ENGINEERING ECONOMICS 2020

LESSON 02: ECONOMIC STUDY METHODS

INTRODUCTION

An engineering project or alternative is formulated to make or purchase a

product, to develop a process, or to provide a service with specified results. An
engineering economic analysis evaluates cash flow estimates for parameters such as
initial cost, annual costs and revenues, nonrecurring costs, and possible salvage value
over an estimated useful life of the product; process, or service.

RATE OF RETURN METHOD

A rate of return (ROR) is the net gain or loss of an investment over a specified time
period, expressed as a percentage of the investment’s initial cost. When calculating
the rate of return, you are determining the percentage change from the beginning
of the period until the end.

 The rate of return (ROR) is used to measure the profit or loss of an investment
over time.
 The metric of ROR can be used on a variety of assets, from stocks to bonds, real
estate, and art.
 The effects of inflation are not taken into consideration in the simple rate of
return calculation but are in the real rate of return calculation.
 The internal rate of return (IRR) takes into consideration the time value of
money.

Interest earned over a specific period of time is expressed as a percentage of the

original amount and is called rate of return (ROR).

The rate of return (ROR) on the capital invested is given by the formula,

𝑛𝑒𝑡 𝑎𝑛𝑛𝑢𝑎𝑙 𝑝𝑟𝑜𝑓𝑖𝑡

𝑅𝑂𝑅 =
𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑒𝑑

The time unit for rate of return is called the interest period, just as for the
borrower’s perspective. Again, the most common period is 1 year.

The term return on investment (ROI) is used equivalently with ROR in different
industries and settings, especially where large capital funds are committed to
engineering-oriented programs.

Rate of return is a measure of the effectiveness of an investment of capital. It is

a financial efficiency. When this method is used, it is necessary to decide whether the
computed rate of return is sufficient to justify the investment. The advantage of this
method is that it is easily understood by management and investors. The applications
of the rate of return method is controlled by the following conditions. 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. The capital invested is the total amount of
capital investment required to finance the project, whether equity or borrowed.

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MINIMUM ATTRACTIVE RATE OF RETURN (MARR)

If, as often the case, the interest rate at which a project should be evaluated
is not known, a target rate, cut-off rate, or valuation rate will be used. This rate is also
called the minimum attractive rate of return (MARR). While dependent on general
company policy, the MARR may also be project specific, and will normally increase
with the risk attending the project. It will certainly be higher than the cost of raising
capital for the project.

SETTING THE MARR

Previously, we introduced the MARR as the smallest yield rate at which a proposed
investment would be acceptable. How is this cut-off rate arrived at?

1. The MARR may be set equal to the interest rate that is available at a local
savings bank or other institution. The MARR then becomes the "opportunity cost
of money," in that it measures the opportunity lost from not placing money in
the bank.

2. For most businesses, the savings bank rate would be lower than their usual
overall rate of return on investment. Thus, the MARR is sometimes set equal to
the firm's current average return on total investment.

3. The MARR may be purposely set higher than either the bank rate on savings or
the firm's current return on investment. It may be set according to the firm's
long-range profit goals, so as to achieve a desired future growth rate; it may
be set at a high, level to encourage the search for more profitable new
ventures; it may be chosen large to offset the high degree of risk attached to
the investment.

Under option 1 and (within the law of averages) under option 2, the MARR is an
attainable rate; i.e., there are investment alternatives that actually achieve that rate.
However, under option 3, the MARR is a target rate, with no guaranteed means of
realization.

ANNUAL WORTH (AW) METHOD

In this method, interest on the original investment (sometimes called minimum

required profit) is included as a cost. If the excess of annual cash inflows over annual
cash outflows is not less than zero the proposed investment is justified – is valid. This
method is covered by the same limitations as the rate of return pattern a single initial
investment of capital and uniform revenue and cost throughout the life of the
investment.

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PRESENT WORTH (PW) METHOD

This pattern for economy studies is based on the concept of present worth. If
the present worth of the net cash flows is equal to, or greater than, zero, the project is
justified economically. The present worth method is flexible and can be used for any
type of economy study. It is used extensively in making economy studies in the public
works field, where long-lived structures are involved.

FUTURE WORTH (FW) METHOD

The future worth method for economy studies is exactly comparable to the
present worth method except that all cash inflows and outflows are compounded
forward to a reference point in time called the future. If the future worth of the net
cash flows is equal to, or greater than, zero, the project is justified economically.

