COURSE TITLE:

ENGINEERING ECONOMICS

BASIC METHODOLOGIES OF ENGINEERING

ECONOMIC ANALYSIS

MARR, Equivalent Worth Method, Rate of Return Method (IRR)

 Learning Objective
After studying this lecture students will be able to learn:

➢The concept of Minimum Attractive rate of Return (MARR)

➢The concept of equivalent worth method (Present Worth, Future

Worth, and Annual Worth).

➢The Concept of rate of return method, Internal rate of return

(IRR)
 Introduction
➢If an organization have a huge sum of money in the
investment pool and there are many alternatives (projects)
whose initial investment cost and annual revenues are
known then the organization has to select the best
alternative among the different projects.

➢The worthiness of the project has to be determined,

Whether a proposed project can generate revenue or not to
recover the invested capital. [1]
 Basic Methods for determining worthiness

1. Equivalent Worth Method 3. Benefit Cost Analysis (B/C ratio)

Present worth method (PW) Conventional B/C
Future worth method (FW)
Modified B/C
Annual worth method (AW)
4. Payback Period Method
2. Rate of Return Method
Simple payback period
Internal rate of return (IRR)
External rate of return (ERR) Discounted payback period
Minimum Attractive Rate of Return

➢The minimum attractive rate of return (MARR) is the

interest rate at which a firm can always earn or borrow
money. [2]
➢It is the rate set by an organization to designate the lowest
level return that makes an investment acceptable. [3]
➢MARR is determined from the opportunity cost viewpoint,
which results from the capital rationing phenomenon.
➢Capital rationing refers to the situation where the funds
available for capital investment are not sufficient to cover
potentially acceptable projects.
 Minimum Attractive Rate of Return (Cont’d….)

It is generally dictated by management considering the

following points: [2]
➢The amount of money available for investment - Source
and cost of these funds (equity, borrowed funds etc.)
➢The number of good project available for investment
➢The amount of perceived risk associated with the
investment
➢The type of organization involved (government, public,
private)
Determination of MARR

Consider the firm has 40

Annual rate of profit (%)

35%
35
Available amount A
A
30%
30 Capital Supply
= $ 60 million 25 B 26%
23%
Seven projects C 19%
20
D 16%
available with total 15 14%
E Reject project F
10
amount = $ 75 million F
and G
5
G

20 30 40 50 60 70 80
$ in million
Fig : MARR Determination [2]
Determination of MARR (Cont’d…)

• Last funded project = Project E

• Prospective rate of profit = 19%
• Best rejected project = F (by not being able to invest in
project F, the firm would presumably be forfeiting the chance
to realize on 16% annual return)
• MARR = 16% per year (as the amount of investment capital
and opportunities available change over time, the firm’s
MARR will also change)
 Equivalent worth Method
Present worth method (PW) or Net Present
Value (NPV)
➢The NPW or Present Worth or (NPV) of a given series of cash
flow is the equivalent values of the cash flows at the end of year
zero (i.e. beginning of year 1). [4]
➢In other words, how much money we have to set aside to provide
for future cash flow.
➢All cash inflows and outflows are discounted to present point in
time at MARR.
➢Net present worth = Equivalent present worth of future cash flow –
Initial investment
➢Here we use NPW or NPV as PW
 Present Worth Analysis (PW)

➢Determine the interest rate that the firm wishes to earn on

their investment, which is referred as either required rate of
return or MARR (minimum attractive rate of return). [5]
➢Estimate the service life of the project.
➢Estimate the cash inflow and out flow for each service
period.
➢Determine the net cash flows
= Cash inflow – cash out flow
 Present Worth Analysis (PW) (Cont’d…)
Present worth of each net cash flow as shown in figure , at
MARR as:- A A A A A A
1 2 3 4 N-1 N

0
1 2 3 4 N-1 N

PW

PW (i%) = A1/ (1+i)1 + A2 / (1+i)2 + A3 / (1+i)3…… AN/(1+i)N

N
An
= 
n =0 (1 + i)n An will be +ve if the corresponding
period has a net cash inflow and -ve if
N there is net cash outflow.
= 
n =0
An ( P / F , i%, N )
 Decision Rule for PW

➢ If PW (i) > 0’ accept the investment

➢ If PW (i) = 0’ remain indifferent
➢ If PW (i) < 0’ reject the investment
Present Worth Example
A construction company needs equipment which costs
$ 10, 00,000 and has a salvage value of $ 1, 00,000 at
the end of 10 years. The equipment suppliers are also
willing to provide the equipment on hire for $ 1, 25,000
per year for 10 years. What will you do? Purchase or
Hire. Use PW. MARR =12%
Present Worth Example (Cont’d….)
For the purchasing case 1, 00,000

