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ES 20 Basic Economy Study Methods Assignment

The document outlines various methods for evaluating investment projects in engineering economy, including the Minimum Attractive Rate of Return (MARR), Present Worth (PW), Future Worth (FW), Annual Worth (AW), Payback Period, and Benefit/Cost Ratio methods. Each method provides criteria for determining the economic justification of projects based on cash flows and returns relative to the company's desired rate of return. Additionally, it includes assignments to apply these methods to real-world investment scenarios.

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charmaine.morales
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10 views22 pages

ES 20 Basic Economy Study Methods Assignment

The document outlines various methods for evaluating investment projects in engineering economy, including the Minimum Attractive Rate of Return (MARR), Present Worth (PW), Future Worth (FW), Annual Worth (AW), Payback Period, and Benefit/Cost Ratio methods. Each method provides criteria for determining the economic justification of projects based on cash flows and returns relative to the company's desired rate of return. Additionally, it includes assignments to apply these methods to real-world investment scenarios.

Uploaded by

charmaine.morales
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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ENGINEERING

ECONOMY
III. Basic Economy Study Methods
MINIMUM ATTRACTIVE RATE OF RETURN

Minimum Attractive Rate of Return(MARR) – the rate of return on


investment chosen to maximize the economic well-being of an
organization (sometimes called the‘hurdle rate’). It can be viewed as
the interest rate set by the company that they want their investment to
earn.
It is the usual basis or criterion used by company to decide whether to
accept the investment or not. Example if the MARR of the company is
25%, the project would be accepted as the ROI is 28%, more than the
minimum return on investment that the company wants to earn.
THE PRESENT WORTH (PW) METHOD

The PW method is based on the concept of the equivalent worth of all


cash flows relative to some base or beginning point in time called the
present. That is, all cash inflows or outflows are discounted to the
present point in time at an interest rate that is generally the MARR.

This pattern for economy studies is based on the concept of present


worth. If the present worth of the net cash flows is equal to, or greater
than, zero, the project is justified economically. The present worth
method is flexible and can be used for any type of economy study. It is
used extensively in making economy studies in the public works field,
where long-lived structures are involved.
THE PRESENT WORTH (PW) METHOD

𝑃𝑊 = 𝑃𝐼 − 𝑃𝑂
PW=net present worth of cash flows
𝑃𝐼= present worth of Cash Inflow
𝑃O= present worth of Cash Outflow

PW decision rule: if PW (i=MARR) ≥ 0, the projectis


economically justified
THE FUTURE WORTH (FW) METHOD

The FW is 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.

The future worth method for economy studies is exactly


comparable to the present worth method except that all cash
inflows and outflows are compounded forward 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 FUTURE WORTH (FW) METHOD

𝐹𝑊 = 𝐹𝐼 − 𝐹𝑂

FW=net future worth of cash flows


𝐹𝐼= future worth of cash inflows
𝐹O= future worth of cash outflows

FW decision rule: if FW (i=MARR) ≥ 0, the projectis


economically justified
THE ANNUAL WORTH (AW) METHOD

The AW of the project is an equal annual series of dollar amounts,


for a stated study period, that is equivalent tot eh cash inflows and
outflows at an interest rate that is generally the MARR.

In this method, interest on the original investment (sometimes


called minimum required profit) is included as a cost.
THE ANNUAL WORTH (AW) METHOD

𝐴𝑊 = 𝐴𝐼 − 𝐴𝑂
AW= annual worth of cash flows
AI=annual worth of cash inflows
AO=annual worth of cash outflows
AO= All annual expenses + annual depreciation charge +minimum required profit

FW decision rule: if FW (i=MARR) ≥ 0, the projectis


economically justified
THE PAYBACK (PAYOUT) PERIOD METHOD

The payback method, which is often called the simple payout


method, mainly indicates a project’s liquidity rather than its
profitability

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.
It is a measure of the speed with which an investment is
recovered by the cash inflows it produces.
THE PAYBACK (PAYOUT) PERIOD METHOD

𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 − 𝑠𝑎𝑙𝑣𝑎𝑔𝑒 𝑣𝑎𝑙𝑢𝑒


𝑃𝑎𝑦𝑜𝑢𝑡 𝑝𝑒𝑟𝑖𝑜𝑑 𝑦𝑒𝑎𝑟𝑠 =
𝑛𝑒𝑡 𝑎𝑛𝑛𝑢𝑎𝑙 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤𝑠

A low-valued payback period is considered desirable. The


payback method calculates the number of years required for
cash inflows to just equal cash outflows.
BENEFIT/COST RATIO METHOD

