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Basic Methods for Making Economy Studies

Engineering Economy (Lyceum of the Philippines University)

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Chapter 5

Basic Methods for Making Economy Studies

BASIC METHODS OR PATTERNS FOR MAKING ECONOMY STUDIES

Engineering economy studies are made for the purpose of determining whether
capital should be invested in a project or whether it should be used differently than it
presently is being used. They should consider the return that a given project will or should
produce.

The basic question is; whether a proposed capital investment and its associated
expenditures can be recovered by revenue overtime in addition to return on the capital
that is sufficiently attractive in view of the risk involved and the potential alternative uses.

THE RATE OF RETURN (ROR) METHOD

The rate of return on the capital invested is given by the formula,
𝑛𝑒𝑡 𝑎𝑛𝑛𝑢𝑎𝑙 𝑝𝑟𝑜𝑓𝑖𝑡
Rate of return =
𝑐𝑎𝑝𝑖𝑡𝑎 𝑖𝑛𝑣𝑒𝑠𝑡𝑒𝑑

Minimum Attractive Rate of Return

The MARR, sometimes called the hurdle rate, should be chosen to maximize
the economic well-being of an organization, subject to the following considerations:

1. The amount of money available for investment, and the source and cost of
these funds (equity or borrowed capita).
2. The number of good projects available for investment and their purpose.

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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 (government, public utility, or competitive industry).

Methods in Investment of Capital

Let I = initial Investment
R= annual revenue or income
E = annual expenses or costs
Sv = salvage value
n = useful life

Rate of return is a measure of the effectiveness of an investment of capital. It is a

financial efficiency. When this method is used, it is necessary to decide whether the
computed rate of return is sufficient to justify the investment. The advantage of this
method is that it is easily understood by management and investors. The applications of
the rate of return method are controlled by the following conditions. A single investment
of capital at the beginning of the first year of the project life and identical revenue and
cost data for each year. The capital invested is the total amount of capital investment
required to finance the project, whether equity or borrowed.

Example
An investment of P10,000 can be made in project that will produce a uniform
annual revenue of P5310 for five years and then have a salvage value of P2000. Annual
expenses will P3000 each year. The company is willing to accept any project that will
earn 10% per year or more on all investment capital. Show whether this is desirable
investment.

Given: I = investment 10,000

R = revenue/income 5130
n = 5 years
Sv = 2000
E = 3000/year
MARR = 10%/year
Required: Evaluation of the investment of capital

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Solution:
To evaluate the problem by rate of return method, determine the total expenses
including the annual cost of depreciation (sinking fund method):

𝑖
𝑑 = (𝐶𝑜 − 𝐶𝐿 ) [ 𝑛 ]
(1 + 𝑖) − 1

0.1
𝑑 = (𝑃5000 − 2000) [ ]
5
(1.1) − 1

d = 1310

Determine the annual profit:

Profit = Income – Expenses

Profit = 5310 – 4310 = P1,000
1000
RoR = × 100 = 10%
10000

Since the computed rate of return is equal to MARR, then the investment of capital is
desirable.

THE ANNUAL WORTH (AW) METHOD

In this method, interest on the original investment (sometimes called minimum
required profit) is included as a cost. If the excess of annual cash inflows over cash
outflows is not less than zero the proposed investment is justified – is valid. This method
is covered by
In this method, the minimum required profit (MRP) is included as a cost or expenses. This
computed as:

𝑀𝑅𝑃 = 𝐼𝑛𝑖𝑡𝑖𝑎𝑙𝐼𝑛𝑣𝑒𝑠𝑡 × 𝑀𝐴𝑅𝑅

Then excess is computed as:
𝐸𝑥𝑐𝑒𝑠𝑠 = 𝐼𝑛𝑐𝑜𝑚𝑒 − 𝐸𝑥𝑝𝑒𝑛𝑠𝑒𝑠

If the computed excess is

Excess ≥ 0 , the investment of capital is justified
Excess ≤ 0, the investment of capital is not justified

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EXAMPLE
Solve the same problem using annual cost method

To evaluate the problem using annual cost method, determine the minimum
required profit and include this in the total expenses:

MRP = I × MARR
= 10000 (0.1) = 1000

Total Expenses = E + annual depreciation + MRP

= P3000 + P1310 + P1000
= P5310

Compute the excess as:

Excess = Income – Expenses
= P5310 – P5310
=0

Since the computed excess is equal to zero, the investment of capital is

justified

THE FUTURE WORHT (FW) METHOD

The future worth method for economy studied is exactly comparable to the present
worth method except that all cash inflows and outflows are compounded forwards to a
reference point in time called the future. If the future worth of the net cash flows is equal
to, or greater than, zero, the project is justified economically.

