W5_ASY_Project Evaluation Using ERR Method


Problem Statement

Continue to discuss further using topic from my W4 posting here I want to talk about using ERR for evaluating this project. The tools as discussed in in Engineering Economy Engineering Book, chapter 5, page 178-211. This is introducing external reinvestment rate (ɛ) per period. Just like IRR, ERR is used to evaluate the economic justification of project. But this time ERR that taken into account the interest rate external at which cash flow generated over the lifecycle of project. This method is also useful for solving similar problems as stated in in problem 5-46 at this book. But, instead of using MARR = 12%, in this posting I am using ɛ = MARR 20% because as I am using real life example as described in my blog posting W4 previously.

Feasible Alternatives

Recall data from previous blog, then make summary for what is needed to make an assessment, the following business economic profile is as described below:


Table.1

Summarized as follows:


Table.2

The general steps for using this ERR method is divided into 3 steps:

  1. First, all net cash outflows are discounted into present at ɛ % per compound period
  2. Second, all net cash inflows are compounded to period N at ɛ %
  3. Third, the External Rate of Return which is the interest rate that establishes equivalence between the two quantity can be determined

Outcomes/ Calculations of Each Alternative

Combining the calculation from step 1 and step 2 we got the result as showed bellows:

IDR 17.596.000 (F/P, i’ %,5) =IDR 7.818.078 (F/A, 20 %,5) + IDR 1.000.000

(F/P, i’ %,5) =

3.3632

And from interest and annuity tables for discrete compounding here the result for I’ =18% and 25%

for (F/P,18 %,5) =

2.2878

for (F/P,25 %,5) =

3.0518

Then we can extrapolate to find what is the interest rate for value from the calculation result from step 1 and step 2.


Figure.1

Extrapolation for i’ :

( i’ – 25 )

( 3,3632 – 3,30518 )

————-

= ———————-

( 25 – 18 )

( 3,30518 – 2,2878)

( i’ – 25 ) =

2.891

i’ =

27.891

Extrapolation results : i’ = 27.891

The External Rate of Return of the project is = 27.891 %

Setting Minimum/ Selection Criteria

The economic justification for this project is based on ERR > given MARR

Analysis/ Comparison of the Alternatives against the Criteria

By using IRR method rather than using ERR method as the re-investment assumption for the project is not always a good decision at the time from management perspective, for example if IRR is higher above MARR re-investment of net cash may not be proceed exceeding the MARR value

Selection of the Best/ Preferred Alternative Compared against the Criteria

The criteria of this project is economically justified if ERR is greater than MARR

Performance Monitoring and Post Evaluation of Result/ Follow up Assessment

Now we know that the laundry business economic project proposal is still economically justified according to ERR method, and we already know that revenue gained absolutely influenced by the company’s productivity. But sometimes another measure is still needed to convince decision of investment. There is a secondary measure can be used to give the picture of project risk. we can use payback or payout terminology. It calculates the number of years required to equal cash outflows. Payback method comes in two types, first ignores time value of money (simple payback) and second considering time value of money (discounted payback).

The calculation is as described at tabel.3 below :


Tabel.3


Figure.2, ( x-end of year, y-axis : Cumulative Present Worth (IDR) )

References :

  1. Hartono Elektronika (2013). Front Loading Washer. [ONLINE] Available at: https://www.hartonoelektronika.com/en/washer-and-dryer/washer-and-dryer-en/front-loading-washer-en-2/. [Last Accessed 15 Sept 203].
  2. Sullivan, William G., Wick, Elin M., Koelling, C. Patric. (2012), Engineering Economy. Chapter 5 Pp. 178 – 211, Fifteenth edition, Prentice hall.
  3. Laundry Dashboard (2012). Improve The Efficiency of Your Laundry in Three Steps. [ONLINE] Available at: http://www.laundrydashboard.com/. [Last Accessed 20 September 2013].
  4. PT PLN (Persero) (2013). Tarif Tenaga Listrik. [ONLINE] Available at: http://www.pln.co.id. [Last Accessed 6 September 2013].
  5. Jual Kios (2013). Sewa Kios di Pasar Modern Bintaro Jaya Sektor 7. [ONLINE] Available at: http://www.jualsewakios.com/538/sewa-kios-di-pasar-modern-bintaro-jaya-sektor-7/. [Last Accessed 20 September 2013].
  6. Beritajakarta (2012). Peraturan Gubernur Provinsi Daerah Khusus Ibukota Jakarta. [ONLINE] Available at: http://www.beritajakarta.com/Download/SK/Detail/Pergub_189_2012.pdf. [Last Accessed 20 September 2013].
  7. Coin Laundry Association (2013). Laundry Industry Overview. [ONLINE] Available at: http://www.coinlaundry.org/resources-education/laundry-industry-overview/. [Last Accessed 20 September 2013].
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1 Comment

Filed under Asyhad, Week 05

One response to “W5_ASY_Project Evaluation Using ERR Method

  1. WONDERFUL, Pak Asyad!!! Nice analysis on an EXCELLENT case study!!!

    I was happy to see you explain the weakness of using IRR and why ERR is now a more highly regarded “analysis tool” to be using.

    Looking forward to seeing other examples where you are using the tools and techniques not only from Engineering Economy, but also Humphrey’s to solve real life problems!!!

    Be sure to claim credit for problems from these chapters and also don’t forget to charge some of your time to both the Problem Solving Project as well as the Blog Project. Don’t charge all your time to the Blog, otherwise you will skew the CPI/SPI as well as EAC for BOTH projects if you don’t allocate your time appropriately….

    BR,
    Dr. PDG, Jakarta

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