0
Initial cost (P) = $ 10,00,000 , 10

Salvage Value (S) = $ 1,00,000, N = 10 years

10, 00,000
Using PW
PW (12%) = - 10,00,000 + 1,00,000 (P/F, 12%,10)
= -10,00,000 + 1,00,000 (1+0.12)-10
= $ – 9, 67,802.67
Present worth of purchasing the equipment is
$ 9, 67,802.67
 Present Worth Example (Cont’d….)
For the Hiring case
Annual cost (A) = $ 1, 25,000 1 2 3 4 8 9 10
0
Using PW formulation
PW (12%) = - 1, 25,000 (P/A, 12%, 10) 1, 25,000
= - 1, 25,000 [ (1+0.12)10 -1/(1+0.12)10 *0.12]
= $ -7, 06,277.87
Present worth of hiring the equipment is $ 7, 06,277.87
Since the PW of Hiring cost is less than the PW of the
Purchasing cost, Hire the equipment.
 Future worth method (FW) or Net Future
Value (NFV)
• Net present worth measures the surplus in an investment
project at time zero where as net future worth measures this
surplus at time period other than zero. [5]
• Net future worth analysis is particularly useful on an
investment solution where we need to compute the
equivalent worth of a project at the end of investment
period rather than its beginning.
Decision Rule for FW

➢ If FW (i%) > 0’ accept the investment

➢ If FW (i%) = 0’ remain indifferent
➢ If FW (i%) < 0’ reject the investment
Future Worth Example

A construction company needs equipment which costs $

10, 00,000 and has a salvage value of $ 1, 00,000 at the
end of 10 years. The equipment suppliers are also willing
to provide the equipment on hire for $ 1, 25,000 per year
for 10 years. What will you do? Purchase or Hire. Use
FW. MARR =12%
Future Worth Example (Cont’d….)
For the purchasing case
1, 00,000
Initial cost (P) = $ 10,00,000 , 0 10
Salvage Value (S) = $ 1,00,000, N = 10 years
Using FW 10, 00,000

FW (12%) = - 10,00,000 (F/P, 12%,10) + 1,00,000

= -10,00,000 (1+0.12)10 + 1,00,000
= $ – 3,005,800
Future worth of purchasing the equipment is
$ 3,005,800
Future Worth Example (Cont’d….)

For the Hiring case 1 2 3 4 8 9 10

Annual cost (A) = $ 1, 25,000 0

Using FW formulation
1, 25,000
FW (12%) = - 1, 25,000 (F/A, 12%, 10)
= - 1, 25,000 [ (1+0.12)10 -1/0.12]
= - $ 2,193,587.5
Future worth of hiring the equipment is $ 2,193,587.5
Since the FW of Hiring cost is less than the FW of the
Purchasing cost, Hire the equipment.
Annual worth Method (AW) or Net Annual
worth Method (NAW)
➢Annual worth method provides the basis for measuring
investment worth by determining equal payments on an
annual basis. [5]
➢The AW of a project is its annual equivalent receipts (R)
minus annual equivalent expenses (E) minus annual
equivalent capital Recovery (CR). R, E, and CR are
calculated at MARR [2]
AW (i) = R – E – CR
R = annual revenues, E = annual expenses, CR = capital
recovery
Capital Recovery (CR)

• In any investment project, two types of costs are involved,

i.e. Capital cost and operation cost.
• Operating cost is recurred over the life of project and they
are estimated on annual basis.
• Capital costs tend to be one time cost. This one time cost
must translated into its annual equivalent over the life of
the project.
• This annual equivalent of capital cost is given a special
name: Capital Recovery cost designated as CR (i)
Capital Recovery (CR) (Cont’d..)

CR (i%) = I (A/P, i%, N) – S (A/F, i%, N) S

i%
Where, 0 N
I = Initial Investment of a project.
S = Salvage value at the end of project.
I
N = project study period.
Capital recovery amount for a project is the equivalent uniform
annual cost of the capital invested.
 Decision Rule for AW

➢ If AW (i%) > 0’ accept the investment

➢ If AW (i%) = 0’ remain indifferent
➢ If AW (i%) < 0’ reject the investment
 Annual Worth Example

You purchased a building 5 years ago for $ 10,00,000.

