Economic Analysis Basics

Transcription

1 Chapter 9 Ecoomic Aalysis Basics Motivatio The maority of GE 494 proects are specified such that the ecoomic aalysis is a crucial part, if ot the most importat part of the report for determiig the fial recommedatios to the sposor, ad the pla for their implemetatio. This is because the sposorig compaies, i the broadest sese, are ivestmet firms whose goal is to maximize profits for the compay owers ad shareholders. The sposor chooses to ivest i its ow processes, product developmet, ad productio capability, because it ca reliably achieve a far greater retur o ivestmet tha ay other outside ivestmet such as stocks, bods, real estate, etc. Because of this, ecoomics will determie the ultimate decisios the sposor will make with respect to the proect. The egieerig compoet of the proect provides the possible techical solutios to the problem. The ecoomic aalysis (geerally) will be used to choose the best solutio(s) ad the order ad timig of their implemetatio. Cost Data, Savigs, ad Verificatio with Sposor Your ecoomic aalysis will typically rely o costig ad fiacial data provided by the sposor for scrap rates, material costs, labor rates, overhead or burde, warraty claims, icreased sales, ad other types of appropriate costs ad reveues. Start early i your proect to make the proper cotacts with your sposor to get the types of iformatio you will eed for your ecoomic aalysis. Ofte, this data must be estimated by the sposor or retrieved from sources that may take may weeks to access ad compile. As metioed earlier i this hadbook, a valid path to fid the best solutio i may proects is to follow the moey. Gai a full ad accurate uderstadig of how costs, savigs ad reveues are recogized by your sposor. Do this as early as possible. This will give valuable isights to your ecoomic aalysis ad help guide your proect. Establish guidelies for the upper boud to the amout of savigs ad/or additioal profits possible if the full goal of your proect is achieved. This will give you early directio about feasibility of possible solutios. Some proects may geerate savigs of several hudred thousad dollars per year, which support very ambitious ad costly solutios. Other proects may result i savigs of oly a few tes of thousads of dollars per year. This may immediately 69

2 elimiate may costly solutios from cosideratio by the proect team ad save precious time. Typically your results will show a savigs to the sposor after your recommeded capital expeses are made by the sposor. Make sure your costig data is accurate ad takes ito accout labor, overhead, maiteace, materials, scrap, traiig, testig, calibratios, ad ay other costs that may affect the aalysis. I some cases, savigs ca be directly calculated by the proect team for verificatio by the sposor. I other cases, reasoable estimates for savigs are made by the proect team ad must receive the sposor s edorsemet before beig used i the fial reports. I ALL cases, ALL calculatios for costs, savigs, etc. must be edorsed by your compay sposor for use i your ecoomic aalysis. Proects ofte result i several alterative solutios, as well as may differet optioal solutios. I these cases, preset your solutios i a table listig capital cost alog with payback period, ROI, ad NPV as show later i this chapter. It is ofte best to preset a stepwise implemetatio of recommedatios that begi with the lowest cost or greatest ROI ivestmets first. The sposor will use the early savigs to fud the later implemetatios. Recommedatios should also be made i a maer that is miimally disruptive to curret productio processes ad cash flows. See previous GE 494 reports available i 14 TB ad o the GE 494 web site for examples of ecoomic aalyses. For more detail, referece your materials from GE 188/288 as well as the help iformatio provided with MS Excel. Calculatio Techiques The mathematics of ecoomic aalysis is based o simple time value of moey calculatios. Although these are ot complex, ote that Albert Eistei called them "the greatest mathematical discovery of all time", ad "the most powerful force i the uiverse." Compoud iterest ca be demostrated by a sigle deposit placed ito a iterest bearig accout. If the iterest (i) is compouded aually, the fial value of the accout is determied by the umber of years that the iterest is compouded: F = P( 1+ i) F = future value P = iitial deposit i = iterest rate = umber of compoudig periods 7

3 As a example if $1 is deposited for 6 years at 1% compouded aually, the future value is foud to be $1, Similarly, to fid the preset value (P) of a future paymet (F) made after () compoudig periods at iterest rate (i) the equatio is simply: P = F ( 1+ i ) The term (1+i) is a key term i ust about all time value of moey calculatios. This should be a review of earlier course material you had i your udergraduate courses GE 188/288. The preset value (P) of a series of () future paymets (A) with a prevailig iterest rate (i) per compoudig period is give by: P = A = 1 (1 + i) If all paymets (A) are equal, the preset value (P) simplifies to: P = A 1 = 1 (1 + i) 1 Ad the term (1 i = 1 + ) ca be used to fid the amout of a loa paymet: P =1 ( 1+ i) = A Where: P = loa amout = moths of the loa i = iterest rate per moth = aual rate/12 A = loa paymet For a 3 year loa of $1, borrowed at a aual rate of 1%, the mothly paymet would be: 71