PAYBACK (PAYOUT) PERIOD METHOD

The payback period is commonly defined as the length of the 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.

𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 − 𝑠𝑎𝑙𝑣𝑎𝑔𝑒 𝑣𝑎𝑙𝑢𝑒

𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑃𝑒𝑟𝑖𝑜𝑑 (𝑦𝑒𝑎𝑟𝑠) =
𝑛𝑒𝑡 𝑎𝑛𝑛𝑢𝑎𝑙 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤

IILUSTRATIVE PROBLEMS

1. An investment of Php 270, 000 can be made in a project that will produce a
uniform annual revenue of Php 185, 400 for 5 years and then have a salvage
value of 10% of the investment. Out-of-pocket costs for operation and
maintenance will be Php 81, 000 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

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period of the investment? Use the sinking fund method to compute the
depreciation.

Rate of Return Method

𝑛𝑒𝑡 𝑎𝑛𝑛𝑢𝑎𝑙 𝑝𝑟𝑜𝑓𝑖𝑡

𝑅𝑂𝑅 =
𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑒𝑑

Compute for the annual depreciation using the sinking fund method.

𝑖
𝑑 = (𝐶 − 𝐶 )
(1 + 𝑖) − 1

0.25
𝑑 = (270, 000 − 27, 000)
(1 + 0.25) − 1

𝑑 = 𝑃ℎ𝑝 29, 609

Annual Revenue = Php 185, 400

Annual Costs:
Depreciation = Php 29, 609
Operation and maintenance = Php 81, 000
Taxes and Insurance = Php 270, 000 (0.04) = Php 10, 800
Total annual cost = Php 121, 409
Net Annual Profit = Php 63, 991

𝑃ℎ𝑝 63, 991

𝑅𝑂𝑅 = × 100
𝑃ℎ𝑝 270, 000

𝑹𝑶𝑹 = 𝟐𝟑. 𝟕𝟎%

Since the rate of return is less than 25%, the investment is not justified

Annual Worth Method

Compute for the annual depreciation using the sinking fund method.

𝑖
𝑑 = (𝐶 − 𝐶 )
(1 + 𝑖) − 1

0.25
𝑑 = (270, 000 − 27, 000)
(1 + 0.25) − 1

𝑑 = 𝑃ℎ𝑝 29, 609

Annual Revenue = Php 185, 400

Annual Costs:
Depreciation = Php 29, 609
Operation and maintenance = Php 81, 000
Taxes and Insurance = Php 270, 000 (0.04) = Php 10, 800

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Interest on capital = Php 270, 000 (0.25) = Php 67, 500

Total annual cost = Php 188, 909
Excess (Annual revenue – Annual cost) = - Php 3, 509

Since the excess of annual cash inflows over annual cash outflows is less than
zero (i.e. negative value), the investment is not justified.

Present Worth Method

(1 + 𝑖) − 1
𝑃𝑊 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤𝑠 = 𝐴 + 𝐹(1 + 𝑖)
𝑖(1 + 𝑖)

(1 + 0.25) − 1
𝑃𝑊 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤𝑠 = 185, 400 + 27, 000(1 + 0.25)
0.25(1 + 0.25)

𝑃𝑊 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤𝑠 = 𝑃ℎ𝑝 507, 439.872

𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑠𝑡𝑠 (𝑒𝑥𝑐𝑙𝑢𝑑𝑖𝑛𝑔 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛) = 𝑃ℎ𝑝 81, 000 + 𝑃ℎ𝑝 270, 000(0.04)

𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑠𝑡𝑠 (𝑒𝑥𝑐𝑙𝑢𝑑𝑖𝑛𝑔 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛) = 𝑃ℎ𝑝 91, 800

(1 + 0.25) − 1
𝑃𝑊 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑜𝑢𝑡𝑓𝑙𝑜𝑤𝑠 = 𝑃ℎ𝑝 270, 000 + 91, 800
0.25(1 + 0.25)

𝑃𝑊 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑜𝑢𝑡𝑓𝑙𝑜𝑤𝑠 = 𝑃ℎ𝑝 516, 875.904

