 All engineering economy studies of capital projects should consider the return that a

given project will or should produce.

 There is no single method for performing engineering economic analyses that is ideal
for all cases.
5 methods for evaluating the economic profitability of a single proposed problem
solution (i.e., alternatives):
1. Present Worth (PW) convert cash flows resulting from a proposed
problem solution into their equivalent worth at
2. Future Worth (FW) some point (or points) in time using MARR
3. Annual Worth (AW) (minimum attractive rate of return)
4. Internal Rate of Return (IRR) produce annual rates of profit, or returns, resulting from
5. External Rate of Return (ERR) an investment, and are then compared to the MARR
 Payback period is often used to supplement information produced by the 5 primary
methods for it ignores time value of money
 Minimum Attractive Rate of Return (MARR) – usually a policy issue resolved by the
top management of an organization in view of numerous considerations
Considerations for MARR:
1. The amount of money available for investment, and the source and cost of
these funds (i.e., equity funds or borrowed funds)
2. The number of good projects available for investment and their purpose (i.e.,
whether they sustain present operations and are essential or whether they
expand on present operations and are elective)
3. The amount of perceived risk associated with investment opportunities
available to the firm and the estimated cost of administering projects over
short planning horizons versus long planning horizons
4. The type of organization involved (i.e., government, public utility, or competitive
industry)
 MARR is sometimes called “hurdle rate” which should be chosen to maximize the
economic well-being of an organization
 Opportunity cost is one popular approach to establish MARR which results from
the phenomenon of capital rationing
Because opportunity costs are unseen
by definition, they can be easily
overlooked. Understanding the potential
missed opportunities when a business or
individual chooses one investment over
another allows for better decision
making.

Opportunity cost is a strictly internal cost used for

strategic contemplation; it is not included in
accounting profit and is excluded from external
financial reporting.
 MARR is sometimes called “hurdle rate” which should be chosen to maximize the
economic well-being of an organization
 Opportunity cost is one popular approach to establish MARR which results from
the phenomenon of capital rationing
 Capital rationing exists when the management decides to limit the total amount of
capital invested
 Capital rationing may arise when the amount of available capital is insufficient to
sponsor all worthy investment opportunities

