Chapter 5

By:
Gabrielle Plasos
Neil Z. Salvaloza
Alexis Atupan
 Basic Methods for
Making Economy Studies

By: Gabrielle Plasos

Objectives:
 To demonstrate the mechanics of calculations
for six basic methods for making economy
studies.
 To briefly describe the underlying assumptions
and interrelationships of those methods
Six different basic methods for
economy studies

 Annual Worth (A.W.)

 Present Worth (P.W.)
 Future Worth (F.W.)
 Internal Rate of Return (I.R.R.)
 External Rate of Return (E.R.R.)
 Explicit Reinvestment Rate of Return
(E.R.R.R.)
Six different basic methods for
economy studies
 The 1st three methods convert all financial
happenings into equivalent worth at some point
in time using an interest rate equal to the cost
of capital, or the minimum attractive rate of
return (M.A.R.R.).
 The last three methods are different ways to
calculate a rate of profit or savings (annual
return as a percent investment) so that, in turn,
be compared against the M.A.R.R.
The annual worth method
 - the term annual worth means a uniform annual series
of net cash flows for certain period of time that is
equivalent in amount to particular schedule of cash
inflows (receipts or savings) and cash outflows
(disbursements or opportunity costs) under
consideration.
 - If net annual worth ≥ 0 the project is economically
justified; otherwise, it is not.
 - If disbursements only are considered, the criterion is
usually expressed as annual worth-cost (A.W.-C.), or
annual cost (A.C.)
Calculation of capital recovery cost

 Capital recovery cost (C.R.) – the equivalent

uniform annual cost of the capital invested for a
project. It covers two items:
 Depreciation (loss of value in the asset).
 Interest (minimum required profit) on invested
capital.
Calculation of capital recovery cost
Example:
 Consider a machine or other asset that will cost $10,000, last 5
years, and have a salvage value of $2,000. Further, the interest
on invented capital, i, is 10%.
 There are several formulas by which capital recovery cost may be
calculated. One formula is just to subtract the annual equivalent of
the investment minus the annual equivalent value of the salvage
value.
 C.R. = P(A/P, i %, N) – F(A/F, i %, N)
Where P = investment at the beginning of life
F = salvage value at the end of life
N = life of project
C.R. = $10,000(A/P, 10%, 5) - $2,000(A/F, 10%, 5)
= $10,000(0.2638) – $2,000(0.1638) = $2,310
Table 5-1
Calculation of equivalent cost of interest and capital
recovery cost assuming straight line depreciation

Interest on
Beginning-of-
Value of investment Year
at the beginning investment at
Year of the year 10% Present worth of interest at 10%
1 $10,000 $1,000 $1,000(P/F, 10%, 1) = $ 909
2 8,400 840 840(P/F, 10%, 2) = 694
3 6,800 680 680(P/F, 10%, 3) = 511
4 5,200 520 520(P/F, 10%, 4) = 355
5 3,600 360 360(P/F, 10%, 5) = 224
Total $2,693

Annual equivalent interest = $2,693(A/P, 10%, 5) =

$710
Total C.R. cost = annual depreciation + annual
equivalent interest= ($10,000 - $2,000)/5 + $710
= $2,310
Calculation of capital recovery cost
 Another way is to add the annual sinking fund depreciation charge
(deposit) to the interest on original investment (minimum required
profit).
C.R. = (P – F)(A/F, i%, N) + P(i%)
C.R. = ($10,000 - $2,000)(A/F, 10%, 5) + $10,000(10%)
= $8,000(0.1638) + $10,000(0.10) = $2310
Another way again is:
C.R. = (P – F)(A/P, i%, N) F(i%)
= $8,000(0.2638) + $2,000(0.10) = $2,310
Lastly, is this approximation formula called the straight line
depreciation plus average profit method.
C.R. ≈ (P – F)/N + (P – F)[(N + 1)/2N](i) + F(i)
≈ ($10,000 - $2,000)/5 + ($10,000 - $2,000)(0.6)(10%) +
$2,000(10%)
≈ $2480
Calculation of capital recovery cost
 Example 5-1
An investment of $10,000 can be made in a project that
will produce a uniform annual revenue of $5,310 for 5
years and then have a salvage value of $2,000. Annual
disbursements will be $3,000 each year for operation
and maintenance costs. The company is willing to
accept any project that will earn 10% or more, before
income taxes, on all invested capital. Show whether
this is a desirable investment using the annual worth
method.
Calculation of capital recovery cost

Solution:

