2 | Engineering Economy 1

UNIT 3: BASIC ECONOMY STUDY METHODS

3.0 Intended Learning Outcomes

By the end of this unit you should be able to:

a. Define of Minimum Attractive Rate of Return and its use.
b. Explain the concept of annuity.
c. Determine P, F, or A values of a series starting at a time other than
period one (1).
d. Determine the P, F, or A values of a shifted series and randomly placed
single cash flows.
e. Select the best of equal-life alternatives using present worth analysis.
f. Select the best of different life alternatives using present worth
analysis.
g. Select the best alternative using future worth analysis, annual worth
analysis, and capitalized cost (cc) analysis.
h. Use a PW or AW relation to determine the Rate of Return (ROR) of a
series of cash flows.
i. Determine the external rate of return using the techniques of modified
ROR and return on invested capital.
j. Determine the payback period of a project at I = 0% and I > 0%
k. Explain the cautions when using payback analysis.
l. Calculate the benefit/cost ratio and use it to evaluate a single project.
m. Select the better of two alternatives using the incremental benefit/cost
ratio method.

3.1 Introduction
In the early 20th century, engineers are just concerned with the design,
construction, operation of machine structures, and process. However, as
technological advancement continues to progress, modern engineers are
expected to plan, build, solve problems, manage, and choose the best options
available for innovation.

As the design and industrial process becomes more complex, modern

engineers make decisions involving money to a greater extent. A systematic
evaluation of the benefits and cost of projects involving the engineering
design is addressed.
 2 | Engineering Economy 2

Thus, as future engineers, you are expected to be a good decision maker not
just with the engineering design but also with the money involved. You
should be able to quantify the benefits and cost relating engineering projects
to determine if your desired option is relevant and saves enough money to
warrant the capital investment. Your role is to choose the best options among
all potential alternatives involved in an engineering project. The discussions
in previous unit, Unit 2 – Money Time Relationship and Equivalence, is the
basic ingredient in helping you choose the best alternative.

In this unit, we will discuss how to compare alternatives on an equal basis for
selecting the wisest alternative from an economic standpoint.

The common methods of comparison of alternatives are the following:

 Present Worth Method
 Future Worth Method
 Annual Worth Method
 Internal Rate of Return (IRR) Method
 External Rate of Return (ERR) Method
 Payback Period Method
 Benefit/Cost Ratio Method

These methods will be discussed in the succeeding section. But, before that, let
us discuss alternatives and its classification.
 2 | Engineering Economy 3

Figure 3.1 – Types of Alternatives

3.2 Pre-Assessment

Answer the following questions given below. If the answers will be sent through
online platform always send a CLEAR IMAGE of your answer and use
“CAMSCANNER” if possible. Always KEEP a BACK-UP FILE.

Evaluation Criteria:

Originality of the Answer 50%

Organization 15%
Cleanliness 15%
Timeliness 20%
100 %

1. Explain Minimum Attractive Rate of RETURN? (10 pts.)

2. Define annuity and the define the different types of annuity. (10 pts)
3. Identify the different basic economy study and define each. (10 pts.)

3.3 Topics
3.3.1 The Minimum Attractive Rate of Return
The Minimum Attractive Rate of Return (MARR) also known as hurdle rate
is usually a policy issue resolved by the top management of an organization
in view of numerous considerations.

Among these considerations are the following:

1. The amount of money available for investment, and the source and cost of
these funds (i.e., equity funds or borrowed funds).
2. The number of good projects available for investment and their purpose (i.e.,
whether they sustain present operations and are essential, or whether they
expand on present operations and are elective).
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 private
industry).

The Minimum Rate of Return (MARR), from the word itself, is the minimum
rate of return that your alternatives should achieve for it to be considered
economically feasible.
 2 | Engineering Economy 4

One popular approach to establishing a MARR involves the opportunity cost

viewpoint (the cost of the best rejected opportunity), and it results from the
phenomenon of capital rationing (the act of placing restrictions on the
amount of money in an investment or project). This situation may arise when
the amount of available capital is insufficient to sponsor all worthy
investment opportunities.

For example, consider the figure below (Figure 3.2), a company has 7
independent potential investment projects (Projects A, B, C, D, E, F, and G).
However, the company has only $600 million available capital to invest.

Since the capital is limited, we need to divide this money to the all worthy
potential investment projects (alternatives) that has greater gain. This
phenomenon is what we call capital rationing. [Gin rarasyon naton an limitado
nga capital ha alternatives na may mas dako an balik ha aton]

The potential investment projects are now arranged in a manner that has
greater annual rate of return (ROR) or profit with least required capital.

Figure 3.2 Determination of MARR based on the Opportunity Cost

Viewpoint

 Project A is the first on the list since it has a large annual ROR (35%)
and has minimal required capital investment (Approx. $60 million).
 Project B is the second on the list since it has 30% annual ROR and
approximately $130 million required capital investment.
 Project C is the third on the list since it has 26% annual ROR and
approximately $230 million required capital investment.
 Project D and Project E are the fourth and fifth on the list since it has
23% and 19% annual ROR and approximately $90 million and $100
million required capital investment.
 Project F and Project G are the sixth and seventh on the list since it has
16% and 14% annual ROR and approximately $90 million and $50
million required capital investment.
 2 | Engineering Economy 5

Since our available capital is limited, we can only fund Projects A to E and
reject the remaining investments, Project F and G.

In this case, the MARR by the opportunity cost principle (best rejected
opportunity) is the ROR of the best project that is rejected (Project F) which is
16% annual ROR. Thus, MARR = 16% annual ROR.

3.3.2 Annuity
Before we discuss the different methods of comparison of alternatives, we
need to understand an important concept that would help us in the analysis of
those methods known as annuity.

Annuity is a series of equal payments “A” made at equal intervals of time.

