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Exam III Topical Review_1_

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					Cost/Benefit Analysis Review
•   Cost/Benefit can done using NPW or EAW, pick one!
    (choose whichever method is easiest for the problem statement)

•   Criteria:    Benefits – Disbenefits (to the public)
                        Costs           (to the sponsor)
     •    Benefits must outweigh costs, so if the B/C ratio is:
                 >1             project is justified
                 =1             barely justified – political
                 <1             not justified
•   Alternative viewpoints complicate the process!
•   Terms:
     •    Primary Benefits –     easy to measure, change to $$
     •    Secondary Benefits – difficult to quantify (political)
     •    Disbenefits –          paid by public users (tolls, etc.)
     •    Costs –          1st costs & salvage, O & M paid – revenues
                           collected by sponsor
  Incremental Analysis with B/C

• Incremental Analysis MUST be used when comparing!
       (Cost/Benefit Ratio is a relative measure)
• Caution: Must compare only feasible projects!
• Steps:
     • Order projects by increasing TOTAL costs AND
       eliminate any infeasible projects
     • Use first feasible project – becomes current best
         •    Compare with Doing Nothing if that is an option
         •    Do same “apples to apples” comparison for all
     • Pairwise Comparison on Incremental Cash Flow
         •    If incremental B/C > 1, then higher cost is better
         •    If incremental B/C ≤ 1, then lower cost is better

     Note: There is NO modified B/C analysis on exam!
            Replacement Review
• Essentially, there are two aspects to replacement:
     • What is the economic service life of the replacement
       alternatives (challengers)?

     • What is the ownership life of the existing system
       (defender)?
• Criteria: Choose the lowest EAC method today
     • Must take an outsider’s perspective when valuing the
       existing system
• Terms:
     •   Physical Life         • Fair Market Value
     •   Ownership Life               • Market Value
     •   Economic Service Life        • Trade-in Value
     •   Accounting Life              • Book Value
     Economic Service Life Review
• Economic Service Life (ESL) is the length of time that
  minimizes the equivalent annual cost for the system
• Relationship: Total EACTotal = EACownership + EACoperation
      • EACownership:
            •   1st Costs(A/P, i, N) – Salvage(A/F, i, N)
            •   Typically decrease with longer lifetime (N)
      • EACoperation:
            •   Annualized Operating + Maintenance Costs
            •   Typically increase with longer lifetime (N)
• Steps:
      • Find EACTotal for each year of remaining life (N = 1, 2, …)
      • Find the lowest cost lifetime (ESL) among EACtotal:
           •   Plan to use until end of ESL year
           •   Plan to replace at the start of the next year
The system with the lowest cost ESL is the best replacement Challenger!
   Outsider’s Perspective Review
• The outsider would have to purchase the existing
  system in order to use it – paying “Fair Market Value”

 Priority Order:      (& information sources)
     1.   Market Value
           •   Independent Audit / Appraisal
           •   Want/For Sale Ads in paper/trade magazine
           •   Selling/Asking price at auction
     2.   Trade-In Value
           •   Must use if accepting lower challenger price
               from vendor
           •   Can shop around to different vendors
           •   “Blue Book” price
           •   Bank / Savings & Loan estimate
     3.   Book Value
           •   Prefer Book depreciation to MACRS value
            Opportunity Cost Approach
           The fair market value of the defender will be
           treated as a cost to retain the defender
           (this is the opportunity cost that is foregone by
           retaining the defender)

DEFENDER DIAGRAM:
                                             Salvage

                           1   2       3      n = Lifetime
                    0
    Overhaul Cost
                                             Operating Cost
     Fair Mkt. Value
                       Overhaul Cost         Maintenance Cost
           Ownership Life Review
• Ownership Life is the length of time to keep the existing
  system that minimizes the equivalent annual cost for the
  ongoing performance of the function
• Decision is based on expected costs as known today
     • No sunk costs (original price doesn’t matter)
     • Relevant costs only (common costs are just clutter)
• Steps:
     • Use the Opportunity Cost approach
           (Fair Market Value appears as a cost on the Defender CFD)
     • Find ESL of the best Challenger option
     • Find each EACtotal up through the physical lifetime for
       the Defender:
          •   Find the Ownership Life of the Defender
          •   Plan to replace with the Challenger at the start of
              the next year: when the EACDefender > ESLChallenger

				
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posted:10/25/2012
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