4 A = 1, 36 = 1 (1 + (.1 /12)) = $ From the bak s perspective, which borrows moey at a aual iterest rate of 6%, the et preset value (NPV) of a series of 36 loa paymets of $877.57, which iitially cost the bak $1,, is give by: 36 1 NPV = 1, + (1 + (.6 /12)) = = $46, Note that NPV icludes subtractig the iitial cost of the loa, as see from the bak s perspective. So, the et preset value to the bak for makig this loa is $46, The simple Payback Period for the loa is the amout of time eeded to recover the iitial $1, cost of the loa. This is simple cash recovery ad does ot take ito accout ay iterest rate. Payback Period = 1,/ = moths = years The Retur O Ivestmet (ROI) is defied as the iterest rate which makes NPV =. This is also called the Iteral Rate of Retur. I the above example, ROI = 1% simple aual iterest. Note that iterest rates used i the formulas are the simple iterest rate per compoudig period. If 1% simple aual iterest is compouded aually, the effective iterest rate is exactly 1%. If 1% simple aual iterest is compouded mothly, the effective aual iterest rate becomes: Effective Iterest Rate = (1 + (.1 /12)) 12 1=.147 = 1.47% Proect Ecoomic Aalysis Example Likewise, ay busiess looks at its ivestmets ito ew products, process improvemets, etc., from the same stadpoit. To aalyze ivestmets ad their returs, costruct a cash flow chart ad apply time value of moey calculatios. The example show below is for a maufacturig process improvemet proect that reduces the scrap rate of the process from 5% to 1%. The prevailig aual iterest rate for the duratio of this example is 1%. All umbers are i thousads of dollars. 72

5 Year Capitalizatio Productio Scrap Savigs Maiteace Salvage Cash Flow 1-1 NPV - 1. ROI (IRR) % % % % % % % % % % Key poits: 1. Capital cost of the scrap reductio equipmet is $1K. This is purchased at the begiig of the first year or at time zero. 2. Productio for the first year is $18K ad varies with product demad over the 1 years of the proect. 3. Savigs from scrap is 4% of total productio. 4. Maiteace icreases with the age of the equipmet. 5. Partial recapitalizatio of $3K is doe i year 5 to reduce maiteace costs. 6. By year 1, the product market is dwidlig, ad the process is discotiued. The sale of the productio equipmet for $15K is listed i the salvage colum. The first step i the aalysis is to costruct a Net Cash Flow Diagram for the life of the proect. Note that this is et cash flow, takig ito accout the savigs as well as the costs. Savigs are show as positive ad costs are show as egative. 73

6 Net Cash Flow per Year Cash Flow diagram for above example The simple Payback Period for the above example is the amout of time to recover the capital cost of the iitial ivestmet. This is doe usig the et cash flow per year for the first few years: payback period = (capital cost)/(cash flow/year) payback period = 1/6 = 1.67 years Net Preset Value (NPV) is calculated by fidig the value of each cash flow (A) whe it is brought back to the preset by use of the iterest or discout rate, alog with subtractig the capital cost. This calculatio is accurate with the assumptio that the cash flow comes at the ed of the iterest period. NPV = = 1 (1 + i) A - capital cost A = periodic cash flows NPV = $18,194 Note that whe the NPV() fuctio i MS Excel is used for this calculatio, the iitial capital cost at time zero is ot cosidered, ad must be icluded maually. Retur O Ivestmet (ROI) is defied as the iterest rate at which the NPV is zero. Note that this sets NPV to zero ad solves for (i). It is clear that this calculatio does ot have a closed form solutio. It is solved iteratively by successively testig iterest rate values ad checkig for a NPV of zero. 74

7 NPV A = = - capital cost = 1 (1 + i) MS Excel uses the fuctio IRR(), which takes as its argumets all of the periodic cash flows, icludig the iitial capital ivestmet, ad requires a guess to begi the iteratio process. For the example above ROI = 57.16% for a 1-year proect life spa. The followig graph shows Cash Flow, NPV ad ROI or IRR together. Note that both NPV ad IRR are time fuctios from the stadpoit of how far ito the future the aalyst desires to cosider these values for purposes of compariso of preset ivestmet decisios. Net Cash Flow, NPV ad IRR vs. Year 2 8% 15 6% 1 4% Dollars (thoudads) % % -2% Iteral Rate of Retur Cash Flow NPV IRR -1-4% -15 Year -6% Compariso of the Three Methods The three methods show above are ot iterchageable. Each method gives a differet view of the cash flow patter of the proect beig aalyzed. Note this carefully. This is why all three methods (Payback Period, NPV, ROI) must be icluded i your proect report alog with the cash flow diagram. 75

