ENGINEERING ECONOMY

Seventeenth Edition

Chapter 5
Evaluating A Single Project
 Method of determining project profitability

Light weighting cars improves fuel efficiency, but Carbon fibers cost more than metal at present time.

What are the risks and economic trade offs?

Minimum Attractive Rate Of Return (MARR)

• Convert cash fl ows into equivalent worth

• Policy issue based on:
– Amount for investment, source and cost of these funds
– Number and purpose of good projects available for
investment
– Amount of perceived risk of investment opportunities and
estimated cost of administering projects over short and long
run
– Type of organization involved
• MARR is sometimes referred to as hurdle rate depends of 3 variables
• MARR=Cost of Capital+Risk+Profi t=i
Capital Rationing

• Establishing a MARR involves opportunity cost viewpoint

• Exists when management decides to restrict the total
amount of capital invested
• Arise when the capital is insuffi cient to sponsor all
worthy investment
• Select only those projects which provide annual rate of
return in excess of MARR
• As the capital and opportunities change over time, MARR
will also change
Present Worth Method (PW)

• Based on concept of equivalent worth

• All cash infl ows and outfl ows discounted to present
• A measure of how much money can be aff orded for an
investment in excess of its MARR
• if Net Present Value (NPV) is positive at MARR, then the
project is economically viable. Otherwise, the project is
rejected
 Finding Present Worth
• Discount future amounts to the present by using the interest rate
over the appropriate study period
N
PW (i %)   FK (1  i )  K
K 0

i = effective interest rate

– k = index for each compounding period
– Fk = future cash flow at the end of period k
– N = No. of compounding periods
• Constant interest rate throughout life of a project
• The higher the interest rate and further into future a cash flow
occurs, the lower its PW
Present Worth (PW) Method

• Evaluate machine XYZ on the basis of the PW

method when the MARR is 20 % per year.
Pertinent cost data are as follows
– Initial Investment: $50,000
– Annual Revenues: $20,000
– Annual Operating Costs: $2,500
– Salvage Value @ EOY 5: $10,000
– Study Period: 5 years
– MARR 20% per year
Solution

• Cash fl ow diagram

• PW(20%) =-50,000 + (20,000 –2,500)(P/A,20%,5)

+ 10,000(P/F,20%,5)= $6,354.50
• PW = $6,354.50 tells us
– We ha ve rec o vered o u r en tire $50, 000 in vestm ent,
– We ha ve ea rned o ur desired 20% o n t his investm ent,
– We ha ve m a de a lum p su m equ iva lent pro fi t o f $6, 354. 50 beyo nd
w h a t w a s expec t ed
 Future Worth Method (FW)
• FW is based on the equivalent worth of all cash inflows and outflows
at the end of the planning horizon
• FW of a project is equivalent to PW
FW (i%) = PW ( F / P, i%, N )
• If FW > 0, it is economically justified
N
FW (i %)   FK (1  i ) N  K
K 0

• Project’s future worth

– i= effective interest rate
– k = index for each compounding period
– Fk = future cash flow at the end of period k
– N = number of compounding periods in study
Example

• Considering the previous example

• FW(20%) = -50,000(F/P,20%,5)+(20,000- 2,500)

(F/A,20%,5)+10,000= $15,813
• Since FW(20%)>0, the project is profi table
Annual Worth Method (AW)

• AW is an equal annual series of dollar amounts equivalent

to the cash infl ows and outfl ows at interest rate
• AW is annual equivalent revenues ( R ) minus annual
equivalent expenses ( E ), less the annual equivalent capital
recovery (CR)
AW ( i % ) = R - E - CR ( i % )
• Annual equivalent recovery
CR(%)=I(A/P, i%, N) – S(A/F, i%, N)
– I is the initial investment for the project,
– S is the salvage value at the end of the study period,
– N is the project study period
Annual Worth Method (AW)-Cont.

