TUFTS UNIVERSITY DEPARTMENT OF CIVIL AND ENVIRONMENTAL ENGINEERING ES 053 INTEGRATING ENGINEERING ECONOMICS AND SYSTEMS Associate Professor Emeritus Stephen H. Levine Fall 2012 Lesson 5 Deciding Among Alternatives Topics to be Covered Comparing PW’s, IRR’s, and the MARR Inflation: Real and actual dollar cash flows Depreciation and depreciation schedules Taxes: Before and after tax cash flows Hyperinflation examples One of the basic problems in engineering economics is deciding among alternatives, remembering that in many cases one of the alternatives is the do-nothing alternative. So let’s say you have several alternative projects or investments and you are making your decision based on rate of return. Then you will want to find out which of the alternatives has the best rate of return (IRR). Or maybe which one has the largest PW. The assumption is that the do-nothing alternative has a rate of return equal to the MARR, which is another way of looking at the MARR. (Actually, the MARR might be a little higher than do-nothing rate of return because of the existence of risk. How does that work?) The MARR, again, really is a measure of opportunity cost. Our next problem is one of comparing alternatives. The Problem: The Advanced Technology Corporation (ATC), a multi-million dollar concern, is considering adding a new underwater mining robot to its product line. The decision as to whether to bring this new robot to production is dependent on its production cost. A significant part of the cost of producing this new robot is ATC’s need to obtain a specialized production machine from General Machine Company (GMC). GMC produces two models of this production machine, the Standard Model, which it will only sell, and the recently introduced Super Model, which it will only lease. Based on preliminary estimates ATC expects to be producing its new robot for 10 years, after which it will want to be rid of the production machine. Here are the details on the two options. They will introduce a number of new concepts which heavily impact cash flows and thus PW’s and IRR’s. Option 1. Purchase a Standard Model production machine for $6,000,000. The government will allow ATC to fully depreciate this machine over 6 years, using the Straight Line depreciation method. The present salvage value of a 10- year old machine of this type is estimated at $600,000. The Standard Model machine is expected to enable the production of robots generating $1,150,000 of before tax net revenue in the first year, not accounting for the purchase price and annual maintenance cost of the es053 Lesson 5 - 1 production machine. While production levels of robots is expected to remain constant over the 10 year period this annual net revenue is expected to increase due to inflation at an annual rate of 3%. Annual maintenance cost for the production machine is expected to begin at $50,000 in year 1 and increase at 2% per year above the general annual inflation rate due to aging of the machine. Option 2. Lease a Super Model production machine at $1,100,000 per year for the 10 years. To do so they must put down a $2,000,000 security deposit refundable when the lease is up. This machine is expected to generate $1,350,000 of before tax net revenue in the first year, not accounting for the leasing fee, and this will again increase at an annual rate of 3% due to inflation. The maintenance is all covered in the leasing contract. The leasing down payment is not deductible and the refund is not taxable. The general annual inflation rate is expected to be 4% and the tax rate is 34%. ATC uses a real, after tax MARR = 7%. Which, if either, option should ATC pursue? Some Basic Concepts Well, as we noted earlier, it is economics at least as much as technical capability that determines what engineers actually get to produce. We should also note that as in the first problem many of the numbers are in fact estimates. We haven’t considered it yet but the sensitivity of our results and the decisions they lead to is an important aspect of any economic analysis. There are a number