Part VI: Quantitative Methods for IQP's Common IQP Methodologies
Prepared for The Interdisciplinary and Global Studies Division
by Douglas W. Woods
SS&PS
General Introduction
Part VI reviews quantitative methods for IQPs in four broad areas: Investment Decisions and Life Cycle Costing (1), Regression Analysis (2), Econometric Modeling (3) and System Dynamics (4). These areas were chosen because of their relevance to interactive project work. Past experience has shown that the need for these techniques arises more frequently in IQP's than most other types of quantitative analysis.
Of the four topics discussed here, the last three listed above are presented briefly, with just enough information to enable the reader to understand the purpose of the methodology, the types of problems in which its application may be required and to a limited extent, how to use it. Readers who need to employ these techniques can obtain the necessary additional information from the references listed at the end of each section.
The aim of Chapter 12, which discusses Investment Decisions and Life Cycle Costing, however, is more ambitious. The reader willing to invest several hours studying this section should acquire the ability to analyze thoroughly the financial aspects of most types of investment decisions. The reader should come away with an understanding of how these methods of analysis work, why they yield correct decisions and how to apply them. This chapter is accompanied by an available computer disk containing electronic spreadsheet solutions to a set of sample problems. Many readers will find that these solutions can be applied to their own problems simply by changing the input data.
Chapter 12: Investment Decisions - Life Cycle Costing
Introduction
The analysis of investment decisions and life cycle costing are closely related methods for evaluating investments involving initial expenditures for equipment, installation, service and/or training etc. that will have future benefits or will impact future costs. In business financial management the process of evaluating and choosing from among such investments is termed capital budgeting. In engineering economic analysis this process is referred to as "economic evaluation of investment proposals" or as " comparison or selection of alternatives". All of these terms refer to a common body of analytical techniques that are essential tools for investment decision making by government, private agencies, homeowners or business firms. Any IQP or MQP which recommends or evaluates courses of action involving investments requires the use of these techniques to support its conclusions.
The essence of an investment is a sacrifice now in exchange for future benefits. In a typical investment decision the question is, should a project be undertaken? Do the future benefits from doing so outweigh the initial costs? Examples would be a decision by a state DPW to construct a new highway or a power company to build a hydroelectric plant. The benefits may be in the form of additional future income or revenue or may be intangible and non-pecuniary in nature. (This chapter deals only with the analysis of the quantifiable, financial aspects of investment decisions. Methods exist for assessing intangible costs or benefits, in some cases quantifying them, but are beyond our present scope. They are discussed in the literature referenced at the end of the chapter.)
In life cycle costing, the issue is how best to accomplish a given task - what is the least cost method, taking into account both the initial outlay required and future operating costs. An example would be determining which system among several alternatives for heating a new house would be most economical over the system's entire operating life. Life cycle costing also involves investment decisions, in the sense that some of the methods under consideration will require larger initial outlays but achieve lower future costs than others.
Because of the need to consider relevant intangible benefits (and costs), the analysis of investment decisions is broader in scope than life cycle costing. What both techniques have in common is the requirement that future costs (life cycle costing) or net benefits (investment decisions) must be measured on a common scale along with the initial outlay. In doing so, account must be taken of what is called the "time value of money." The latter refers to the fact that money in hand right now could be invested elsewhere, i.e. in stocks or bonds, at a positive rate of interest. That money with accumulated interest would amount to more in the future than it does right now. Consequently, any money to be received or spent in the future is equivalent to a smaller sum of money to be received or spent right now.
This chapter focuses on the various methods available for taking account of the time value of money, the interest factor, in evaluating investments. Use of these methods (frequently, referred to as discounted cash flow or DCF techniques) is not optional. Failure to employ them will result in erroneous economic evaluations and incorrect decisions.
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