THE PAYBACK (PAYOUT) PERIOD METHOD

The payback period is commonly defined as the length of time required to recover
the first cost of an investment from the net cash flow produced by that investment for an
interest rate of zero.
Payout period (years) = investment – salvage value over net annual cash flow

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Example
An investment of P270, 000 can be made in a project that will produce a uniform
annual revenue of P185, 400 for 5 years and then have a salvage value of 10% of the
investment. Out-of-pocket costs for operation and maintenance will be P81, 000 per year.
Taxes and insurance will be 4% of the first cost per year. The company expects capital
to earn not less than 25% before income taxes. Is this a desirable investment? What is
the payback period of the investment?
Solution
By the rate of return method
Annual revenue P185, 000
Annual cost:
𝑃270,000−𝑃27,000 𝑃243,0000
Depreciation = = = P29, 609
𝐹𝐴,25%,5 8.2070

Operations and maintenance =81, 000

Taxes and insurance = P270, 000(0.04) =10, 800
Total annual cost P121, 409
Net annual profit P63, 991
𝑃63,991
Rate of return = 𝑥 100 = 23.70%
𝑃270,000

Since the rate of return is less than 25%, the investment is not justified.
By the annual worth method
Annual revenue P185, 000
Annual cost:
𝑃270,000−𝑃27,000
Depreciation = = P29, 609
𝐹 𝐴,25%,5

Operations and maintenance = 81, 000

Taxes and insurance = 10, 800
Interest on capital = 67, 500
Total annual cost P188, 909
Excess -P 3, 509

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Since the excess of annual cash inflows over cash outflows is less than zero (-
P3, 509), the investment is not justified.
By the present worth method
P27,000

P185,400P185,400P185,400P185,400P185,400

0 1 2 3 4 5
Cash flow diagram of cash inflows

PW of cash inflows = P185, 400 (P/A, 25%, 5) + P27, 000 (P/F, 25%, 5)
=P185, 400 (2.6893) + P27, 000 (0.3277)
=P506, 370
Annual cost (excluding depreciation) = P81, 000 +P270, 000 (0.04)
= 91, 800

0 1 2 3 4 5

P91,800P91,800P91,800P91,800P91,800
P270,000

PW of cash outflows = P270, 000 + P91, 800(P/A 25%, 5) = P516, 880

Since the PW of the net cash flows is less than zero (-P10, 510), the investment
is not justified.

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By the future worth method

Referring to the cash flow diagrams in the solution by the PW method.
FW of cash inflows = P27, 000 + P185, 400 (F/A, 25%, 5)
= P27, 000 P185, 400 (8.2070)
= P1, 548, 580
FW of cash outflows = P91, 800 (F/A, 25%, 5) + P270, 000 (F/P, 25%, 5)
= P91, 800 (8.2070) + P270, 000 (3.0518)
= P1, 577, 390
Since the FW of the net cash flows is less than zero (-P28, 810), the investment
is not justified.
By the payback period
Total annual cost = P81, 000 + P270, 000 (0.04) = P91, 800
Net annual cash flows = P185, 400 – P91, 800 = P93, 600
𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡−𝑠𝑎𝑙𝑣𝑎𝑔𝑒 𝑣𝑎𝑙𝑢𝑒 𝑃270,000−𝑃27,000
Payback period = =
𝑛𝑒𝑡 𝑎𝑛𝑛𝑢𝑎𝑙 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤𝑠 𝑃93,600

= 2.6 years
In computing the total annual cost, depreciation was not included because the
method does not consider the time value of money or interest. The use of payback period
for making investments decisions should be avoided as it may produce misleading
results.
Example
a businessman is considering building a 25-unit apartment in a place near a progressive
commercial center. He felt that because of the location of the apartment it will be occupied
90% at all time. He desires a rate of return of 20%. Other pertinent data are the following:
Land investment P 5, 000, 000
Building investment P 7, 000, 000
Study period 20 years
Cost of land after 20 years 20, 000, 000
Cost of building after 20 years 2, 000, 000

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Rent per unit per month 6, 000

