ECLT 5930/SEEM 5740: Engineering Economics

2016–17 First Term

Master of Science in ECLT & SEEM

Instructor: Dr. Keith Wong

Department of Systems Engineering & Engineering Management
The Chinese University of Hong Kong

October 6, 2016
 Recap: The Time Value of Money

1. Concept of equivalence: reduction to present/future worth

2. Fundamental formula under compounding interest rate:

F = P (1 + i)N ,

where
• N = number of periods;
• i = per period interest rate;
• P = total worth at period 0 (i.e., present worth); and
• F = total worth at period N (i.e., future worth).

3. Cash flow diagram

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 This Lecture: Evaluating a Single Project

• Central question: Is a proposed project solution economically profitable?

– outflow: capital investment and expenditure
– inflow: revenue, savings, return on capital
– timing of the cash flows

• Technique: Converting the cash flows into their equivalent worth at some point
of time using an interest rate called Minimum Attractive Rate of Return (MARR)

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 Minimum Attractive Rate of Return (MARR)

• Why not just use the interest rate? Because there may be other considerations:
– cost and amount of money available for investment
– number of good projects available for investment and their purpose
– amount of perceived risk associated with an investment
– estimated adminstration cost as determined by the planning horizon

• One popular approach for establishing MARR involves the opportunity cost,
which arises when there is capital rationing.

• We assume that MARR is constant throughout the course of the project.

– Thus, MARR serves as an interest rate in our considerations.

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 The Present Worth (PW) Method

• All cash inflows and outflows are discounted to the present time at the MARR.

• The present worth of a series of cash inflows and outflows at an interest rate (or
MARR) of i% is given by

∑
N
PW(i%) = F0(1 + i)0 + F1(1 + i)−1 + · · · + FN (1 + i)−N = Fk (1 + i)−k ,
k=0

where
– i = effective interest rate, or MARR, per period;
– Fk = cash flow at the end of period k; and
– N = number of periods in the planning horizon.

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 The Present Worth (PW) Method (Cont’d)

• The method has two main assumptions:

– The future is known with certainty.
– Money can be borrowed and lent at the same interest rate.

• To evaluate a project according to the PW method, we use the following:

PW Decision Rule: If PW(MARR) ≥ 0, then the project is economically

justified.

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 PW Decision Rule: Example

• A piece of equipment costs $25,000 now and will have a market value of $5,000
at the end of the fifth year.

• Increased productivity attributable to the equipment will bring in $8,000 per

year.

• Suppose that MARR is 20%.

$5, 000
$8, 000 $8, 000 $8, 000 $8, 000 $8, 000

0
1 2 3 4 5

MARR = 20%
$25, 000

Figure 1: Cash Flow of Equipment Purchase

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 PW Decision Rule: Example (Cont’d)

• We use the PW method to determine whether it is justified to buy the equipment.

First, we have

F0 = −$25, 000, F1 = · · · = F4 = $8, 000, F5 = $8, 000 + $5, 000 = $13, 000.

Hence,
∑
5
PW(20%) = Fk (1.2)−k = $934.29.
k=0
Since PW(20%) ≥ 0, the equipment is justified.

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 Application: Bond Value

• A bond is an IOU, in which you agree to lend the bond issuer money for a
specified length of time.

• In return, you receive periodic interest payments from the issuer, plus a promise
to return the face value of the bond when it matures.

• Specification of the bond:

– Z = face, or par, value (typically set at $1,000)
– C = redemption, or disposal, price (typically equal to Z)
– r = bond rate (nominal interest) per interest period
– i = bond yield rate per period
– N = number of periods before redemption

• Payments to the bond owner

– N interest payments, each amounting to rZ
– a single payment of C when the bond is retired or sold

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 Application: Bond Value (Cont’d)

• The present worth of a bond is given by

P = C × (P/F, i%, N ) + rZ × (P/A, i%, N )

C (1 + i)N − 1
= + rZ × .
(1 + i)N i(1 + i)N

• Example
– Suppose that N = 20, i = 10%, C = Z = $5, 000 and r = 8%. Then, we
have

P = $5, 000 × (P/F, 10%, 20) + $5, 000 × 0.08 × (P/A, 10%, 20)
= $4, 148.44.

