Republic of the Philippines

CAVITE STATE UNIVERSITY

CCAT Campus
Rosario, Cavite
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www.cvsu-rosario.edu.ph

DEPARTMENT OF ENGINEERING
BACHELOR OF SCIENCE IN ELECTRICAL ENGINEERING
ENSC 30 – ENGINEERING ECONOMY

ECONOMIC STUDY METHODS

SUBMITTED BY:
BERNARTE, ADAM VAN JEZTER B.
CAILING, LUCILLE ANNE SOPHIA S.
VENDEVIL, RIZZA MAE S.
VILLARUBIA, SHAN JOHN V.

SUBMITTED TO:
ENGR. JOEL C. GAMMAYAO

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 INTRODUCTION
Economic Study Methods would be the study of the methods, particularly the
scientific process, as they relate to economics, as well as the fundamental ideas of
economic reasoning. It should be designed in such a way that it takes into account
the return that a certain project will or should generate. A projected capital
investment and its accompanying expenses should be returned by revenue over
time, in addition to a sufficiently attractive return on capital in relation to the risks
involved and potential alternative uses. The interest and money-time correlations are
also key parts in this analysis, and they are used in a variety of evaluations. Because
capital investment, revenue cash flows, and expense cash flows in different projects
might be extremely diverse, there is no one approach for completing engineering
economic analysis that is optimal for all circumstances. As a result, numerous ways
or patterns are widely utilized in practice, and all will give equally satisfying results
and lead to the same conclusion in scenarios when the basic assumptions of each
are relevant. They provide a certain role and serve a specific purpose for those
organizations or individuals that intend to invest. The Minimum Attractive Rate of
Return (MARR) is calculated to aid in the evaluation and selection of alternatives.
The Basic Economic Methods like Present Worth, Future Worth, Annual Worth,
Internal Rate of Return, External Rate of Return, and Other Methods like Discounted
Payback Period and Benefit-Cost Ratio are some methods for evaluating and
analyzing project feasibility.

OUTLINE
• The Minimum Attractive Rate of Return
• Basic Economic Study Methods: Present Worth, Future Worth, Annual
Worth, Internal Rate of Return, External Rate of Return
• Other Methods: Discounted Payback Period, Benefit-Cost Ratio

LEARNING OBJECTIVES
1. To define the Minimum Attractive Rate of Return.
2. To determine the Basic Economic Study Methods specifically Present Worth,
Future Worth, Annual Worth, Internal Rate of Return, and External Rate of
Return, and their formulas.
3. To determine and explain if the projects are viable using the Basic Economic
Methods.
4. To know other methods which are Discounted Payback Period and Benefit-
Cost Ratio.
5. After the discussion, you will be able to know the purpose and connection
between the Minimum Attractive Rate of Return and Basic Economic Study
Methods.

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 DISCUSSION
Key Terms:
 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.
𝒏𝒆𝒕 𝒂𝒏𝒏𝒖𝒂𝒍 𝒑𝒓𝒐𝒇𝒊𝒕
ROR = x 100
𝒄𝒂𝒑𝒊𝒕𝒂𝒍 𝒊𝒏𝒗𝒆𝒔𝒕𝒆𝒅

 Annuity - Series of equal payments paid regularly over a period of time.

MINIMUM ATTRACTIVE RATE OF RETURN

• The Minimum Attractive Rate of Return (MARR) or “Hurdle Rate” is the
minimum rate that is set by an organization or individual in order to determine
if the project is economically viable or worth to be invested in.
• MARR is a reasonable rate of return established for the evaluation and
selection of alternatives. A project is not economically viable unless it is
expected to return at least the MARR.

How to compute the Minimum Attractive Rate of Return? Is there any formula
to use in order to determine the MARR? Why do we have to know MARR?

• There is NO specific computation

• The organization or individual will indicate or set the Minimum Attractive Rate
of Return (MARR).

