Chapter 8 BASIC METHODS IN MAKING ENGINEERING ECONOMY STUDIES

The primary motive of investing in a business project is to earn profit. To assess whether an
investment will earn profit, an economic analysis will have to be conducted. There are several
methods for making economic analysis to determine the economic viability of investing in a
proposed project. The most commonly used methods are the following:
1
2
3
4
5
6

Rate of Return method (ROR)

Annual Worth methods (AW)
Present Worth method (PW)
Internal Rate of return method (IRR)
Payback Period method (PP)
Benefit/Cost ratio method (B/C)

8.1 Rate of Return method (ROR)

It shows the expected return of the capital invested or the investments financial efficiency. It is a
measure of the effectiveness of an investment of capital.
In applying the method, it requires the following: (1) a single lump sum investment at the
beginning of the first year of the projects life, and (2) a uniform revenue and cost data at
the end of each year of the projects life.
If the computed ROR is greater than or equal to the Minimum Acceptable Rate of Return
(MARR),
the investment is justified.
The model for this method is as follows:
Annual Revenue
Less
Annual Costs
Depreciation (SFF method)
Operation and maintenance
Taxes and insurance
Equals
(Other annual costs)
Net Annual Profit
ROR=

Net Annual Profit

Capital Investment

8.2 Annual Worth method (AW)

In this method, the interest on the capital investment is included as an annual cost, and the total
annual cost is subtracted from the annual revenue. If the difference is positive or zero, the
investment is justified.
The model for this method is as follows:
Annual Revenue
Less
Annual costs
Depreciation (SFF method)
Operation and maintenance
Taxes and insurance
Interest on Capital = Capital investment MARR
Equals
(other annual costs)
(Difference) or Net AW
8.3 Present Worth method (PW)
In this method, the interest on the capital investment and the depreciation are not included in the
cost computation. The PW all cash outflows (cost) is subtracted from the PW of
all cash
inflows. If the difference is positive or zero, the investment is justified.

The model for this method is as follows:

PW of all cash inflows
Less
PW of all cast outflows
Equals
(Difference) or Net PW
8.4 Future Worth method (FW)
In this method, the interest on the capital investment and the depreciation are not included in the
cost computation. The FW of all cash outflows (costs) is subtracted from the FW of all
cash inflows. If the difference is positive or zero, the investment is justified.

The model for this method is as follows:

FW of all cash inflows
Less
FW of all cash outflows
Equals
(Difference) or Net FW

8.5 Internal Rate of Return method (IRR)

Is the ROR that makes the PW of all cash flows equal to
This method shows the internal rate of interest that the project yield
In this method, the interest on the capital investment and the depreciation are not included in the
cost computation.
The net PW or net FW equation of all cash flows is set up with the unknown interest rate (i). The
Net PW or Net FW is then equated to zero and the unknown (i) is solved from the
equation using interpolation or trial and error method. If the solved (i) is equal to or
greater than the Minimum Attraction Rate of Return (MARR), the investment is justified.
Or

Net PW = PW of Inflows PW of outflows = 0

Net FW = FW of inflows FW of Outflows = 0

8.6 Payback Period method (PP)

with the unknown i (or IRR) to

be determined

This method shows the number of years that a capital investment can be recovered.
In this method, the interest on the capital investment and the depreciation are not included in the
cost computation.
This method requires the cast outflows and the cash inflows (benefits to be annual. The total
annual cash outflow is subtracted from the total annual cash inflow to get the Net Annual
Positive
Cash flow.
The formula is as follows:
Payback Period=

Capital investment Salvage value

Net Annual PositiveCas h Flow

8.7 Benefit/Cost Ratio method (B/C)

This is the most commonly used method by the government agencies in analysing the desirability
of public projects because of its capability to take into consideration a projects benefits
and detriments that cannot be readily expressed in monetary value
This method requires the benefits, detriments, and cost to be expressed at the same basis, i.e. if
benefits are in annuity, the detriments & cost must also be in annuity.
The formula is as follows:
Benefit /Cost Ratio=

Be nefit Detriments
Costs

The depreciation & interest on capital are not included in the computations
If the B/C ratio is greater than or equal to (1.0), the investment is justified.