Recall in Unit 2, we have discussed the uniform series cash flow. This cash
flow is actually the cash flow of annuity.
 2 | Engineering Economy 6

There are four types of annuity. Consider the figure below:

Figure 3.3 Types of Annuity

3.2.2.1 Ordinary Annuity

Ordinary annuity is a type of annuity where the payments are made at the
end of each period.
A = Uniform Amounts
A A A A A

0 n = number
1 2 3 n-1
of interest
i = Interest Rate per Period periods

P = Present Worth F = Future Worth

Formulas
 Future Worth:

Uniform Series Compound Amount Factor (USCAF)

 Present Worth:

Uniform Series Present Worth Factor (USPWF)

Where:
A = Uniform amounts
n = Number of periods
i = Rate of interest per period
F = Future Worth
P = Present Worth
 2 | Engineering Economy 7

Example: Ordinary Annuity

1. Money borrowed today to be paid in 6 equal payments at the end of 18
months. If the interest is 12% compounded quarterly, how much was
initially borrowed if the quarterly payments is ₱ 2,000?
Given:
A = ₱ 2,000
r = 12%
m = 4 (quarterly)
n=6
Required: P
Solution:

2. What is the accumulated amount of five-year annuity, paying ₱ 6,000 at

the end of each year with interest at 15% compounded annually?
Given:
A = ₱ 6,000
r = 15%
m = 1 (annually)
n=5
Required: F
Solution:

3.2.2.2 Deferred Annuity

Deferred annuity is a type of annuity where the first payment is made later
than the first or is made several periods after the beginning of annuity.
 2 | Engineering Economy 8

*Note that for deferred annuity, the future worth formula is the same with the
ordinary annuity the only difference is the present worth formula.

A = Uniform Amounts
A A A

0 1 2 n
0 1 2 j
i = Interest Rate per Period

P = Present Worth F = Future Worth

Where:
A = Uniform amounts
n = Number of periods (number of payments/deposits)
j = Number of periods before the first annuity
i = Rate of interest per period (payments/deposits)
F = Future Worth
P = Present Worth

Formulas
 Future Worth:

Uniform Series Compound Amount Factor (USCAF)

 Present Worth:

Example: Deferred Annuity

3. What is the present worth of a ₱ 500 annuity starting at the end of the
third year and continuing to the end of fourth year, if the annual
interest is 10%?
Given:
A = ₱ 500 2 3 4
0 1
r = 10%
m = 1 (annually)
n=2 ₱ 500 ₱ 500
j=2
Required: P
Solution:
 2 | Engineering Economy 9

3.2.2.3 Annuity Due

Annuity due is a type of annuity where payments is made at the beginning of
each period.

Formulas
 Future Worth:

 Present Worth:

Where:
A = Uniform amounts
n = Number of periods (number of deposits)
i = Rate of interest per period
F = Future Worth
P = Present Worth

Example: Annuity Due

4. Daniel wants to deposit ₱ 300 into a fund at the beginning of each
month. If he can earn 10% compounded interest monthly, how
much will be there in the fund at the end of 6 years?
Given:
A = ₱ 300
r = 10%
m = 12 (monthly)
 2 | Engineering Economy 10

n = 6 years
Required: F
Solution:

5. The monthly rent on an apartment is ₱ 1000 per month payable at the

beginning of each month. If the current interest is 12% compounded
monthly, what single payment 12 months in advance would be equal
to a year’s rent?
Given:
A = ₱ 1000
r = 12%
m = 12 (monthly)
n = 12
Required: P
Solution:

3.2.2.4 Perpetuity
Perpetuity is a type of annuity in which the periodic payments continue
indefinitely. Since this type of annuity is unending, the future value
cannot be calculated.

Formulas
 2 | Engineering Economy 11

 Present Worth:

Where:
A = Uniform amounts
n = Number of periods (number of deposits)
i = Rate of interest per period
P = Present Worth

Example: Perpetuity
6. Daniel wants to retire and receive ₱ 3,000 a month. He wants to pass
this monthly payment to future generations after his death. He can
earn an interest of 8% compounded annually. How much will he need
to set aside to achieve his perpetuity goal?
Given:
A = ₱ 3,000 per month
r = 8%
m = 12 (monthly)

Required: P
Solution:
 2 | Engineering Economy 12

Table 3.1 Summary of Formulas for Types of Annuity

To Find: Given: Formula
Ordinary Annuity

F A, i, n

P A, i, n

Deferred Annuity

F A, i, n

P A, i, n, j

Annuity Due

F A, i, n

P A, i, n

Perpetuity

P A, i

3.3.3 The Present Worth Method

3.3.3.1 Review of Concepts & Formulas

Now that we have discussed the MARR and Annuity in the previous sections.
We are now equipped to study one of the methods in comparing alternatives.
But before that, consider the table below, it will be useful in the calculations
for the methods in comparing alternatives.

Moreover, note that it is useful to memorize the factor functional symbol since
we will be using it in the calculations later.

Table 3.2 Summary of Formulas

To Given Factor by which Factor Name Factor
Find: to Multiply Functional Symbol
“Given”
For Single Cash Flows:
Single Payment
F P Compound Amount (F/P, i%, n)
Factor (SPCAF)
 2 | Engineering Economy 13

Single Payment Present

P F (P/F, i%, n)
Worth Factor (SPPWF)
For Uniform Series (Ordinary Annuity):
Uniform Series
F A Compound Amount (F/A, i%, n)
(USCAF)
Uniform Series Present
P A (P/A, i%, n)
Worth Factor (USPWF)

A F Sinking Fund Factor (A/F, i%, n)

A P Capital Recovery Factor (A/P, i%, n)

Recall that there are two types of economic proposals:

 Mutually Exclusive (ME) Alternatives
- Only one can be selected
- Compete with each other
 Independent Alternatives
- More than one can be selected
- Do not compete with each other
- Compete only against DN (do nothing approach)

3.3.3.2 Present Worth Analysis

Present Worth (PW) Analysis is a method of comparison of alternatives

wherein we convert all cashflows to present worth (time = 0) using interest
rate equal to the minimum attractive rate of return (i = MARR). Then,
depending on the type of decision, the best alternative will be selected by
comparing the present worth amounts of the alternatives.

