**1. Introduction**

630 Mechanical Engineering

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Research carried out in recent decades shows that the use of discounted cash flow (DCF) methods for engineering project evaluation has increased enormously. Klammer and Walker (1984) established in 1984 that in the USA the use of discounting grew from 19 percent in 1960 to 57 percent in 1970. Their research further stated that the use of discounted cash flow methods grew to 75 percent in 1980 for those projects dealing with the expansion of existing capacities. A few years later, Pike (1988) established that the use of either the internal rate of return or net present value methods in large UK companies grew from 58 percent to 84 percent between 1975 and 1986. Research carried out by Pšunder and Ferlan (2007 & 2008) among Slovenian project managers shows that the use of discounted cash flow methods depends on the project managers' field of education. Among project managers who have an education in civil engineering, only 50 percent use the net present value method and 66.7 percent the internal rate of return. Among mechanical engineers, 62.5 percent use the net present value method and 87.5 percent the internal rate of return.

Pšunder and Ferlan (2007) further established that among discounted cash flow methods – net present value (NPV), net present value index (NPVI), internal rate of return (IRR) and modified internal rate of return (MIRR) were taken into consideration – the most commonly used method in Slovene companies is the net present value method (average use is 70.5 percent), while the least popular is the use of the modified internal rate of return method (on average less than 30 percent). Employees with an education in mechanical engineering most often use the internal rate of return method (87.5 percent), followed by the net present value method (62.5 percent), while the modified internal rate of return method and net present value index is used by only half of these. The authors explain that the use of the internal rate of return method among experts with an education in mechanical engineering is explicable in terms of the method's ease of understanding, since the result is expressed in a percentage (of rate of return). At the same time, results can easily be compared between different projects and between different forms of other investments. Although the calculation demands trial and error procedure or interpolation, financial calculators and electronic spreadsheets contain standard procedures for internal rate of return calculation. The frequency of use of the net present value method can be explained by the simplicity of its calculation and by the generally widespread use of this method (a standard function on calculators and electronic spreadsheets).

Use of Discounted Cash Flow Methods for Evaluation of Engineering Projects 633

capital gain be included in the calculation. This means that non-discounting methods are based on the assumption that every investment will have the same capital gain or loss.

Despite the evident deficiencies of non-discounting methods, they are wide spread among project managers and other decision makers. According to Pšunder and Ferlan (2007), approximately 80 percent of project managers with an education in mechanical engineering and approximately two thirds of other project managers with an education in engineering

In contrast to non-discounting methods, in the discounting ones the calculation is based on the time value of money. That means the differences in maturity of payments can be considered. With discounting methods, capital gain or loss can be included in the (last) payment of the project. Since the methods deal with a discount rate, the differences in the

Discounting methods always deal with cash flow analysis of a project or an investment. There are several methods – e.g. the net present value index and modified internal rate of return method – but by far the most commonly used among the discounting methods are the net present value method and the internal rate of return method (Pšunder and Ferlan, 2007).

The main advantage of discounting methods over non-discounting ones is the consideration of the time value of money. This is particularly important in engineering projects where duration of projects is usually long, and payments can be vastly deferred. Thus, by using discounting

By using the net present value method, we compare the present value of future payments with initial investment. In this way we determine the surplus from a project or an investment in present value terms. The advice of the method is positive if the net present value of project or investment is greater than or equal to 0, which means a project or an investment will generate a surplus by a given discount rate. Since the risk premium is included in the discount rate, the surplus represents extra gain for the investor, measured in present value terms. Of course, the investor does not receive the sum immediately, but that "extra gain" represents the present value of future surpluses from the cash flow of a project or an investment. Mathematically, the

> <sup>0</sup> <sup>1</sup> 1 *<sup>n</sup> <sup>i</sup>*

*r*

*i CF NPV I*

In equation 1, *CFi* stands for the cash flow in the period *i*, *n* represents the number of periods

The internal rate of return method is quite similar to the net present value method, but despite these similarities, it produces different results. With the internal rate of return method, we calculate the return rate by equalizing the net present value with 0. The result is a measure of the rate of return earned on that capital used in the project during the time that the capital is

According to Puxty and Dodds (1991) the internal rate of return method is no more difficult to understand. Though the mathematics are just as easy, it is trickier because in normal circumstances the solution can only be found by trial and error. The goal of the method is to

used, after allowing for the recoupment of the initial capital outlay (Holmes, 1998).

*i*

(1)

methods for project analyses, we can overcome the time inconsistency of payments.

(e.g., civil engineering or electrical engineering) are still using them.

risk premium can be considered as well.

net present value can be calculated by using equation 1:

and *r* is the discount rate.

Following on from this research, the modified internal rate of return method is the least used among the methods studied in the research, although this method avoids the deficiencies that occur with the internal rate of return method (e. g., one avoids the presumption that all payments are reinvested at the same rate of return as the internal one).

It is also interesting that the research showed that most experts simultaneously use a number of discounted cash flow methods, a technique which diminishes the possibility of false conclusions. 57.1 percent of experts with an education in mechanical engineering who evaluate investments by means of discounted cash flow methods most often use a combination of two methods, but only 35.7 percent of experts in other sciences use a combination of two methods.

Research also shows that, according to their personal opinion, project managers are not sufficiently aware of the limitations of discounted cash flow methods. In establishing the level of knowledge about flaws in discounted cash flow methods, Pšunder and Ferlan's research (2007) established that less than half (43.2 percent) of experts (in all sciences) are familiar with multiple internal rate of return, and only 16 percent know the problem of results (conflicting advice) between the internal rate of return method and the net present value method. Major differences occur between experts of different profiles (Table 1).


Table 1. Knowledge of flaws of discounted cash flow methods by field of education (Pšunder and Ferlan, 2007).