Capital rationing is the process through which companies decide how

to allocate their capital among different projects, given that their
resources are not limitless. The main goal is to maximize the return
on their investment.
 Present Worth (PW) Method - based 𝑃𝑊 𝑖% = ∑ 𝐹 (1 + 𝑖)
on the concept of equivalent worth of
all cash flows relative to some base or where:
beginning point in time called the i = effective interest rate or MARR
present
k = index for each compounding period
 PW Method discounts cash inflows and (0 ≤ k ≤ N)
cash outflows to the present point in
time at an interest rate that is generally 𝐹 = future cash flow at the end of
the MARR. period k (+ if inflow; - if outflow)
 The PW of an investment alternative is N = number of compounding periods
a measure of how much money an  Constant interest rate throughout the
individual or a firm could afford to pay life of the project (↑ 𝑀𝐴𝑅𝑅, ↓ 𝑃𝑊)
for the investment in excess of its cost.
 𝑃𝑊 ≥ 0, 𝑎𝑐𝑐𝑒𝑝𝑡𝑎𝑏𝑙𝑒
Ex.: An investment of Php 10,000 can be made in a project that will produce a
uniform annual revenue of Php 5,310 for five years and then have a market (salvage
value) of Php 2,000. Annual expenses will be Php 3,000 each year. The company is
willing to accept any project that will earn 10% per year or more, on all invested
capital. Show whether this is a desirable investment by using the PW method.
𝑃𝑊 10% = −10,000 + 5,310 𝑃⁄𝐴, 10%, 5) + 2,000(𝑃⁄𝐹 , 10%, 5 − 3,000(𝑃⁄𝐴, 10%, 5)
𝑃𝑊 10% = −10,000 + 20,129 + 1,241 − 11,372 disregarded decimal values
𝑃𝑊 10% = 𝑃ℎ𝑝 0
𝐵𝑒𝑐𝑎𝑢𝑠𝑒 𝑡𝑜𝑡𝑎𝑙 𝑃𝑊 10% ≈ 𝑃ℎ𝑝 0, 𝑡ℎ𝑒 𝑝𝑟𝑜𝑗𝑒𝑐𝑡 𝑖𝑠 𝑚𝑎𝑟𝑔𝑖𝑛𝑎𝑙𝑙𝑦 𝑎𝑐𝑐𝑒𝑝𝑡𝑎𝑏𝑙𝑒.
Ex.: A piece of new equipment has been proposed by engineers to increase the
productivity of a certain manual welding operation. The investment cost is Php
25,000, and the equipment will have a market value of Php 5,000 at the end of a study
period of 5 years. Increased productivity attributable to the equipment will amount
to Php 8,000 per year after extra operating costs have been subtracted from the
revenue generated by the additional production. If the firm’s MARR is 20% per year,
is this proposal a sound one? Use the PW method.
𝑃𝑊 20% = −25,000 + 5,000 𝑃⁄𝐹 , 20%, 5 + 8,000(𝑃⁄𝐴, 20%, 5)
𝑃𝑊 20% = −25,000 + 2,009.39 + 23,924.90
𝑃𝑊 20% = 𝑃ℎ𝑝 934.29
𝑌𝑒𝑠! 𝐵𝑒𝑐𝑎𝑢𝑠𝑒 𝑃𝑊 20% ≥ 0, 𝑡ℎ𝑖𝑠 𝑒𝑞𝑢𝑖𝑝𝑚𝑒𝑛𝑡 𝑖𝑠 𝑒𝑐𝑜𝑛𝑜𝑚𝑖𝑐𝑎𝑙𝑙𝑦 𝑗𝑢𝑠𝑡𝑖𝑓𝑖𝑒𝑑.
 Future Worth (FW) Method – based on the equivalent worth of all cash inflows and
outflows at the end of the planning horizon (study period) at an interest rate that is
generally the MARR
 Future Worth (FW) Method – very useful in capital investment decision situations
for it provides economic information about the future wealth of the owners of the
firm
𝐹𝑊 = 𝑃𝑊(𝐹 ⁄𝑃, 𝑖%, 𝑁)
𝐹𝑊 𝑖% = ∑ 𝐹 (1 + 𝑖)
𝐹𝑊 ≥ 0, 𝑎𝑐𝑐𝑒𝑝𝑡𝑎𝑏𝑙𝑒
Ex.: A piece of new equipment has been proposed by engineers to increase the
productivity of a certain manual welding operation. The investment cost is Php 25,000,
and the equipment will have a market value of Php 5,000 at the end of a study period of 5
years. Increased productivity attributable to the equipment will amount to Php 8,000 per
year after extra operating costs have been subtracted from the revenue generated by the
additional production. If the firm’s MARR is 20% per year, is this proposal a sound one?
Use the FW method.
𝐹𝑊 20% = −25,000(𝐹 ⁄𝑃, 20%, 5) + 5,000 + 8,000(𝐹 ⁄𝐴, 20%, 5)
