Economic Analysis of Industrial Projects

Economic Analysis of Industrial Projects, Third Edition, provides the best possible methods for applying economic analysis theory to practice. Completely revised and expanded in this new edition, the text now includes five new chapters and new material on real options analysis and replacement analysis.

Ted G. Eschenbach is Professor Emeritus of Engineering Management at the University of Alaska Anchorage.

Neal A. Lewis is an Associate Professor of Technology Management at the University of Bridgeport.

Joseph C. Hartman is Dean of the Francis College of Engineering at the University of Massachusetts Lowell.

Lynn E. Bussey was a Professor of Industrial Engineering at Kansas State University for several decades. He is the original author of Economic Analysis of Industrial Projects.

PART ONE: Basic Concepts

1. The Firm Economic Exchanges and Objectives
1.1 Introduction
1.2 Economic ExchangeÄThe Input-Output Basis of the Firm
1.3 Functions of the Firm: Financing, Investing, Producing
1.4 Objectives of the Firm
1.5 Sources and Uses of Funds
1.6 Summary
References
Problems

2. Interest, Interest Factors, and Equivalence
2.1 What is Interest?
--2.1.1 Perfect capital market assumptions
--2.1.2 The consumption basis of single-period exchange
--2.1.3 Multi-period exchange
--2.1.4 Fundamental interest equation
--2.1.5 The equilibrium market price concept of interest rates
2.2 Notation and Cash Flow Diagrams
2.3 Tabulated Compound Interest Factors
--2.3.1 Factors relating P and F
--2.3.2 Factors relating A and F
--2.3.3 Factors relating P and A
--2.3.4 Arithmetic gradient conversion factors
2.4 Examples of Time Value of Money Calculations
2.5 Geometric Gradients
2.6 Nominal and Effective Interest Rates
2.7 Continuous Interest Factors
2.8 Extended Engineering Economy Factors and Spreadsheets and Calculators
--2.8.1 Advantages of extended engineering economy factors
--2.8.2 Notation for extended engineering economy factors
--2.8.3 Spreadsheet annuity functions
--2.8.4 Time value of money (TVM) calculators
2.9 Spreadsheets and Cash Flow Tables
--2.9.1 Advantages of spreadsheets for economic analysis
--2.9.2 Effective and efficient spreadsheet construction
2.10 Economic Interpretation of Equivalent Annual Amount
2.11 Summary
References
Problems

3. Estimating Costs and Benefits-Lead Coauthor Heather Nachtmann
3.1 Introduction
3.2 Cash Flow Estimates
3.3 Life Cycle Estimation
3.4 Classification of Estimates
3.5 Estimation Data
3.6 Basic Estimation Techniques-Indexes and Per Unit
--3.6.1 Indexes
--3.6.2 Unit Technique
3.7 Factor Technique
3.8 Cost Estimation Relationships
--3.8.1 Development Process
--3.8.2 Capacity Functions
--3.8.3 Learning Curves
3.9 Growth Curves
3.10 Estimating Product Costs
--3.10.1 Direct costs
--3.10.2 Indirect costs
3.11 Sensitivity Analysis
3.12 Summary
References
Problems

