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# The Economic Analysis of Industrial Projects

## byTed Eschenbach, Neal Lewis, Joseph Hartman

### Hardcover | January 20, 2015

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Economic Analysis of Industrial Projects, Third Edition, provides the best possible methods for applying economic analysis theory to practice. Completely revised and expanded in this new edition, the text now includes five new chapters and new material on real options analysis and replacementanalysis.

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Title:The Economic Analysis of Industrial ProjectsFormat:HardcoverDimensions:528 pages, 9.25 × 7.5 × 0.98 inPublished:January 20, 2015Publisher:Oxford University PressLanguage:English

The following ISBNs are associated with this title:

ISBN - 10:0195178742

ISBN - 13:9780195178746

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Table of Contents

PART ONE Basic Concepts1. The Firm: Economic Exchanges and Objectives1.1 Introduction1.2 Economic Exchange: The Input-Output Basis of the Firm1.3 Functions of the Firm: Financing, Investing, Producing1.4 Objectives of the Firm1.5 Sources and Uses of Funds1.6 SummaryReferencesProblems2. Interest, Interest Factors, and Equivalence2.1 What is Interest?2.1.1 Perfect capital market assumptions2.1.2 The consumption basis of single-period exchange2.1.3 Multi-period exchange2.1.4 Fundamental interest equation2.1.5 The equilibrium market price concept of interest rates2.2 Notation and Cash Flow Diagrams2.3 Tabulated Compound Interest Factors2.3.1 Factors relating P and F2.3.2 Factors relating A and F2.3.3 Factors relating P and A2.3.4 Arithmetic gradient conversion factors2.4 Examples of Time Value of Money Calculations2.5 Geometric Gradients2.6 Nominal and Effective Interest Rates2.7 Continuous Interest Factors2.8 Extended Engineering Economy Factors and Spreadsheets and Calculators2.8.1 Advantages of extended engineering economy factors2.8.2 Notation for extended engineering economy factors2.8.3 Spreadsheet annuity functions2.8.4 Time value of money (TVM) calculators2.9 Spreadsheets and Cash Flow Tables2.9.1 Advantages of spreadsheets for economic analysis2.9.2 Effective and efficient spreadsheet construction2.10 Economic Interpretation of Equivalent Annual Amount2.11 SummaryReferencesProblems3. Estimating Costs and Benefits-Lead Coauthor Heather Nachtmann3.1 Introduction3.2 Cash Flow Estimates3.3 Life Cycle Estimation3.4 Classification of Estimates3.5 Estimation Data3.6 Basic Estimation Techniques-Indexes and Per Unit3.6.1 Indexes3.6.2 Unit Technique3.7 Factor Technique3.8 Cost Estimation Relationships3.8.1 Development Process3.8.2 Capacity Functions3.8.3 Learning Curves3.9 Growth Curves3.10 Estimating Product Costs3.10.1 Direct costs3.10.2 Indirect costs3.11 Sensitivity Analysis3.12 SummaryReferencesProblems4. Depreciation: Techniques and Strategies4.1 Introduction4.2 Depreciation Strategies4.3 Definitions4.3.1 Depreciable property4.3.2 Basis of property4.3.3 Recovery period4.3.4 Salvage value4.3.5 Symbols and notation4.4 Basis and Book Value Determination4.4.1 Definition of initial basis and book value4.4.2 Special first-year write-offs4.4.3 Like-for-like replacement4.5 Methods of Depreciation4.5.1 Introduction4.5.2 The straight-line method4.5.3 The declining balance method4.5.4 The sum-of-the-years' digits (SOYD) method4.5.5 Switching4.5.6 Units of production4.5.7 Reasons for accelerated depreciation4.5.8 Modified Accelerated Cost Recovery System (MACRS)4.5.9 Job Creation and Worker Assistance Act4.5.10 Comparing book values with different depreciation methods4.6 The Present Value of the Cash Flow Due to Depreciation4.6.1 Straight-line method4.6.2 Declining balance method4.6.3 Sum-of-years' digits method4.6.4 Modified accelerated cost recovery system4.7 Simple Depreciation Strategies4.7.1 Accelerated depreciation is better4.7.2 Declining balance method versus the straight-line method4.7.3 The declining balance method versus the sum-of-years' digits method4.8 Complications Involving Depreciation Strategies4.9 Summary of Conclusions: Depreciation4.10 Depletion of Resources4.10.1 Entitlement to depletion4.10.2 Methods for computing depletion deductions4.10.3 The depletion deduction4.10.4 Typical percentage depletion rates4.11 Amortization of Prepaid Expenses and Intangible PropertyReferencesProblems5. Corporate Tax Considerations5.1 Introduction5.2 Ordinary Income Tax Liability5.3 Federal Income Tax