𝐹𝑊 20% = −62,208 + 5,000 + 59,532.80
𝐹𝑊 20% = 𝑃ℎ𝑝 2,324.80
𝑌𝑒𝑠! 𝐵𝑒𝑐𝑎𝑢𝑠𝑒 𝐹𝑊 20% > 0, 𝑡ℎ𝑖𝑠 𝑒𝑞𝑢𝑖𝑝𝑚𝑒𝑛𝑡 𝑖𝑠 𝑒𝑐𝑜𝑛𝑜𝑚𝑖𝑐𝑎𝑙𝑙𝑦 𝑗𝑢𝑠𝑡𝑖𝑓𝑖𝑒𝑑.
𝑜𝑟 𝐹𝑊 20% = 934.29(𝐹 ⁄𝑃, 20%, 5)
𝐹𝑊 20% = 𝑃ℎ𝑝 2,324.81
 Annual-Worth (AW) – equal annual where:
series of monetary amounts for a stated
study period that is equivalent to the R = annual equivalent revenues or savings
cash inflows and outflows at an interest E = annual equivalent expenses
rate that is generally the MARR.
𝐴𝑊 𝑖% = 𝑅 − 𝐸 − 𝐶𝑅 𝑖% CR = annual equivalent capital recovery
𝐶𝑅 = 𝐹𝐶(𝐴⁄𝑃, 𝑖%, 𝑁) − 𝑆𝑉(𝐴⁄𝐹 , 𝑖%, 𝑁) FC = first cost or initial investment
𝐶𝑅 = (𝐹𝐶 − 𝑆𝑉)(𝐴⁄𝐹, 𝑖%, 𝑁) + 𝐹𝐶(𝑖%) SV = salvage value
𝐶𝑅 = (𝐹𝐶 − 𝑆𝑉)(𝐴⁄𝑃, 𝑖%, 𝑁) + 𝑆𝑉(𝑖%) N = project study period
 When revenues are absent, designate this
metric as equivalent uniform annual cost 𝐴𝑊 = 𝑃𝑊(𝐴⁄𝑃, 𝑖%, 𝑁) 𝑜𝑟
(EUAC) (↓ 𝑏𝑒𝑡𝑡𝑒𝑟)
𝐴𝑊 = 𝐹𝑊(𝐴⁄𝐹, 𝑖%, 𝑁)
 Capital recovery – equivalent uniform
annual cost of the capital invested 𝐴𝑊 ≥ 0, 𝑎𝑐𝑐𝑒𝑝𝑡𝑎𝑏𝑙𝑒
covering loss of value of the asset and
interest on invested capital
Ex.: An investment of Php 10,000 can be made in a project that will produce a
uniform annual revenue of Php 5,310 for five years and then have a market (salvage
value) of Php 2,000. Annual expenses will be Php 3,000 each year. The company is
willing to accept any project that will earn 10% per year or more, on all invested
capital. Show whether this is a desirable investment by using the AW method.
𝐴𝑊 𝑖% = 𝑅 − 𝐸 − [(𝐹𝐶 − 𝑆𝑉)(𝐴⁄𝑃, 𝑖%, 𝑁) + 𝑆𝑉(𝑖%)]
𝐴𝑊 10% = 5,310 − 3,000 − [ 10,000 − 2,000 𝐴⁄𝑃 , 10%, 5 + 2,000(0.10)]
𝐴𝑊 10% = 𝑃ℎ𝑝 0 𝑑𝑖𝑠𝑟𝑒𝑔𝑎𝑟𝑑𝑒𝑑 𝑑𝑒𝑐𝑖𝑚𝑎𝑙 𝑣𝑎𝑙𝑢𝑒𝑠
𝐵𝑒𝑐𝑎𝑢𝑠𝑒 𝐴𝑊 10% ≈ 𝑃ℎ𝑝 0, 𝑡ℎ𝑒 𝑝𝑟𝑜𝑗𝑒𝑐𝑡 𝑖𝑠 𝑚𝑎𝑟𝑔𝑖𝑛𝑎𝑙𝑙𝑦 𝑎𝑐𝑐𝑒𝑝𝑡𝑎𝑏𝑙𝑒.
Ex.: A piece of new equipment has been proposed by engineers to increase the
productivity of a certain manual welding operation. The investment cost is Php
25,000, and the equipment will have a market value of Php 5,000 at the end of a study
period of 5 years. Increased productivity attributable to the equipment will amount
to Php 8,000 per year after extra operating costs have been subtracted from the
revenue generated by the additional production. If the firm’s MARR is 20% per year,
is this proposal a sound one? Use the AW method.
𝐴𝑊 𝑖% = 𝑅 − 𝐸 − [(𝐹𝐶 − 𝑆𝑉)(𝐴⁄𝑃, 𝑖%, 𝑁) + 𝑆𝑉(𝑖%)]
𝐴𝑊 20% = 8,000 − [ 25,000 − 5,000 𝐴⁄𝑃 , 20%, 5 + 5,000(0.20)]
𝐴𝑊 20% = 𝑃ℎ𝑝 312.41
𝑌𝑒𝑠! 𝐵𝑒𝑐𝑎𝑢𝑠𝑒 𝐴𝑊 20% ≥ 0, 𝑡ℎ𝑖𝑠 𝑒𝑞𝑢𝑖𝑝𝑚𝑒𝑛𝑡 𝑖𝑠 𝑒𝑐𝑜𝑛𝑜𝑚𝑖𝑐𝑎𝑙𝑙𝑦 𝑗𝑢𝑠𝑡𝑖𝑓𝑖𝑒𝑑.
Ex.: An investment company is considering building a 25-unit apartment complex in
a growing town. Because of the long-term growth potential of the town, it is felt that
the company could average 90% of full occupancy for the complex each year. If the
following items are reasonably accurate estimates, what is the minimum monthly rent
that should be charged if a 12% MARR (per year) is desired (use the AW method)?
Land investment cost Php 2.5M (salvage value of investment)
Building investment cost Php 11.25M
Study period, N 20 years
Rent per unit per month ?
Upkeep/maintenance expense per unit Php 1,750
per month
Property taxes and insurance per year 10% of the total initial investment
𝐴𝑊 𝑖% = 𝑅 − 𝐸 − [(𝐹𝐶 − 𝑆𝑉)(𝐴⁄𝑃, 𝑖%, 𝑁) + 𝑆𝑉(𝑖%)]
𝐴𝑊 𝑜𝑓 𝑐𝑜𝑠𝑡𝑠 = 0.10 13.75𝑀 + 1,750 25 12 0.90
+[(13.75𝑀 − 2.5𝑀)(𝐴⁄𝑃, 12%, 20) + 2.5𝑀(0.12) ]
𝐴𝑊 𝑜𝑓 𝑐𝑜𝑠𝑡𝑠 = 1,375,000 + 472,500 + 1,806,136.27
𝐴𝑊 𝑜𝑓 𝑐𝑜𝑠𝑡𝑠 = 𝑃ℎ𝑝 3,653,636.27
, , .
𝑅𝑒𝑛𝑡𝑎𝑙 𝑎𝑚𝑜𝑢𝑛𝑡 = ( )( . )