Benefit-cost analysis is a systematic method of assessing the


desirability of government projects or policies when it is important to
take a long view if future effects and a broad view of possible side
effects. It involves the calculation of a ratio of benefits to costs

The B/C ratio is defined as the ratio of the equivalent worth measure
applied can be present worth,annual worth,or future worth.It is also
known as Savings-Investment Ratio (SIR) by some governmental
agencies. A project is desirable or acceptable when the B/C ratio is
greater than or equal to 1.0.
BENEFIT/COST RATIO METHOD

Conventional B/C ratio with PW

Where:
𝑃𝑊 = present worth
𝐵 = benefits of the proposed project
𝐼 = initial investment in the proposed projects
𝑂&𝑀 = operating and maintenance costs of the proposed project
BENEFIT/COST RATIO METHOD

Modified B/C ratio with PW

Where:
𝑃𝑊 = present worth
𝐵 = benefits of the proposed project
𝐼 = initial investment in the proposed projects
𝑂&𝑀 = operating and maintenance costs of the proposed project
BENEFIT/COST RATIO METHOD

Conventional B/C ratio with AW

Where:
A𝑊 = Annual worth
𝐵 = benefits of the proposed project
CR = capital recovery account (the equivalent annual cost of the initial
investment,I,including an allowance for salvage value,if any.)
𝑂&𝑀 = operating and maintenance costs of the proposed project
BENEFIT/COST RATIO METHOD

Modified B/C ratio with AW

Where:
A𝑊 = Annual worth
𝐵 = benefits of the proposed project
CR = capital recovery account (the equivalent annual cost of the initial
investment,I,including an allowance for salvage value,if any.)
𝑂&𝑀 = operating and maintenance costs of the proposed project
BENEFIT/COST RATIO METHOD

Conventional B/C ratio with PW, Salvage Value (S) Included

Where:
𝑃𝑊 = present worth
𝐵 = benefits of the proposed project
𝐼 = initial investment in the proposed projects
𝑂&𝑀 = operating and maintenance costs of the proposed project
BENEFIT/COST RATIO METHOD

Modified B/C ratio with PW, Salvage Value (S) Included

Where:
𝑃𝑊 = present worth
𝐵 = benefits of the proposed project
𝐼 = initial investment in the proposed projects
𝑂&𝑀 = operating and maintenance costs of the proposed project
BASIC ECONOMY STUDY METHODS
Assignment 1

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 (Use AW,
PW, & FW)? What is the payback period of the investment?
BASIC ECONOMY STUDY METHODS
Assignment 2
You purchased a building 5 years ago for P100,000. It’s annual
maintenance cost has been P5000 per year. At the end of 3 years, you
spent P9000 on roof repairs. At the end of 5 years, you sell the building
for P120,000. During the period of ownership, you rented the building
for P10,000 per year paid at the beginning of each year. Use the PW,FW
and AW methods to evaluate this investment when your minimum
attractive rate of return (MARR) is 12%
BASIC ECONOMY STUDY METHODS
ASSIGNMENT 3
A piece of new equipment has been proposed by engineers to increase
the productivity of a certain manual welding operation. The investment
cost is P26,000 and the equipment will have market value of P5500 at
the end of a study period of five years. The revenue generated by the
additional production will amount to P10,000 per year and annual extra
operating costs is P1800. If the company’s MARR is 20% is this proposal
acceptable? (Use PW, FW, AW method to evaluate the proposal
BENEFIT/COST RATIO METHOD
Assignment 4:
The city of Baguio is considering extending the runways of its Municipal Airport so that
commercial jets can use the facility. The land necessary for the runway extension is currently
farmland, which can be purchased for P350,000. Construction costs for the runway extension
are projected to be P600,000, and the additional annual maintenance costs for the extension
are estimated to be P22,500. If the runways are extended, a small terminal will be
constructed at a cost of P250,000. The annual operating and maintenance costs for the
terminal are estimated at P75,000. Finally, the projected increase in flights will require the
addition of 2 air traffic controllers, at an annual cost of P100,000. Annual benefits of the
runway extension have been estimated as follows:
P325,000 rental receipts from airlines leasing space at the facility
P 65,000 airport tax charged to passengers
P 50,000 convenience benefit for residents of Baguio
P 50,000 additional tourism dollars of Baguio
Apply the B/C ratio method with a study period of 20 years and a nominal interest rate of 10%
per year to determine whether the runways at Baguio Municipal Airport should be extended.
Thank Youfor
Listening!
Any Questions?

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