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𝑃𝑊 𝑜𝑓 𝑛𝑒𝑡 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤𝑠 = 𝑃𝑊 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤𝑠 − 𝑃𝑊 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑜𝑢𝑡𝑓𝑙𝑜𝑤𝑠

𝑃𝑊 𝑜𝑓 𝑛𝑒𝑡 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤𝑠 = 𝑃ℎ𝑝 507, 439.872 − 𝑃ℎ𝑝 516, 875.904

𝑷𝑾 𝒐𝒇 𝒏𝒆𝒕 𝒄𝒂𝒔𝒉 𝒇𝒍𝒐𝒘𝒔 = −𝑷𝒉𝒑 𝟗, 𝟒𝟑𝟔. 𝟎𝟑𝟐

Since the PW of the net cash flows is less than zero (negative), the investment
is not justified.

Future Worth Method

(1 + 0.25) − 1
𝐹𝑊 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤𝑠 = 185, 400 + 27, 000
0.25

𝐹𝑊 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤𝑠 = 𝑃ℎ𝑝 1, 548, 583.594

𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑠𝑡𝑠 (𝑒𝑥𝑐𝑙𝑢𝑑𝑖𝑛𝑔 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛) = 𝑃ℎ𝑝 81, 000 + 𝑃ℎ𝑝 270, 000(0.04)

𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑠𝑡𝑠 (𝑒𝑥𝑐𝑙𝑢𝑑𝑖𝑛𝑔 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛) = 𝑃ℎ𝑝 91, 800

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(1 + 0.25) − 1
𝐹𝑊 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑜𝑢𝑡𝑓𝑙𝑜𝑤𝑠 = 91, 800 + 270, 000(1 + 0.25)
0.25

𝐹𝑊 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑜𝑢𝑡𝑓𝑙𝑜𝑤𝑠 = 𝑃ℎ𝑝 1, 577, 380.078

𝐹𝑊 𝑜𝑓 𝑛𝑒𝑡 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤𝑠 = 𝐹𝑊 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤𝑠 − 𝐹𝑊 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑜𝑢𝑡𝑓𝑙𝑜𝑤𝑠

𝐹𝑊 𝑜𝑓 𝑛𝑒𝑡 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤𝑠 = 𝑃ℎ𝑝 1, 548, 583.594 − 1, 577, 380.078

𝑭𝑾 𝒐𝒇 𝒏𝒆𝒕 𝒄𝒂𝒔𝒉 𝒇𝒍𝒐𝒘𝒔 = −𝑷𝒉𝒑 𝟐𝟖, 𝟕𝟗𝟔. 𝟒𝟖𝟒

Since the FW of the net cash flows is less than zero (negative), the investment
is not justified.

Payback Period

𝑇𝑜𝑡𝑎𝑙 𝑎𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑠𝑡 = 𝑃ℎ𝑝 81, 000 + 𝑃ℎ𝑝 270, 000(0.04) = 𝑃ℎ𝑝 91, 800

𝑁𝑒𝑡 𝑎𝑛𝑛𝑢𝑎𝑙 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤𝑠 = 𝑃ℎ𝑝 185, 400 − 𝑃ℎ𝑝 91, 800 = 𝑃ℎ𝑝 93, 600

𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 − 𝑠𝑎𝑙𝑣𝑎𝑔𝑒 𝑣𝑎𝑙𝑢𝑒

𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑃𝑒𝑟𝑖𝑜𝑑 =
𝑛𝑒𝑡 𝑎𝑛𝑛𝑢𝑎𝑙 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤

𝑃ℎ𝑝 270, 000 − 𝑃ℎ𝑝 27, 000

𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑃𝑒𝑟𝑖𝑜𝑑 =
𝑃ℎ𝑝 93, 600

𝑷𝒂𝒚𝒃𝒂𝒄𝒌 𝑷𝒆𝒓𝒊𝒐𝒅 = 𝟐. 𝟓𝟗𝟔 𝒚𝒆𝒂𝒓𝒔

Apparently, the time required for the initial investment is 2.596 years which is
less than the useful life. Since there is no set time to recover the initial investment, it
seems that the investment is justifiable. In computing the total annual cost,
depreciation was not included because the method does not consider the time
value of money or interest. The use of the payback period for making investment
decisions is oftentimes avoided as it may produce misleading results.

