Econ 101E(Hand-out 3)

Module 6, 7 & 8
Module 6: Basic Economy Study Methods(part 1)
1. Rate of Return on Investment (ROI) – is the yearly profit divided by the total initial
investment necessary or needed. It represents the fractional return on investment, and this
fraction times 100 is the standard percent return on investment.
Formula: ROI = ____Annual Profit_____
Total Initial Investment
Example 1) A proposed manufacturing plant requires an initial fixed-capital investment of
$900,000 and $100,000 working capital. It is estimated that the annual income will be
$800,000 and the annual expenses will be $520,000. Determine the rate of return in
investment.
Solution:
ROI = ____Annual Profit_____
Total Initial Investment
Annual Profit = Annual Revenues – Annual expenses
= $800,000 - $520,000
= $280,000
Total Initial Investment = Fixed-capital investment + Working capital
= $900,000 + $100,000
= $1,000,000
ROI = __$280,000__
$1,000,000
ROI = 0.28 or 28%
a. 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. In the sample problem just solved, 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.
2.
3. Present Worth (PW) Method –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 to the present point in time at an interest rate that is generally the
MARR.
PW(i%) = F0(1 + i)0 + F1(1 + i)-1 + F2(1 + i)-2 + ….. + Fk(1 + i)-k + . .
+ . . . . . + Fn(1 + i)-n
where: i = effective interest rate, or MARR, per compounding period
k = index for each compounding period (0 ≤ k ≤ n)
Fk = future cash flow at the end of period k
n = number of compounding periods in the planning horizon
(i.e., study period, service life, etc.)
The PW of an investment alternative is a measure of how much money an
individual or a firm could afford to pay for the investment in excess of its cost.
Conditions: a) If Net Present Worth, NPW ≥ 0, project is justified economically.
b) If only outflows (disbursements) are considered, the method is
characterized by negative-value present worth and can be expressed as
present worth-cost(PW-C). A low-valued NPW-C is preferred to a high-
valued NPW-C.

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 Example 2) A piece of new equipment has been proposed by engineers to increase the
productivity of a certain manual welding operation. The investment cost is $25,000, and the
equipment will have a market value of $5,000 at the end of a study period of five years.
Increased productivity attributable to the equipment will amount to $8,000 per year after
extra operating costs have been subtracted from the revenue generated by the additional
production. If the company’s MARR is 20%, is this proposal acceptable?
CFD: A A A A A = 8,000

Sv = 5,000

1 2 3 4 5

I = 25,000
i = 20%
Solution:
NPW = PWI + PWA + PWSv
NPW = I + A [(1 + i)n – 1] + ___ Sv___
[ i (1 + i)n] (1 + i)n
NPW = - 25,000 + 8,000[(1.20)5 – 1] + _ 5,000_
[0.20(1.20)5] (1.20)5
NPW = 934.28 > 0, therefore investment is acceptable.
4. Future Worth(FW) Method - based on the concept of equivalent worth of all cash flows at the
end of the planning horizon( study period) at an interest rate that is generally the MARR.
FW(i%) = F0(1 + i)n + F1(1 + i)n - 1 + F2(1 + i)n - 2 + ….. + Fk(1 + i)n - k + . .
+ . . . . . + Fn(1 + i)0
where: i = effective interest rate, or MARR, per compounding period
k = index for each compounding period (0 ≤ k ≤ n)
Fk = future cash flow at the end of period k
n = number of compounding periods in the planning horizon
(i.e., study period, service life, etc.)
The FW method is very useful in capital investment decision situations because the
primary objective of all time value of money method is to maximize the future wealth of
the owners of a firm.
Conditions: a) If Net Future Worth, NFW ≥ 0, project is justified economically.

Example 3) Given the previous example IV.2, is this proposal

acceptable using NFW method?
CFD: A A A A A = 8,000

Sv = 5,000

1 2 3 4 5

I = 25,000
i = 20%
Solution:
NFW = FWI + FWA + FWSv
NFW = I(1 + i)n + A [(1 + i)n – 1] + Sv
(i)
NFW = - 25,000(1.20)5 + 8,000[(1.20)5 – 1] + 5,000
[0.20]
NFW = 2,324.8 > 0, therefore investment is acceptable.

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 5. Annual Worth(AW) Method – similar to PW and FW except that cash flows are in
equal/uniform annual series of amount.
The AW of a project is an equal annual series of amounts for a stated study period
that is equivalent to the cash inflows and outflows at an interest rate that is generally the
MARR.