• The organization or individual has their own reason why they chose that value
as their standard that they must justify.
How can it be said that the project meets the MARR standard?
• Present Worth Method
• Future Worth Method
• Annual Worth Method
• Internal Rate of Return (IRR)

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 • External Rate of Return (ERR)

BASIC ECONOMIC STUDY METHODS:

PRESENT WORTH METHOD
This pattern for economy studies is based on the concept of present worth.
The present worth method is flexible and can be used for any type of economy
study.
If the PW (Present Worth), using the MARR as the interest is greater than or
equal to zero, then the project is economically viable.
PW (ί = MARR) > 0, ∴ economically viable

FUTURE WORTH METHOD

The Future Worth method for economy studies is exactly comparable to the
Present Worth method except that all cash inflow and outflows are compounded
forward to a reference point in time called future.
If the FW (Future Worth), using the MARR as the interest is greater than or
equal to zero, then the project is economically viable.
FW (ί = MARR) > 0, ∴ economically viable

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 ANNUAL WORTH METHOD
In this method, interest on the original investment (sometimes called minimum
required profit) is included as a cost.
If the AW (Annual Worth), using the MARR as the interest is greater than or
equal to zero, then the project is economically viable.
AW (ί = MARR) > 0, ∴ economically viable

 Revenue - is the amount of money that a company actually receives during a

specific period, including discounts and deductions.
 Expenses – is the cost required for something; the money spent on
something such as sales, marketing, goods, etc. to earn revenue.
 CR (capital recovery rate) - is the annual cost of the capital invested

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).
IRR Decision Rule: if IRR > MARR , ∴ economically viable

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 Notation:

Example:
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 (salvage) value of $5,000 at the end of its
expected life 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
value of the additional production. Determine the IRR of this project. Is the
investment a good one? Recall that the MARR is 20% per year.

Since the computed IRR is 21.58% which is greater than the MARR. Thus, we
conclude that the new equipment is economically feasible.

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 EXTERNAL RATE OF RETURN (ERR)
This method directly takes into account the interest rate (E) external to a
project at which net cash flows generated (or required) by the project over its life can
be reinvested (or borrowed).

ERR Decision Rule: if ERR > MARR , ∴ economically viable

Notation:

REMINDERS IN CALCULATING ERR:

• All net cash outflows are discounted to time zero (the present) at Є% per
compounding period.
• All net cash inflows are compounded to period N at €%.
• The ERR (i'), which is the interest rate that establishes equivalence between
the two quantities, is determined.

Example:
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 (salvage) value of $5,000 at the end of its
expected life 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
value of the additional production. Suppose that E = MARR=20\% per year. What is
the project's ERR, and is the project acceptable?

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Solution:
1. All net cash outflows are discounted to time zero (the present) at Є% per
compounding period.

2. All net cash inflows are compounded to period N at Є%.

3. The ERR (ï'), which is the interest rate that establishes equivalence between
the two quantities, is determined.

Since the computed ERR is 20.88% which is greater than the MARR. Thus,
we conclude that the new equipment is economically feasible.

OTHER METHODS:
DISCOUNTED PAYBACK PERIOD (DPP)
The discounted payback period is a capital budgeting procedure used to
determine the profitability of a project. A discounted payback period gives the
number of years it takes to break even from undertaking the initial expenditure, by
discounting future cash flows and recognizing the time value of money.
 It is also known as adjusted payback.
 It is used to know if the management or a company should accept the project
or to reject it.
 We constantly select the project which has the shortest payback period since
the sooner we get our own money back the better.
 GENERAL RULE
 Using the discounted payback period is to accept projects that have
a payback period that is shorter than the target timeframe.

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 The company uses a discount rate of 10% and requires that the projects
payback within 3 years.

𝟒𝟓, 𝟎𝟎𝟎 − 𝟐𝟐, 𝟕𝟐𝟕 = 𝟐𝟐, 𝟐𝟕𝟑

𝟐𝟐, 𝟐𝟕𝟑 − 𝟏𝟒, 𝟖𝟕𝟔 = 𝟕, 𝟑𝟗𝟕
𝟕, 𝟑𝟗𝟕
= 𝟎. 𝟔
𝟏𝟐, 𝟎𝟐𝟏
𝟕, 𝟑𝟗𝟕 – 𝟏𝟐, 𝟎𝟐𝟏
We can see that we just needed 7,397 cash to recoup our initial investment
but then the cash flow given is 12,021. It means that in the 2.6 years, we get our own
money back and earn an amount of 4,624. That means that this project should be
accepted by the management.

The company uses a discount rate of 10% and requires that the payback is
within 3 years.
𝟔,𝟔𝟒𝟗
DPP = = 0.28
𝟐𝟑,𝟗𝟎𝟓

3+0.28 = 3.28 years

This project should be rejected.

COST-BENEFIT ANALYSIS (CBA)

 A cost-benefit analysis (CBA) is the process of calculating the benefits of a

choice or action less the costs associated with that decision or action.