Note that in PW analysis, you must always compare alternatives with equal
life service. So, before you do any comparison, you have to make sure that the
alternatives being compared has equal life service.
Profit, revenue, salvage value (all inflows to an organization) will be assigned
with positive sign. The costs (outflows) will be assigned with negative sign.

Cash Inflows  Positive (+)

Cash Outflows  Negative (-)

EVALUATION
 For one project, if PW 0, it is acceptable
 For mutually exclusive (ME) alternatives, select one with the
numerically highest PW, that is, less negative or more positive
 For independent alternatives, accept all alternatives with PW 0
 2 | Engineering Economy 14

Example: PW Analysis – Equal Life

7. There are two mutually exclusive alternatives – A & B as follows:

Alternative A: Has a first cost of ₱ 30,000, an operating cost of ₱ 8,000
per year, and a ₱ 6,000 salvage value after 5 years.
Alternative B: will cost ₱ 35,000 with an operating cost of ₱ 4,000 per
year and a salvage value of ₱ 7,000 after 5 years. At a MARR of 12% per
year, which would be accepted?

Solution:

For a PW analysis, we are going to convert this cash-flow to present

worth and select the one with the highest PW (ME alternatives).
i = MARR = 12% and n = 5 years

 Alternative A
₱ 6,000

0 1 2 2 2 2
2 3 4 5

₱ 8,000 ₱ 8,000 ₱ 8,000 ₱ 8,000 ₱ 8,000

₱ 30,000

Cost will be negative and salvage value will be positive. The

formula will be:

The operating cost is per year with the same amount therefore
we are going to use the formula for annuity. (See table 3.2)

PW = A (P/A, i%, n) Functional Symbol Notation

The salvage value (scrap value or the value of the asset when it
is no longer usable) has a future worth, thus, we need to convert
it into present worth using the formula for single cash flow. (See
table 3.2).
PW = F (P/F, i%, n) Functional Symbol Notation

Thus, the calculation will be,

 2 | Engineering Economy 15

 Alternative B
₱ 7,000

0 1 2 2 2 2
2 3 4 5

₱ 4,000 ₱ 4,000 ₱ 4,000 ₱ 4,000 ₱ 4,000

₱ 35,000

Since Alternative B ( ) is numerically higher than

Alternative A ( ), select Alternative B.

8. A retrofitted space-heating system is being considered for a small office

building. The system can be purchased and installed for ₱110,000, and
it will save an estimated 30,000 kilowatt-hours (kWh) of electric power
each year over a six-year period. A kilowatt-hour of electricity costs
₱10, and the company uses a MARR of 15% per year in its economic
evaluations of refurbished systems. The market value of the system
will be ₱8,000 at the end of six years, and additional annual operating
and maintenance expenses are negligible. Use the PW method to
determine whether this system should be installed.

Solution:

For a PW analysis, we are going to convert this cash-flow to present

worth and accept if the PW > 0 (single project).
i = MARR = 15% and n = 6 years
 2 | Engineering Economy 16

Since it will save 30,000 KWh per year, and the electricity cost is ₱10 per
KWh, it will save:

₱ 8,000

₱ 300,000 ₱ 300,000 ₱ 300,000 ₱ 300,000 ₱ 300,000 ₱ 300,000

0 1 2 2 2 2 2
2 3 4 5 6

₱ 110,000

Since PW > 0, accept the alternative. Thus, the system should be

installed.

The PW analysis must always compare alternatives for equal life service (i.e.
alternatives must end at the same time). However, in real life study, not all the
alternatives that is analyzed has equal life. Thus, you need to manipulate the
service life using techniques that will be discussed later so that they would
have equal service life.

Techniques to analyze alternatives with different life using PW method are as

follows:
 Least Common Multiple (LCM)
 This technique is always used in PW analysis to compare
alternatives with different life unless the problem specified
otherwise.
 In this technique, you use the LCM of the service life of the
alternatives that is being compared.
 Specific Study Period
 In this technique, you decide how many years you want to be
studied.

Example: PW Analysis – Different Life (LCM)

9. Compare the machines below using PW analysis at MARR = 10% per

year. Select which machine is better using LCM technique.

Machine A Machine B
 2 | Engineering Economy 17

First Cost (FC) in 20,000 30,000

Annual Cost (AC) in 9,000 7,000

Salvage Value (SV) in 4,000 6,000

Life in years 3 6

Solution:

Notice that the alternatives being compared have different life. So,
we’ll use the LCM method.

Since the service life of the machines are 3 and 6 its LCM = 6, thus, we
will repurchase Machine A after 3 years. As a result, within the 6 years
there will be two Machine A.

For a PW analysis, we are going to convert the cash-flow to present

worth and select the one with the highest PW (ME alternatives).
i = MARR = 10% and n = 6 years

Machine A
₱ 4,000 ₱ 4,000

0 1 2 2 2 2 2
2 3 4 5 6

₱ 9,000 ₱ 9,000 ₱ 9,000 ₱ 9,000 ₱ 9,000 ₱ 9,000

₱ 20,000 ₱ 20,000

Remember that for PW analysis we need to move all the values in the
cash flow into time zero for it the be in present worth

Cost will be negative and salvage value will be positive. The formula
will be:

The annual cost (AC) is per year with the same amount therefore we
are going to use the formula for annuity. (See table 3.2 for formula).