Upkeep per unit per year 500
Property taxes 1%
Insurance 0.50%
Is this a good investment?
Solution
Annual income:
Rental = (P6, 000) (12) (25) (0.90) = P1 620,000
𝑃20,000,000−𝑃5,000,000 𝑃15,000,000
Land = = =
𝐹 𝐴,20%,20 186.688
80, 350
Total annual income P1, 700, 350

Annual cost:
𝑃7,000,000−𝑃2,000,000
Depreciation = = P 26, 780
𝐹 𝐴,20%,20

Upkeep = P500 (25) = P12, 500

Taxes = P12, 000, 000 (0.01) =P120, 000
Insurance = P7, 000, 000 (0,005) = P35, 000
Total annual cost P194, 280
Net annual profit P 1, 506, 070
𝑃 1,506,0707
Rate of return = 𝑥 100 = 𝑃12.55% < 20%
𝑃 12,000,000

The businessman should not invest.

Another solution
Investment = P 5, 000, 000 + P7, 000, 000 = P12, 000, 000
Amount of investment after 20 years = P20, 000, 000 + 2, 000, 000
= P22, 000, 000

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Annual income = (P6, 000) (12) (25) (0.90) = P1, 620, 000
Annual cost:
𝑃12,000,000−𝑃22,000,000
Depreciation = =P-53, 570
𝐹𝐴,20%,20

Upkeep = P500 (25) = 12, 500

Taxes = P12, 000, 000 (0.01) = 120, 000
Insurance = P7, 000, 000 (0.005) = 35, 000
𝑃1,506 ,070
Rate of return = 𝑥 100 = 12. 55% < 20%
𝑃12,000,000

The businessman should not invest.

(The negative sign for depreciation means that the value of the investment has
increased after 20 years.)
Example
A man is considering investing P500, 000 to open a semi-automatic auto-washing
business in a city of 400, 000 population. The equipment can wash, on the average, 12
cars per hour, using two men to operate it and to do small amount of hand work. The man
plans to hire two men, in addition to himself, and operate the station on an 8-hour basis,
6 days per week, 50 weeks per year. He will pay his employees P25. 00 per hour. He
expects to charge P25. 00 for a car wash. Out-of-pocket miscellaneous cost would be P8,
500 per month.
He would pay his employees for 2 week for vacations each year. Because of the
length of his lease, he must write off his investment within 5 years. His capital now is
earning 15%, and he is employed at a steady job that pays P25, 000 per month. He
desires a rate of return of at least 20% on his investment.
Would you recommend the investment?
Solution
By the rate of return method
Annual revenue = (12) (25) (8) (6) (50) =P720, 000
Annual cost:
𝑃500,000 𝑃 500,000
Depreciation = = = 74, 160
𝐹 𝐴,15%,5 6.7424

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Labor = (2) (48) (50) (P25. 00) =120, 000

Vacation pay = (2) (2) (48) (25. 00) =4, 800
Miscellaneous = P8, 500 (12) = 102, 000
Owner’s salary = P25, 000 (12) =300, 000
Total annual cost P600, 960
Net annual profit P119, 040
𝑃119,040
Rate of return = 𝑥 100 = 23. 81% >20%
𝑃500,000

The man should invest.

By the annual worth method
Annual revenue = (12) (P25) (8) (6) (50) P720, 000
Annual cost:
Miscellaneous = P8, 500 (12) =102, 000
𝑃 500,000
Depreciation = = 74, 160
𝐹/ 𝐴,15%,5

Labor = (2) (48) (50) (P25) = 120, 000

Vacation pay = (2) (2) (48) (P25. 00) = 4, 800
Owner’s salary = P25, 000 (12) = 300, 000
Interest on capital = P500, 000 (0.20) = 100, 000
Total annual cost P700, 960
Excess P19, 040
Since the excess of annual revenue over annual cost is greater than zero, the
investment is justified. The man should invest.

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Example
A firm is considering purchasing equipment that will reduce cost by P 400, 000.
The equipment costs P300, 000 and has a salvage value of P50, 000 and a life of 7 years.
The annual maintenance cost is P6, 000. While not in use by the firm, the equipment can
be rented to others to generate an income of P10, 000 per year. If money can be invested
for an 8 per cent return, is the firm justified in buying the equipment?
Solution
Annual savings
Reduction in annual cost =P40, 000
Rental = 10, 000
Annual cost:
𝑃300,000−𝑃50,00 𝑃250,000
Depreciation =
𝐹/ 𝐴,∗%,7
= 8.9228
= P28, 018

Maintenance = 6, 000
Total annual cost P34, 018
Annual net savings P15, 982
𝑎𝑛𝑛𝑢𝑎𝑙 𝑛𝑒𝑡 𝑠𝑎𝑣𝑖𝑛𝑔𝑠 𝑃15,982
Rate of return = = 𝑃300,000 𝑥 100
𝑐𝑎𝑝𝑖𝑡𝑎𝑙

= 5.33% < 8%
The equipment should not be purchased.