 A CBA includes measurable financial measures such as income gained or

expenditures spent as a result of the project decision.

 Intangible benefits and costs or impacts of a decision, such as staff morale

and customer satisfaction, can also be included in a CBA.

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 BENEFIT-COST RATIO (BCR)

 The Benefit-Cost Ratio (BCR) is a monetary or qualitative statistic that shows

the link between the relative costs and benefits of a proposed project.

 There is often a wide range of possible BCR results.

 A project with a BCR greater than 1.0 is predicted to provide a positive net
present value for a company and its investors.

 If a project's BCR is less than 1.0, the costs outweigh the benefits, and the
project should be rejected.

 The primary limitation of the BCR is that it simplifies a project to a simple

number although the success or failure of an investment or expansion is
dependent on a variety of factors and might be affected by unforeseeable
circumstances.
 The Benefit-Cost-Ratio is calculated by dividing a project's proposed total
cash benefit by its proposed total cash cost.

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 SUMMARY
Economic Study Methods would be the study of the methods, particularly the
scientific process, as they relate to economics, as well as the fundamental ideas of
economic reasoning. They provide a certain role and serve a specific purpose for
those organizations or individuals that intend to invest. The Minimum Attractive Rate
of Return (MARR) is a suitable rate of return determined for the purpose of
evaluating and selecting alternatives. If a project is not predicted to generate at least
the MARR, it is not economically feasible. There are different methods that can be
used to analyze the feasibility of a project like the Basic Economic Methods like
Present Worth, Future Worth, Annual Worth, Internal Rate of Return, External Rate
of Return, and Other Methods like Discounted Payback Period and Benefit-Cost
Ratio. Present Worth Method helps us to know if we will have profit in the present or
at that point, Future Worth Method helps us to know if we will have profit in the future
from our investment, Annual Worth Method helps us to know what will be the profit of
our investment yearly. The more positive value, the more profitable and justifiable or
worth it the investment is. The Internal Rate of Return (IRR) is a financial analysis
measurement used to determine the profitability of possible investments. In a
discounted cash flow analysis, IRR is a discount rate that makes the net present
value of all cash flows equal to zero. IRR is calculated in the same way as net
present value, except that it sets the NPV to zero. IRR is great for studying capital
budgeting projects in order to comprehend and compare potential annual rates of
return throughout time. The External Rate of Return (ERR) is the rate of return on a
project in which any 'extra' capital from the project is considered to earn interest at a
pre-determined explicit rate, which is commonly the MARR. On the other hand, the
Discounted Payback Period or DPP is use to check if the propose project or the
project itself will recoup the investment and earn within the given period of years. It
somehow verifies if the project should be accepted or not since it sets standard or
timeframe that needs to be fulfilled or satisfy. Commonly financial analyst
recommends to choose the propose project which has the shortest payback period
because the sooner we get our own money back the better. The Benefit-Cost Ratio
(BCR) is an indicator that shows the relationship between a proposed project's
relative costs and benefits. If a project's BCR is more than 1.0, it is predicted to
create profits; if it is less than 1.0, it is expected to generate losses.

CONCLUSION
In conclusion, the Minimum Attractive Rate of Return (MARR) has a vital or
huge role for every organization or individual who is planning to invest. MARR also
helps us to see if our project is viable economically and if it is worth it to take the risk
with the help of basic economic study methods in order for us to see if we have net
gain or loss on our investment. The basic methods have their own functions in order
for us to see if we have net gain or loss on our investment in such a way that we can
see the Present, Future, and Annual Worth. Internal Rate of Return (IRR) is also
great for studying capital budgeting projects in order to comprehend and compare
potential annual rates of return throughout time and the External Rate of Return
(ERR) is the rate of return on a project in which any 'extra' capital from the project is
considered to earn interest at a pre-determined explicit rate, which is commonly the
MARR. Aside from that, the Discounted Payback Period (DPP) is essential for every

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company or management who is planning to invest in a project. DPP helps us to
determine whether the project should be accepted or not since it shows us how long
does the project will take to regain the invested funds. Moreover, management or
companies constantly selects which has the shortest payback period. On the other
hand, Benefit-Cost Ratio is a useful starting point in determining a project’s feasibility
and whether it can generate incremental value. But, although it is a simple tool to
gauge the attractiveness of a project or asset, it should not be the sole determinant
of a project’s feasibility.

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