Economic Study Methods

The Minimum Attractive Rate of Return

For any investment to be profitable, the investor (corporate or individual) expects to receive
more money than the amount of capital invested. In other words, a fair rate of return, or
return on investment, must be realizable. The definition of ROR in Equation [1.4] is used in this
discussion, that is, amount earned divided by the principal.

Basic Economic Study Methods

Present Worth
The PW method is based on the concepts of equivalent worth of all cash flows relative
to some base or beginning point in time called the present. That is, all cash flow inflows and
outflows are discounted to the present point in time at an interest rate that is generally the
MARR. A positive PW for an investment project is a dollar amount of profit over the minimum
amount required by investors. It is assumed that cash generated by the alternative is available
for other uses that earn an interest at a rate equal to the MARR.
Future Worth
The FW method is used particularly in an investment situation where we need to
compute the equivalent worth of the project at the end of its investment period For Example,
Building a nuclear power plant, where it is time consuming. In such situation it is more common
to measure the worth of the investment at the time of commercialization

Annual Worth
The annual worth (AW) method is commonly used for comparing alternatives. All cash
flows are converted to an equivalent uniform annual amount over one life cycle of the
alternative. The AW value is easily understood by all since it is stated in terms of dollars per
year. The major advantage over all other methods is that the equal service requirement is met
without using the least common multiple (LCM) of alternative lives. The AW value is calculated
over one life cycle and is assumed to be exactly the same for any succeeding cycles, provided all
cash flows change with the rate of inflation or deflation.
Internal Rate of Return
The internal rate of return (IRR) is a discounting cash flow technique which gives a rate
of return earned by a project. The internal rate of return is the discounting rate where the total
of initial cash outlay and discounted cash inflows are equal to zero.

External Rate of Return

The external rate of return (ERR) is the rate of return on a project where any “excess”
cash from a project is assumed to earn interest at a pre-determined explicit rate — usually the
MARR.

Discounted Payback Period

The discounted payback period is a capital budgeting procedure used to determine the
profitability of a project. A discounted payback period gives the number of years it takes to
break even from undertaking the initial expenditure, by discounting future cash flows and
recognizing the time value of money. The metric is used to evaluate the feasibility and
profitability of a given project.

Benefit-Cost Ratio
A benefit-cost ratio (BCR) is a ratio used in a cost-benefit analysis to summarize the
overall relationship between the relative costs and benefits of a proposed project. BCR can be
expressed in monetary or qualitative terms. If a project has a BCR greater than 1.0, the project
is expected to deliver a positive net present value to a firm and its investors.
Example 1
A car loan requires 30 monthly payments of $199.00 starting today at an annual rate of
12 percent compounded monthly, how much money is being lent?
(P/A,i,N) = (1+i)N-1/i(1+i)N.
A = $199
i = 12%/12 months = 1% per month
P = 199 + A(P/A,i,N)

P = 199 + 199 x {(1+0.01 )29 -1/ 0.01(1+0.01)29}

P = $5,187.09

Example 2
City engineers are considering several plans for building municipal aqueduct tunnels.
They use an interest rate of 8 percent. One plan calls for a full-capacity tunnel that will meet
the needs of the city forever. The cost is $3000000 now and $100000 every 10 years thereafter
for repairs. What is the total present worth of the costs of building and maintaining the
aqueduct?

A
P =3,000,000 +
i
0.08
A = 100000 = 6902.95
(1+0.08)10−1
6902.95
P = 3,000,000 +
0.08
P = $3,086,286.88

Example 3
How much money will be in a bank account at the end of 15 years if $100 is deposited
today and the interest rate is 8 percent compounded annually?

