ENGR.

NORVEIN CALIBO

Engineering Economics
Economic Analysis Techniques
 Objectives:
• Calculate the rate of return of a series of cash flows
using the various economic analysis techniques.
• Compare and choose among the alternatives

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 Outline:
• Minimum Attractive Rate of Return
• Present Worth Analysis
• Future Worth Analysis
• Annual Worth Analysis
• Internal Rate of Return Method
• External Rate of Return Method
• Payback Period Method
• Basic Concepts for Comparing Alternatives

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 Introduction to
Determining the Minimum
Attractive Rate of Return

• MARR is the minimum required interest rate for

invested money, also called the hurdle rate.
• Should be chosen to maximize the economic
well-being of an organization.

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Introduction to
Determining
the Minimum
Attractive Rate
of Return
THE LAST FUNDED PROJECT WOULD BE E, WITH
A P R O S P E C T I V E R AT E O F P R O F I T O F 1 9 % P E R
Y E A R , A N D T H E B E S T R E J E C T E D P R O J E C T I S F. I N
THIS CASE, THE MARR BY THE OPPORTUNITY
COST PRINCIPLE WOULD BE 16% PER YEAR.
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Economic Criteria

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 Present Worth
PW(i%) = PW of
Method cash inflows –
PW of cash
outflows

• The PW method is based on the concept of

equivalent worth of all cash flows relative to
NPW/NPV =
some base or beginning point in time called PW of benefits-
the present. PW of costs

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 Present Worth
Method
PW Decision
Rule: If PW (i =
MARR) ≥ 0, the
project is
economically
justified.

𝑷𝑾 = 𝑷𝑾 𝑩𝒆𝒏𝒆𝒇𝒊𝒕𝒔 − 𝑷𝑾(𝑪𝒐𝒔𝒕𝒔)
i = effective interest rate, or MARR, per compounding period;
k = index for each compounding period (0 ≤ k ≤ N);
Fk = future cash flow at the end of period k;
N = number of compounding periods in the planning horizon (i.e., study period). 9
 Present Worth
Method: Capitalized
Worth

• Capitalized-Worth (CW) method involves

determining the PW of all revenues or expenses
over an infinite length of time.
• The CW method is a convenient basis for
comparing mutually exclusive alternatives when
the period of needed service is indefinitely long.

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Present Worth
Method: Capitalized
Worth

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 The Net Present
Value (NPV)
• Ascertains whether the benefits of a project (in terms of
the PV/PW of the cash inflows) are greater than, less
than or equal to the costs of a project (in terms of the
PV/PW of the cash outflows).
• For a single project, a positive NPV indicates
acceptability.
• For multiple projects, the highest NPV is the most
acceptable.

𝑵𝑷𝑽 = 𝑷𝑾 𝒃𝒆𝒏𝒆𝒇𝒊𝒕𝒔 − 𝑷𝑾 (𝑪𝒐𝒔𝒕𝒔)

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 Practice Solving
Present Worth
Analysis
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 value
of $5,000 at the end of a study period of five years.
Increased productivity attributable to the equipment
will amount to $8,000 per year after extra operating
costs have been subtracted from the revenue
generated by the additional production. A cash-flow
diagram for this investment opportunity is given below.
If the firm’s MARR is 20% per year, is this proposal a
sound one?
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 Practice Solving
Present Worth
Analysis
𝑃𝑊(20%) = 𝐴 𝑃/𝐴, 20%, 5 + 𝐹 𝑃/𝐹, 20%, 5 − $25, 000

𝑃𝑊(20%) = $8, 000 2.9906 + $5,000(0.4019) − $25, 000

𝑃𝑊(20%) = $25, 934.3 − $25, 000

𝑷𝑾(𝟐𝟎%) = $ 𝟗𝟑𝟒. 𝟑𝟎
𝑩𝒆𝒄𝒂𝒖𝒔𝒆 𝑷𝑾 𝟐𝟎% ≥ 𝟎, 𝒕𝒉𝒊𝒔 𝒆𝒒𝒖𝒊𝒑𝒎𝒆𝒏𝒕 𝒊𝒔 𝒆𝒄𝒐𝒏𝒐𝒎𝒊𝒄𝒂𝒍𝒍𝒚 𝒋𝒖𝒔𝒕𝒊𝒇𝒊𝒆𝒅.

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 Future Worth
Method

• The FW is based on the equivalent worth of

all cash inflows and outflows at the end of
the planning horizon (study period) at an
interest rate that is generally the MARR.

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 Future Worth
Method
FW Decision
Rule: If FW (i =
MARR) ≥ 0, the
project is
economically
justified.

