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Economic analysis in individual project selection
Using net present value analysis instead of the rate of return will treat investment scale as one of the key value drivers, and will help engineers select money-making projects
June 18, 2012
(This is a summary of the full article published in Consulting-Specifying Engineer)
Consulting engineers are always under pressure to deliver the most cost-effective project possible for their client, whether it is for a simple replacement pump selection or a full HVAC system selection on a large building. This is no small feat, as cost effectiveness depends not only on the upfront cost of a project, but also on its impact on future operational and other costs. Most engineers will use some type of lifecycle cost estimate to make these types of decisions, to balance upfront and future costs for a client. This analysis might include consideration of any of the following measures:
- The project's payback ratio (simple payback)
- Its internal rate of return
- The net present value of its cash flows.
The payback ratio is an ad hoc measure that, while easy to apply, can provide misleading signals. The finance literature supports the internal rate of return and net present value metrics as the more proper tools for general economic analysis. Nevertheless, when a specific problem involves mutually exclusive investments, analysts should employ only the net present value measure, and not the rate of return. When projects compete directly against each other for capital, it is important that differences in investment scale factor into the analysis. The internal rate of return measures only return per dollar of capital invested, thereby eliminating the impact of scale in specific project analysis.
Finance principles make it clear that firms should maximize wealth, which can be measured only in dollars. Unlike rates of return, which are percentages, the net present value result is dollar based, aligning more properly with finance principles in that regard.
We demonstrate these points using theoretical finance examples, then end with a real-world example showing that a large-scale geothermal heating and cooling system is economically superior to a smaller-scale conventional HVAC design, even though the conventional system has a quicker payback and a higher rate of return.