• Using the relationships among the

factors
– AW = PW ( A / P, i %, N )
– AW = FW ( A / F, i %, N )
• If AW > 0, project is economically
attractive
Example

• Consider the same example we used previously

• Using the equation for Capital Recovery
– CR(i%) = I (A/P,i%,N) - S (A/F,i%,N)
– CR(20%) = $50,000(A|P,20%,5) -10,000 (A|F,20%,5)=
15,376
• Using the equation for the annual worth;substitute the
values
– AW(20%) = R – E – CR(20%)
– AW(20%) = $20,000 - $2,500 - $15,376 = $2,124
• Since AW(20%) ≥ 0, project is profi table
Bond as Example of Present Worth

• Determine the purchase of a bond

• Present worth of the future cash receipts
• Bond owner receives two types of payments
– periodic interest payments until the bond is
retired
– redemption or disposal payment when the bond is
retired
• PW of the bond is the sum of the present values of
these two payments
Present Worth Of A Bond
• Use the following notation to evaluate
Z = face, or par, value
C = redemption or disposal price (usually Z )
r = bond rate per interest period
N = number of periods before redemption
i = bond yield rate per period
V N = value of the bond N interest periods
V N = C ( P / F, i%, N ) + rZ ( P / A, i%, N )
• rZ is the periodic interest payments
• When the bond is sold, the bond holder will receive
single payment (C)
Example

• How much can be paid for a $5,000,

4.5% bond, with interest paid
semiannually, if the bond matures in
10 years?
• Assume that the purchaser will be
satisfied with 8% nominal interest
compounded semiannually.
Solution
• C = Z = $5,000 (face value)
• Other data
r = 4.5% per year paid semiannually
N = 10 x 2= 20 periods
i = .08/2=0.04 or 4% per 6 month period

• Using equation we have

VN = 5000 ( P / F, 4%, 20 ) + 0.045(5000) ( P / A, 4%, 20 )
= 2317 + 3080
= 5397
Internal Rate Of Return Method (IRR)
• IRR solves for the interest rate that equates the
equivalent worth of an alternative’s cash infl ows to the
equivalent worth of cash outfl ows
• Also referred to as:
– investor’s method
– discounted cash fl ow method
– profi tability index
• IRR is positive for a single alternative only if:
– both receipts and expenses are present in the cash fl ow
pattern
– the sum of receipts exceeds sum of cash outfl ows
Figure 5-3: Plot of PW versus Interest
Rate
Figure 5-5: Use of Linear Interpolation to Find the Approximation
of IRR for Example 5-12
Figure 5-6: Spreadsheet Solution, Example 5-12
Figure 5-7: Spreadsheet Solution, Example 5-13 (1 of 2)
Figure 5-7: Spreadsheet Solution, Example 5-13 (2 of 2)
 Internal Rate Of Return Method – Cont.
• IRR is i’%, using the following PW formula:
N N

R
K 0
K ( P / F i ' %, K )   E K ( P / F i ' %, K )
K 0

R k = net revenues or savings for the kth year

E k = net expenditures including investment
costs for the kth year
N = project life ( or study period )
• If i’ > MARR, the alternative is acceptable
• To
N
compute
N
IRR for alternative,
N
set net PW = 0
 PW
K 0
  RK ( P / F i ' %, K ) 
K 0
E
K 0
K ( P / F i ' %, K ) 0

• i’ is calculated on the beginning-of-year unrecovered

investment through the life of a project
Example
• Benjamin Franklin, according to the American Bankers
Association, left $5,000 to the residents of Boston in
1791, with the understanding that it should be allowed
to accumulate for a hundred years. By 1891 the
$5,000 had grown to $322,000. A school was built, and
$92,000 was set aside for a second hundred years of
growth. In 1960, this second century fund had reached
$1,400,000. As Franklin put it, in anticipation: "Money
makes money and the money that money makes,
makes more money."
Solution
• We have
• P = $5,000, n = 100, F = $322,000 , Find: i'% per year
• We can write
• F = P(F/P, i'%, 100) or $322,000 = $5000(F/P, i'%,
100)
• Substituting the given values
– F = P(1+i’) n or 64.4 = (1+i') 1 0 0 or i' = 4.25%
per year
Difficulties With the IRR Method