0.08
(
ie = 1+
2 ) = 0.0816 x 100% = 8.16%
2

F = 100 x (1 + 0.0816)15
F = $323.34
Example 4
How much is accumulated over 20 years in a fund that pays 4 percent interest,
compounded yearly, if $1,000 is deposited at the end of every fourth year?
i = 4% a year
ie= (1+ 0.04)4-1 = 0.1699x100% =16.99%

(1+i) N −1
(F/A,i,N) = ; N = 5 compounding periods over 20n years
i
(1+0.1699)5−1
F = 1000 x
0.1699
F = $7,013

Example 5
The Kelowna Go-Kart Klub has decided to build a club house and track five years from now. It
must accumulate $50,000 by the end of five years by setting aside a uniform amount from its
dues at the end of each year. If the interest rate is 10 percent, how much must be set aside
each year?
(A/F,i,N)=i/(1+i)N-1
F=50000
i=10%
N = 5 years

A =50000 x (0.1)/(1+0.1)5-1
A = $8,189.87
Example 6
The management of VGA Textile Company is considering to replace an old machine with
a new one. The new machine will be capable of performing some tasks much faster than the old
one. The installation of machine will cost $8,475 and will reduce the annual labor cost by
$1,500. The useful life of the machine will be 10 years with no salvage value. The minimum
required rate of return is 15%.
Internal rate of return factor = $8,475 /$1,500 = 5.650

the internal rate of return promised by the project is 12%. (  “present value of an annuity of $1 in
arrears table“. )

According to internal rate of return method, the proposal is not acceptable because the internal
rate of return promised by the proposal (12%) is less than the minimum required rate of return
(15%)

Example 7
The Delta company is planning to purchase a machine known as machine X. Machine X
would cost $25,000 and would have a useful life of 10 years with zero salvage value. The
expected annual cash inflow of the machine is $10,000.

Since the annual cash inflow is even in this project, we can simply divide the initial investment
by the annual cash inflow to compute the payback period.
Payback period = $25,000/$10,000
= 2.5 years
Example 8

The management of Health Supplement Inc. wants to reduce its labor cost by
installing a new machine. Two types of machines are available in the market – machine
X and machine Y. Machine X would cost $18,000 where as machine Y would cost
$15,000. Both the machines can reduce annual labor cost by $3,000.

Which is the best machine to purchase according to payback method?

Payback period of machine X: $18,000/$3,000 = 6 years

Payback period of machine Y: $15,000/$3,000 = 5 years

According to payback method, machine Y is more desirable than machine X because it

has a shorter payback period than machine X.

Example 9
A proposed bridge on the interstate highway system is being considered at the cost of
$2 million. It is expected that the bridge will last 20 years. The federal and state governments
will pay these construction costs. Operation and maintenance costs are estimated to be
$180,000 per year. Benefits to the public are estimated to be $900,000 per year. The building of
the bridge will result in an estimated cost of $250,000 per year to the general public. The
project requires a 10% return. Determine the B/C ratio for the project. State any assumption
made about benefits or costs.

$250,000 cost to general public is disbenefit.

AWBENEFITS = 900,000 - 250,000 = $650,000
AWCOSTS = 2,000,000(A/P, 10%, 20) + 180,000 = $415,000

AW BENEFITS 650,000
B/C = = =1.57
AW COST 415,000
Example 10

The town of Podunk is considering building a new downtown parking lot. The land will cost
$25,000 and the construction cost of the lot is estimated to be $150,000. Each year costs associated
with the lot are estimated to be $17,500. The income from the lot is estimated to be $18,000 the first
year and increase by $3,500 each year for the twelve year expected life of the lot. Determine the B/C
ratio if Podunk uses a cost of money of 4%.

PWBENEFITS = 18,000(P/A, 4%, 12) + 3,500(P/G, 4%, 12) = $334,298

PWCOSTS = 175,000 + 17,500(P/A, 4%, 12) = 339,238

PW BENEFITS 334,298
B/C = = =0.99
PW COST 339,238
Reflection
In these topic, I easily understood that the value of money changes gradually over time
and under different kind of circumstance and this is because in the past topics of these subject I
have already learned that money isn’t exactly the same as it was before than it is now as stated
in time value of money or also known as TVM. In real life, money doesn’t actually change its
value unless you invest it on something for example in a bank or in equipment or a machine.
Only then, you will understand that the value you invested on something can actually change
over time and this is what this topic is all about. It is really amazing that I get to study this kind
of topic because now I am well aware of how I should handle my financial cases and put this
knowledge to good use.
As for the near future, I might be ready to apply these knowledge’s in my career choice
and even in my personal financial problems. I just need a little flexibility of mind to be able to
overcome these challenges I might be facing regarding finance.