Economic Analysis of Industrial Projects

PART ONE: Basic Concepts ; 1. The Firm Economic Exchanges and Objectives ; 1.1 Introduction ; 1.2 Economic ExchangeAThe 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 ProjectsARandom 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