𝑭𝑾 = 𝑷𝑾 𝑭/𝑷, 𝒊%, 𝑵
𝑭𝑾 = 𝑭𝑾 𝑩𝒆𝒏𝒆𝒇𝒊𝒕𝒔 − 𝑭𝑾(𝑪𝒐𝒔𝒕𝒔)
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 Practice Solving
Future Worth
Analysis
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
value of $5,000 at the end of a study period of five years. Increased productivity attributable to the
equipment will amount to $8,000 per year after extra operating costs have been subtracted from the
revenue generated by the additional production. A cash-flow diagram for this investment opportunity is
given below. If the firm’s MARR is 20% per year, is this proposal a sound one?

Evaluate the FW of the potential improvement project described in the previous example. Show the
relationship between FW and PW.

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 Practice Solving
Future Worth
Analysis
𝐹𝑊(20%) = 𝐴 𝐹/𝐴, 𝑖%, 𝑁 + $5, 000 − 𝑃 𝐹/𝑃, 𝑖%, 𝑁
𝐹𝑊(20%) = $8, 000 𝐹/𝐴, 20%, 5 + $5, 000 − $25, 000 𝐹/𝑃, 20%, 5
𝐹𝑊(20%) = $8, 000 7.4416 + $5, 000 − $25, 000 2.4883
𝑭𝑾 𝟐𝟎% = $𝟐, 𝟑𝟐𝟓. 𝟑𝟎
𝑻𝒉𝒆 𝒑𝒓𝒐𝒋𝒆𝒄𝒕 𝒊𝒔 𝒔𝒉𝒐𝒘𝒏 𝒕𝒐 𝒃𝒆 𝒂 𝒈𝒐𝒐𝒅 𝒊𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕 (𝑭𝑾 ≥ 𝟎)

𝑃𝑊(20%) = 𝐹𝑊 𝑃/𝐹, 𝑖%, 𝑁

𝑃𝑊 20% = $2,325.30 0.4883
𝑷𝑾 𝟐𝟎% = $𝟗𝟑𝟒. 𝟒𝟎
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 The Annual Worth
Method

• The AW of a project is an equal annual

series of dollar amounts, for a stated study
period, that is equivalent to the cash inflows
and outflows at an interest rate that is
generally the MARR

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 The Annual Worth
Method
AW Decision
𝑨𝑾 𝒊% = 𝑹 − 𝑬 − 𝑪𝑹(𝒊%) Rule: If AW (i =
𝑨𝑾 𝒊% = 𝑹 − 𝑬 − 𝑰 𝑨/𝑷, 𝒊%, 𝑵 − 𝑺(𝑨/𝑭, 𝒊%, 𝑵) MARR) ≥ 0, the
project is
economically
justified.

• The AW of a project is annual equivalent

revenues or savings (R) minus annual
equivalent expenses (E), less its annual
equivalent capital recovery (CR) amount
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 Capital Recovery

• Loss in value of the asset

• Interest on invested capital (i.e., at the
MARR)

𝑪𝑹 𝒊% = 𝑰 𝑨/𝑷, 𝒊%, 𝑵 − 𝑺(𝑨/𝑭, 𝒊%, 𝑵)

I = initial investment for the project

S = salvage (market) value at the end of the study period
N = project study period 21
 Practice Solving
Annual Worth
Analysis
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
value of $5,000 at the end of a study period of five years. Increased productivity attributable to the
equipment will amount to $8,000 per year after extra operating costs have been subtracted from the
revenue generated by the additional production. A cash-flow diagram for this investment opportunity is
given below. If the firm’s MARR is 20% per year, is this proposal a sound one?

By using the AW method, determine whether the equipment should be recommended.

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 Practice Solving
Annual Worth
Analysis
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 value of $5,000 at the end of a study period of five years. Increased
productivity attributable to the equipment will amount to $8,000 per year after extra operating costs have been subtracted from the
revenue generated by the additional production. A cash-flow diagram for this investment opportunity is given below. If the firm’s MARR
is 20% per year, is this proposal a sound one? By using the AW method, determine whether the equipment should be recommended.

𝐴𝑊 𝑖% = 𝑅 − 𝐸 − 𝐼 𝐴/𝑃, 𝑖%, 𝑁 − 𝑆(𝐴/𝐹, 𝑖%, 𝑁)

𝐴𝑊 20% = $8, 000 − $25, 000 𝐴/𝑃, 20%, 5 − $5, 000(𝐴/𝐹, 20%, 5)
𝐴𝑊 20% = $8, 000 − $25, 000 0.3344 + $5, 000(0.1344)
𝑨𝑾 𝟐𝟎% = $𝟑𝟏𝟐. 𝟎𝟎

This piece of equipment should be recommended as an attractive investment opportunity.

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