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Example
The MGC Company has a contract with a hauler to transport its naptha
requirements of 3, 600, 000 liter per year from a refinery in Batangas to its site in Paco at
a cost of P1. 05 per liter. It is proposed that the company buys a tanker with a capacity of
18, 000 liters to service its requirements at a first cost of P 8, 000, 000 life is 6 years and
a salvage value of P 800, 000. Other expenses are as follows:
(a) Diesel fuel at P7, 95 per liter and the tanker consumers 120 liter per round trip
from Paco to Batangas and back.
(b) Lubricating oil servicing is P3, 200 per month.
(c) Labor including overtime and fringe benefits for one driver and one helper is
P21, 000 per month.
(d) Annual taxes and insurance. 5% of first cost.
(e) General maintenance per year is P40, 000
(f) Tires cost P 32, 000 per set and will be renewed every 150 round trips.
What should the MGC Company do if a 5% interest rate on investment is
included in the analysis?
Solution
Hauling
Annual cost = (P1. 05) (3, 600, 000) = P3, 780, 000
Buying Tanker
Annual cost:
𝑃8,000,000−𝑃800,000 𝑃7,200,000
Depreciation =
𝐹/ 𝐴,15%,6
= 8.753
= P822, 575

3,500,000
Fuel = (120) (P7. 95) = 190, 800
18,000

Oil = (P3, 200) (12) = 38, 400

Labor = (P21, 000) (12) = 252, 000
Taxes & insurance = (P8, 000, 000) (0.05) = 400, 000
Maintenance = 40, 000
3,600,000
Tires = (𝑃32, 000) = 42, 667
(18,000)(150)

Total annual cost P1, 786, 442

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Annual savings = P3, 780, 000 – P1, 786, 442 = P1, 993, 550
𝑃1,993,558
Rate of return = x 100 = 24.94% > 25%
𝑃8,000,000

The company should buy the tanker.

Example
A machine that is not equipped with a brake “coast” 30 seconds after the power is
turned off upon completion of each piece, thus preventing removal of the work from the
machine. The time per piece, exclusive of this stopping time in 2 minutes. The machine
is used to produce 40, 000 pieces per year. The operator receives P35. 00 per hour and
the machine overhead rate is P20. 00 per hour.
How much could the company afford to pay for a brake that would reduce the
stopping time to 3 seconds, if it would have a life of 5 years? Assume zero salvage value,
capital worth 18% and that repairs and maintenance would total not over P300 per month.
Solution
27
Annual savings = (P35 + P20) (40, 000) = 16, 500
3,600

Let C = the amount that can be invested for the brake

Annual cost:
𝐶 𝐶
Depreciation =
𝐹 𝐴,10%,5
= 6.1051 = P 0.1638C

Repairs and maintenance = (P300) (12) 3,600

Interest on capital = P 0.1800C
Total annual cost P 0.3438C + P3, 600
Equating annual savings to annual cost
P0. 3438 + P3, 600 = P16, 500
C = 37, 522
In any problem where the unknown quantity is the investment or capital, the best
method to use is the annual worth method.

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Example
A newly-built business property, containing space for a store and two offices, can
be purchased for P1, 200, 000. A prospective buyer estimates that during the next 10
years he can obtain annual rentals of at least P458, 460 from the property and that the
annual out-of-pocket disbursements will not exceed P60, 000. He believes that he should
be able to dispose of the property at the end of 10 years at not less than P700, 000.
Annual taxes and insurance will total 2.5% of the first cost.
(a) Assume he has sufficient equity capital to purchase the property, and that the
average return he is obtaining from his capital is 20%. Would you recommend
the investment?
(b) What recommendation would you make if he had to borrow 25% of the
required capital, on the basis of a 10-year amortization with interest of 18%?
(c) If the entire capital can be obtained by floating bonds at 15% that will mature
in 10 years, what would you recommend? Sinking fund interest is 15%
Solution
(a) Annual revenue P458, 460
Annual cost:
𝑃1,200,000−𝑃700,000
Depreciation = = P19, 260
𝐹 𝐴,20%,10

Disbursements = 60, 000

Taxes & insurance = P1, 200, 000(0.025) = 30, 000
Total annual cost P109, 260
Net annual profit P349, 200
𝑃349,000
Rate of return = x 100 = 29.1 >20%
𝑃1,200,000

The investment is justified.