AW(i%) = Annual equivalent of all cash flows

Conditions: a) If Net Annual Worth, NAW ≥ 0, project is justified

economically. An AW of zero means that annual return exactly equal to the
MARR has been earned.
b) If revenues are absent, we call it ‘equivalent uniform annual cost’(EUAC).A
low-valued EUAC is preferred to a high-valued EUAC.
Example 4) Given the previous example 2, is this proposal
acceptable using NAW method?
CFD: A A A A A = 8,000

Sv = 5,000

1 2 3 4 5

I = 25,000
i = 20%
Solution:
NAW = AWI + AWA + AWSv

NAW = I [i(1 + i)n ]_ + A + ___Sv( i )___

[(1 + i)n – 1] [(1 + i)n – 1]

NAW = - 25,000[0.20(1.20)5] + 8,000 + __5,000(0.20)

[(1.20)5 – 1] [(1.20)5 -1]
NFW = 312.4 > 0, therefore investment is acceptable

Module 7: Basic Economy Study Methods(part 2)

6. Internal Rate of Return(IRR)
This method solves for the interest rate that equates the equivalent worth of an
alternative’s cash inflows (receipts or savings) to the equivalent worth of cash outflows
(expenditures, including investment costs). Equivalent worth may be computed with any of
the PW, FW or AW method. The resultant interest rate is termed the Internal Rate of
Return(IRR).
This method is sometimes called the investor’s method, discounted cash flow method
or profitability index.
Condition: If i' ≥ MARR, the alternative is acceptable.
Method:
Cash inflow at i' % = Cash outflow at i' %
Solve for i'.
Example 6) Given the previous example 2, is this proposal
acceptable using the IRR method?
CFD: A A A A A = 8,000

Sv = 5,000

1 2 3 4 5

I = 25,000

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 Solution:
PW cash inflows = PW cash outflows
PWA + PWSv = PWI
A [(1 + i’)n – 1] + ___ Sv___ = I
[ i'(1 + i')n] (1 + i')n
8,000[(1 + i)5 – 1] + _ 5,000_ = 25,000
[i'(1 + i')5] (1 + i')5

By trial and error (or spreadsheet solution)

i’ ≈ 21.6% > 20% (MARR), therefore project is
economically justified.
7. External Rate of Return(ERR)
This method directly takes into account the interest rate (Є) external to a project at
which net cash flows generated or required by the project over its life can be reinvested or
borrowed. If this external reinvestment rate, which is usually the firm’s MARR, happens to
equal the project’s IRR, then the ERR method produces results identical to those of the IRR
method.
Steps for computation:
1. All net cash outflows are discounted to time 0 (present) at Є%
per compounding period.
2. All net cash inflows are compounded to period n at Є%.
3. The external rate of return, which is the interest rate that establishes equivalence
between the two quantities, is determined. The absolute value of the present
equivalent worth of the net cash outflows at Є% (first step) is used in this last step.
Condition: If Є% ≥ MARR, the project is acceptable.
The ERR method has two basic advantages over the IRR method:
1. It can usually be solved directly, without needing to resort to trial and error.
2. It is not subject to the possibility of multiple rates of return.

Example 7) Given the previous example 2, is this proposal

acceptable using the ERR method?
CFD: A A A A A = 8,000

Sv = 5,000

1 2 3 4 5

I = 25,000
Solution:
FW cash outflows(at Є%) = FW cash inflows(at MARR)
FWI = FWA + FWSv
P(1 + Є) = A [(1 + MARR)n – 1]
n
+ Sv
(MARR)
25,000(1 + Є)5 = 8,000[(1.20)5 – 1] + 5,000
(0.20)
Є = 20.88% > 20% (MARR), therefore
project is economically justified.

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Module 7: Basic Economy Study Methods(part 3)
8. Payback/Pay-out Period – is defined as the minimum length of time theoretically necessary to
recover the original capital investment in the form of cash flow to the project.
a. Simple Payback period – ignores the time value of money.

Payback Period = __Capital Investment__

(in years) Cash flow/year

b. Discounted Payback period – takes into account the time value of

money at interest rate, i.

Payback Period = ____Capital Investment_____

(in years) discounted cash flow/year

Example IV.5) Given the previous example 2,

CFD: A A A A A = 8,000

Sv = 5,000

1 2 3 4 5

I = 25,000

a) What is the simple payback period?

b) What is the discounted payback period if the company’s MARR is 20%?
Solution:
a) simple payback period
Payback Period = __Capital Investment__
(in years) Cash flow/year
Payback Period = __$25,000_
(in years) $8,000year
Payback Period = 3.125 years

b) discounted payback period

End-of-year Net cash flow PW of cash flow Cumulative PW
0 -$25,000 -$25,000 -$25,000
1 8,000 6,667 - 18,333
2 8,000 5,556 - 12,777
3 8,000 4,630 - 8,147
4 8,000 3,858 - 4,289
5 13,000 5,223 +934

Therefore, payback period is around 5 years, the year when cumulative

discounted balance turns positive.

