Sell Your Project! (page 5) (Link to page 1)
EXAMPLE
Let's pull this all together with an example. Suppose you want to install a new heat treatment line for your transmission gears. You will incur startup costs (equipment, installation, wiring, training, change notices, etc.) of $2 million. You currently spend $1,600,000 on production of these gears each year, and expect the new line to shave off $450,000 each year. You will also be able to sell some of your old equipment for $1 million, but not until two years after the new line is installed because you will still need it for some rework of gears from the old process. Your Capital Review Board will not even consider a proposal with less than a 20% payback in the first five years. Does your proposed change meet the hurdle rate during the first five years?
First, we must convert everything to a Present Value, using our formulas or the appropriate tables, and assuming the 20% hurdle rate and a five year horizon:
Startup Costs = - $2,000,000 (already a PV)
PV of Savings = $450,000[((1 + 0.20)5 - 1) / (0.20(1 + 0.20)5)] = $1,345,950
PV of Equipment Sale = $1,000,000(1+ 0.20)-2 = $694,400
Total PV of project = - ($2,000,000) + $1,345,950 + $694,400 = $40,350
Since the present value is positive, the project meets, and exceeds, the hurdle rate of 20% payback during the first five years. Since we have only profits after the five year mark, we don't have to worry about the further out years.
FOR FURTHER READING
This has just been an overview of the Cost Benefit Analysis topic, of course. We haven't discussed future value analysis, gradient cash flows, sunk costs, continuous compounding, etc. Further details can be found in any good reference book, such as those listed below. Also, a number of software packages are available to automate the calculations, as described in the sidebar.
1.
Engineering Economic Analysis, Donald G. Newnan, Engineering Press, Inc., San Jose, 1988
Engineering Economic Analysis, Donald G. Newnan, Engineering Press, Inc., San Jose, 19882.Cost-Benefit Analysis, 2nd Ed., R. Layard and S. Glaister, Cambridge University Press, 1994
Cost-Benefit Analysis, 2nd Ed., R. Layard and S. Glaister, Cambridge University Press, 19943.A Guide to Benefit-Cost Analysis, Edward M. Gramlich, Prentice Hall, 1990
A Guide to Benefit-Cost Analysis, Edward M. Gramlich, Prentice Hall, 19904.Cost Benefit Analysis: Concepts and Practice, Anthony E. Boardman, Prentice Hall, 1996
Cost Benefit Analysis: Concepts and Practice, Anthony E. Boardman, Prentice Hall, 19965.Applied Cost-Benefit Analysis, Robert J. Brent, Edward Elgar Publishing, 1997
Applied Cost-Benefit Analysis, Robert J. Brent, Edward Elgar Publishing, 1997
