Payback Period Analysis

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Payback Period Analysis Life-Cycle Cost

• Engineering Economics

Lecture 5 24 August, 2007
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So far -

• Compound interest/equivalence
• PW and AW analysis techniques
• MARR
• EAC, AOC, CR costs
• Selecting alternatives using AW analysis

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This week -

• Example - AW analysis
• Payback Period Analysis
• Conventional
• Discounted
• Life Cycle Costs
• Acquisition phase
• Operation phase

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2005 exam Q4

• A company is evaluating two alternative methods
  of producing one of its product lines.
• Method A costs 80,000 initially and will have a
  15,000 salvage value after 3 years. The
  operating cost of this method will be 30,000 per
  year.
• Method B will have an initial cost of 120,000,
  an operating cost of 8,000 per year and a
  40,000 salvage value after its operating life of
  2 years.
• At an interest rate of 18, which method should
  be used?

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18 Table
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Solution
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Payback Period Analysis

• Two forms for this method
• Conventional Payback Period (zero interest rate)
• Discounted Payback Period (uses an interest rate)
• Payback is the period of time it takes for the
  cash flows to recover the initial investment.
• It is useful in providing the initial screening
  for a number of alternatives.
• What is the relationship between the payback
  period and the actual useful life of an item?

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Example

• An organisation leases 4 x 2 Mbps point-to-point
  digital service to interconnect its private
  network in 5 buildings in the CBD from the local
  telecom carrier for 52,000 per annum.
• The organisation decided to install and operate
  its own digital microwave radio links for the
  capital investment of 140,000
• The annual licence fee 1,500 and maintenance
  contract 4,800 will be ongoing expenses.

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Network Diagram
2
3
2Mbps
2Mbps
1
2Mbps
2Mbps
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4
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Conventional Payback Period

• The conventional payback period for the capital
  investment would be
• np 140,000 / 52,000 2.7 years
• This method is very simple and can be give very
  misleading results.
• It may be acceptable as a rough indication only
  but not as a business evaluation tool.

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Questions to be asked

• What is the revenue or benefit that the
  organisation gets from this service ?
• Where will the organisation get the 140,000
  initial investment from ?
• What is the useful life of the equipment ?
• Are there any other costs or factors that need to
  be considered ?

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Possible Answers

• Having the private links, the organisation will
  not have to pay 52,000 a year for connectivity.
• If the organisation borrowed the money, it will
  have to pay interest. Even if the organisation
  had the money, it can earn interest on it.
  (Opportunity Cost)
• The useful life has to be significantly longer
  than the payback period (typically 10 to 15
  years)
• System design, permits and licences,
  installation, commissioning, and maintenance must
  be considered.

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Discounted Payback Period

• An interest rate i gt 0 is used for this
  calculation.
• There is a logical linkage between this method
  and the breakeven analysis.
• The analysis produces a payback period np that is
  the estimated time, usually in years, it will
  take for the estimated revenues and other
  economic benefits to recover the initial
  investment and a stated rate of return.

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Discounted Payback Approach

• Find the value of np such that

where P is the initial investment, NCF is the
estimated net cash flow for each year t as
determined by the equation
NCF cash inflows - cash outflows
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Calculations

• Given the requirement 0 - P ?NCFt(P/F,i,t)
• and in this simple case
• ?NCFt(P/F,i,t) A(P/A,i,t)
• for P 140,000, A 52,000 and i 0.1 (10)
• gt 0 52,000 (P/A,10,n)
• gt (P/A,i,n) 2.692
• the number of years (n) is 3.29 years
• derived by trial and error using Excel or by
  interpolation using the 10 table

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10 Table
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Comments

• Even if the organisation did not have to borrow
  the 140,000 an interest rate must be considered.
• The discounted cash flow method show that the
  payback period is much longer than that obtained
  using the conventional method.
• The ongoing licence and maintenance fees must not
  be forgotten.

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Cost Elements

• System engineering
• Permits and licences
• Capital investment (equipment)
• Installation and commissioning
• Annual maintenance
• Annual licences
• Salvage/Disposal

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Payback Method - Summary

• Payback is only a rough estimator of desirability
• Use as an initial screening method
• Avoid using this method as a primary analysis
  technique for selection projects
• Totally avoid the no-return payback period

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Payback Method - Summary

• The No-return method
• Does not employ the time value of money
• Disregards all cash flows past the payback time
  period
• If used, can lead to conflicting selections when
  compared to more technically correct methods like
  present worth!

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Life Cycle Costs ( LCC )
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Life Cycle Costs (LCC)

• Extension of the Present Worth method
• Used for projects over their entire life span
  where cost estimates are employed
• Used for
• Military/Defense Projects
• New Product Lines
• Large construction projects

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Phases of Life Cycle

• Needs Assessment Phase
• Conceptual Design Phase
• Detailed Design Phase
• Production/Construction Phase
• Operation (upgrading to extend) Phase
• Retirement/Disposal Phase

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Life Cycle Two General Phases
Cost-
Cumulative Life Cycle Costs
Time
Acquisition Phase
Operation Phase
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The Design Phase

• The design phase is the most critical phase in
  the system engineering process.
• If not managed correctly, it can lead to some
  undesired outcomes
• There will always be changes during the design
  phase, the amount of which can be attributed to
  the phases preceding it.

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LCC Impact of Design Changes

• Cost of a design change tends to multiply by 10
  with each phase
• Any design changes that might occur late in the
  life cycle drastically increase the total life
  cycle costs!
• Design freeze period

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LCC Acquisition Phase
Rule About 80 of LCC are locked in by the end
of the Acquisition Phase. Emphasis is on good
design!
Costs -
Needs Assessment
Conceptual Design
Detailed Design
Acquisition Phase
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Life-Cycle Costs Purpose

• Make as explicit as possible the relationship of
  costs over the total life span of a
  product/system
• Design Process Objective
• Minimize the life-cycle costs
• And meet other performance requirements
• By making correct trade-offs between costs in the
  acquisition phase and costs during the operations
  phase

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Life-Cycle Costs Warning

• Beware of introducing certain cost- cutting
  measures in the acquisition phase and early
  production phase
• Such cost-cutting measures could impact the
  future operations and degrade safety or require
  modifications later on
• These cost-cutting measures can be misleading and
  dangerous!

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Life-Cycle Costs Warning

• Engineers have a ethical and moral responsibility
  to ensure that designs are
• Economically sound
• Functional
• Safe
• Perform as expected

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LCC of the Microwave System

• For Microwave example
• Useful life 10 years
• Interest rate 10
• Initial costs 153,000
• Recurring costs 8,800 per annum
• Salvage value 0
• Total PW 207,072
• Total PW for carrier-provided service 346,717
• Refer to the spreadsheet example Microwave
  Example also includes AW analysis.

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References

• Blank, L., Tarquin, A., Engineering Economy,
  McGraw-Hill, 5/e (Chapter 5)

Thanks for your attention