 2: Unequal Lives

Project Initial Ann. Net Project

Investment Cash Flows Life Yrs

A -$8,000 $3,870 6

B -15,000 2,930 9

C -8,000 2,680 5

D -8,000 2,540 4

Example 2: PV Summary

Bundle Project(s) PV Comments

1 A $+6,646

2 B -1,019 Reject

3 C 984

4 D -748 Reject

5 AC 7,630 Max Bundle

6 AD 5,898

7 CD 235

8 Do Nothing 0

Select { AC } for $16,000: $4,000 assumed

invested at the MARR

Two Independent Bundles A and B

o Assume two independent projects, A and B;

o Life of A = nA;

o Life of B = nB;

o A B (unequal lives).

o Assume A and B have the same net cash flow each time

period.

Notation for Unequal Life Problem

o nL = life of the longer lived project;

o nj = life of the shorter lived project;

o nA = Life of A

o nB = Life of B

o Diagram the two cash flows on the next slide.

Unequal-Life Projects; A and B

FWB

PWB

nB = nL

B Investment

Longer life Project: i = MARR

For B

FWA

PWA FW

Period of reinvestment @

MARR

A nA nL

Investment

For A

Shorter Project: A with Reinvestment

FWA

PWA FW

A Period of reinvestment @

MARR

nA nL

Investment

For A

Compute the FW from nA out to nL of A.

Assumed to be reinvested at the MARR rate!

Yield FWA given reinvestment at the MARR rate.

Then, find PWA from FWA at the MARR rate.

Bundling A and B: Unequal Lives

o Now A and B have unequal lives;

o If reinvestment at the MARR is assumed for the shorter-

life project out to the life of the longer life project, then:

o One can create a bundle of A and B by computing;

o PWBundle = PWA + PWB

C and D in Example 2

Project Init. Inv. ANCF Life

C -$8,000 $2,680 5

D -8,000 2,540 4

o Unequal life situation.

Bundle { C, D }. Over 9 years

o Bundle Cash Flow:

FW = $57,111

$2,540/yr (D)

$2,680 (C)

0 1 2 3 4 5 6 7 8 9

-$16,000

PW(C,D @ 15%) = -$16,000 + 57,111(P/F,15%,9)

= +$235.00

Summary

o Capital represents a scarce resource;

o Capital is limited and must be rationed;

o Evaluate the capital budgeting from:

n Equal life projects;

n Unequal life projects.

o Apply the PW method;

o Create mutually exclusive bundles;

Summary

o For m projects there are 2m possible combinations or bundles;

o Manual solutions work only for very small problems;

o Larger problems require a mathematical programming

formulation;

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