Rates5.3.1 Investment tax credit5.4 Generalized Cash Flows from Operations5.5 Tax Liability When Selling Fixed Assets5.5.1 What are Section 1231 assets?5.5.2 Tax treatment of 1231 assets5.6 Typical Calculations for After-Tax Cash Flows5.7 After-Tax Replacement Analysis5.8 Value-added TaxReferencesProblems6. The Financing Function6.1 Introduction6.2 Costs of Capital for Specific Financing Sources6.3 Cost of Debt Capital6.3.1 Short-term capital costs6.3.2 Capital costs for bonds6.4 Cost of Preferred Stock6.5 Cost of Equity Capital (Common Stock)6.5.1 Dividend valuation model6.5.2 The Gordon-Shapiro growth model6.5.3 The Solomon growth model6.5.4 Note on book value of stock6.5.5 Capital asset pricing model (CAPM)6.5.6 Cost of retained earnings6.5.7 Treasury stock6.6 Weighted Average Cost of Capital6.7 Marginal Cost of Capital6.7.1 Market values imply a marginal cost approach6.7.2 Marginal cost-marginal revenue approach6.7.3 A discounted cash flow approach6.7.4 Mathematical approach to marginal cost of capital6.8 Numerical Example of the Marginal Weighted Average Cost of Capital6.8.1 Calculation of the present weighted average cost of capital6.8.2 The future weighted average cost of capital after provision for new capital6.8.3 The marginal cost of capital6.9 MARR and Risk6.10 WACC and the Pecking Order Model6.11 SummaryReferencesSummaryPART TWO Deterministic Investment Analysis7. Economic Measures7.1 Introduction7.2 Assumptions for Unconstrained Selection7.3 Some Measures of Investment Worth (Acceptance Criteria)7.4 The Payback Period7.4.1 Payback rate of return7.4.2 Discounted payback7.5 Criteria Using Discounted Cash Flows7.6 The Net Present Value Criterion7.6.1 Production-consumption opportunities of the firm7.6.2 The present value criterion for project selection7.6.3 Multi-period analysis7.6.4 Characteristics of net present value7.7 The Benefit-Cost Ratio Criteria7.8 Internal Rate of Return7.8.1 Defining the internal rate of return7.8.2 The fundamental meaning of internal rate of return7.8.3 Conventional and nonconventional investments (and loans)7.8.4 Conventional investments and internal rate of return7.9 Nonconventional Investment7.9.1 Nonconventional investment defined7.9.2 Conventional, pure investments7.9.3 Analyzing nonconventional investments7.9.4 Numerical examples7.10 Roots for the PW Equation7.10.1 Using the root space for P, A, and F7.10.2 Defining the root space for P, A, and F7.10.3 Practical implications of the root space for P, A, and F7.11 Internal Rate of Return and the Lorie-Savage Problem7.11.1 Multiple positive roots for rate of return7.11.2 Return on invested capital7.11.3 Present worth and the Lorie-Savage problem7.12 Subscription/Membership Problem7.13 SummaryReferencesProblems8. Replacement Analysis8.1 Introduction8.2 Infinite Horizon Stationary Replacement Policies8.2.1 Stationary costs (no technological change)8.2.2 Technological change and stationary results8.3 Non-Stationary Replacement Policies8.3.1 Age-based state space approach8.3.2 Length of service state space approach8.3.3 Applying dynamic programming to an infinite horizon problem8.3.4 Solving with linear programming8.4 After-Tax Replacement Analysis8.5 Parallel Replacement Analysis8.6 Summary and Further TopicsReferencesProblems9. Methods of Selection Among Multiple Projects9.1 Introduction9.2 Project Dependence9.3 Capital Rationing9.4 Comparison Methodologies9.5 The Reinvestment Rate Problem9.6 The Reinvestment Assumption Underlying Net Present Value9.7 The Reinvestment Assumption Underlying the Internal Rate of Return: Fisher's Intersection9.8 Incremental Rates of Return9.8.1 Incremental rate of return applied to the constrained project selection problem9.8.2 Inclusion of constraints9.9 The Weingartner Formulation9.9.1 Objective function9.9.2 Constraints9.9.3 The completed Weingartner model9.9.4 Constrained project selection using Solver9.10 Constrained Project Selection by Ranking on IRR9.10.1 The opportunity cost of foregone investments9.10.2 Perfect market assumptions9.10.3 Internally imposed budget constraint9.10.4 Contrasting IRR and WACC assumptions9.10.5 Summary of ranking on IRR9.11 SummaryReferencesProblemsPART THREE Investment Analysis under Risk and Uncertainty10. Optimization in Project Selection (Extended Deterministic Formulations)10.1 Introduction10.2 Invalidation of the Separation Theorem10.3 Alternative Models of the Selection Problem10.3.1 Weingartner's horizon models10.3.2 The Bernhard generalized horizon model10.3.3 Notation10.3.4 