Ex. 8.1 : An investment of 270,000 can be made in a project that will produce a uniform annual
revenue of 185,400 for 5 years and then have a salvage value of 10% of the investment.
Out-of-pocket cost for operation and maintenance will be 81,100 per year. Taxes and
insurance will be 4% of the first cost per year. The company, expects the capital to earn
not less than 25% before income taxes. Is this a desirable investment? What is the
payback period of the investment?
Soln
Given: Capital Investment (Co) = 270,000
Uniform annual revenue = 185,400
Life of project (L) = 5 years
Salvage value (Cl) = 10% (270T) = 27,000
Operation & Maintenance = 81,000/yr
Taxes & Insurance = 4% (270T) = 10,800/yr
Minimum Acceptable Rate of Return (MARR) = 25%
CFD:
185,400

270T
81T + 10,800 = 91,800

27T

Soln to Ex. 8.1 by PW method

A1= 185,400

27,000

PW
0

270T
A2= 81,000 + 10,8000 = 91,800

FW

Net PW =PW of cash inflowsPW of cash outflows

185,400

1( 1.25 )
0.25

+27,000 ( 1.25 )5270 T 91,800

1( 1.25 )
0.25

Net PW = 9,436

Since the difference (Net PW) is negative, the investment is not desirable.
Soln to Ex. 8.1 by FW method
Net PW =FW of cash inflowsFW of cash outflows

( 1.25 )5 1
( 1.25 )51
27,000+185,400
91,800
270,000 ( 1.25 )5
0.25
0.25
Net FW = 28,796

Since The Difference (Net FW) is Negative, the investment is not desirable.
Soln to Ex. 8.1 by ROR method
Annual Revenue
Less
Annual Cost
Dep n=( 270 T 27 T )
Optn & Maintenance
Taxes & Insurance

185,400

0.25
=29,609
( 1.25 )51
=81,500
=10,800
121,409 -121,409

Net Annual Profit = 63,991

ROR=

63,991
100=23.70
270,000

Since ROR < MAAR, the investment is not desirable.

Soln to Ex. 8.1 by AW method

Annual Revenue
Less
Annual Cost
Depreciation
Optn & Maintenance
Taxes & Insurance
Interest on capital = 25% (270T)

185,400

=29,609
=81,500
=10,800
=67,500
188,909 188,909
Difference = -3,509
Since the difference is negative, the investment is not desirable.
Soln to Ex. 8.1 by IRR method
Net PW =PW of cash inflowsPW of cash outflows
0=185,400

1 (1i )
i

270,000=93,600

+27,000 ( 1+i )5 270,00091,800

1 (1+i )5
+27,000 (1+i )5
i

Using interpolation method to find i:

x
[ 0.23 = 271,995.50
0.01
[
i = 270,000
0.24 = 266,177.89
x=( 0.01 )

1 (1i )
i

]-1,995.60
]

1.995 .5
( 5,817.61
)=0.0034

i=0.23+ x=0.23+ 0.0034

i=0.2334=23.34 =IRR

Since the IRR < MARR, the investment is not desirable.

Soln to Ex. 8.1 by B/C Ratio method
*By the equivalent Annuity
Annual Benefit =185,400+27,000

0.25
= 188,689.86
( 1.25 )51

-5,817.61

1( 1.25 )
0.25

Annua lCost=270 T
B /C Ratio=

188,689.86
=0.98
192,198.6

Since the B/C Ratio is less than one (1), the investment is not desirable.

Payback Period
Net Annual
Cash Flow

= Annual Cash Inflow Annual Cash Outflow

= 185,400 (81,000 + 10,800)
= 93,600_________________
PP=

(270T 27 T )
=2.6 years
93,600