The essential idea of investing is to give up something valuable now for the expectation of receiving something of greater value later. An investment may be thought of as an exchange of resources now for an expected flow of benefits in the future. Business firms, other organizations, and individuals all have opportunities to make such exchanges. A company may be able to use funds to install equipment that will reduce labour costs in the future. These funds might otherwise have been used on another project or returned to the shareholders or owners. An individual may be able to studv to become an engineer. Studying requires that time be given up that could have been used to earn money or to travel. The benefit of study, though, is the expectation of a good income from an interesting- job in the future.
Not all investment opportunities should be taken. The company considering a labour-saving investment may find that the value of the savings is less than the cost of installing the equipment. Not all investment opportunities can be taken. The person spending the next four years studying engineering cannot also spend that time getting degrees in law and science.
Engineers play a major role in making decisions about investment opportunities. In many cases, they are the ones who estimate the expected costs of and returns from an investment. They then must decide whether the expected returns outweigh the costs to see if the opportunity is potentially acceptable. They may also have to examine competing investment opportunities to see which is best. Engineers frequently refer to investment opportunities as projects. Throughout the rest of this text, the term project will be used to mean investment opportunity.
In this chapter and in Chapter 5, we deal with methods of evaluating and comparing projects, sometimes called comparison methods. We start in this chapter with a scheme for classifying groups of projects. This classification system permits the appropriate use of any of the comparison methods. We then turn to a consideration of several widely used methods for evaluating opportunities. The present worth method compares projects by looking at the present worth of all cash flows associated with the projects. The annual worth method is similar, but converts all cash flows to a uniform series, that is, an annuity. The payback period method estimates how long it takes to "pay back" investments. The study of comparison methods is continued in Chapter 5, which deals with the internal rate of return.
We have made six assumptions about all the situations presented in this chapter and in Chapter 5:
1. We have assumed that costs and benefits are always measurable in terms of money. In reality, costs and benefits need not be measurable in terms of money For example, providing safe working conditions has many benefits, including improvement of worker morale. However, it would be difficult to express the value of improved worker morale objectively in dollars and cents. Such other benefits as the pleasure gained from appreciating beautiful design may not be measurable quantitatively. We shall consider qualitative criteria and multiple objectives in Chapter 13.
2. We have assumed that future cash flows are known with certainty. In reality, future cash flows can only be estimated. Usually the farther into the future we try to forecast, the less certain our estimates become. We look at methods of assessing the impact of uncertainty and risks in Chapters 11 and 12.
3. We have assumed that cash flows are unaffected by inflation or deflation. In reality, the purchasing power of money typically declines over time. We shall consider how inflation affects decision making in Chapter 9.
4. LJnless otherwise stated, we have assumed that sufficient funds are available to implement all projects. In reality, cash constraints on investments may be very important, especially for new enterprises with limited ability to raise capital. We look at methods of raising capital in Appendix 4A.
5. We have assumed that taxes are not applicable. In reality, taxes are pervasive. We shall show how to include taxes in the decision-making process in Chapter 8.
6. Unless otherwise stated, we shall assume that all investments have a cash outflow at the start. These outflows are calledfirst costs. We also assume that projects with first costs have cash inflows after the first costs that are at least as great in total as the first costs. In reality, some projects have cash inflows at the start, but involve a commitment of cash outflows at a later period. For example, a consulting engineer may receive an advance payment from a client, a cash inflow, to cover some of the costs of a project, but to complete the project the engineer will have to make disbursements over the project's life. We shall consider evaluation of such projects in Chapter 5.
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