Annual Worth
Annual Revenue $5,310
Annual -$3,000
Disbursements
C.R. cost -$2,310
Total -$5,310
Net A.W. $ 0
Present worth method
the present worth method for economy is based on
the concept of equivalent worth of all cash flows
relative to some base or beginning point in time
called the present. All cash inflows and outflows are
discounted back at an interest rate that is generally
the M.A.R.R.
If the net present worth ≥0, the project is economically
justified.
If only outflows (disbursements) are considered, the
method is characterized by negative-valued present
worth amounts expressed as present worth-cost
(P.W.-C.).
Present worth method
 Example 5-2
Considering the same project as in example 5-1, show whether it is
justified using the P.W. method.
Present
worth
Annual revenue: $5,310(P/A, 10%, 5 $20,000
Salvage value: $2,000(P/F, 10%, 5) $ 1,245
Investment -$10,000
Annual disbursements: $3,000(P/A, 10%, -$11,370
5)
Total -$21,370
Net P.W. $ 0
Four different methods for
economy studies

By: Neil Z. Salvaloza

 Four different methods for
economy studies

 The future worth method(FW)

 The internal rate of return method
(I.R.R.)
 The external rate of return
method(ERR)
 Explicit reinvestments rate of return
method(ERRR)
The future worth method (F.W.)

 It is just 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
The future worth method (F.W.)

 Example
– An investment of 10,000 can be made in a project
that will produce a uniform annual revenue of 5,310
for 5 years and then have a salvage value of 2,000.
annual disbursements will be 3,000 each year for
operation and maintenance costs. The company is
willing to accept any project that will earn 10% or
more, before income taxes, on all invested capital.
The future worth method (F.W.)

Solution
future worth
Annual revenue: 5310(F/A, 10%, 5) 32,420
salvage value 2,000
Investment : 10,000(F/P, 10%, 5) -16,105
Annual disbursements: 3,000(F/A, 10%, 5) -18,315
total -34,420
NET F.W. 0
The internal rate of return method
(I.R.R.)
 the rate of return promised by an investment
project over its useful life.
 The most general and widely used rate of
method
– Investors method
– Discounted cash flow method
– Receipts versus disbursements method
– Profitability index
The internal rate of return method
(I.R.R.)

N N
∑Rk(P/F,i%,k) = ∑Dk(P/F,i%,k)
k=0 k=0

Rk = net receipts for kth year

Dk = net disbursements for kth year
N = project life for a maximum number of
years for study
The internal rate of return method
(I.R.R.)
Using the example above:

I’ = 5%: -10,000 + 2,3140(4.3295) + 2,000(.7835) = + 1,568

I’ = 25%: -10,000 + 2,3140(2.6893) + 2,000(.3277) = - 3,132

(25%-5%)/(1,568-(-3,132)) = (I’% - 5%)/(1,568-0)

= 5% + 6.7%
= 11.7%
Selecting trial rates of return when
using the I.R.R. method

 To reduce the number of trials required to

obtain an acceptably accurate answer

 Cash inflow:
annual receipts: 5,310 x 5 26,550
salvage 2,000
total 28,550
Selecting trial rates of return when
using the I.R.R. method

 Cash outflow:
Annual disbursements: 3,000 x 5 - 15,000
Investment - 10,000
Net cash inflow (profit) 13,550
Average profit per year = 13,550/5=710
Average investment = (10,000+2,000)/2 =6,000
Average profit per year/ Average investment =
710/ 6,000= 11.8%
The external rate of return method
(E.R.R.)

 Involves the assumption that all recovered

funds can be reinvested at some specified rate
of return

– Two advantages over I.R.R

 Can be solved directly rather than by trial and error
 Not subject to the possibility of multiple rates of return
The external rate of return method
(E.R.R.)

N N

∑Dk(P/F,e%,k)(F/P,i’%,N) = ∑Rk(F/P,e%,N-k)
k=0 k=0

Dk= net outflow(excess of disbursements over receipts) for kth year

Rk = net inflow (excess of receipts over disbursements) for kth year
N = project life for maximum number of years for study
e = external reinvestment rate
The external rate of return method
(E.R.R.)
– Consider the same example
M.A.R.R. = 10%
10,000(F/P,i’%,5) = (5,310-3,000)
(F/a,10’%,5) + 2,000
= 2,310(6.105) + 2,000
(F/P,i’%,5) = 1.61
Explicit reinvestments rate of
return method (E.R.R.R)

 Is a computationally easy means of calculating

a rate of return when there is a single lump
sum investment and uniform cash savings or
returns at the end of each period throughout
the life , N, of the investment project
Explicit reinvestments rate of
return method (E.R.R.R)