9. Benefit-Cost Ratio Method

The B-C ratio is defined as the ratio of the equivalent worth of benefits to the equivalent
worth of costs. The equivalent-worth measure applied can be present worth, annual worth or future
worth, but customarily, either PW or AW is used.
Condition: If B-C ≥ 1.0, the project is acceptable
Conventional B-C ratio with PW:
PW(benefits of the proposed proj ects)
𝐵𝐵 − 𝐶𝐶 =
PW(total cost of the proposed proj ects)
PW(B)
=
I−PW(MV)+PW(O&𝑀𝑀)

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 where:: PW = Present Worth
B = benefits of the proposed project
I = initial investment of the proposed project
MV = market value at the end of service life
O&M = operating and maintenance cost of the proposed project

Modified B- C ratio with PW:

PW(B)_−PW(O&𝑀𝑀)
B–C=
I−PW(MV)

Example 8) An engineering project has the following data:

Investment cost = $10,000
Expected life = 5 years
Market (salvage value at end of life) = $1,000
Annual receipts = $8,000
Annual O&M expenses = $4,000
Using conventional and modified B-C ratio with PW and with the MARR of 15% per year, is
this project acceptable?
Solution:
Using Conventional B-C ratio with PW:

PW(B)_______________
B-C =
I−PW(MV)+PW(O&𝑀𝑀)

A [(1 + i)n – 1]
= ___________[ i (1 + i)n]______________
I - ___ MV___ + O&M __[(1 + i)n – 1]__
(1 + i)n [ i (1 + i)n]
8000 [(1 + .15)5 – 1]
= _________[ .15 (1 + .15)5]______________
10000 - ___ 1000___ + 4000 __[(1 + .15)5 – 1]__
(1 + .15)5 [ .15 (1 + .15)5]
B–C= _______26,817.24_________
10,000 – 497.18 + 13,408.62

B – C = 1.17 > 1.0 ; Therefore, project is acceptable.

Modified B- C ratio with PW:

PW(B)_−PW(O&𝑀𝑀)
B–C=
I−PW(MV)
8000 [(1 + .15)5 – 1] - 4000 __[(1 + .15)5 – 1]__
= ____[ .15 (1 + .15)5]____ [ .15 (1 + .15)5]___
10000 - ___ 1000___
(1 + .15)5
B–C= _______26,817.2 -_13,408.62______
10,000 – 497.18
B – C = 1.41 > 1.0 ; Therefore, project is acceptable.

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 Supplemental Problems:
1. A company is planning to purchase a new machine for Php600,000. The machine is
expected to generate a net cash flow of Php150,000 annually for six years which is the
estimated service life of the machine. What is the rate of return of the initial investment?
a) 17.5% b) 20% c) 22.5% d) 25%

2. Determine the PW of the following engineering project when the MARR is 15% per
year. Is this project acceptable?
Investment cost = $10,000
Expected life = 5 years
Market (salvage value at end of life) = $1,000
Annual receipts = $8,000
Annual expenses = $4,000
a) No, NPW = -$7,492 b) Yes, NPW = $3,906
c) Yes, NPW = $4,409 d) No, NPW = -$3,906

3. A specialized automatic machine costs Php30,000 and is expected to save Php11,837.50

per year while in operation. Using a 12% interest rate, what is the discounted payback
period?
a) 3 years b) 4 years c) 5 years d) 6 years

4. A company invested a certain amount in an 8-year project. It expects a net cash flow of
Php200,000 per year for the first 4 years and Php150,000 in the last 4 years of the project
life. If the investment was based on MARR of 12%, how much was the investment?
a) $897,013 b) $958,732 c) $992,209 d) $841,515

5. What is the IRR in the following cash flows?

End of year Cash flow($)
0 -3,345
1 1,100
2 1,100
3 1,100
4 1,100
a) 9.05% b) 10.45% c) 11.95% d) 12.45%

6. The construction of the a bypass is P800,000,000 and P20,000,000 would be required each year for
maintenance. The annual benefits to the project have been estimated to be P80,000,000. The study
period(estimated life) of the project is 50 years.
6.1 (5 points) Using Modified Benefit-Cost Ratio method with PW and an MARR of 8% is this
project acceptable?
a) Yes, B-C Ratio is 1.4 b) No, B-C Ratio is 0.85
c) Yes, B-C Ratio is 1.1 d) No, B-C Ratio is 0.92
6.2 (5 points) Using Modified Benefit-Cost Ratio method with PW and an MARR of 4% is this
project acceptable?
a) Yes, B-C Ratio is 1.6 b) No, B-C Ratio is 0.85
c) Yes, B-C Ratio is 1.1 d) No, B-C Ratio is 0.94

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