of new concepts in this problem. They include (but as we shall see not limited to): (1) inflation; (2) general inflation rate; (3) tax rate; (4) before and after tax cash flow; (6) depreciation; (7) Straight Line depreciation schedule; (8) real dollars and actual dollars (8) real, after tax, MARR. What do we know about these? What do they have to do with evaluating the alternatives? Inflation: Historically, prices have tended to rise over time. (As an example, my starting salary as an engineer with a MS in 1964 was $9000/year, but my new Chevrolet was $2000.) But that means if you stick $1000 under the pillow for 10 years it is likely to have lost a lot of purchasing power. In addition, inflation is one more reason that a future payment may be worth less than a present payment. In evaluating cash flows inflation es053 Lesson 5 - 2 needs to be taken into account. General Inflation Rate: Different items inflate at different rates, and some may deflate while the rest inflate. Thus, while cars have increased in price, computers have decreased. The general inflation rate is a sort of average overt all types of goods. It is represented in things like the consumer price index (CPI), an average over the products consumers typically buy. From Robert C. Sahr at Oregon State University we have the following table indexed to 2008. Year CF Year CF Year CF Year CF 1854 0.039 1894 0.040 1934 0.063 1974 0.231 1855 0.041 1895 0.039 1935 0.064 1975 0.252 1856 0.040 1896 0.039 1936 0.065 1976 0.267 1857 0.041 1897 0.039 1937 0.068 1977 0.284 1858 0.039 1898 0.039 1938 0.066 1978 0.306 1859 0.039 1899 0.039 1939 0.065 1979 0.341 1860 0.039 1900 0.039 1940 0.066 1980 0.387 1861 0.041 1901 0.040 1941 0.069 1981 0.427 1862 0.047 1902 0.040 1942 0.076 1982 0.453 1863 0.059 1903 0.041 1943 0.081 1983 0.467 1864 0.074 1904 0.042 1944 0.083 1984 0.488 1865 0.077 1905 0.041 1945 0.084 1985 0.505 1866 0.075 1906 0.042 1946 0.092 1986 0.514 1867 0.069 1907 0.044 1947 0.105 1987 0.533 1868 0.067 1908 0.043 1948 0.113 1988 0.555 1869 0.064 1909 0.043 1949 0.112 1989 0.582 1870 0.061 1910 0.045 1950 0.113 1990 0.613 1871 0.057 1911 0.045 1951 0.122 1991 0.639 1872 0.057 1912 0.046 1952 0.124 1992 0.658 1873 0.056 1913 0.046 1953 0.125 1993 0.678 1874 0.053 1914 0.047 1954 0.126 1994 0.695 1875 0.052 1915 0.047 1955 0.126 1995 0.715 1876 0.050 1916 0.051 1956 0.128 1996 0.736 1877 0.049 1917 0.060 1957 0.132 1997 0.753 1878 0.047 1918 0.071 1958 0.136 1998 0.765 1879 0.047 1919 0.081 1959 0.137 1999 0.782 1880 0.048 1920 0.094 1960 0.139 2000 0.808 1881 0.048 1921 0.084 1961 0.140 2001 0.831 1882 0.048 1922 0.079 1962 0.142 2002 0.844 1883 0.047 1923 0.080 1963 0.144 2003 0.863 1884 0.046 1924 0.080 1964 0.145 2004 0.886 1885 0.045 1925 0.082 1965 0.148 2005 0.916 1886 0.044 1926 0.083 1966 0.152 2006 0.946 1887 0.045 1927 0.082 1967 0.157 2007 0.973 1888 0.045 1928 0.080 1968 0.163 2008 1.000 1889 0.043 1929 0.080 1969 0.172 2009 1.022 1890 0.043 1930 0.078 1970 0.182 2010 1.045 1891 0.043 1931 0.071 1971 0.190 2011 1.069 1892 0.043 1932 0.064 1972 0.196 2012 1.092 es053 Lesson 5 - 3 1893 0.042 1933 0.061 1973 0.208 2013 1.117 Tax Rate: “Nothing is sure but death and taxes” so we had better worry about how taxes affect cash flows, since you don’t get to keep all that net revenue (profit). Income tax is of course only one type of tax (Others?) but it is the only one that we will consider in this course. Tax policies can be quite complex but we will keep it simple; a certain fraction of taxable income. Before and After Tax Cash Flow: The payment of taxes represents a cash flow so to get to the latter we will need to subtract the taxes from the former. Depreciation: The value of many items such as cars and machinery decreases over time due to use, obsolescence, going out of style, and so on. When business equipment depreciates in value this is a type of economic loss to the business and the government recognized that this loss should be reflected in reducing taxable income. It also represents a reduction in the value of a business asset.