2. A man is considering investing Php 500, 000 to open a semi-automatic auto-

washing business in a city of 400, 000 population. The equipment can wash,
on the average, 12 cars per hour, using two men to operate it and to do small
amount of hand work. The man plans to hire two men, in addition to himself,
and operate the station on an 8-hour basis, 6 days per week, 50 weeks per
year. He will pay his employees Php 25.00 per hour. He expects to charge Php
25.00 for a car wash. Out-of-pocket miscellaneous cost would be Php 8, 500
per month.

He would pay his employees for 2 weeks for vacations each year. Because of
the length of his lease, he must write off his investment within 5 years. His

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capital now is earning 15%, and he is employed at a steady job that pays Php
25, 000 per month. He desires a rate of return of at least 20% on his investment.
Would you recommend the investment?

a. By rate of return (ROR) method

𝑖
𝑑 = (𝐶 − 𝐶 )
(1 + 𝑖) − 1

0.15
𝑑 = (500, 000)
(1 + 0.15) − 1

𝑑 = 𝑃ℎ𝑝 74, 157.776

Annual Revenue = (12)(25)(8)(6)(50) = Php 720, 000

Annual Costs:
Depreciation = Php 74, 157.776
Labor = (2)(48)(50)(25) = Php 120, 000
Vacation Pay = (2)(2)(48)(25) = Php 4, 800
Miscellaneous = 8, 500(12) = Php 102, 000
Owner’s Salary = 25, 000(12) = Php 300, 000
Total annual cost = Php 600, 957.776
Net annual profit = Php 119, 042.224

𝑛𝑒𝑡 𝑎𝑛𝑛𝑢𝑎𝑙 𝑝𝑟𝑜𝑓𝑖𝑡

𝑅𝑂𝑅 =
𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑒𝑑

119, 042.224
𝑅𝑂𝑅 = × 100
𝑃ℎ𝑝 500, 000

𝑅𝑂𝑅 = 23.808 %

𝑅𝑂𝑅 = 23.808 % > 20%, ∴ 𝑖𝑡 𝑖𝑠 𝑟𝑒𝑐𝑜𝑚𝑚𝑒𝑛𝑑𝑒𝑑 𝑡ℎ𝑎𝑡 𝑡ℎ𝑒 𝑚𝑎𝑛 𝑠ℎ𝑜𝑢𝑙𝑑 𝑖𝑛𝑣𝑒𝑠𝑡.

b. By annual worth method

𝑖
𝑑 = (𝐶 − 𝐶 )
(1 + 𝑖) − 1

0.15
𝑑 = (500, 000)
(1 + 0.15) − 1

𝑑 = 𝑃ℎ𝑝 74, 157.776

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Annual Revenue = (12)(25)(8)(6)(50) = Php 720, 000

Annual Costs:
Depreciation = Php 74, 157.776
Labor = (2)(48)(50)(25) = Php 120, 000
Vacation Pay = (2)(2)(48)(25) = Php 4, 800
Miscellaneous = 8, 500(12) = Php 102, 000
Owner’s Salary = 25, 000(12) = Php 300, 000
Interest on Capital = 500, 000(0.2) = Php 100, 000
Total annual cost = Php 700, 957.776
Excess (Annual revenue – Annual cost) = Php 19, 042.224

Since the excess of annual revenue over annual cost is greater than zero, the
investment is justified. The man should invest.

INTERNAL RATE OF RETURN (IRR)

Calculating Rate of Return using PW

The ROR value is determined in a generically different way compared to the PW

value for a series of cash flows. Using the MARR, which is established independent of
any particular project’s cash flows, a mathematical relation determines the PW
value in actual monetary units, say, pesos or dollars. For the ROR values calculated in
this and later discussions, only the cash flows themselves are used to determine an
interest rate that balances the present worth relation. Therefore, ROR may be
considered a relative measure, while PW are absolute measures. Since the resulting
interest rate depends only on the cash flows themselves, the correct term is internal
rate of return (IRR); however, the term ROR is used interchangeably.

To determine the rate of return, develop the ROR equation using PW relation, set it
equal to 0, and solve for the interest rate. Alternatively, the present worth of cash
outflows (costs and disbursements) PW O may be equated to the present worth of
cash inflows (revenues and savings) PWI . That is, solve for i using either of the
relations

3. Applications of green, lean manufacturing techniques coupled with value

stream mapping can make large financial differences over future years while
placing greater emphasis on environmental factors. Engineers with Monarch
Paints have recommended to management an investment of Php 10, 000,

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000 now in novel methods that will reduce the amount of wastewater,
packaging materials, and other solid waste in their consumer paint
manufacturing facility. Estimated savings are Php 750, 000 per year for each
of the next 10 years and an additional savings of Php 15, 000, 000 at the end
of 10 years in facility and equipment upgrade costs. Determine the rate of
return.

