BASIC METHODS FOR

MAKING ECONOMY
STUDIES
By:
ENGR. CHEZANIE MIYA ASUNCION
ENGR. KRISTELLE ANN GINEZ
ENGR. JERICO FIEL
Isabela State University-Ilagan Campus
Engineering Economy Studies
• All engineering economy studies of capital projects should be made so as to
include consideration of the return that a given project will or should produce.
Since the patterns in capital investment, revenue or saving flows, and cost flows
are quite different in various projects, there is no ideal method for making
economy studies.
• Consequently, several methods, or patterns are commonly used in practice, and
all will produce equally satisfactory results and will lead to the same decision in
cases where the inherent assumptions of each are applicable.
 Basic Methods or Patterns for
Making Economy Studies
Engineering economy studies are made for the purpose
of determining whether capital should be invested in
a project or whether it should be used differently To evaluate
whether it is
than it presently is being used. They should consider
“Financially viable”
the return that a given project will or should
to invest
produce. capital in a
specific project
The basic question is; whether a proposed capital
investment and its associated expenditures can be
recovered by revenue overtime in addition
to return on the capital that is sufficiently
attractive in view of the risk involved and the
potential alternative uses
 THE RATE OF RETURN (ROR) METHOD
Basic Methods or
Patterns for Making THE ANNUAL WORTH (AW) METHOD
Economy Studies
THE PRESENT WORTH (PW) METHOD

THE FUTURE WORTH (FW) METHOD

THE PAYBACK (PAYOUT) PERIOD

METHOD
 The Rate of Return (ROR) Method
it is easily understood by
The rate of return on the management
capital and investors. The applications
invested is given by the of the
formula, rate of return method are
controlled by

Rate of return is a measure of the following conditions. A

the single

effectiveness of an investment investment of capital at the

of capital. It is a financial beginning

efficiency. of the first year of the

 THE 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 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 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.
 THE FUTURE WORTH (FW) METHOD
The future worth method for economy studied is exactly comparable
to
the present worth method except that all cash inflows and
outflows are
compounded forwards 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.
 THE PAYBACK (PAYOUT) PERIOD METHOD

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

An investment of ₱270,000 can be made in a project that will produce a

uniform annual revenue of ₱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 ₱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
period of the investment?
 Examples
By the rate of return method:

Solution
 Examples
By the rate of return method:

Solution

Since the rate of return is less than 25%, the investment is not justified.
 Examples
By the annual worth method:

Solution
 Examples
By the annual worth method:

Since the excess of annual cash inflows over

Solution
annual cash outflows is less than zero
(₱−3,509), the investment is not justified.
 Examples
By the present worth method:

Solution
 Examples
By the present worth method:

Solution
 Examples
By the present worth method:

Since the present worth of the net cash flows is

Solution
less than zero (-₱9,436.03), the investment is
not justified.
 Examples
By the future worth method:
Referring to the cash flow
diagrams in the solution by the
Solution
present worth method:
 Examples
By the future worth method:
Referring to the cash flow
diagrams in the solution by the
Solution
present worth method:

Since the future worth of the net cash flows is less than zero
(-₱28,796.49), the investment is not justified.
 Examples
By the payback method:

Solution
 Examples
A businessman is considering building a 25-unit apartment in a place near a
progressive commercial center. He felt that because of the location of the
apartment it will be occupied 90% at all time. He desires a rate of return of 20%.
Other pertinent data are the following:
 Examples
Annual income:

Solution
 Examples
Annual Cost:

Solution
 Examples
Annual Cost:

Solution

The businessman should not invest.

 Examples

Another Solution:

The businessman should not invest.

 Examples
Annual Cost:

Another Solution:

The businessman should not invest.

 Examples
Annual Cost:

Another Solution:

The businessman should not invest.

(The negative sign for depreciation means that the value of the
investment has increased after 20 years.)
 Examples
A man is considering investing ₱500,000 to open a semi-automatic autowashing
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
P25. 00 per hour. He expects to charge ₱25.00 for a car wash. Out-of-pocket
miscellaneous cost would be ₱8,500 per month.

He would pay his employees for 2 week for vacations each year. Because of the length
of his lease, he must write off his investment within 5 years. His capital now is
earning
15%, and he is employed at a steady job that pays ₱25,000 per month. He desires
a rate of return of at least 20% on his investment.
 Examples
By rate of return method:

Solution

The businessman should not invest.

 Examples
By rate of return method:

Solution

The man should invest

 Examples
By the annual worth method:

Solution

Since the excess of annual

revenue over the annual
cost is greater than zero,
the investment is justified.
The man should invest. The businessman should not invest.
 Examples
A proposed project will require the immediate investment of ₱50,000 and is
estimated to have year-end revenues and costs as follows:
Year Revenue Costs
1 ₱75,000 ₱60,000
2 ₱90,000 ₱77,500
3 ₱100,000 ₱75,000
4 ₱95,000 ₱80,000
5 ₱60,000 ₱47,500
An additional investment ₱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 of ₱25,000 at that time. Is this a good investment?
 Examples
Solve for the internal rate of return (IRR)
and then decide whether the investment
justified. The internal rate
of return is that rate of return that will
exactly reduce the worth of the investment to
zero atSolution
the end of the
life of the investment. Thus, present worth of
cash inflows minus the present worth of cash
outflows must
equal to zero.

The businessman should not invest.

 Examples

Solution
 Examples

Solution
 Examples

Solution

The investment is not justified. The internal rate of

return of 15.68% is easily obtained in easy investment.
THANK YOU FOR
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