CE40-2: ENGINEERING ECONOMICS

CHAGAYATIN

LEARNING OUTCOME

CE40-2: The objective of this chapter on EVALUATING a SINGLE PROJECT is to

discuss and critique contemporary methods for determining project
profitability. Proposed capital projects can be evaluated in several

ENGINEERING ways.
1. Determining the Minimum Attractive Rate of Return (MARR)

ECONOMICS 2. The Present Worth Method

3. The Future Worth Method
4. The Annual Worth Method
COURSE OUTCOME 2 5. The Internal Rate of Return Method
Evaluate project profitability by 6. The External Rate of Return Method
applying methods of Engineering 7. The Payback (Payout) Period Method (generally not appropriate
as a primary decision rule)
Economic Analysis
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Engr. Charity Hope Gayatin
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CE40: ENGINEERING ECONOMICS CE40-2: ENGINEERING ECONOMICS

CHAGAYATIN CHAGAYATIN

MINIMUM ATTRACTIVE RATE OF RETURN (MARR) PRESENT WORTH METHOD

To be attractive, a capital project must provide a return that exceeds The most-used method is the present worth method.
a minimum level established by the organization.

The present worth (PW) is found by discounting all cash inflows and
This minimum level is reflected in a firm’s Minimum Attractive Rate of
outflows to the present time at an interest rate that is generally the
Return (MARR).
MARR.

Many elements contribute to determining the MARR

Amount, source, and cost of money available A positive PW for an investment project means that the project is
acceptable (it satisfies the MARR).
Number and purpose of good projects available
Perceived risk of investment opportunities
Type of organization

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CE40-2: ENGINEERING ECONOMICS CE40-2: ENGINEERING ECONOMICS

CHAGAYATIN CHAGAYATIN

PRESENT WORTH PROBLEM PRESENT WORTH PROBLEM

Consider a project that has an initial investment of $50,000 and that Consider a project that has an initial investment of $50,000 and that
returns $18,000 per year for the next four years. If the MARR is 12%, is returns $18,000 per year for the next four years. If the MARR is 12%, is
this a good investment? this a good investment?

PW
= – 50,000 + 18,000 (P/A, 12%, 4)
= $4,671.40
→ This is a good investment!

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CHAGAYATIN CHAGAYATIN

PRESENT WORTH PROBLEM PRESENT WORTH PROBLEM

Evaluation of New Equipment Purchase Using PW Evaluation of New Equipment Purchase Using PW
A piece of new equipment has been proposed by engineers to increase the productivity of a certain manual welding
A piece of new equipment has been proposed by engineers to 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
increase the productivity of a certain manual welding operation. The operating costs have been subtracted from the revenue generated by the additional production. A cash-flow
investment cost is $25,000, and the equipment will have a market value diagram for this investment opportunity is given below. If the firm’s MARR is 20% per year, is this proposal a sound one?
Use the PW method. $5,000
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 $8,000 $8,000 $8,000 $8,000 $8,000

revenue generated by the additional production. A cash-flow diagram

for this investment opportunity is given below. If the firm’s MARR is 20%
per year, is this proposal a sound one? Use the PW method. $25,000
$5,000
PW
= PW inflows – PW outflows
$8,000 $8,000 $8,000 $8,000 $8,000
= $8,000 (P/A, 20%, 5) + $5,000 (P/F, 20%, 5) – $25,000
= $934.29 0,
$25,000 → This equipment is economically justified

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CE40-2: ENGINEERING ECONOMICS CE40-2: ENGINEERING ECONOMICS

CHAGAYATIN CHAGAYATIN

PRESENT WORTH METHOD CAPITALIZED COST

Assumptions of the present worth method. The sum of the first cost and the present worth of all costs of
replacement, operation, and maintenance for a long time or forever.
Case 1: Maintenance / Operation
1. It is assumed we know the future with certainty.
CC = FC + A/i
2. It is assumed we can borrow or lend money at the same interest
rate. Case 2: Replacement
CC = FC + X
S
X=
(1 + i)K −1
S – Amount needed to replace a property every K periods
X – Amount of principal invested at rate i%, the interest on which
will amount to S every K periods

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CE40-2: ENGINEERING ECONOMICS CE40-2: ENGINEERING ECONOMICS

CHAGAYATIN CHAGAYATIN

CAPITALIZED COST PROBLEM CAPITALIZED COST PROBLEM

Case 1: Maintenance / Operation Case 1: Maintenance / Operation

Determine the capitalized cost of a structure that requires an initial Determine the capitalized cost of a structure that requires an initial
investment of P1,500,000 and an annual maintenance of P150,000. investment of P1,500,000 and an annual maintenance of P150,000.
Interest is 15%. Interest is 15%.

CC
= 1.5M + 150K/0.15
= P2.5M

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CHAGAYATIN CHAGAYATIN

CAPITALIZED COST PROBLEM CAPITALIZED COST PROBLEM

Case 2: Replacement Case 2: Replacement

A new boiler was installed by a textile plant at a cost of P300,000 and A new boiler was installed by a textile plant at a cost of P300,000 and
projected to have a useful life of 15 years. At the end of its useful life, it projected to have a useful life of 15 years. At the end of its useful life, it
is estimated to have a salvage value of P30,000. Determine the is estimated to have a salvage value of P30,000. Determine the
capitalized cost if interest is 18% compounded annually. capitalized cost if interest is 18% compounded annually.

CC
= 300K + (300K–30K) / [(1.18)15 –1]
= P324,604.17

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CE40-2: ENGINEERING ECONOMICS CE40-2: ENGINEERING ECONOMICS

CHAGAYATIN CHAGAYATIN

CAPITALIZED WORTH CAPITALIZED WORTH PROBLEM

Capitalized worth is a special variation of present worth.
Capitalized worth is the present worth of all revenues or expenses over
an infinite length of time.
If only expenses are considered this is sometimes referred to as
capitalized cost.
Suppose that a firm wishes to endow a laboratory at a university. The
endowment principal will earn interest that averages 8% per year,
which will be sufficient to cover all expenditures incurred in the
establishment and maintenance of the laboratory for an indefinitely
long period of time. Cash requirements of the laboratory are estimated
to be $100,000 now, $30,000 per year indefinitely, and $20,000 at the
end of every 4th year for equipment replacement.

The capitalized worth method is especially useful in problems involving What amount of endowment principal is required to establish the
endowments and public projects with indefinite lives. laboratory and then earn enough interest to support the remaining
cash requirements of this laboratory for a long time?

As n becomes very large, (P/A) = 1/i. So, CW = A (1/i) .

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CE40-2: ENGINEERING ECONOMICS CE40-2: ENGINEERING ECONOMICS

CHAGAYATIN CHAGAYATIN

CAPITALIZED WORTH PROBLEM

Suppose that a firm wishes to endow a laboratory at a university. The endowment principal will earn
interest that averages 8% per year, which will be sufficient to cover all expenditures incurred in the
establishment and maintenance of the laboratory for an indefinitely long period of time. Cash
requirements of the laboratory are estimated to be $100,000 now, $30,000 per year indefinitely, and
$20,000 at the end of every 4th year for equipment replacement.
What amount of endowment principal is required to establish the laboratory and then earn enough
interest to support the remaining cash requirements of this laboratory for a long time?

A
= $30,000 +$20,000 (A/F, 8%, 4)
= $34,438
CW
= – $100,000 – $34,438 (P/A, 8%, ∞)
= – $100,000 – $34,438/0.08
= – $530,475

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