4. Depreciation: Techniques and Strategies
4.1 Introduction
4.2 Depreciation Strategies
4.3 Definitions
--4.3.1 Depreciable property
--4.3.2 Basis of property
--4.3.3 Recovery period
--4.3.4 Salvage value
--4.3.5 Symbols and notation
4.4 Basis and Book Value Determination
--4.4.1 Definition of initial basis and book value
--4.4.2 Special first-year write-offs
--4.4.3 Like-for-like replacement
4.5 Methods of Depreciation
--4.5.1 Introduction
--4.5.2 The straight-line method
--4.5.3 The declining balance method
--4.5.4 The sum-of-the-years' digits (SOYD) method
--4.5.5 Switching
--4.5.6 Units of production
--4.5.7 Reasons for accelerated depreciation
--4.5.8 Modified Accelerated Cost Recovery System (MACRS)
--4.5.9 Job Creation and Worker Assistance Act
--4.5.10 Comparing book values with different depreciation methods
4.6 The Present Value of the Cash Flow Due to Depreciation
--4.6.1 Straight-line method
--4.6.2 Declining balance method
--4.6.3 Sum-of-years' digits method
--4.6.4 Modified accelerated cost recovery system
4.7 Simple Depreciation Strategies
--4.7.1 Accelerated depreciation is better
--4.7.2 Declining balance method versus the straight-line method
--4.7.3 The declining balance method versus the sum-of-years' digits method
4.8 Complications Involving Depreciation Strategies
4.9 Summary of Conclusions: Depreciation
4.10 Depletion of Resources
--4.10.1 Entitlement to depletion
--4.10.2 Methods for computing depletion deductions
--4.10.3 The depletion deduction
--4.10.4 Typical percentage depletion rates
4.11 Amortization of Prepaid Expenses and Intangible Property
References
Problems

5. Corporate Tax Considerations
5.1 Introduction
5.2 Ordinary Income Tax Liability
5.3 Federal Income Tax Rates
--5.3.1 Investment tax credit
5.4 Generalized Cash Flows from Operations
5.5 Tax Liability When Selling Fixed Assets
--5.5.1 What are Section 1231 assets?
--5.5.2 Tax treatment of 1231 assets
5.6 Typical Calculations for After-Tax Cash Flows
5.7 After-Tax Replacement Analysis
5.8 Value-added Tax
References
Problems

6. The Financing Function
6.1 Introduction
6.2 Costs of Capital for Specific Financing Sources
6.3 Cost of Debt Capital
--6.3.1 Short-term capital costs
--6.3.2 Capital costs for bonds
6.4 Cost of Preferred Stock
6.5 Cost of Equity Capital (Common Stock)
--6.5.1 Dividend valuation model
--6.5.2 The Gordon-Shapiro growth model
--6.5.3 The Solomon growth model
--6.5.4 Note on book value of stock
--6.5.5 Capital asset pricing model (CAPM)
--6.5.6 Cost of retained earnings
--6.5.7 Treasury stock
6.6 Weighted Average Cost of Capital
6.7 Marginal Cost of Capital
--6.7.1 Market values imply a marginal cost approach
--6.7.2 Marginal cost-marginal revenue approach
--6.7.3 A discounted cash flow approach
--6.7.4 Mathematical approach to marginal cost of capital
6.8 Numerical Example of the Marginal Weighted Average Cost of Capital
--6.8.1 Calculation of the present weighted average cost of capital
--6.8.2 The future weighted average cost of capital after provision for new capital
--6.8.3 The marginal cost of capital
6.9 MARR and Risk
6.10 WACC and the Pecking Order Model
6.11 Summary
References
Problems


PART TWO: Deterministic Investment Analysis

7. Economic Measures
7.1 Introduction
7.2 Assumptions for Unconstrained Selection
7.3 Some Measures of Investment Worth (Acceptance Criteria)
7.4 The Payback Period
--7.4.1 Payback rate of return
--7.4.2 Discounted payback
7.5 Criteria Using Discounted Cash Flows
7.6 The Net Present Value Criterion
--7.6.1 Production-consumption opportunities of the firm
--7.6.2 The present value criterion for project selection
--7.6.3 Multi-period analysis
--7.6.4 Characteristics of net present value
7.7 The Benefit-Cost Ratio Criteria
7.8 Internal Rate of Return
--7.8.1 Defining the internal rate of return
--7.8.2 The fundamental meaning of internal rate of return
--7.8.3 Conventional and nonconventional investments (and loans)
--7.8.4 Conventional investments and internal rate of return
7.9 Nonconventional Investment
--7.9.1 Nonconventional investment defined
--7.9.2 Conventional, pure investments
--7.9.3 Analyzing nonconventional investments
--7.9.4 Numerical examples
7.10 Roots for the PW Equation
--7.10.1 Using the root space for P, A, and F
--7.10.2 Defining the root space for P, A, and F
--7.10.3 Practical implications of the root space for P, A, and F
7.11 Internal Rate of Return and the Lorie-Savage Problem
--7.11.1 Multiple positive roots for rate of return
--7.11.2 Return on invested capital
--7.11.3 Present worth and the Lorie-Savage problem
7.12 Subscription/Membership Problem
7.13 Summary
References
Problems