 E.R.R.R. = (R-D-P[P-F][A/F,e,N])/P

– R = uniform annual receipts or savings

– D = uniform annual costs or disbursements
– P = investment
– F = salvage value
– e = reinvestment rate
Explicit reinvestments rate of
return method (E.R.R.R)

 M.A.R.R. = 10%
– Solution
annual revenue 5,310
annual disbursements -3,000
depreciation: (10,000-2000)(A/F,10%,5) -1,310
TOTAL -4,310
Net annual profit 1,000
ERRR = (net annual profit)/(investment)
=1,000/10,000 = 10%
Summary comparison of economy
study methods

 You may wonder why there are six different

methods for economy studies have been
presented, when any one of these methods will
give a valid answer for the reinvestment
assumption in that method.
– The best answer is that it preferences differ
between analyst and decision makers and also that
often one method is easier to use than the other
method because of the particular cash flow patterns
An undesirable economy
study method

By: Alexis Atupan

An undesirable economy study
method
 =) used as supplemental information in conjunction with a correct economy study
method
 Payout period method
 =) also called payback period method
 =)determines the number of year that will have to elapse in order for the
invested capitral to be recovered out of the net incoming cash flow(determination
must be made on an after-cash basis)
 =) does not consider possible earnings from reinvested capital that is
recovered during the payout period
 =) does not take into consideration the economic life of the physical asset
 *if revenue and cost are uniform each year, the determination form is:
 Number of years for payment = (P-F)/(R-D)
 *if the salvage value is ignored, the formula is
 Number of years for payment = P/(R-D)
 Where: R-D represents the net annual cash flow
Economy study of a new venture
using various methods
 Example 5-7 involving a single, initial investment, and uniform revenue
and cost data
 Mr. Brown has an opportunity to purchase an apartment house that
has just been completed. It is located in the suburban area in a medium-
size city that contains a fair amount of industrial plants. It is also within a
walking distance of a quite large university. The apartment house is in the
process of being rented and now is more than 80% occupied, with
prospect of being fully rented within a few weeks. The purchase price
would be $85,000, of which $10,000 represents the value of the land. The
building is consists of 10 four-room apartments, a small apartment for the
caretaker, and garage space for 11 automobiles. Form a study of similar
apartment buildings, Mr. Brown estimates that each apartment can be
rented for $110 per month, with at least 95% occupancy at all times. Heat
and water are included in the rental. The operating costs are estimated to
be as follows:
Economy study of a new venture
using various methods
 Caretaker $175 per month plus his apartment
 Fuel $400 per year
 Water $150 per year
 Maintenance and repair equal to 1 month’s rental on each
rental unit per year
 Taxes $4 per $100 of assessed value ; assessed
value will be approximately 30% of costs of
building and land
 Insurance 0.5% of first cost building, per year
 Agent’s commission 2 ½ of gross rental revenue
Economy study of a new venture
using various methods

 At present Mr. Brown's capital is invested in

bonds that yield approximately 5% before
income taxes and he feels that the project of
this should earn at least 7% before income
taxes. E estimates that the economic life of the
apartment house will be at least 40 years and
that the $10,000 for the land will be the only
salvage value at the end of that time..
Economy study of a new venture
using various methods
 The revenue each year can be computed as 10 x $110 x 12 x 0.95 = $12,540.
 The out pocket costs (disbursement) each year can be computed as:
 Caretaker : $175 x 12 $2,100
 Fuel 400
 Water 150
 Maintenance and repair:10 x $110 1,100
 Taxes; ($85,000/$100)x 0.3 x $4 1,020
 Insurance: $75,000 x 0.005 375
 agent's commission: $12,550 x 0.025 314

 total $5,495
 hence the net cash inflow (revenue minus disbursement) each year is $12,540 -
$5,495 = $7,081.
Economy study of a new venture
using various methods
Show whether Mr. Brown should purchase the apartment house using the
I.R.R. Method.

Solution:
the present worth can be written
-$85,000 + $7,081 (P/A,i', 40) + $10,000 (P/F,i', 40) =0
at i' = 5%: - $85,000 + $7,081 (17.1591) + $10,000 (0.1420) ~= $38,000
at i' = 10%: - $85,000 + $7,081 (9.7791) + $10,000 (0.0221)~= -$15,500
Since we are seeking the I' at which the present worth equation is zero, by
linear interpolation we find that
i'= I.R.R. ~= 5% + [$38,000/($38,000 + $15,500)](10% - 5%) ~= 8.6%
since 8.6% is greater than 7% the project is apparently worthy of investment.
Economy study of a new venture
using various methods
Example 5-8
Analyze the same investment project as in Example 5-7 using E.R.R.R. Method.
Assume that he expects to reinvest accumulated depreciation funds in bonds
earning 5%.