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 Application: To Lend or Not to Lend?

• Suppose that your savings account gives you an annual interest rate 6%. You
have $100,000 in that account.

• A relative of yours needs some money urgently. He proposes to borrow your

$100,000 now and pay back in the following scheme:

Year 1 Year 2 Year 3

$10,000 $50,000 $60,000

• Question: Should you do it (assuming there is no default risk, and no moral

obligations as well)?

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 The Capitalized Worth (CW) Method

• Sometimes, it is of interest to determine the PW over an infinite length of time

(e.g., a bridge, an airport, certain kinds of bonds, etc.).

• Suppose that we have a perpetual series of end–of–period uniform payment of A

at an interest rate of i%. Then, mathematically, the capitalized worth is given
by

(1 + i)N − 1 A
CW(i%) = lim A × (P/A, i%, N ) = lim A × N
= .
N →∞ N →∞ i(1 + i) i

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 The Future Worth (FW) Method

• There is no reason why we should be restricted to present worth.

• In fact, since our objective is to maximize future worth, it is natural to determine

the worth at the end of the planning horizon.

• To determine the future worth, it suffices to use the fundamental formula!

∑
N
FW(i%) = PW(i%) × (F/P, i%, N ) = Fk (1 + i)N −k .
k=0

In particular, to determine whether a project is economically justified, we use

the following:

FW Decision Rule: If FW(MARR) ≥ 0, then the project is economically

justified.

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 FW Decision Rule: Example
• Consider again the equipment example.

$5, 000
$8, 000 $8, 000 $8, 000 $8, 000 $8, 000

0
1 2 3 4 5

MARR = 20%
$25, 000

Figure 2: Cash Flow of Equipment Purchase

• We have already calculated that PW(20%) = $934.29. By the fundamental

formula, we have

FW(20%) = $934.29 × (1.2)5 = $2324.80,

which again shows that the equipment is justified.

• Question: Can the PW and FW decision rules lead to different conclusions?

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 The Annual Worth (AW) Method
• The AW of project is the equivalent annualized series of dollar amounts for the
cash inflows and outflows at a given interest rate or MARR.

• To compute AW, note that a project generally has three types of cash flow:
– annual equivalent revenue or saving (denoted R)
– annual equivalent expenditure (denoted E)
– annual equivalent capital recovery (denoted CR), which is the uniform annual
cost of invested capital

• Capital recovery covers the loss in value of asset, as well as the interest on
invested capital (at the given interest rate or MARR). Mathematically, we have

CR(i%) = I × (A/P, i%, N ) − S × (A/F, i%, N ),

where
– I = PW of all investment amount;
– S = salvage value at the end of period; and
– N = number of periods.

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 The Annual Worth (AW) Method (Cont’d)
• Hence, the AW of a project is given by

AW(i%) = R − E − CR(i%)
i(1 + i)N i
= R−E−I × + S × .
(1 + i) − 1
N (1 + i) − 1
N

• Note that the AW can also be computed from PW or FW via

AW(i%) = PW(i%) × (A/P, i%, N ),

AW(i%) = FW(i%) × (A/F, i%, N ).

• To evaluate a project according to the AW method, we use the following:

AW Decision Rule: If AW(MARR) ≥ 0, then the project is economically

justified.

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 The Annual Worth (AW) Method: Example
• Consider the equipment example again.

$5, 000
$8, 000 $8, 000 $8, 000 $8, 000 $8, 000

0
1 2 3 4 5

MARR = 20%
$25, 000

Figure 3: Cash Flow of Equipment Purchase

• We compute

CR(20%) = $25, 000 × (A/P, 20%, 5) − $5, 000 × (A/F, 20%, 5)

= $7, 687.6.

• The annual revenue is R = $8,000, and no other expense is specified. Hence,

we have
AW(20%) = $8, 000 − $7, 687.6 = $312.4.

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 Application: Leasing an Apartment

• A real–estate agency decides to build a 25–unit apartment complex for leasing.

The costs are as follows:

Land $50,000
Building $225,000
# of years 20
Maintenance $420/year/occ. unit
Tax 10% of investment

• Suppose the occupancy is 90% and the MARR is 12%.

