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BASIC METHODS FOR

ENGINEERING
ECONOMIC STUDY
Module 5.1
BASIC METHODS FOR
ENGINEERING ECONOMIC STUDY
to determine the feasibility of investing
capital in a proposed venture.
Basic Question:
Are the future benefits large enough
to justify the costs of the project?
is a measure of the effectiveness of an
investment of capital.
is easily understood.
Condition:
A single investment of capital at the beginning of
the first year of the project life and identical
revenue and cost data for each year.
1. THE RATE OF RETURN METHOD (ROR)
1. THE ROR cont.
INVESTED CAPITAL
PROFIT ANNUAL NET
ROR =
ROR i (investment is feasible and justified)
%) 100 (
FC
P
ROR
b
b
=
where Pb = net profit before income taxes, thus
) ( D AC AI P
b
+ =
Where: FC = required investment
AI = gross annual income / annual revenue
AC = annual expenses or costs
= includes materials, direct labor, overhead, property taxes
O operation
M maintenance
T taxes
T M O AC + + =
D = depreciation
(

+

=
i
i
SV FC
D
N
1 ) 1 (
1. THE ROR cont.
the minimum required profit is included as a
cost.
if the excess of annual cash inflows over annual
cash outflows is not less than zero, then the
proposed investment is justified or valid.
Condition:
A single investment of capital at the beginning of
the first year of the project life and identical
revenue and cost data for each year.
2. THE ANNUAL WORTH METHOD
Inflow Outflow (investment is feasible and justified)
where: Fci = interest on capital
2. THE ANNUAL WORTH METHOD cont.
) ( FCi D AC AI P
b
+ + =
3. THE PRESENT WORTH METHOD
if the present worth of the net cash flows is
equal to, or greater than zero, then the project
is justified economically.
flexible, can be used in any type of economy
study.
depreciation is excluded in the cash outflow.
Inflow Outflow (investment is feasible and justified)
3. THE PRESENT WORTH METHOD cont.
INFLOWS:
AI AI AI
AI
SV
N 1 2 3 0
. . . . . . .
(going to present)
3. THE PRESENT WORTH METHOD cont.
OUTFLOWS:
AC AC
AC AC
FC
N
1 2 3
0
. . . . . . .
(going to present)
4. THE FUTURE WORTH METHOD
if the future worth of the net cash flows is equal
to, or greater than zero, then the project is
justified economically.
depreciation is excluded in the cash outflow
Inflow Outflow (investment is feasible and justified)
4. THE FUTURE WORTH METHOD cont.
INFLOWS:
AI AI AI
AI
SV
N 1 2 3 0
. . . . . . .
(going to future)
4. THE FUTURE WORTH METHOD cont.
OUTFLOWS:
AC AC
AC AC
FC
N
1 2 3
0
. . . . . . .
(going to future)
5. THE PAYBACK PERIOD METHOD
the payback period is 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.
FLOW CASH ANNUAL NET
VALUE SALVAGE INVESTMENT
Period Payback
years

=
AC AI
SV FC
Period Payback
years

=
SAMPLE PROBLEM 1
An investment of P 270,000.00 can be made in a project
that will produce uniform annual revenue of P 185,400.00
for 5 years and then have a salvage value of 10% of the
investment. Out-of pocket costs for operation and
maintenance will be P 81,000.00 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? What is the
payback period of the investment?
(Ans. ROR = 23.70%; Inflow = P 185,400.00, Outflow = P 188,908.76;
P
income
= P 507,439.87, P
costs
= P 516,875.90; F
income
= P 1,548,583.59,
F
costs
= P 1,577,380.08; PP = 2.6 years)
SAMPLE PROBLEM 2
A project capitalized for P 50,000.00 invested in depreciable
assets will earn a uniform, annual income of P 19,849.00 in
10 years. The salvage value is P 2000.00. The cost for
operation and maintenance total P 9,000.00 a year, and
taxes and insurance will cost 4% of the first cost each year.
If the company expects its capital to earn 12% before
income taxes, is the investment worthwhile?