Solution:
Annual revenue $12,550
Annual costs:
Out - of – pocket $5,495
Depreciation:
$75,000(A/F,5%,40)= $75,000(0.0083) 622
total $ 6,081
Net annual profit $ 6,469
E.R.R.R. = $6,469 / $85,000 = 7.6%
Since 7.6% is greater than 7% he would probably invest the apartment house.
Economy study of a new venture
using various methods
Example 5-9
Analyze the same investment project as in Ex. 5-7 using the annual worth method.

Solution:
Annual revenue $12,550
Annual costs:
Out -of – pocket $5,495
Depreciation:
$75,000(A/F,7%,40)= $75,000(0.0050) 375
Minimum required profit :$85,000(0.07) 5,950
total $11,784

Since the annual revenue of $12,550 exceeds the total annual costs of $11,784, the
investment would be justified.
Economy study of a new venture
using various methods
Example 5-10
Analyze the same investment project as in Ex. 5-7 using the present worth method.
Solution:
P.W. Of inflow:
Revenue: $12,550(p/a,7%,40) = $12,550(13.3317) $167,500
Salvage of land: $10,000(P/F,7%,40) = $10,000(0.0668) 668
total $168,168
P.W. Of outflow:
Investment $85,000
Out – of – pocket : $5,495(P/A,7%,40) 72,700
total $157,700

Since $168,168 > $157,700, the project is once again shown to be worthy of investment.
Discussion of decision criteria to
supplement economy study or studies

In order to arrive at a decision on the project for which economy

studies were made in Ex.'s 5-7 through 5-10 Mr. Brown would
have to consider a number of factors, first item undoubtedly
should br the revenue estimate. Some question to be answered:

>Is the assumed rental rate reasonable, particularly in relationship to

similar apartments?
>Is the assumed occupancy rate a reasonable one for this type of
housing?
>How will possible changes in economic conditions affect the rentals,
both as to price and occupancy rate?
An example with important intangibles
In many economy studies the final decision is determined
primarily by the intangibles that exist in the situation. The
following illustrate this type of problem

Example 5-11
The management of a hotel in a city an an inland valley of
California was considering the installation of an air-cooling system
for all the rooms. This hotel had 150 guest rooms and was
considered to be one of three first-class hotels in the city. One of
the other hotel had installed such a system the previous year .A
bid of $18,000 had been received for installing the system. It was
estimated that the cooling system would have to be operated at
full capacity for 14 weeks of each year, and at reduced capacity at
6 weeks. Operation costs at full capacity would be $17 per day
and, at reduced capacity, $12 per day. The annual maintenance
expense was estimated to be$125, and taxes and insurance to be
$200. The life of the installation was estimated to be not less than
15 years.
Discussion of decision criteria to
supplement economy study or
studies
 If the cooling system were installed, it was estimated
that 90% of the rooms would be rented during the 20
weeks of the hot weather, whereas only 80%, of the
rooms could be rented if no air cooling was available.
These estimates were based on results of similar
hotels in the other cities. The existing average profit on
each room that was rented was $2 per day. The
owners had capital invested in stocks, paying about 6%
before taxes, which could be used to finance the
project. Determine if the investment should be made
using E.R.R.R method.
Discussion of decision criteria to
supplement economy study or studies

Solution:
Annual income:150 x (0.9 – 0.8) x 7 x 20 $4,200
Annual expenses:
Depreciation:418,000(A/F,6%,15) $ 774
Out – of – pocket costs:
Operation:$17 x 7 x 14 1,666
$12 x 7 x 6 504
Maintenance 125
Taxes and insurance 200
total $3,260
Profit $ 931
E.R.R.R = $931 / $18,000 = 5.5%
An example of a proposed investment to reduce
costs
 Example 5-12