PW = A (P/A, i%, n) Functional Symbol Notation

PW = 9,000 (P/A, 10%, 6) Functional Symbol Notation

The repurchase cost has a future worth since we will repurchase after 3
years, thus, we need to convert it into present worth using the formula
for single cash flow. (See table 3.2 for formula).
 2 | Engineering Economy 18

PW = F (P/F, i%, n) Functional Symbol Notation

PW = 20,000 (P/F, 10%, 3) Functional Symbol Notation

The salvage value (SV) (scrap value or the value of the asset when it is
no longer usable) has a future worth, thus, we need to convert it into
present worth using the formula for single cash flow. (See table 3.2 for
formula).

PW = F (P/F, i%, n) Functional Symbol Notation

For the 1st machine:

PW = 4,000 (P/F, 10%, 3) Functional Symbol Notation

For the 2nd machine:

PW = 4,000 (P/F, 10%, 6) Functional Symbol Notation

Machine B ₱ 6,000

0 1 2 2 2 2 2
2 3 4 5 6

₱ 7,000 ₱ 7,000 ₱ 7,000 ₱ 7,000 ₱ 7,000 ₱ 7,000

₱ 30,000

Remember that for PW analysis we need to move all the values in the
cash flow into time zero for it the be in present worth

Cost will be negative and salvage value will be positive. The formula
will be:

The annual cost (AC) is per year with the same amount therefore we
are going to use the formula for annuity. (See table 3.2 for formula).

PW = A (P/A, i%, n) Functional Symbol Notation

 2 | Engineering Economy 19

PW = 7,000 (P/A, 10%, 6) Functional Symbol Notation

The salvage value (SV) (scrap value or the value of the asset when it is
no longer usable) has a future worth, thus, we need to convert it into
present worth using the formula for single cash flow. (See table 3.2 for
formula).

PW = F (P/F, i%, n) Functional Symbol Notation

PW = 6,000 (P/F, 10%, 3) Functional Symbol Notation

Since Alternative B ( ) is numerically higher than

Alternative A ( ), select Alternative B.

Example: PW Analysis – Different Life (Specific Study Period)

10. Compare the machines below using PW analysis at MARR = 10% per
year
Select which machine is better for a study period of 3 years.

Machine A Machine B
First Cost (FC) in 20,000 30,000
Annual Cost (AC) in 9,000 7,000
/yr
Salvage Value (SV) in 4,000 6,000 (after 6 years)
10,000 (after 3
years)
Life in years 3 6

Solution:

For a PW analysis, we are going to convert the cash-flow to present

worth and select the one with the highest PW (ME alternatives). i =
MARR = 10% and n = 3 years

Since the problem has a specific study period of 3 years, n = 3.

Disregard all estimates after 3 years.

Remember that for PW analysis we need to move all the values in the
cash flow into time zero for it the be in present worth
 2 | Engineering Economy 20

Machine A

Cost will be negative and salvage value will be positive. The formula
will be:

Machine B

Cost will be negative and salvage value will be positive. The formula
will be:

Marginally (for a period of 6 years), Alternative A ( ) is

numerically higher than Alternative B ( ), select
Alternative A.

3.3.4 The Future Worth Method

Future worth (FW) analysis over a specified study period is often utilized if
the asset (equipment, a building, etc.) might be sold or traded at some time
before the expected life is reached. Analysis of alternatives using FW values is
especially applicable to large capital investment decisions when a prime goal
is to maximize the future wealth of a corporation’s stockholders.

“FW is exactly like PW analysis except that we should calculate the future
worth”

Computation of this type of analysis is somewhat the same with the present
worth analysis except that instead of comparing the alternatives in its present
worth, we will compare alternatives by its future worth.

General guidelines for FW analysis are the same with PW analysis:

 2 | Engineering Economy 21

Profit, revenue, salvage value (all inflows to an organization) will be assigned

with positive sign. The costs (outflows) will be assigned with negative sign.

Cash Inflows  Positive (+)

Cash Outflows  Negative (-)

EVALUATION
 For one project, if FW 0, it is acceptable
 For mutually exclusive (ME) alternatives, select one with the
numerically highest FW, that is, less negative or more positive.
 For independent alternatives, accept all alternatives with FW 0

Example: FW Analysis (Different life)

11. Two processes can be used for producing a polymer that reduces friction
loss in engines. Process T will have a first cost of ₱ 750,000, an operating
cost of ₱ 60,000 per year, and a salvage value of ₱ 80,000 after its 2-year
life. Process W will have a first cost of ₱ 1,350,000, an operating cost of ₱
25,000 per year, and a ₱ 120,000 salvage value after its 4-year life. Process
W will also require updating at the end of year 2 at a cost of ₱ 90,000.
Which process should be selected on the basis of a future worth analysis
at an interest rate of 12% per year?

Process T Process W
First Cost (FC) in 750,000 1,350,000
Operating Cost (OC) in 60,000 25,000

Salvage Value (SV) in 80,000 120,000

Updating Cost n/a 90,000 (in year 2)
Life in years 2 4

Solution:

Notice that the alternatives being compared have different life. So, we’ll
use the LCM method.

Since the service life of the machines are 2 and 4 its LCM = 4, thus, we
will repurchase Process T after 2 years and have 2 life cycle of this
process.

For a FW analysis, we are going to convert the cash-flow to future

worth, that is year 4, and select the one with the highest FW (ME
alternatives).
i = MARR = 12% and n = 4 years.

Process T ₱ 80,000 ₱ 80,000

0 1 2 2 2
2 3 4

₱ 750,000 ₱ 60,000 ₱ 60,000 ₱ 60,000 ₱ 60,000

 2 | Engineering Economy 22

Remember that for FW analysis we need to move all the values in the cash
flow into year 4 for it the be in future worth

Cost will be negative and salvage value will be positive. The formula will be:

Process W ₱ 120,000

0 1 2 2 2
2 3 4

₱ 25,000 ₱ 25,000 ₱ 25,000 ₱ 25,000

₱ 1,350,000 ₱ 90,000

Process T ( ) is numerically higher than Process W

( ), select Process T.