Objective function10.3.5 Constraints10.3.6 Problems in the measurement of terminal wealth10.3.7 Additional restrictions10.3.8 The Kuhn-Tucker conditions10.3.9 Properties of10.3.10 Special cases10.4 Project Selection by Goal Programming Methods10.4.1 Goal programming format10.4.2 An example of formulating and solving a goal programming problem10.4.3 Project selection by goal programming10.5 SummaryAppendix 10.A Compilation of Project Selection ProblemReferencesProblems11. Utility Theory11.1 Introduction11.1.1 Definitions of Probability11.2 Choices under Uncertainty: The St. Petersburg Paradox11.3 The Bernoulli Principle: Expected Utility11.3.1 The Bernoulli solution.11.3.2 Preference theory: the Neumann-Morgenstern hypothesis11.3.3 The axiomatic basis of expected utility11.4 Procuring a Neumann Morgenstern Utility Function11.4.1 The standard lottery method.11.4.2 Empirical determinations of utility functions11.5 Risk Aversion and Utility Functions11.5.1 Risk aversion as a function of wealth11.5.2 Other risk-avoiding utility functions11.5.3 Linear utility functions: Expected monetary value11.5.4 Complex utility functions: Risk seekers and insurance buyers11.5.5. Reconciling firm's utility and behavior by employees and managers11.6 SummaryReferencesProblems12. Stochastic Cash Flows12.1 Introduction12.2 Single Risky Projects: Random Cash Flows12.2.1 Estimates of cash flows12.2.2 Expectation and variance of project net present value12.2.3 Autocorrelations among cash flows (same project)12.2.4 Probability statements about net present value12.3 Multiple Risky Projects and Constraints12.3.1 Variance of cross-correlated cash flow streams12.3.2 The candidate set of projects12.3.3 Multiple project selection by maximizing expected net present value12.4 Accounting for Uncertain Future States12.5 SummaryReferencesProblems13. Decision Making Under Risk13.1 Introduction13.2 Decision Networks13.3 Decision Trees13.4 Sequential Decision Trees13.5 Decision Trees and Risk13.5.1 Stochastic decision trees13.5.2 Applications13.6 Expected Value of Perfect Information13.7 Simulation13.8 SummaryReferencesProblems14. Real Options Analysis14.1 Introduction14.2 Financial Options14.3 Real Options14.3.1 Historical development14.3.2 The real option model14.3.3 Interest rates14.3.4 Time14.3.5 Present value of future cash flows14.4 Real Option Volatility14.4.1 Actionable volatility14.4.2 Logarithmic cash flow method14.4.3 Stock proxy method14.4.4 Management estimates method.14.4.5 Logarithmic present value returns method (CA method)14.4.6 Standard deviation of cash flows14.4.7 Internal Rate of Return14.4.8. Actionable volatility revisited14.5 Binomial Lattices14.6 The Deferral Option: Dementia Drug Example14.6.1 Definition and NPV calculation14.6.2 Volatility14.6.3 Black-Scholes results14.6.4 Binomial lattices14.7 The Deferral Option: Oil Well Example14.7.1 NPV.14.7.2 Delay option formulation14.7.3 Black-Scholes results14.7.4 Binomial lattices14.8 The Abandonment Option14.9 Compound Options14.9.1 Multi-stage options modeling14.9.2 Multi-stage option example.14.9.3 Closed form solution14.9.4 Volatility issues in multi-stage modeling.14.10 Current Issues with Real Options14.11 SummaryAppendix 14.A Derivation of the Black-Scholes EquationReferencesProblems15. Capacity Expansion and Planning15.1 Introduction15.2 Expansion Analysis15.2.1 Dynamic deterministic evaluation15.2.2 Dynamic probabilistic evaluation15.3 Capacity Planning Strategies15.3.1 Maximizing market share strategy15.3.2 Maximizing utilization of capacity strategy15.4 SummaryReferencesProblems16. Project Selection Using Capital Asset Pricing Theory16.1 Introduction16.2 Portfolio Theory16.2.1 Securities and portfolios16.2.2 Mean and variance of a portfolio16.2.3 Dominance among securities and portfolios16.2.4 Efficient portfolios16.2.5 The risk in a portfolio16.3 Security Market Line and Capital Asset Pricing Model (CAPM)16.3.1 Combinations of risky and riskless assets16.3.2 The security market line16.3.3 The capital asset pricing model (CAPM)16.4 Firm's Security Market Line and Project Acceptance16.4.1 Projects and the capital asset pricing model (CAPM)16.4.2 Risk/return trade-offs and the firm's security market line16.5 The Firm's Portfolio of Projects16.5.1 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 portfolios16.5.4 Can the capital asset pricing model for securities be extended to projects?16.6 SummaryReferencesProblemsAppendixIndex

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