 A manufacturer of jewelry is contemplating the installation of a system

that will recover a large portion of the fine particles of gold and platinum
that result from the various manufacturing operations. At the present time
a little over $5,000 worth of these metals is being lost per year, and it is
anticipated that, because of the growth of the company, this amount will
increase by $500 each year for the next ten years. The proposed system,
involving a network of exhaust ducts and separators, will recover at least
two-thirds of the gold and platinum that otherwise would be lost. The
complete installation would cost $14,000.The best estimates for the
operating cost of the system. obtained from operations of similar systems,
are $1,000 per year for operating expense,$180 per year for maintenance
and repairs, and 2% of the first cost annually for taxes and insurance. The
company would require the investment to be written off within 10 years.
The average earnings of the company, before taxes, have been about
15%.Should the recovery system be installed?
An example of a proposed
investment to reduce costs
Solution :
Such an investment is made to reduce some of the operating
expenses, in this case the cost of the material used. Thus the saving
(income) to be obtained by making an investment is almost entirely within
the control of the investors. The company knows exactly what expenses
have been. If the efficiency of the proposed equipment is known, the only
factors that should affect the saving are the variation of production,
operation, and maintenance expenses of the proposed equipment and
depreciation expense. In most cases of this type these items are known
or may be predicted quite accurately. The company would have a good
idea of how its volume would vary. Operation and maintenance expenses
can usually be estimated accurately, especially if historical data are
available on the proposed equipment. Depreciation cost can be placed on
the safe side by using a write-off period shorter than actual physical life.
Investment where income is
unknown
 Decisions to invest or not to invest capital often must
be made when it is impossible to know or evaluate the
return. In some cases it is not particularly necessary to
know what the income will be. These often occurs
when public or governmental improvements are made.
The returns are often in a non-monetary form, yielding
convenience and satisfaction to the public. When
companies spend large sums of money to create
customer or employee goodwill, a precise
measurement of the return is impossible. Yet such
investments must often be made.
Investment where income is
unknown
 Probably the only rule that can be established for such cases is
that generally no more should be invested than is required to give
a satisfactory result. Obviously, this rule cannot be followed rigidly.
When public roads are built, for example, it may be advisable to
spend more than a bare minimum to assure permanence and low
maintenance cost. I such cases the rule rule of least annual cost
becomes important. The income (or at least a large part of it)
resulting from many projects that at first thought do not appear
subject to the type of analysis under discussion can be measured
if the undertakings are analyzed fully. Whenever this can be done,
it should not be neglected. Greater efficiency in the use of capital
is bound to result.
An example of an investment to
reduce risk
 There are cases where we consider making an
investment in order to reduce, or eliminate, future costs
that may result from various types of risk, usually
associated with such events as fires or floods. The
basic economic aspects can be illustrated by a simple
example. Assume that a man agrees that once each
year, for the next 20 years, he will cut a deck of 52
playing cards and that if he cuts an ace he will pay
$500 to a second individual. How much could he afford
to pay, in one immediate sum,to avoid this obligation
and risk, assuming that capital is worth 6% to him?
An example of an investment to
reduce risk
With four aces in a deck of 52 cards it is apparent that, on the
average, an ace will be cut four times out of 52 attempts. In other
words , it is probable that an ace will be cut in 1/13 of the
attempts. Therefore the expected cost to him in any one year is
1/13 * $500 = $38.46.
With money worth 6%, the present worth of 20 annual
payments of $38.46 would be $38.46 * (P/A, 6%, 20) = $38.46 *
11.4699 = $441.13.
Thus, if the probability of occurrence of an event as well as
the cost of that event when it occurs is known, a single or annual
amount that we can afford to pay to avoid the liability resulting
from its occurrence can be calculated.
An example of an investment to
reduce risk

The foregoing type of calculation forms the basis

for all insurance. The annual premium that is
paid for insurance represents the average
annual loss that might occur, except that it also
must include an extra charge to pay the
overhead and profit costs of the insurance
company.
An application of an economy study aspects
of such a situation is illustrated in the following
problem.
EXAMPLE 5-13
A company has a warehouse that has no automatic sprinkler system.
Annual fire insurance premiums have been $1,200. If a sprinkler
system costing $8,000 is installed, the insurance premium will be
reduced by 50%. The system is estimated to have a life of 30
years with the annual costs for taxes and maintenance amounting
to $75. Capital is worth 8%.
The company engineer estimates that the actual loss resulting
from any fire, including such factors as lost orders and personnel
required to arrange for repairs, would be at least 50% greater
than the physical loss covered by insurance. It is assumed that
the reduction in
insurance premium is a good measure of the difference in the
probable annual physical loss without and with a sprinkler system.
EXAMPLE 5-13
 Solution:
With the premium reduction being equal to $600 per year,
the probable saving in actual loss due to fire is
estimated to be $600 * 1.5= $900. The costs would be
Capital recovery:$8,000(A/P, 8%, 30)=$8,000(0.0888)
$710
Taxes and maintenance 75
TOTAL ANNUAL COST $785  
Thus the probable annual savings of $900 exceeds the
annual cost of $785, so from a long range viewpoint,
the sprinkler system would be a good investment.
Basic Methods for Making
Economy Studies

 QUESTIONS