3.3.5 The Annual Worth Method

Annual worth (AW), is also known as equivalent annual worth (EAW),
equivalent annual cost (EAC), annual equivalent (AE), and equivalent
uniform annual cost (EUAC).
 2 | Engineering Economy 23

The Annual worth (AW) value is the annual amount “A” value that we have
discussed so far in the previous section (Annuity, PW analysis, and FW
analysis).

It is a method of comparison that is often desired in engineering economic

study compared to PW analysis, FW analysis, and rate of return (will be
discussed in 3.2.7-3.2.8), since annual worth method offers an advantage
because the AW value needs to be calculated for only one life cycle.

The AW value determined over one life cycle is the AW for all future life
cycles.

Therefore, it is not necessary to use the LCM technique to satisfy the equal-
service requirement.

EVALUATION
 One alternative (Single Project): If AW 0, the requested MARR is
met or exceeded and the alternative is economically justified.
 Two or more alternatives (ME alternatives): Select the alternative with
the AW that is numerically largest, that is, less negative or more
positive. This indicates a lower AW of cost for cost alternatives or a
larger AW of net cash flows for revenue alternatives.
 If the projects are independent, the AW at the MARR is calculated. All
projects with AW 0 are acceptable.

Example: Annual Worth (One & Two Life Cycles)

12. A machine has a first cost of ₱ 20,000, an annual operating and maintenance
cost of ₱ 5,000, and a salvage value of ₱ 3,000 after 2 years. Calculate the AW
at i = 10% for (a.) one life cycle (b.) two life cycle.

Solution:
To find the AW, we have to convert all cash flows into annual amount “A”. Since the
annual operating and maintenance cost is already in annual value, we will leave it as
it is.

(a.) One Life Cycle

₱ 3,000

0 1 2
2

₱ 5,000 ₱ 5,000

₱ 20,000
 2 | Engineering Economy 24

(a.) Two Life Cycle

₱ 3,000 ₱ 3,000

0 1 2 3 4

₱ 5,000 ₱ 5,000 ₱ 5,000 ₱ 5,000

₱ 20,000 ₱ 20,000

Note that we have to move the cash flows in year 2 to present worth (year 0) before we convert
it to annual worth for 4 years. Also, the cost of buying the machine which is ₱ 20,000 will be
subtracted by the salvage value of ₱ 3,000 of the first machine, that will be ₱ 17,000.

Notice that the annual worth of one cycle is also equal to the annual worth of
2 cycles. This proves our previous statement, “AW value determined over
one life cycle is the AW for all future life cycles” holds true.

Example: Annual Worth Analysis

13. RR Racing and Performance Motor Corporation wishes to evaluate two

alternative CNC machines for NHRA engine building. Use the AW method
at 10% per year to select the better alternative.

Machine R Machine S
First Cost (FC) in 250,000 370,000
Operating Cost (OC) in 40,000 50,000
 2 | Engineering Economy 25

Salvage Value (SV) in 20,000 30,000

Life in years 3 5

Solution:

For AW analysis, we are going to convert the cash-flow to its annual

equivalent worth, and select the one with the numerically highest AW (ME
alternatives). i = MARR = 10%

Machine R

Machine S

Machine R (AW = ) is numerically higher than Machine S (AW

= ), select Machine R.

3.3.6 The Capitalized Cost and Annual Cost

3.3.6.1 Capitalized Cost Analysis

If the life of the alternatives is considered to be very long or infinite, capitalized
cost (cc) analysis is the method of comparison that is best used.

This type of method of analysis is applied in many public sectors such as

bridges, dams, highways and toll roads, railroads, hydroelectric and other
power generation facilities, and permanent donations for charitable
organizations and universities since all of these have very long expected
useful lives.

Capitalized Cost (CC) is known as a specialized present worth (PW) since it is

the present worth of a project that has a very long life (approximately more
than 35 or 40 years) or when the planning horizon is considered very long or
infinite.

The equation for CC analysis is derived from the present worth (PW) as life
(n) approaches to infinity:
 2 | Engineering Economy 26

1 0

Thus, equation for CC:

 Notice that this formula is the same as perpetuity which we have discussed
in the earlier section.
 This formula is useful when you have already an annual worth analysis
such as Example 12 and 13. We would just divide those values by the
interest and we will have the capitalized cost (cc) value.

EVALUATION
 Two or more alternatives (ME alternatives): The alternative with a capital
cost that is nearest to zero will represent the more economical one.

Example: Capitalized Cost (CC) Analysis (Non—Infinite Life)

14. Find the capitalized cost of the machines in Example 13 (page 50), Machine R
has an whereas Machine S has an . Both
operates at an interest rate of 10% per year.

Solution:

Since Machine R has a CC value nearest to zero. Select Machine R.

Notice that in the above example problem, the selection is the same whether it is
an AW analysis or a CC analysis.

Procedure to determine the CC for an infinite sequence cash flow:

 2 | Engineering Economy 27

When you are given an infinite cash flow diagram or a cash flow diagram that
would last “forever”, determination of CC are as follows:
1. Draw a cash flow diagram showing all nonrecurring (one-time) cash
flows and at least two cycles of all recurring (periodic) cash flows.
2. Find the present worth of all nonrecurring amounts. This is their CC
value.
3. Find the A value through one life cycle of all recurring amounts. (This is
the same value in all succeeding life cycles, as explained in Annuity). Add
this to all other uniform amounts (A) occurring in years 1 through
infinity. The result is the total equivalent uniform annual worth (AW).
4. Divide the AW obtained in step 3 by the interest rate i to obtain a CC
value. This is an application of Equation .
5. Add the CC values obtained in steps 2 and 4.