• Furthermore, suppose that the agency can sell the entire complex at the end of
the 20th year for $400,000.

• Question: How much rent per month should the agency charge?

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 Application: Leasing an Apartment (Cont’d)
• The initial investment is I = ($50, 000 + $225, 000) × 1.1 = $302, 500.

• The annual maintenance expenditure equals $420 × 25 × 0.9 = $9, 450.

• The salvage value is S = $400, 000.

• Hence, the annual equivalent expenditure is

$302, 500 × (A/P, 12%, 20) − $400, 000 × (A/F, 12%, 20) + $9, 450
= $44, 396.82

• It follows that the minimum monthly rent should be

$44, 396.82
= $164.43.
12 × 25 × 0.9

• Note that this is just the breakeven rent. One should always consider whether it
is realistic.

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 The Internal Rate of Return (IRR) Method

• Suppose that we have a set of cash inflows and outflows (which may occur at
different times).

• One could ask at what interest rate would we breakeven. This rate is known as
the internal rate of return (IRR).

• Mathematically, i∗ is the IRR if it satisfies

∑
N ∑
N
Rk × (P/F, i∗%, k) = Ek × (P/F, i∗%, k),
k=0 k=0

where
– Rk = total revenue of the k–th period;
– Ek = total expenditure of the k–th period; and
– N = number of periods in the planning horizon.

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 The Internal Rate of Return (IRR) Method: Example

• Consider the following cash flows:

Year 0 Year 1 Year 2 Year 3

−$100,000 $10,000 $50,000 $60,000

• Since (P/F, i%, k) = (1 + i)−k , the IRR is the interest rate i∗ that solves the
following equation:

$10, 000 $50, 000 $60, 000

∗
+ ∗ 2
+ ∗ 3
= $100, 000.
1+i (1 + i ) (1 + i )

• Using a computer, one finds i∗ = 7.89%.

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 IRR Decision Rule

• To evaluate a project according to the IRR method, we use the following:

IRR Decision Rule: If IRR ≥ MARR, then the project is economically

justified.

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 IRR Decision Rule: Example
• Consider the equipment example again.

$5, 000
$8, 000 $8, 000 $8, 000 $8, 000 $8, 000

0
1 2 3 4 5

MARR = 20%
$25, 000

Figure 4: Cash Flow of Equipment Purchase

– The IRR is the interest rate i∗ that satisfies

∑
5
$8, 000 $5, 000
+ = $25, 000.
(1 + i∗)k (1 + i∗)5
k=1

– The solution is i∗ = 21.58%. Since i∗ ≥ MARR = 20%, the equipment is

justified.

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 Application: Bond Yield

• Recall that payments to the bond owner include

– N interest payments, each amounting to rZ; and
– a single payment of C when the bond is retired or sold.

• The yield i∗ is then defined by the IRR of the promised cash flow. In particular,
i∗ solves the following equation:

∑
N
rZ C
+ = P,
(1 + i∗)k (1 + i∗)N
k=1

where P is the present worth of the bond.

• In particular, for a zero–coupon bond (i.e., r = 0), the yield is given by

( )1/N
C
i∗ = − 1.
P

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 Application: A Loan Deal

• A small company needs to borrow $160,000.

• The local banker makes the following statement:

We can loan you $160,000 at a very favorable rate of 12% per year
for 5 years. However, to ensure this loan you must agree to establish
a checking account in which there is no interest and the minimum
average balance is $32,000. In addition, your interest payments are
due at the end of each year and the principal will be repaid in a lump-
sum amount at the end of year five.

• Questions
– Determine the cash flows and their timing.
– What is the effective annual interest rate being charged?

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 Application: A Loan Deal (Cont’d)

• The cash flows are given as follows:

Year 0 $160, 000 − $32, 000 = $128, 000

Year 1 to 4 −$160, 000 × 0.12 = −$19, 200
Year 5 −($160, 000 × 0.12 + $128, 000) = −$147, 200

• Hence, the effective annual interest rate i∗ satisfies the following equation:

∑
5
$19, 200 $128, 000
+ = $128, 000.
(1 + i∗)k (1 + i∗)5
k=1

• Upon solving, we get i∗ = 15%, which is higher than what the banker claimed!