𝑅𝑒𝑛𝑡𝑎𝑙 𝑎𝑚𝑜𝑢𝑛𝑡 = 𝑃ℎ𝑝 13,531.99

 Internal Rate of Return (IRR) Method – ∑ 𝑅 (𝐹 ⁄𝑃, 𝑖 %, 𝑁 − 𝑘) − ∑ 𝐸 (𝐹 ⁄𝑃, 𝑖 %, 𝑁 − 𝑘) = 0
most widely used rate of return method
for performing engineering economic
analyses 𝑖 ≥ 𝑀𝐴𝑅𝑅, 𝑎𝑐𝑐𝑒𝑝𝑡𝑎𝑏𝑙𝑒
 IRR is also called investor’s method,
discounted cash flow method, and
profitability index where:
 IRR – this method solves for the resultant 𝑅 = net revenues or savings for the kth
interest rate that equates the equivalent year
worth of an alternative’s cash inflows
(receipts or savings) to the equivalent 𝐸 = net expenditures including any
worth of cash outflows (expenditures, investment costs for the kth year
including investment costs)
𝑁 = project life (or study period)
∑ 𝑅 (𝑃⁄𝐹, 𝑖 %, 𝑘) = ∑ 𝐸 (𝑃⁄𝐹, 𝑖 %, 𝑘)