Reminder!

o CC value of a non-recurring (one time) amount is PW

o CC value of a recurring (periodic, such as: annuity) is PW = AW/i
o CC (total) = CC (non-recurring) + CC (recurring)
CC (total) = PW (non-recurring) + PW (recurring)
CC (total) = PW (non-recurring) + AW/i

Example: Capitalized Cost (CC) Analysis (With Infinite Life)

15. Compare the alternatives shown on the basis of their capitalized costs (cc)
using an interest rate of 10% per year.

Alternative M Alternative N
First Cost (FC) in 150,000 800,000
Operating Cost (OC) in 50,000 12,000

Salvage Value (SV) in 8,000 100,000

Life in years 5

Solution:

Alternative N

Notice that Alternative N have an expected life of 5 years. The best technique
to be used here is to find its AW value and divide it by the interest to
determine the CC value.
 2 | Engineering Economy 28

Alternative M

Notice that Alternative M have an infinite expected life. The best technique to
be used here is the procedure discussed (page 52).

Step 1: Draw a cash flow diagram showing all nonrecurring (one-time) cash
flows and at least two cycles of all recurring (periodic) cash flows.
₱ 100,000

0 1 2 …

₱ 12,000 ₱ 12,000 ₱ 12,000 ₱ 12,000

₱ 800,000

Step 2: Find the present worth of all nonrecurring amounts. This is their CC
value.

Non-recurring amount: First Cost (FC) and Salvage Value (SV). FC is already
in its present worth (time = 0). SV will be neglected since the alternative has
infinite life:

Step 3: Find the A value through one life cycle of all recurring amounts. (This
is the same value in all succeeding life cycles, as explained in Annuity). Add this to
all other uniform amounts (A) occurring in years 1 through infinity. The result
is the total equivalent uniform annual worth (AW).
Recurring Amount: Operating Cost (OC), this value is already in annual
amount, and there is no other recurring amount aside from this value. Thus,

Step 4: Divide the AW obtained in step 3 by the interest rate i to obtain a CC value.
This is an application of Equation .
 2 | Engineering Economy 29

Step 5: Add the CC values obtained in steps 2 and 4.

Since Alternative N has a CC nearest to zero, select alternative N.

3.3.7 The Internal Rate of Return Method

The Internal Rate of Return (IRR) method, sometimes called by several other
names, such as the investor’s method, the discounted cash-flow method, and the
profitability index, is the most widely used rate-of-return method in
engineering economic analysis.

To understand this method, we need to understand first what is an internal

rate of return (IRR):

Internal rate of return (IRR)

 It is the interest that makes the present worth or annual worth of a cash
flow series equal to 0.

 This also means that it is the interest that makes the present worth or
annual worth of all inflows (receipts, revenues or savings) equal to the
present worth or annual worth of all outflows (cost, disbursements or
expenditures).

 Note that IRR is sometimes referred as the breakeven interest rate.

 It is important to note that IRR is the interest we have determined
based on the cash flow, it is not given, that is why it is called
“internal” rate of return.

For a single alternative, from the lender’s viewpoint, the IRR is not positive
unless:
(1) both receipts and expenses are present in the cash-flow pattern, and
(2) the sum of receipts exceeds the sum of all cash outflows.
 2 | Engineering Economy 30

Be sure to check both of these conditions in order to avoid the unnecessary

work involved in finding that the IRR is negative. (Visual inspection of the
total net cash flow will determine whether the IRR is zero or less.)

EVALUATION

 If IRR ≥ MARR, the project is economically justified, otherwise, it is

not.

Example: Internal Rate of Return (IRR) Method vs. PW Method

16. A company is planning to install a machine has a first cost of ₱ 20,000,

an operating and maintenance cost of ₱ 1000 per year, and it will generate a
savings of ₱ 7,000 per year, and a salvage value of ₱ 3,000 after 5 years. MARR
is at 12%. Determine if the plan is economically feasible using (a.) PW analysis
(b.) IRR method

Solution:

(a.) PW Method of Analysis

Since PW > 0, the plan is feasible, accept the installation.

(a.) IRR Method of Analysis

In IRR analysis, the unknown is the interest rate i = IRR, and we need to compare it
with the MARR for decision making. Also, we will set PW=0

 Using the “solve” function in your calculator.

 Input the equation in your scientific calculator, (change the IRR to
variable X).
 2 | Engineering Economy 31

 Next, use the solve function by clicking the “shift” then “calc”
button.

When this shows click the equal sign “=“

 This may take a while, just wait for the calculator to solve.

The IRR is 0.18155 or 18.155%. Since IRR > MARR, accept the alternative.

Drawbacks (Limitation) of IRR Method

 Computation for the IRR gets complicated when several cash flows are
present.
 Depending on the complexity of the problem, there would be instances in
which there will be more than one value of IRR.
 The IRR must be carefully applied and interpreted in the analysis of two or
more alternatives when only one of them is to be selected (i.e., mutually
exclusive alternatives).
 Do not compare the IRRs of mutually exclusive alternatives (or
IRRs of the differences between mutually exclusive alternatives)
against those of other alternatives. Compare an IRR only against
MARR (IRR ≥ MARR) in determining the acceptability of an
alternative.

3.3.8 The External Rate of Return Method

 2 | Engineering Economy 32

Since the IRR method has many drawbacks, the rise of other rate of return
methods emerge to mitigate or address the weakness of IRR. One of these
methods is the external rate of return (ERR) method.

External rate of return (ERR) method introduces an external interest rate (∈) or
an interest outside of the project at which net cash-flow (net cash-flow =
inflow – outflow) generated or required 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 a
decision identical to those of the IRR method.

EVALUATION

 If ERR ≥ MARR, the project is economically justified, otherwise, it is

not.

