Chapter 5: Evaluation Tools
Suppose that in ten years you are the engineering manager at a large agricultural equipment manufacturing plant. You are faced with some important management decisions. For example, say there is a new piece of equipment available that would allow the company to manufacture plows more efficiently. The equipment is expensive but would shorten the time required to manufacture each plow. This could increase the number of plows made each year, and reduce the cost of each plow. The company has estimated the amount of production time the equipment would save on each plow, but they cannot be sure about how the demand for their plows will change in the coming years. Should the company purchase the equipment?
Even in this small example, there are many factors to consider when choosing whether to purchase the equipment. Some questions the company might need consider include:
- How long will the equipment last?
- How many more plows would need to be sold each year to offset the cost of the equipment?
- How accurate are their projections for future sales?
- Is the company likely to lose money on this purchase?
- How accurate do their production time estimates need to be to give them confidence in their decision?
In this chapter, we will discuss the primary analysis techniques that can be applied to this situation and many others like it. First, we will discuss the criteria and metrics used for decision making, and how to determine their thresholds. Then, we will cover several commonly used evaluation methods. This will include a discussion into how these methods can be applied to projects with different time scales. Finally, we will examine how different evaluation methods can be used to assess the riskiness of a project or investment.
Key Concepts and Terms
- Minimum Acceptable Rate of Return (MARR) selection, cost of capital
- Net Present Value (NPV), Annual Equivalent Value (AEV), payback period, Internal Rate of Return (IRR)
- Analysis period and project lives
- Risk assessment and evaluation
After completing this chapter, students should be able to:
- Define and apply MARR and cost of capital
- Choose and apply the appropriate evaluation methods (payback period, NPV, AEV, etc.) for given problems
- Compare scenarios for different project or investment durations
- Evaluate risk by considering variability in estimates