∑ 𝑅 (𝑃⁄𝐹, 𝑖 %, 𝑘) − ∑ 𝐸 (𝑃⁄𝐹, 𝑖 %, 𝑘) = 0
Ex.: An investment of Php 10,000 can be made in a project that will produce a
uniform annual revenue of Php 5,310 for five years and then have a market (salvage
value) of Php 2,000. Annual expenses will be Php 3,000 each year. The company is
willing to accept any project that will earn 10% per year or more, on all invested
capital. Determine whether it is acceptable by using the IRR method.
𝑃𝑊 = −10,000 + (5,310 − 3,000) 𝑃⁄𝐴, 𝑖′%, 5) + 2,000(𝑃⁄𝐹 , 𝑖′%, 5 = 0
By linear interpolation:
@ 𝑖 = 11%, 𝑃𝑊 = −𝑃ℎ𝑝 275.58
@ 𝑖 = 12%, 𝑃𝑊 = −𝑃ℎ𝑝 538.11
𝑖 = 0.0995 𝑜𝑟 9.95% ≈ 10%
𝑌𝑒𝑠! 𝐵𝑒𝑐𝑎𝑢𝑠𝑒 𝐼𝑅𝑅 ≥ 𝑀𝐴𝑅𝑅, 𝑡ℎ𝑖𝑠 𝑒𝑞𝑢𝑖𝑝𝑚𝑒𝑛𝑡 𝑖𝑠 𝑒𝑐𝑜𝑛𝑜𝑚𝑖𝑐𝑎𝑙𝑙𝑦 𝑗𝑢𝑠𝑡𝑖𝑓𝑖𝑒𝑑.
Ex.: A piece of new equipment has been proposed by engineers to increase the
productivity of a certain manual welding operation. The investment cost is Php 25,000,
and the equipment will have a market value of Php 5,000 at the end of a study period of
5 years. Increased productivity attributable to the equipment will amount to Php 8,000
per year after extra operating costs have been subtracted from the revenue generated
by the additional production. If the firm’s MARR is 20% per year, is this proposal a sound
one? Evaluate the IRR of the proposed equipment. Is the investment a good one?
𝑃𝑊 = −25,000 + 5,000 𝑃⁄𝐹 , 𝑖 %, 5 + 8,000(𝑃⁄𝐴, 𝑖′%, 5) = 0
By linear interpolation:
@ 𝑖 = 21%, 𝑃𝑊 = 𝑃ℎ𝑝 335.59
@ 𝑖 = 22%, 𝑃𝑊 = −𝑃ℎ𝑝 240.89
𝑖 = 0. 2158 𝑜𝑟 21.58%
𝑌𝑒𝑠! 𝐵𝑒𝑐𝑎𝑢𝑠𝑒 𝐼𝑅𝑅 ≥ 𝑀𝐴𝑅𝑅, 𝑡ℎ𝑖𝑠 𝑒𝑞𝑢𝑖𝑝𝑚𝑒𝑛𝑡 𝑖𝑠 𝑒𝑐𝑜𝑛𝑜𝑚𝑖𝑐𝑎𝑙𝑙𝑦 𝑗𝑢𝑠𝑡𝑖𝑓𝑖𝑒𝑑.
 External Rate of Return (ERR) Method – directly takes into account the interest rate
(𝜖 or 𝜀) external to a project at which net cash flows generated (or required) by the
project over its life can be reinvested (or borrowed)
∑ 𝐸 (𝑃⁄𝐹, 𝜖%, 𝑘)(𝐹 ⁄𝑃, 𝑖 %, 𝑁) = ∑ 𝑅 (𝐹 ⁄𝑃, 𝜖%, 𝑁 − 𝑘)
where:
𝑅 = excess of receipts over expenses in period k
𝐸 = excess of expenditures over receipts in period k
𝑁 = project life or number of periods of the study
𝜖 = external reinvestment rate per period
𝑖 ≥ 𝑀𝐴𝑅𝑅, 𝑎𝑐𝑐𝑒𝑝𝑡𝑎𝑏𝑙𝑒
Ex.: A piece of new equipment has been proposed by engineers to increase the
productivity of a certain manual welding operation. The investment cost is Php
25,000, and the equipment will have a market value of Php 5,000 at the end of a study
period of 5 years. Increased productivity attributable to the equipment will amount
to Php 8,000 per year after extra operating costs have been subtracted from the
revenue generated by the additional production. If the firm’s 𝜖 and MARR are 20%
per year, what is the project’s ERR and is the project acceptable?
25,000 𝐹 ⁄𝑃 , 𝑖 %, 5 = 8,000(𝐹 ⁄𝐴, 20%, 5) + 5,000
, .
𝐹 ⁄𝑃 , 𝑖 %, 5 = ,
= 2.5813 = (1 + 𝑖 )
𝑖 = 0.2088 𝑜𝑟 20.88%
𝑌𝑒𝑠! 𝐵𝑒𝑐𝑎𝑢𝑠𝑒 𝑖′ ≥ 𝑀𝐴𝑅𝑅, 𝑡ℎ𝑖𝑠 𝑒𝑞𝑢𝑖𝑝𝑚𝑒𝑛𝑡 𝑖𝑠 𝑒𝑐𝑜𝑛𝑜𝑚𝑖𝑐𝑎𝑙𝑙𝑦 𝑗𝑢𝑠𝑡𝑖𝑓𝑖𝑒𝑑.
Ex.: When 𝜖 =15% and MARR = 20% per year, determine whether the project is
acceptable whose total cash inflows are Php 5,000 from the end of 2nd year to 6th year
and cash outflows are Php 10,000 for the initial cost and Php 5,000 at the end of 1st
year. Notice in this problem that the use of an 𝜖% different from the MARR is
illustrated. This might occur if, for some reason, part or all of the funds related to a
project are “handled” outside the firm’s nominal capital structure.
[10,000 + 5,000 𝑃⁄𝐹 , 15 %, 1 ](𝐹 ⁄𝑃 , 𝑖′ %, 6) = 5,000(𝐹 ⁄𝐴, 15%, 5)
𝑖 = 0.1530 𝑜𝑟 15.30%
𝑁𝑜! 𝐵𝑒𝑐𝑎𝑢𝑠𝑒 𝑖 ≤ 𝑀𝐴𝑅𝑅, 𝑡ℎ𝑖𝑠 𝑒𝑞𝑢𝑖𝑝𝑚𝑒𝑛𝑡 𝑖𝑠 𝑛𝑜𝑡 𝑒𝑐𝑜𝑛𝑜𝑚𝑖𝑐𝑎𝑙𝑙𝑦 𝑗𝑢𝑠𝑡𝑖𝑓𝑖𝑒𝑑.
 Payback method – often called the simple payout method, mainly indicates a
project’s liquidity rather than its profitability
 Payback period – measure of the speed with which an investment is recovered by
cash inflows it produces
 Simple Payback Period

