APPLICATIONS OF MONEY-TIME RELATIONSHIPS

All engineering economy studies of capital projects should consider the return
that a given project will or should produce. By using several methods of making
engineering economy studies to evaluate the economic profitability of a proposed
problem solution.

The Present Worth (PW), Annual Worth (AW) and the Future Worth (FW)
methods convert cash flows resulting from a proposed solution into their equivalent
worth at some point (or points) in time by using an interest rate known as the Minimum
Attractive Rate of Return (MARR). The Internal Rate of Return (IRR), Explicit
Reinvestment Rate of Return (ERRR) and the External Rate of Return (ERR) methods
produce annual rates of profit, or returns, resulting from an investment, and are then
compared against the MARR. The last method, the payback period, is a measure of
speed with which an investment is recovered by the inflows it produces.

DETERMINING THE MINIMUM ATTRACTIVE RATE OF RETURN

The MARR is usually a policy issue resolved by the top management of an

organization in view of numerous considerations. Among these are:

1. The amount of money available for investment, and the source and cost of this funds
(i.e., equity funds or borrowed funds).
2. The number of good projects available for investment and their purpose.
3. The amount of perceived risk associated with investment opportunities available to
the firm and the estimated cost of administering projects over short planning horizons
versus long planning horizons.
4. The type of organization involved (i.e., government, public utility, or competitive
industry)

Illustrative Problem.
1. A firm has the following capital structure:
Source of Fund Capital Cost of Capital
Common Stock 20M 15%
Preferred Stock 6M 8%
Debt 45M 9%
Retained Earnings 19M 15%
Determine the MARR.

BASIC METHODS IN MAKING ENGINEERING ECONOMY STUDIES

1. Present Worth (PW) – is based on the concept of equivalent worth of all cash flows
relative to some base or beginning point in time called the present. The PW is a
measure of how much money an individual or firm could afford to pay for the
investment in excess of its cost. Or, stated differently, a positive PW for an

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 investment project is a dollar amount of profit over the minimum amount required by
investors. Therefore, a positive PW would accept the proposed solution.
To find PW, it is necessary to discount future amounts to the present by using the
formula:
N
PW   Fk 1  i 
k

k 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)
I = investment
S = salvage value

Illustrative Problem.
1. A special purpose machine is to be acquired by paying a P15,000 initial cash
payment plus a debt assumption of P135,000. The machine will generate
additional net annual cash inflow of P40,000 for the firm throughout the 10 years
of useful life of the asset. At the end of its life, a salvage value of 10% of its
initial cost will be realized. Assuming that the MARR is 13.2% per annum, is the
project justified using the PW method?

2. Annual Worth (AW) – is an equal annual series of dollar amounts, for a stated study
period, that is equivalent to the cash inflows and outflows at an interest rate that is
generally the MARR. As long as the AW is greater than or equal to zero, the project
is economically attractive; otherwise, it is not. An AW of zero means that an annual
return exactly equal to the MARR has been earned.

N  i 1  i  N 
AW   Fk 1  i 
k
 
 1  i  1
N
k 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)
I = investment
S = salvage value

Illustrative Problem.
1. A manufacturing process can be carried out by using a machine which can be
acquired for P20,000. The annual receipts generated by the investment is
P150,000 and the annual disbursement is P138,000. The asset will have a life of

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 10 years in which it will have a salvage value of P2,000 at the end of its life.
MARR = 20% Is the project acceptable using the AW method?

3. Future Worth (FW) – is based on the equivalent worth of all cash inflows and
outflows at the end of the planning horizon at an interest rate that is generally the
MARR. A positive FW would result to acceptance of the problem solution

N
FW   Fk 1  i 
N k

k 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)
I = investment
S = salvage value

Illustrative Problem.
1. Given: I = 150,000; N = 5 years; S = 15,000; MARR = 25%

Year 1 2 3 4 5
Cash flow -25,000 -10,000 50,000 70,000 90,000

Is the project justified using the FW method?

4. Internal Rate of Return (IRR) – is the most widely used rate of return method for
performing engineering economic analyses. 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).
The IRR must consequently be compared with the MARR, an IRR that is greater than
the MARR would result to acceptance of the problem solution.
To compute for the IRR, equate the PW to zero, then solve for the i by either
“trial and error” or “interpolation”.

