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Lecture on Economic Analysis of Engineering Projects-1

The lecture covers key economic analysis methods for engineering projects, including Break-Even Analysis, Cost-Benefit Ratio (CBR), Net Present Value (NPV), and Internal Rate of Return (IRR). It explains how to calculate Present Value of Costs (PVC) and Present Value of Benefits (PVB), emphasizing their importance in cost-benefit analysis. The document provides formulas and examples for each method to illustrate their application in evaluating project feasibility.

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Hana Hana
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3 views

Lecture on Economic Analysis of Engineering Projects-1

The lecture covers key economic analysis methods for engineering projects, including Break-Even Analysis, Cost-Benefit Ratio (CBR), Net Present Value (NPV), and Internal Rate of Return (IRR). It explains how to calculate Present Value of Costs (PVC) and Present Value of Benefits (PVB), emphasizing their importance in cost-benefit analysis. The document provides formulas and examples for each method to illustrate their application in evaluating project feasibility.

Uploaded by

Hana Hana
Copyright
© © All Rights Reserved
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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Lecture on Economic Analysis of Engineering Projects

In this lecture, we will cover the key economic analysis methods: Break-Even Analysis, Cost-
Benefit Ratio (CBR), Net Present Value (NPV), and Internal Rate of Return (IRR). We will
also discuss how to calculate the Present Value of Costs (PVC) and Present Value of Benefits
(PVB) in monetary terms, which are crucial for cost-benefit analysis.

1. Break-Even Analysis
Purpose:

Break-Even Analysis helps you determine the point at which your total costs equal your total
revenue (i.e., where you make no profit or loss). This is essential for understanding how much
you need to produce or sell to cover your costs.

Formula:

Where:

 Fixed Costs are costs that do not vary with the production volume (e.g., rent, insurance).
 Selling Price per Unit is the price at which each unit is sold.
 Variable Cost per Unit is the cost incurred to produce each additional unit.

Example:

 Fixed Costs = $50,000


 Selling Price per Unit = $25
 Variable Cost per Unit = $15

Calculation:

Interpretation: The Company needs to sell 5,000 units to break even. Beyond this point, the
company starts making a profit.
2. Cost-Benefit Ratio (CBR)
Purpose:

Cost-Benefit Ratio (CBR) helps you evaluate whether a project’s benefits compensate its costs.
If the ratio is greater than 1, the project is considered feasible because the benefits exceed the
costs.

Formula:

Where:

 Present Value of Benefits (PVB) is the discounted value of all the benefits that will be
gained from the project.
 Present Value of Costs (PVC) is the discounted value of all the costs associated with the
project.

How to Calculate PVC and PVB in Monetary Terms:

To calculate the present value of both costs and benefits, you need to discount future cash flows
to the present. This takes into account the time value of money, where a dollar received today is
worth more than the same dollar received in the future.

Formula for Present Value (PV):

Where:

 Future Cash Flow represents the future costs or benefits.


 r is the discount rate (often the required rate of return or cost of capital).
 t is the time period (in years).
Example (PVB Calculation):

Let’s assume a project provides the following benefits over three years:

 Year 1: $40,000
 Year 2: $50,000
 Year 3: $60,000
 Discount rate: 10%

Calculation:

Interpretation: The Present Value of Benefits (PVB) is $122,764.13.

Example (PVC Calculation):

Let’s assume the costs over three years are:

 Year 1: $30,000
 Year 2: $35,000
 Year 3: $40,000
 Discount rate: 10%

Calculation:
Interpretation: The Present Value of Costs (PVC) is $86,259.96.

CBR Calculation:

Interpretation: Since the CBR is greater than 1 (1.42), the project is financially viable,
providing more benefits than costs.

3. Net Present Value (NPV)


Purpose:

Net Present Value (NPV) calculates the difference between the present value of cash inflows
(benefits) and cash outflows (costs). A positive NPV indicates that the project is profitable and
worth investing in.

Formula:

Where:

 Cash Flowt_tt is the net cash inflow or outflow during period ttt.
 r is the discount rate.
 n is the total number of periods.

Example:

 Initial Investment: $100,000


 Cash Inflows: $40,000 in Year 1, $50,000 in Year 2, and $60,000 in Year 3
 Discount Rate: 10%
Calculation:

Interpretation: The NPV is positive ($22,764.13), indicating that the project will generate more
value than it costs and is therefore worth pursuing.

4. Internal Rate of Return (IRR)


Purpose:

IRR is the discount rate that makes the NPV of a project equal to zero. It represents the
project’s rate of return. If the IRR is higher than the required rate of return (or hurdle rate), the
project should be accepted.

Formula:

The IRR is found by solving the NPV equation for the discount rate rrr:

Step-by-Step Calculation (Using Interpolation):

Let’s calculate IRR using interpolation, which involves calculating NPVs at two different
discount rates and then estimating the IRR by assuming a linear relationship between NPV and
the discount rate.

Example:

 Initial Investment: $80,000


 Cash Flows: $30,000 in Year 1, $40,000 in Year 2, and $50,000 in Year 3
Step 1: Calculate NPV at Two Discount Rates

For Discount Rate of 10%:

For Discount Rate of 15%:

Step 2: Interpolation Formula:

We can now use interpolation to estimate IRR based on the two NPV values:

Substitute the values:


Interpretation: The IRR is approximately 20.3%. If the required rate of return is less than this,
the project is considered financially viable.

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