8. Replacement Analysis
8.1 Introduction
8.2 Infinite Horizon Stationary Replacement Policies
--8.2.1 Stationary costs (no technological change)
--8.2.2 Technological change and stationary results
8.3 Non-Stationary Replacement Policies
--8.3.1 Age-based state space approach
--8.3.2 Length of service state space approach
--8.3.3 Applying dynamic programming to an infinite horizon problem
--8.3.4 Solving with linear programming
8.4 After-Tax Replacement Analysis
8.5 Parallel Replacement Analysis
8.6 Summary and Further Topics
References
Problems

9. Methods of Selection Among Multiple Projects
9.1 Introduction
9.2 Project Dependence
9.3 Capital Rationing
9.4 Comparison Methodologies
9.5 The Reinvestment Rate Problem
9.6 The Reinvestment Assumption Underlying Net Present Value
9.7 The Reinvestment Assumption Underlying the Internal Rate of Return: Fisher's Intersection
9.8 Incremental Rates of Return
--9.8.1 Incremental rate of return applied to the constrained project selection problem
--9.8.2 Inclusion of constraints
9.9 The Weingartner Formulation
--9.9.1 Objective function
--9.9.2 Constraints
--9.9.3 The completed Weingartner model
--9.9.4 Constrained project selection using Solver
9.10 Constrained Project Selection by Ranking on IRR
--9.10.1 The opportunity cost of foregone investments
--9.10.2 Perfect market assumptions
--9.10.3 Internally imposed budget constraint
--9.10.4 Contrasting IRR and WACC assumptions
--9.10.5 Summary of ranking on IRR
9.11 Summary
References
Problems


PART THREE: Investment Analysis under Risk and Uncertainty

10. Optimization in Project Selection (Extended Deterministic Formulations)
10.1 Introduction
10.2 Invalidation of the Separation Theorem
10.3 Alternative Models of the Selection Problem
--10.3.1 Weingartner's horizon models
--10.3.2 The Bernhard generalized horizon model
--10.3.3 Notation
--10.3.4 Objective function
--10.3.5 Constraints
--10.3.6 Problems in the measurement of terminal wealth
--10.3.7 Additional restrictions
--10.3.8 The Kuhn-Tucker conditions
--10.3.9 Properties of
--10.3.10 Special cases
10.4 Project Selection by Goal Programming Methods
--10.4.1 Goal programming format
--10.4.2 An example of formulating and solving a goal programming problem
--10.4.3 Project selection by goal programming
10.5 Summary
Appendix 10.A Compilation of Project Selection Problem
References
Problems

11. Utility Theory
11.1 Introduction
--11.1.1 Definitions of Probability
11.2 Choices under Uncertainty: The St. Petersburg Paradox
11.3 The Bernoulli Principle: Expected Utility
--11.3.1 The Bernoulli solution.
--11.3.2 Preference theory: the Neumann-Morgenstern hypothesis
--11.3.3 The axiomatic basis of expected utility
11.4 Procuring a Neumann Morgenstern Utility Function
--11.4.1 The standard lottery method.
--11.4.2 Empirical determinations of utility functions
11.5 Risk Aversion and Utility Functions
--11.5.1 Risk aversion as a function of wealth
--11.5.2 Other risk-avoiding utility functions
--11.5.3 Linear utility functions: Expected monetary value
--11.5.4 Complex utility functions: Risk seekers and insurance buyers
--11.5.5. Reconciling firm's utility and behavior by employees and managers
11.6 Summary
References
Problems