8 The payback period or simple cash recovery period igores the iterest rate ad is therefore easiest to calculate. I fact, it ca typically be doe o the back of a apki. But, results ca be very misleadig. Take for example a compay that requires a 2-year payback for all capital proects. The implicit assumptio i this payback requiremet is that the et cash flow model will be similar to the perfect 2-year payback show below: Year Cash Flow Cash Flow Years This model has the followig characteristics: Payback period 2 years NPV $27.23 ROI 49.8% The followig model has the same payback period but a clearly differet cash flow patter: Year Cash Flow This model has the followig characteristics: Payback period 2 years NPV -$17.36 ROI % 76

9 Although this cash flow model passes the payback period test, NPV ad ROI show it to be a terrible ivestmet. Agai, this example demostrates why all three methods should be used to get a more complete picture for decisio makig. Decisio Makig Whe choosig amog mutually exclusive proects or features of the same proect, NPV, ROI, ad payback period should be calculated for each alterative i order to make the best ecoomic choice. If the mutually exclusive optios have differet life spas, NPV is typically the best metric for compariso because all savigs are brought to the preset. Whe decidig whether or ot to fud o-mutually exclusive optios i a proect, a table ca be made to show the cash flow characteristics of each optio. Typically the compay will choose to fud the optios with the highest profitability first, ad the use the savigs to fud the optios with lower rates of profitability. Optios Cost Payback (moths) NPV ROI (%) Quick chage fasteers ,49 1,9 Tool shadow board ,67 8 Cross traiig persoel 2,2 3 51,872 4 Adustmet igs 4, , Automated coveyor rails 8, , Ofte the ecoomic results of a proect may ot be directly measurable, but may be a fuctio of a key parameter of the proect results, whose direct measuremet is beyod the scope of the proect. Oe such proect was a aalysis of airflow efficiecy i a thermoformig process i a effort to icrease airflow rates ad reduce overall cycle times for the thermoformig process. The proect resulted i a 4% icrease of airflow efficiecy, however, direct measuremet of cycle time reductio was impossible durig the proect due to the high cost of productio prototypig. The ecoomic aalysis was preseted as a fuctio of cycle time reductio as follows. (NPV ad ROI are calculated for a 1 year proect life.) Cycle time reductio (secods) Cap Cost Aual Savigs Payback (years) NPV ROI (%) 65, /a -65, /a.5 65, 85, , , 17, , , 255,.25 1,52, , 34,.19 2,24, , 425,.15 2,546, , 51,.13 3,68,

10 This table ca be graphed with aual savigs, payback period, NPV, ad ROI all as a fuctio of the evetual cycle time reductio. 1-Year NPV ad ROI vs Cycle Time Reductio 1-Year NPV 3,5, 3,, 2,5, 2,, 1,5, 1,, 5, Year ROI NPV ROI (%) -5, Cycle Time Reductio (secods) 1 Methods for Product Developmet ad New Techologies Occasioally a proect does ot readily coform to types of aalyses that are discussed above. Note that the methods above are all aalyses of cash flows i oe form or aother. Cash flows may be i the form of a reduced cost i a existig product, a totally redesiged product, a ew product i a existig market, or a ew product i a totally ew market. I these cases, the future cash flows, market shares, price poit ad profit margi for the product, etc., may be ucertai. It is importat to get reasoably good estimates for these cash flows from your compay sposors i order to do the required aalyses. If you have questios about this, see your Advisor, or the Course Chairma. Break Eve Aalysis New product costs typically ivolve toolig, maufacturig, shippig, marketig, distributio, sales, warraty, etc. Estimates for these costs should be accessible by the compay sposor. The compay sposor should also have a idea of the price poit for the ew 78

11 product i the market they are addressig. I order to meet a payback requiremet, the aalysis ca be reverse egieered. Calculatios for the startup costs ad the fixed ad variable costs listed above ca be made. With the price poit of the product, the profit margi ca the be determied. It is the possible to determie how may uits of the ew product must be sold to give the desired payback o the ivestmet i the ew product developmet ad maufacture. Oce this sales target is determied, the marketig departmet of the compay sposor has a clear sales target to meet the compay s requiremets for ivestmets. This etire determiatio is iterative i ature ad ivolves risk, but is a simple ad effective way to evaluate ew product ecoomic potetial. New Product Developmet Direct Value Method The Direct Value Method is used to determie the price poit for ew ad modified products. It is a simple method of marketig research i which the target demographic is asked to fill out a simple questioaire to directly value the product modificatios. From this aalysis, the compay sposor ca get a very good idea of the target price poit that will be successful. It will also give estimates of the profit margi for the ew product. For more iformatio, see Prof. Bria Lilly, or the course Chairma. 79