Annual Maintenance cost is $ 50,000 per year. At the end
of 3 years $ 90,000 was spent on roof repairs. At the end
of 5 years you sell a building for $ 12, 00,000. During the
period of ownership, you rented the building for $ 1,
00,000 per year paid at the beginning of each year. Use
AW method to evaluate the investment if MARR = 12%
Annual Worth Example (Cont’d…)
$ 12,00,000

$ 100,000
i=12%
0 1 2 3 4 5
$ 50,000

$ 10,00,000 $ 90,000

CR (12%) = 10,00,000 (A/P,12%,5) – 12,00,000(A/F, 12%,5)

=10,00,000 { (1+ 0.12) 5 * 0.12} / (1+0.12)5 -1 }
- 12,00,000{0.12 / (1+0.12)5 -1}
= $ 88518.05
Annual Worth Example (Cont’d…)

Annual Expenses (E)

= 50,000 +{ 90,000 (P/F,12%,3)} (A/P,12%,5)
= 50,000 + { 90,000 (1+0.12)-3 } * ((1+ 0.12) 5 * 0.12} / (1+0.12)5 -1
= $ 67770.93
Annual Revenue (R) AW (12%) = R - E - CR
=100,000 (F/P, 12%, 1) =112,000 - 67770.93 - 88518.05
= 1,00,000 (1.12)1 = $ 112,000 = - $ 44288.98
As, AW (12%) < 0, the investment is bad.
 Rate of Return Method

• A rate of return (ROR) is the net gain or loss of an

investment over a specified time period, expressed as a
percentage of the investment’s initial cost. [6]
• Rate of Return is the interest rate earned on the unpaid
balance of an amortized loan. [5]
• Equivalent worth method is absolute measurement
where as the rate of return is the relative measurement
used for comparing mutually exclusive alternatives.
Rate of Return Example.
• Suppose that a bank lends $10,000 and it is repaid $4021
at the end of each year for 3 years.
• How can be the interest rate determined that the bank
charges on this transaction?
P = A (P/A, i%, 3)
$10,000 = $4021 (P/A, i%, 3)
i = 10%
• The bank will earn 10% return annually on its investment
of $10,000.
Example Source: [5]
Internal Rate of Return (IRR)
➢IRR is that interest rate (return rate) which equates the
equivalent worth of an alternative’s cash inflows to the
equivalent worth of cash outflows. [1]
➢IRR is the interest rate that is charged on the un-
recovered project balance of the investment such that,
when the project terminates, the un-recovered balance will
be zero. [5]
➢At this particular rate, the equivalent worth of revenue
generated by project is enough to bear the equivalent
worth of expenses absorbed by project without any
financial burden.
 Mathematical relation of IRR
A project’s return is referred as internal rate of return
(IRR) promised by an investment project over its useful
life.
Based on PW formulation IRR
PW inflow
PW (i*%) = 0
+
PW inflow – PW outflow = 0
Based on FW formulation i*%
0 i%
FW (i*%) = 0 -
FW inflow – FW outflow = 0
PW outflow
 Method of Calculating IRR

1. Direct Solution Method

2. Trial and Error Method
3. Computer Solution Method
Direct Solution Method

➢For the very special case of a project with only a two-

flow transaction (an investment followed by a single
future payment) or service life of 2 years of return, we
can apply direct mathematical solution for determining
the rate of return. [5]
Trial and Error Method

The following steps are followed to calculate the IRR of any

project’s cash flow:

1. Develop an equation for equivalent worth of any point of

time indicating rate of interest by i*% whose value is to be
found.
2. Equate the developed equation as to zero.
3. Solve it to get the value of i*% which would be IRR
 Computer Solution Method
In Microsoft Excel,
1. Click Formula
2. Click Auto Sum
3. Click More Function
4. Type IRR in Search for a Function, Click Ok
5. Insert the value of Cash Flow
6. Click Enter,
7. The result gives the value of IRR.
 Decision Rule of IRR

If IRR > MARR, accept the project

IRR = MARR, remain indifferent
IRR < MARR, reject the project
Graphical representation of IRR

Fig: Investment Balance Diagram [2]

 Drawbacks of IRR

➢The recovered funds are re-invested at i*% rather than

MARR, which leads to the concept of External rate of
return (ERR).
➢It needs trial and error approach for the calculation.
➢If the algebraic sum of the cash flow changes in the
middle of the project more than two times, we might
obtain multiple IRR values.
➢When choosing between the mutually exclusive
alternatives, IRR method can be misleading and does not
compare the scale of investment.
 References:

[1] A Textbook of Engineering Economics : Damodar

Adhikari, First Edition, Dreamland Publication Pvt. Ltd.
Kathmandu, Nepal, 2019.
[2] Engineering Economy: William G. Sullivan, James A.
Bontadelli & Elin M. Wicks, Eleventh Edition, Pearson
Educations, Inc. 2000 .
[3] Engineering Economics: James L. Riggs, David D.
Bedworth and Sabah U. Randhawa, Fourth Edition, Tata
McGraw Hill Education Private Limited, New Delhi, India,
2004.
 References: (Cont’d….)

[4]Engineering Economics : Jose A. Sepulveda, William E. Souder

and Byron S. Gottfried, Tata McGraw – Hill Publishing Company
Limited, New Delhi, India, 2005.
[5] Contemporary Engineering Economics, Chan S. Park Second
Edition, Addison-Wesley Publishing Company, 1997.
[6] https://www.investopedia.com/terms/r/rateofreturn.asp (viewed
on September)
THANK YOU