 
N
PW   Fk 1  i*
k
0
k 0

Where: i* = internal rate of return

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)

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 Illustrative Problem.
1. Given: MARR = 15%

EOY 0 1 2 3 4 5
Cash flow -100,000 30,000 40,000 70,000 50,000 20,000

Determine the IRR?

5. Explicit Reinvestment Rate of Return (ERRR) – solves for the ratio of earning
power. It takes into account the interest rate that equates the annual receipts and
disbursements to the amount of investment. An ERRR that is greater than the
MARR would result to acceptance of the problem solution.

 i 
 R  D   I  S   
 1  i 
N
 1 Net Income
ERRR  
I Investment

Where: i = effective interest rate, or MARR, per compounding period

R = annual receipts
D = annual disbursements
I = investment
S = salvage value

Illustrative Problem.
1. On land worth P800,000, an investor constructs a building worth P3,000,000,
containing a theater, a bank, stores and offices. The owner estimates that the
annual receipts from rental will be P720,000 and the annual disbursements to
cover taxes, insurance and maintenance of the building will be P80,000. He also
estimates that the land can be sold for P1,200,000, the building for P2,000,000 at
the end of 20 years. If his money is now earning 15% before taxes, will this
property earn enough for the investment to be justified?

6. External Rate of Return (ERR) – it directly takes into account the interest rate
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.
To compute, convert cash inflows and outflows to their future equivalent using
the reinvestment rate which is usually the MARR, equate this to the future equivalent
of the investment, and then solve for the ERR.
N
I 1  ERR    Rk  Dk 1  i  N  k  S
N

k 0

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 Where: i = effective interest rate, or MARR, per compounding period
R = annual receipts
D = annual disbursements
I = investment

Illustrative Problem.
1. Given: I = 150,000; N = 5 years; S = 15,000; MARR = 25%

Year 1 2 3 4 5
Cash flow -25,000 -10,000 50,000 70,000 90,000
Is the project justified?

7. Payback (Payout) Period – used as a measure of a project’s riskiness, since liquidity

deals with how fast an investment can be recovered. Quite simply, the payback
method calculates the number of years required for cash inflows to just equal cash
outflows.

Simple Payback Period – 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. This method fails to consider the time value of money. It fails to consider the
consequences of the investment following the payback period, including the
magnitude and timing of the cash flows and expected life of the investment. It is
more desirable to have a shorter payback period, this means that the investment
provides revenues early in its life, enough to cover initial outlay. This quick return in
capital also shortens the time span over which the investment is susceptible to losses.


 R
k 1
k  Dk   I  0

Where: R = annual receipts

D = annual disbursements
I = investment
 = payback period

Discounted Payback Period –considers the time value of money. This method
determines the length of time required until the investments equivalent receipt
exceeds the equivalent capital outlay.


 R  Dk 1  i 
k
k  I 0
k 1

Where: i = effective interest rate, or MARR, per compounding period

R = annual receipts
D = annual disbursements
I = investment

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 Illustrative Problem.
1. A piece of new equipment has been proposed by engineers to increase the
productivity of a certain manual welding operation. The initial investment is
P25,000 and the equipment will have a salvage value of P5,000. Increased
productivity attributable to the equipment will amount to P8,000 per year after
extra operating costs have been subtracted from the value of the additional
production. MARR = 20%. In view of the minimum acceptable payback period
of 5 years, is this alternative attractive?

Exercise.
1. A distillation column can be purchased and installed for P 2,000,000. It will incur
P35,000 in operations and maintenance expenses and yet can start generating
revenues of P125,000 each month as soon as it is installed. The distillation column
could be sold at the end of its useful life of 4 years at an estimated price of P150,000.
The cost of capital is 15% per annum. The reinvestment rate is 12 %. Evaluate the
project using:
a. Present worth method e. ERR method
b. Annual worth method f. ERRR method
c. Future worth method g. Simple payback
d. IRR method h. Discounted payback
For methods (a) to (f) recommend whether the column is acceptable or not.
For methods (g) and (h), Should the column be accepted if the acceptable payback
period is 2.5 years?

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