Solution

The cash flow diagram is presented below

Php 15, 000, 000

i’ = ?

Php 750, 000

Php 10, 000, 000

𝑃𝑊 = 0

(1 + 𝑖′) − 1
𝑃𝑊 = 𝐴 + 𝐹(1 + 𝑖′)
𝑖′(1 + 𝑖′)

(1 + 𝑖′) − 1
10, 000, 000 = 750, 000 + 15, 000, 000(1 + 𝑖′)
𝑖′(1 + 𝑖′)

Solve the value of i’ by trial and error or any applicable numerical method

(1 + 𝑖′) − 1
0 = −10, 000, 000 + 750, 000 + 15, 000, 000(1 + 𝑖′)
𝑖′(1 + 𝑖′)

𝒊′ = 𝟎. 𝟏𝟎𝟓𝟓𝟒𝟖𝟎𝟖𝟒𝟒

𝒊 = 𝟏𝟎. 𝟓𝟓𝟒𝟖 %

4. A proposed project will require the immediate investment of Php 50, 000 and
is estimated to have year-end revenues and costs as follows:

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Year Revenue, Php Costs, Php

1 75, 000 60, 000
2 90, 000 77, 000
3 100, 000 75, 000
4 95, 000 80, 000
5 60, 000 47, 000

An additional investment of Php 20, 000 will be required at the end of the
second year. The project would terminate at the end of the 5th year, and the assets
are estimated to have a salvage value of Php 25, 000 at that time. It was decided
that MARR should be at least 20%. Is this a good investment?

Cash inflows:

Cash outflows:

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Net Cash flows:

𝑃𝑊 𝑜𝑓 𝑛𝑒𝑡 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤𝑠 = 𝐹(1 + 𝑖′)

𝑃𝑊 = −50, 000 + 15, 000(1 + 𝑖 ) − 7, 500(1 + 𝑖 ) + 25, 000(1 + 𝑖 ) + 15, 000(1 + 𝑖 )

+ 37, 500(1 + 𝑖 ) = 0

𝒊′ = 𝟎. 𝟏𝟓𝟔𝟕𝟑𝟗𝟓𝟖𝟏𝟏

𝒊 = 𝟏𝟓. 𝟔𝟕𝟒 %

The internal rate of return is less than MARR, so the investment is not justified.

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EXERCISES 08
Direction: Solve the following problems. Show complete and neat solution. Show
illustrations if necessary.

1. The COE Company currently earns an average rate of return of 30% on its
total investment. The board of directors of COE is considering the three
proposals whose cash flows are specified on the table below. Which
proposal(s) is (are) acceptable, if the board of directors has set a target
MARR of 25%? Use Present Worth (PW) method and ROR method. (Ans. PWA =
-728, 792.5, RORA = 7.7%, PWB = -207, 585.5, RORB = 21.86%, PWC = -867, 200,
RORC = 14.96%)

End of Year Proposal A (Php) Proposal B (Php) Proposal C (Php)

0 -2, 500, 000 -3, 750, 000 -5, 000, 000
1 750, 000 1, 500, 000 1, 750, 000
2 750, 000 1, 500, 000 1, 750, 000
3 750, 000 1, 500, 000 1, 750, 000
4 750, 000 1, 500, 000 1, 750, 000

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2. The ABC company is considering constructing a plant to manufacture a

proposed new product. The land costs Php 15, 000, 000, the building costs
Php 30, 000, 000, the equipment costs Php 12, 500, 000, and Php 5, 000, 000
working capital is required. At the end pf 12 years, the land can be sold for
Php 25, 000, 000, the building for Php 12, 000, 000, the equipment for Php 250,
000 and all of the working capital recovered. The annual disbursements for
labor, materials, and all other expenses are estimated to cost Php 23, 750,
000. If the company requires a minimum return of 25%, what should be the
minimum annual sales for 12 years to justify the investment? (Ans. Php 39, 748,
563.44)

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