Steps in Solving ERR

1. All net cash outflows are discounted to time zero (the present) at i=∈%
per compounding period.
2. All net cash inflows are compounded to period “n” (the future) at
i=∈%
3. Equate the inflow = outflow, by compounding forward the cash
outflow in step 1 to the future solve for i in which i = ERR.
4. Decision: If ERR ≥ MARR, accept the project, otherwise, reject.

Example: External Rate of Return

16. A company is planning to install a machine has a first cost of ₱ 20,000,

an operating and maintenance cost of ₱ 1000 per year, and it will
generate a savings of ₱ 7,000 per year, and a salvage value of ₱ 3,000
after 5 years. MARR is at 12%. Suppose ∈ = MARR = 12%, determine if
the plan is economically feasible using ERR method.

₱ 3,000

₱ 7,000 ₱ 7,000 ₱ 7,000 ₱ 7,000 ₱ 7,000

0 1 2 3 4 5

₱ 1,000 ₱ 1,000 ₱ 1,000 ₱ 1,000 ₱ 1,000

₱ 20,000

Solution: Let i =∈ = MARR = 12%

 2 | Engineering Economy 33

Step 1: All net cash outflows are discounted to time zero (the present)
at i=∈=12% per compounding period.

In this step, we are going to determine the PW of all the cash outflows,
remember we use the absolute value.

Step 2: All net cash inflows are compounded to period “n” (the future)
at i=∈=12%

Here we are going to determine the FW (year 5) of all the cash inflows

Step 3: Equate the inflow = outflow, by compounding forward the cash

outflow in step 1 to the future solve for i in which i = ERR.

Step 4: Decision: If ERR ≥ MARR, accept the project, otherwise, reject.

Since ERR > MARR, 15% > 12%, accept the project.
 2 | Engineering Economy 34

3.3.9 The Payback Period Method

The methods we have discussed so far specifies the profitability of a proposed
alternative in a given study period. The payback period method, sometimes
called the simple payout method and payout period method, mainly indicates a
project’s liquidity (how quickly you can get your hand on your cash) rather
than its profitability.

The payback period method is often used as a measure of a project’s riskiness,

since liquidity deals with how fast an investment can be recovered. A short
payback period is considered desirable.

In simple terms, the payback period method calculates the number of years
required for the cash inflows to equal the cash outflows.

The payback period (np) is an estimated time for the revenues, savings, and
any other monetary benefits to completely recover the initial investment plus
a stated rate of return (i).

There are two types of payback analysis as determined by the required return:
 Simple payback; i = 0%: Also called no return, this is the recovery of
only the initial investment. It ignores the time value of money and all
cash flows that occur after np.

 Discounted payback; i > 0%: The time value of money is considered in

that some return, for example, 10% per year, must be realized in
addition to recovering the initial investment.
Limitation of Payback Period
 It ignores the time value of money. (for simple payback i = 0%)
 It ignores the cashflow after the payback period.
 Its use alone is not recommended except as a supplement to the other four
methods previously discussed (PW, FW, AW, CC).

Example: Payback Period

16. A company is planning to install a machine has a first cost of ₱ 20,000,

an operating and maintenance cost of ₱ 1000 per year, and it will
generate a savings of ₱ 7,000 per year, and a salvage value of ₱ 3,000
after 5 years. MARR is at 12%. Determine the payback period in (a.)
Simple Payback Period, i = 0% (b.) Discounted Payback i = MARR =
12%.

₱ 3,000

₱ 7,000 ₱ 7,000 ₱ 7,000 ₱ 7,000 ₱ 7,000

0 1 2 3 4 5

₱ 1,000 ₱ 1,000 ₱ 1,000 ₱ 1,000 ₱ 1,000

₱ 20,000
 2 | Engineering Economy 35

Solution:

We will use a table for out computation so that it will be organized.

Note that for simple payback:

 The net cash flow (NCF) for each year is the inflow minus the outflow (e.g. in
year 1: Net cashflow = 7,000 – 1000 = 6,000)
 The cumulative PW of year zero is the NCF of year zero
 The cumulative PW of year 1 onwards is the cumulative PW of the previous year
plus the NCF of that specific year.
Example: For year 2,
Cumulative PW = cumulative PW of the previous + NCF of that specific year
= -14,000 + 6,000 = -8,000

Simple Payback, i = 0% Discounted Payback, i = 12%

Net Cash Flow PW of cashflow at i =
Year Cumulative PW Cumulative PW at
(NCF) 12% through year n
(n) at i = 0% through i = 12% through
(Inflow –
year n year n
Outflow)
0 - 20,000 - 20,000 - 20,000 - 20,000
1 6,000 -14,000 5,357 -14,643
2 6,000 -8,000 4,783 -9,860
3 6,000 -2,000 4,271 -5,589
4 6,000 4,000 3,813 -1,776
5 9,000 13,000 5,107 3,331

Note that for discounted payback:

 PW of cashflow at i =12% means you’ll determine the PW value of the NCV of
that specific year. We will use the formula PW = (NCF)(P/F, i%, n)
. Always be careful of the value of n since it changes per year.
 The cumulative PW of year zero is the NCF of year zero
 The cumulative PW of year 1 onwards is the cumulative PW of the previous year
plus the NCF of that specific year.
Example: For year 2,
Cumulative PW = cumulative PW of the previous + NCF of that specific year
= -14,643 + 4,783= -9,860

Simple Payback, i = 0% Discounted Payback, i = 12%

Net Cash Flow PW of cashflow at i =
Year Cumulative PW Cumulative PW at
(NCF) 12% through year n
(n) at i = 0% through i = 12% through
(Inflow –
year n year n
Outflow)
0 - 20,000 - 20,000 - 20,000 - 20,000
1 6,000 -14,000 5,357 -14,643
2 6,000 -8,000 4,783 -9,860
3 6,000 -2,000 4,271 -5,589
4 6,000 4,000 3,813 -1,776
5 9,000 13,000 5,107 3,331

The payback period is somewhere in The payback period is somewhere in

between year 3 and 4 since between year 4 and 5 since
cumulative balance turns positive cumulative balance turns positive
 2 | Engineering Economy 36

Using Calculator Technique:

To determine the value of the payback period, we can use the linear
interpolation method in your calculator using the STAT Mode:

Click the MODE, then click 3 for STAT

Click 2 for A+BX

Input the values of year to column X and the cumulative PW to column

Y

Click AC button and it will show

Click SHIFT, then click 1, then click 5 for Reg, then 4 for
 2 | Engineering Economy 37

will appear on the screen, move the to the left by clicking the
button shown in the second picture, the result will look like the
third picture.