12. Stochastic Cash Flows
12.1 Introduction
12.2 Single Risky ProjectsÄRandom Cash Flows
--12.2.1 Estimates of cash flows
--12.2.2 Expectation and variance of project net present value
--12.2.3 Autocorrelations among cash flows (same project)
--12.2.4 Probability statements about net present value
12.3 Multiple Risky Projects and Constraints
--12.3.1 Variance of cross-correlated cash flow streams
--12.3.2 The candidate set of projects
--12.3.3 Multiple project selection by maximizing expected net present value
12.4 Accounting for Uncertain Future States
12.5 Summary
References
Problems

13, Decision Making Under Risk
13.1 Introduction
13.2 Decision Networks
13.3 Decision Trees
13.4 Sequential Decision Trees
13.5 Decision Trees and Risk
--13.5.1 Stochastic decision trees
--13.5.2 Applications
13.6 Expected Value of Perfect Information
13.7 Simulation
13.8 Summary
References
Problems

14. Real Options Analysis
14.1 Introduction
14.2 Financial Options
14.3 Real Options
--14.3.1 Historical development
--14.3.2 The real option model
--14.3.3 Interest rates
--14.3.4 Time
--14.3.5 Present value of future cash flows
14.4 Real Option Volatility
--14.4.1 Actionable volatility
--14.4.2 Logarithmic cash flow method
--14.4.3 Stock proxy method
--14.4.4 Management estimates method.
--14.4.5 Logarithmic present value returns method (CA method)
--14.4.6 Standard deviation of cash flows
--14.4.7 Internal Rate of Return
--14.4.8. Actionable volatility revisited
14.5 Binomial Lattices
14.6 The Deferral Option: Dementia Drug Example
--14.6.1 Definition and NPV calculation
--14.6.2 Volatility
--14.6.3 Black-Scholes results
--14.6.4 Binomial lattices
14.7 The Deferral Option: Oil Well Example
--14.7.1 NPV.
--14.7.2 Delay option formulation
--14.7.3 Black-Scholes results
--14.7.4 Binomial lattices
14.8 The Abandonment Option
14.9 Compound Options
--14.9.1 Multi-stage options modeling
--14.9.2 Multi-stage option example
--14.9.3 Closed form solution
--14.9.4 Volatility issues in multi-stage modeling
14.10 Current Issues with Real Options
14.11 Summary
Appendix 14.A Derivation of the Black-Scholes Equation
References
Problems

15. Capacity Expansion and Planning
15.1 Introduction
15.2 Expansion Analysis
--15.2.1 Dynamic deterministic evaluation
--15.2.2 Dynamic probabilistic evaluation
15.3 Capacity Planning Strategies
--15.3.1 Maximizing market share strategy
--15.3.2 Maximizing utilization of capacity strategy
15.4 Summary
References
Problems

16. Project Selection Using Capital Asset Pricing Theory
16.1 Introduction
16.2 Portfolio Theory
--16.2.1 Securities and portfolios
--16.2.2 Mean and variance of a portfolio
--16.2.3 Dominance among securities and portfolios
--16.2.4 Efficient portfolios
--16.2.5 The risk in a portfolio
16.3 Security Market Line and Capital Asset Pricing Model (CAPM)
--16.3.1 Combinations of risky and riskless assets
--16.3.2 The security market line
--16.3.3 The capital asset pricing model (CAPM)
16.4 Firm's Security Market Line and Project Acceptance
--16.4.1 Projects and the capital asset pricing model (CAPM)
--16.4.2 Risk/return trade-offs and the firm's security market line
16.5 The Firm's Portfolio of Projects
--16.5.1 Why do firms use project portfolios?
--16.5.2 Can security portfolio theory be extended to project portfolios?
--16.5.3 Reasonable inferences from security portfolio theory to project portfolios
--16.5.4 Can the capital asset pricing model for securities be extended to projects?
16.6 Summary
References
Problems

Appendix

Index