• PW, AW, or the FW assume that the net CF’s

each period are reinvested at the MARR
• IRR method is not limited by this assumption
– Other diffi culties with the IRR method
– Computational diffi culty
– Occurrence of multiple rates of return
• Not meaningful for decision-making purposes
• Another method of evaluation (e.g., PW) should be used
Plot of PW for
CF Series with
Multiple ROR
Values

i* values at ~8%
and ~41%
Payback Period Method

• Sometimes referred to as simple payout method

• Indicates liquidity rather than profitability
• Calculates smallest number of years θ needed for cash
inflows to equal cash outflows -- break-even life
• Mathematically


 (R
K 1
K  E K )  I 0

• Ignores the time value of money

• Rounded to the next highest year
Payback Period Method – Continued

• Produces misleading results, and should only be used with

one of the other methods of determining profitability
• Discounted payback period θ’ ( where θ ‘ < N ) may be
calculated so that the time value of money is considered
'

 (R
K 1
K  E K )( P / F , i %, k )  I 0

– i % is the MARR
– I is the capital investment made at the present time
– ( k = 0 ) is the present time
– θ’ is the smallest value that satisfies the equation
Example
• Uncle Wilbur’s trout ranch is now for sale for $40,000.
• Annual property taxes, maintenance, supplies, and so
on estimated to continue to $3000 per year.
• Revenues from the ranch are expected to be $10,000
next year and then to decline by $500 per year
thereafter through the tenth year.
• If you brought the ranch, you would lay plan to keep
it for only 5 years and at that time to sell it for the
value of the land, which is $15000.
• If you desired annual rate of return 12%, should you
become a trout rancher?
• Use the PW, FW, AW, and PBP method to evaluate
this investment.
Solution
• PW(12%)= -$40,000 + $7,000 (P/A,12%,5) -
$500(P/G,12%,5) +15,000 (P/F,12%,5)= -$9455 < 0
• FW(12%)= -$40,000 (F/P,12%,5) + $7,000 (F/A,12%,5) -
$500 (A/G,12%,5)(F/A,12%,5)+ $15,000= -$16,660 <0
• AW(i%) = R - E - CR(i%)
CR(i%) = I (A/P,i%,N) - S (A/F,i%,N)
CR(12%) = $40,000 (A/P,12%,5) - $15,000 (A/F,12%,5) =$8,735
• AW(12%) = $10,000 - $500(A/G,12%,5) - $3,000 - $8,735=
-$2,620 < 0 Reject
Solution - Cont.
Simple PBP (Pay Back Period) Discounted PBP
EOY CF’s Cumulative CF’s Discounted CF’s Cumulative CF’s
0 -40,000 -40,000 -40,000
1 7,000 -33,000 7000(P/F, 12%, 1)=6250 -33,750
2 6,500 -2,6000 6500 (P/F, 12%, 2)=5182 -28,568
3 6,000 -20,500 6000(P/F, 12%, 3)=4271 -24,292
4 5,500 -15,000 5500(P/F, 12%, 4)=3495 -20,802
5 5,000 -10,000 5000(P/F, 12%, 5)=2837 -17,965
6 4,500 -5,500 4500(P/F, 12%, 6)=2280 -15,685
7 4,000 -1,500 4000(P/F, 12%, 7)=1809 -13,876
8 3,500 2,500 3500(P/F, 12%, 8)=1414 -12,462
Use of PBP

• Avoided except as a measure of how

quickly invested capital will be
recorded (an indicator of risk)
• Longer it takes to recover invested
monies, the greater is riskiness of a
project