Input 0 in front of , click the = button

The answer shows that the simple payback period will be at 3.33
years.

Note that in this calculator technique, we determine the value of

X (years) when the Y (cumulative PW) is zero because the payback
period method calculates the number of years required for the cash
inflows to equal the cash outflows (which also means that the
cumulative PW equal to 0). In simpler terms, we determine the what
year would the cumulative PW=0.
 2 | Engineering Economy 38

Using Linear Interpolation Formula

3.3.10 The Benefit/Cost Ratio Method

As the name suggest, Benefit/Cost (B/C) Ratio Method involves the
calculation of benefits to cost. All cost and benefit estimates must be
converted to a common equivalent monetary unit (PW, AW, or FW) at the
discount rate or interest rate. The B/C ratio is then calculated using one of
these relations:

Conventional Formula:

3.3.10.1 Benefit/Cost for a Single Project

For a single project the calculation of the B/C ratio is the same. To decide
whether the project is economically feasible, refer to the evaluation below.

EVALUATION FOR SINGLE PROJECT

 2 | Engineering Economy 39

 If , the project is economically justified.

 If , the project is break even.
 If , the project is economically unsatisfactory.

Example: Benefit/Cost for Single Project

17. A project has a cashflow diagram shown below. The MARR is 15%.
Compute for the B/C ratio and decide if the project should be
accepted or not.

₱ 8,000

₱ 300,000 ₱ 300,000 ₱ 300,000 ₱ 300,000 ₱ 300,000 ₱ 300,000

0 1 2 3 4 5 6

₱ 110,000

Solution:

Compute for the PW of benefits:

Compute for the PW of cost (outflow):

The cost is already at present value, note that we will take the absolute
value so disregard the sign of the cost:

Compute for B/C Ratio:

Since B/C > 1, project is economically justified, thus, accept the

project.

3.3.10.2 Benefit/Cost for Mutually Exclusive Alternatives

When given two or more alternatives, there would be a slight difference in

calculation for the B/C ratio, the process of calculation is known as
 2 | Engineering Economy 40

incremental benefit/cost method. The B/C ratio for ME alternatives will be

.

The modified formula will be:

Important!
Make sure that the alternatives being compared passed the initial screening.
That means has a B/C ratio of every alternatives being compared (process we
used for single project) is higher than 1. If the project is lower than 1,
automatically reject the project, and proceed with the calculations for
incremental benefit/cost analysis for the ones that passed in this initial
screening

Steps in determining the B/ C ratio for ME alternatives are as follows

(incremental benefit/cost method):
1. Take the higher first cost MINUS the lower first cost
2. Compute for the PW of benefits and costs of the resulting cash flow
3. Divide benefits over cost
4. Decide using the evaluation criteria given below.

EVALUATION FOR TWO OR MORE ALTERNATIVES (ME

ALTERNATIVES)

 If , select the one with the higher cost

 If , select the one with the lower cost

Example: Benefit/Cost for ME Alternatives

18. Given the cashflow diagram of two alternatives, select which is better
using the B/C method. MARR = 9%

₱ 7,000 ₱ 7,000 ₱ 7,000 ₱ 7,000 ₱ 7,000 ₱ 15,000 ₱ 15,000 ₱ 15,000 ₱ 15,000 ₱ 15,000

0 1 2 3 4 5 0 1 2 3 4 5

Alternative R Alternative S
₱ 20,000 ₱ 35,000
 2 | Engineering Economy 41

Solution:
 We have to make sure that every alternative passed the initial screening
(B/C > 1 for single project)

Alternative R
₱ 7,000 ₱ 7,000 ₱ 7,000 ₱ 7,000 ₱ 7,000

0 1 2 3 4 5

Alternative R
₱ 20,000

Since B/C > 1, Passed

₱ 15,000 ₱ 15,000 ₱ 15,000 ₱ 15,000 ₱ 15,000

Alternative S 0 1 2 3 4 5

Alternative S
₱ 35,000

Since B/C > 1, Passed

 Since both alternatives passed the initial screening, proceed to

incremental benefit/cost method

Step 1: Take the higher first cost MINUS the lower first cost
2 | Engineering Economy 42

In the remaining steps we will find the B/C ratio for Alternative
S-R, this value would be the B/ C and proceed with the
evaluation using the criteria for incremental cost analysis to
know which alternative we should choose.

Step 2: Compute for the PW of benefits and costs of the resulting

cash flow

Compute for the PW of ₱ 8,000 ₱ 8,000 ₱ 8,000 ₱ 8,000 ₱ 8,000

benefits:
0 1 2 3 4 5

Alternative S - R
₱ 15,000

Compute for the PW of cost (outflow):

The cost is already at present value, note that we will take the
absolute value so disregard the sign of the cost:

Compute for B/C Ratio:

Note that this value of B/C is the B/ C.

Since , select the one with the higher cost, the higher
cost is Alternative S.

Remember!
o It is necessary to use the incremental benefit/cost method
for those alternatives who passed the B/C ratio for single
project (initial screening).
o DO NOT directly compare the B/C for each project
(initial screening) since there are times that even though
the B/C in the initial screening is higher than the other,
its result of B/ C in the incremental benefit/cost
method tells otherwise.