(b) Annual revenue P458, 460
Annual cost:
𝑃900,000−𝑃700,000
Depreciation = = P7, 700
𝐹 𝐴,20%,10
𝑃1,200,000 (0.25)
Amortization = = 66, 760
𝑃 𝐴,18%,10

Disbursements = 60, 000

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Taxes & insurance = P1, 200, 000 (0.025) =30, 000

Total annual cost P164, 460
Net annual profit P294, 000
𝑃294,000
Rate of return = x 100 = 24. 50% > 20%
𝑃1,200,000

The investment is justified.

(c) Annual revenue P458, 460
Annual cost:
𝑃1,200,000−𝑃700,000
Sinking fund deposit = = P24, 630
𝐹 /𝐴,15%,10
Bond interest = P1, 200, 000 (0.15) 180, 000
Disbursements 60, 000
Taxes and insurance = P1, 200, 000 (0.025) = 30, 000
Total annual cost P294, 630
Net annual profit P163, 830
𝑃163,830
Rate of return = x 100 = 13. 65% < 20%
𝑃1,200,000
The investment is not justified.

Problem
proposed project will require the immediate investment of P50, 000 and is estimated to
have year-end revenues and costs as follows:
Year revenue costs
1 P75, 000 P60, 000
2 90, 000 77, 500
3 100, 000 75, 000
4 95, 000 80, 000
5 60, 000 47, 500

An additional investment P20, 000 will be required at the end of the second year.
The project would terminate at the end of the 5th year, and the assets are estimated to
have of P25, 000 at that time.
Is this a good investment?
Solution
Solve for the internal rate of return (IRR) and then decide whether the investment
justified. The internal rate of return is that rate of return that will exactly reduce the worth

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of the investment to zero at the end of the life of the investment. Thus, present worth of
cash inflows minus the present worth of cash outflows must equal to zero.

Problem
. A company is considering
constructing a plant to manufacture a proposed new product. The land costs P300,000,
the building costs P600,000, the equipment costs P250,000 and P100,000 additional
working capital is required. It is expected that the product will result in sales of P750,000
per year for 10 years, at which time the land can be sold for P400,000, the building for
P350,000 and the equipment for P50,000. All of the working capital would be recovered
at the end of year 10. The annual expenses for labor, materials, and all other items are
estimated to total P475,000. If the company requires a MARR of 15% per year on projects
of comparable risk, determine if it should invest in the new product line. Evaluate using
all methods.

a.) ROR
b.) Annual Worth Method
c.) Present Worth Method
d.) Future Worth Method
e.) Payback Period

Problem
Your firm is considering the purchase of an old office building with an estimated
remaining service life of 25 years. The tenants have recently signed long-term leases,
which leads you believe that the current rental income of $150,000 per year will remain
constant for the first five years. Then the rental income will increase by too for every five-
year interval over the remaining asset life. For example, the annual rental income would
be $165.000 for years six through to, $181,500 for years n through 15. $199, 650 for
year’s i6 through 20. And $21 9.615 for years 21 through 25.You estimate that operating
expenses including income taxes. will be $4.5,000 for the first year and that they will
increase by $3,000 each year thereafter. You estimate that razing the building and selling
the lot on which it stands will realize a net amount of $5o.000 at the end of the 25 year
period. If you had the opportunity to invest your money elsewhere and thereby earn
interest at the rate of 12% per annum, what would be the maximum amount you would
be willing to pay for the building and lot at the present time?

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Problem
A large food-processing corporation is considering using lase technology to speed
up and eliminate waste in the potato-peeling process. To implement the system, the
company anticipates needing P3 million to purchase the industrial strength lasers. The
system will have $1,200,000 per year in labor and materials. However, it will incur an
additional operating and maintenance cost of P250, 000 per year. Annual income taxes
will also increase by P150, 000. The system is expected to have a 10-year service life
and a salvage value of about P200, 000. If the company’s MARR is 15%, justify the
economics of the project, based on the PW method.