∑ (𝑅 −𝐸 ) − 𝐹𝐶 ≥ 0
 Discounted Payback Period

∑ (𝑅 −𝐸 )(𝑃⁄𝐹, 𝑖%, 𝑘) − 𝐹𝐶 ≥ 0
𝜃 ≤ 3, 𝑑𝑒𝑠𝑖𝑟𝑎𝑏𝑙𝑒 𝑖𝑛 𝑈𝑆 ; 𝜃 ≤ 5, 𝑎𝑐𝑐𝑒𝑝𝑡𝑎𝑏𝑙𝑒 (𝑖𝑡 𝑑𝑒𝑝𝑒𝑛𝑑𝑠 𝑜𝑛 𝑡ℎ𝑒 𝑐𝑜𝑚𝑝𝑎𝑛𝑦)
Ex.: Using the cash flow below, what is the simple payback period? Discounted payback
period?
End of the Net Cash Cumulative PW of Cash Cumulative
Year k Flow PW at i = 0% Flow at i = PW of Cash
through year 20%/yr Flow at i =
0 -$25,000
k 20%/yr
1 8,000
2 8,000 -$25,000 -$25,000 -$25,000
3 8,000 -17,000 6,667 -18,333
4 8,000 -9,000 5,556 -12,777
5 13,000 -1,000 4,630 -8,147
+7,000 3,858 -4,289
𝜃 = 4 𝑦𝑒𝑎𝑟𝑠; 𝜃′ = 5 𝑦𝑒𝑎𝑟𝑠
5,223 +934
END OF PRESENTATION