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 Further Remarks on the IRR Method

• One drawback of using the IRR is that it may not be uniquely determined.

• Example: Consider an investment with initial capital $1 million, $5 million return

in one year and $5 million payment at the end of the second year. Then, the
IRR i∗ is the solution to the following equation:

$5, 000, 000 $5, 000, 000

$1, 000, 000 + ∗ 2
= ∗
.
(1 + i ) 1+i

This is a quadratic equation with two solutions:

i∗ = 0.382 or 2.618.

Without further information, it is not possible to determine the correct answer.

• Another drawback is that the IRR is generally difficult to solve.

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 Further Remarks on the IRR Method (Cont’d)
• The IRR method assumes that the revenues can be reinvested at the IRR, which
may or may not be possible in reality.

• Consider an investment project with the following cash flows:

R1 R2 R3 R4

0 1 2 3 4

Figure 5: An investment project

• Recall that by definition, the IRR for this project satisfies

∑
4
Rn
C= n
.
n=1
(1 + IRR)

• In particular, it is implicitly assumed that the cash flows R1, . . . , R4 can be

reinvested at the IRR.

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 Further Remarks on the IRR Method (Cont’d)

• Question: How could those cash flows be reinvested at IRR?

– Unless the company has additional projects, with equally attractive prospects,
in which to invest those cash flows.
– The IRR calculation implicitly assumes the existence of such projects and
incorporates their return in the evaluation of the project in question.

• Otherwise, the company can only earn its cost of capital (which is roughly
MARR) on those cash flows.

• In general, when the IRR is higher than MARR, say, it tends to overestimate the
equivalent return of the project.

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 The External Rate of Return (ERR) Method

• The ERR method corrects the last drawback of the IRR method by taking into
account the interest rate external to a project at which the net cash proceeds
can be reinvested or borrowed. Graphically, the ERR i∗ satisfies the following
relationship:

X
N
Rk × (F/P, u%, N − k)
k=0

0
k N
interest rate = i∗ %
X
N
Ek × (P/F, u%, k)
k=0

Figure 6: The External Rate of Return (ERR)

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 The External Rate of Return (ERR) Method (Cont’d)

• Mathematically, the ERR i∗ satisfies

∑
N ∑
N
Ek × (P/F, u%, k) × (F/P, i∗%, N ) = Rk × (F/P, u%, N − k),
k=0 k=0

where u is the external reinvestment interest rate per period, and Ek , Rk , N are
as before.

• To evaluate a project according to the ERR method, we use the following:

ERR Decision Rule: If ERR ≥ MARR, then the project is economically

justified.

• Fact: When u = IRR, then the IRR and ERR decision rules will lead to the same
conclusion.

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 The External Rate of Return (ERR) Method (Cont’d)

• Advantages of the ERR method

– it can usually be solved directly
– there is no multiple solution

• Indeed, recall that the ERR i∗ satisfies

∑
N ∑
N
Ek × (P/F, u%, k) × (F/P, i∗%, N ) = Rk × (F/P, u%, N − k).
k=0 k=0

Since (F/P, i∗%, N ) = (1 + i∗)N , we have

/
∑
N ∑
N
(1 + i∗)N = Rk × (F/P, u%, N − k) Ek × (P/F, u%, k),
k=0 k=0

so one can solve for i∗ directly.

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 The Payback Period Method

• So far our focus has been on the profitability of the project.

• It is sometimes important to consider the liquidity of the project as well. This

can be achieved by the payback period method.

• Idea: Calculate the number of years required for cash inflows to just equal cash
outflows. Mathematically, we want to find θ (called the discounted payback
period) so that
∑
θ
(Rk − Ek )(P/F, i%, k) − I ≥ 0,
k=1
where I is the initial investment, i is the MARR, and Rk , Ek are as before.

• Remarks
– A larger payback period indicates a greater risk of a project.
– However, the payback period method does not include cash flows occurring
after the payback period.

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 What’s Next?

• Assignment: Read Chapter 5 of the course textbook.

• Next: Comparison and selection among alternatives (Chapter 6 of the course

textbook)

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