Problem
You are face with making a decision on a large capital investment proposal. The
capital investment amount is P640, 000. Estimated annual revenue at the end of the year
in the eight year study period is P180, 000. The estimated annual year-end expenses are
P420, 000 starting in year one. These expenses begin decreasing by P4, 000 per year at
the end of the year four and continue decreasing through the end of the eight. Assuming
a P20,000 market value at the end of the year eight and a MARR of 12% per year, answer
the following questions:

a. What is the PW of this proposal?

b. What is the IRR of this proposal?
c. What is the simple payback period for this proposal?
d. What is your conclusion about the acceptability of this proposal?

Problem
. Uncle Wilbur’s trout ranch is now for sale for P300, 000. Annual property taxes,
maintenance, supplies, and so on are estimated to continue to be P30, 000 per year.
Revenues from the ranch are expected to be P100, 000 next year and then to be decline
by P400 per year thereafter through the 10th year. If your bought the ranch, you would
plan to keep it for only five years and at that time to sell it for the value of the land, which
is P150,000. If your desired MARR is 12% per year should you become a trout rancher?
Use the PW method.

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PROBLEMS
Basic method for making economy studies
1. A young mechanical engineer is considering establishing his own small company. An
investment of P400,000 will be required which will be recovered in 15 years.
It is estimated that sales will be P800,000 per year and that operating expenses will
be as follows.

Materials P160,000 per year

Labor P280,000 per year
Overhead P40,000 +10% of sales per year
Selling expense P60,000

The man will give u his regular job paying P216,000 per year and devote full time to the
operation of the business; this will result in decreasing labor cost by P40,000 per year,
material cost by P28,000 per year and overhead cost by P32,000 per year. If the man
expects to earn at least 20% of his capital, should he invest?

2. The ABC company is considering constructing a plant to manufacture a proposed new

product. The land costs P15,000,000, the building costs P30,000,000, the equipment
costs P12,500,000, and P5,000,000 working capital is required. At the end of 12 years,
the land can be sold for P25,000,000, the building for P12,000,000, the equipment for
P250,000 and all of the working capital recovered. The annual disbursements for labor,
materials, and all other expenses are estimated to cost P23,750,000. If the company
requires a minimum return of 25%, what should be the minimum annual sales for 12 years
to justify the investment?

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3. A man formerly employed as chief mechanic of an automobile repair shop has saved
P1,000,000.00 which are now invested in certain securities giving him an annual dividend
of 15%. He now plans to invest this amount in his own repair shop. In his present job, he
is earning P25,000.00 a month, but he has to resign to run his own business. He will need
the services of the following: 2 mechanics each earning P400.00 a day and 8 helpers
each are earning P200.00 a day. These men will work on the average 300 days per year.
His other expenses are the following:
Rental P30,000.00 a month
Miscellaneous P25,000.00 a month
Sales tax 3% of gross income
Insurance 2%
The length of his lease is 5 years. If the average charge for each car repaired by his shop
is P1,000.00. Determine the number of cars he must service in one year so that he will
obtain a profit of at least 20% on his investment?

4. A firm is charged P150 per ton for hauling its raw materials by a trucking company.
Forty tons per day are hauled for 300 days a year. It is desired to install a railway system
which would bring down the cost of hauling to P6.60 per ton. Maintenance cost of this is
P12,000 per month. Tax is 1%. Average rate if earning is 20%.
a. If the company has the cash necessary for the installation, would you recommend the
change?
b. If the company has to float P5,000,000 worth of noncallable bonds at 15% that will
mature in 10 years to have the capital for the project, would you recommend the change?

5. A food processing plant consumed 600,000 kW of electric energy annually and pays
an average of P2.00 per kWh. A study is being made to generate its own power to supply
the plant the energy required, and that the power plant installed would cost P2,000,000.
Annual operation and maintenance,P800,000. Other expenses P100,000 per year. Life
of power plant is 15 years; salvage value at the end of life is P200,000; annual taxes and
insurances, 6% of first cost; and rate of interest is 15%. Using the sinking fund method
for depreciation, determine if the power plant is justifiable.

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6. A fixed capital investment of P10, 000,000.00 is required for a proposed manufacturing

plant and an estimated working capital of P2,000,000.00. Annual depreciation is
estimated to be 10% of the fixed capital investment. Determine the rate of return on the
total investment and the payout period is the annual profit is P2,500,000.00.

7. A small business purchased now for P50, 000 will lose P9, 600 each year for first 4
years. An additional investment of P30,000 in the business will required at the end of the
fourth year. After 15 years the business can sold for P70, 000. What should be the profit
each year from the fifth through the fifteenth year to obtain a rate return of 25%?

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