Basic Methods of Making Economic

Studies, S5
• Rate of Return Method
– Rate of Return = net annual profit/capital invested
• IRR/ERR
• Annual Worth Method
– If the excess of annual cash inflows over annual cash outflows is not
less than zero, the proposed investment is justified. Includes interest
on investment.
• Present Worth Method
– If the present worth of the net cash flow is equal to or greater than
zero, the proposed investment is justified.
 Basic Methods of Making Economic
Studies
• Future Worth Method
– If the future worth of the net cash flow is equal to or greater than
zero, the proposed investment is justified.
• Payback Period Method
– Payback = (investment – salvage value)/net annual cash flow
 Basic Methods of Making Economic
Studies
Internal Rate of Return
• The internal rate of return (IRR) method is the most widely used rate
of return method for performing engineering economic analysis.
• It is also called the investor’s method, the discounted cash flow
method, and the profitability index.
• If the IRR for a project is greater than an agreed rate, then the project
is acceptable.
 Basic Methods of Making Economic
Studies
• The method of solving for the i'% that equates revenues and expenses
normally involves trial-and-error calculations, or solving numerically
using mathematical software.
• The use of spreadsheet software can greatly assist in solving for the
IRR. Excel uses the IRR(range, guess) or RATE(nper, pmt, pv)
functions.
 Basic Methods of Making Economic
Studies
Reinvesting revenue—the External Rate
of Return (ERR)
• The IRR assumes revenues generated are reinvested at the IRR—
which may not be an accurate situation.
• The ERR takes into account the interest rate, ε, external to a project at
which net cash flows generated (or required) by a project over its life
can be reinvested (or borrowed). This is usually the MARR*.
• If the ERR happens to equal the project’s IRR, then using the ERR and
IRR produce identical results.

*MARR – Min. Attractive Rate of Return (hurdle rate)

 Basic Methods of Making Economic
Studies
Applying the ERR method
For the cash flows given below, find the ERR when the external
reinvestment rate is ε = 12% (equal to the MARR).

Year 0 1 2 3 4
Cash Flow -$15,000 -$7,000 $10,000 $10,000 $10,000

Expenses

Revenue

Solving, we find
 Basic Methods of Making Economic
Studies
Present Worth Example
Consider a project that has an initial investment of P50,000 and that returns
P18,000 per year for the next four years. If the expected return is 12%, is this
a good investment?

PW = -50,000 + 18,000 (P/A, 12%, 4)

PW = -50,000 + 18,000 (3.0373)

PW = P4,671.40  This is a good investment!

 Basic Methods of Making Economic
Studies
Future Worth example
A $45,000 investment in a new conveyor system is projected to improve
throughput and increasing revenue by $14,000 per year for five years. The
conveyor will have an estimated market value of $4,000 at the end of five
years. Using FW and a MARR of 12%, is this a good investment?

FW = -$45,000(F/P, 12%, 5)+$14,000(F/A, 12%, 5)+$4,000

FW = -$45,000(1.7623)+$14,000(6.3528)+$4,000
FW = $13,635.70  This is a good investment!
 Basic Methods of Making Economic
Studies
Annual Worth (AW) is another way to
assess projects.
• Annual worth is an equal periodic series of dollar amounts that is
equivalent to the cash inflows and outflows, at an interest rate that is
generally the MARR.
• The AW of a project is annual equivalent revenue or savings minus
annual equivalent expenses, less its annual capital recovery (CR)
amount.
 Basic Methods of Making Economic
Studies
Capital recovery reflects the capital cost
of the asset.
• CR is the annual equivalent cost of the capital invested.
• The CR covers the following items.
– Loss in value of the asset.
– Interest on invested capital (at the MARR).
• The CR distributes the initial cost (I) and the salvage value (S) across
the life of the asset.
 Basic Methods of Making Economic
Studies
A project requires an initial investment of $45,000, has a salvage value of
$12,000 after six years, incurs annual expenses of $6,000, and provides an
annual revenue of $18,000. Using a MARR of 10%, determine the AW of
this project.

Since the AW is positive, it’s a good investment.

 Basic Methods of Making Economic
Finding the simple and Studies
End of
Year
Net Cash Cumulative Cumulative
Flow PW at 0% PW at 6%
discounted payback period
for a set of cash flows.
0 -$42,000 -$42,000 -$42,000

• The cumulative cash

flows in the table were 1 $12,000 -$30,000 -$30,679
calculated using the
formulas for simple and
2 $11,000 -$19,000 -$20,889
discounted payback.
• From the calculations θ
= 4 years and θ' = 5 3 $10,000 -$9,000 -$12,493
years.
4 $10,000 $1,000 -$4,572

5 $9,000 $2,153
 Sample, S5
A man is considering investing P500,000 to open a semi automatic auto-
washing 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/week, 50 weeks/yr. He
will pay his employees P25/hr. He expects to charge P25 for a car wash. Out-
of-pocket misc. cost would be P8,500/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
P25,000/month. He desired a rate of return of at least 20% on his
investment. Would you recommend the investment?
Solution:
By the rate of return method
Annual revenue =12x25x8x6x50 = P720,000
Annual costs:
Depreciation = P500,000/(F/A,15%,5) = P 74,160
Labor = 2x48x50xP25 = 120,000
Vacation pay = 2x2x48xP25 = 4,800
Misc. = P8500 x 12 = 102,000
Owner’s salary = P25000x12 = 300,000
Net annual profit P119,040

Rate of return = P119,040/P500,000 x100=23.81%

Owner should invest.
Solution:
By the annual worth method
Annual revenue =12x25x8x6x50 = P720,000
Annual costs:
Depreciation = P500,000/(F/A,15%,5) = P 74,160
Labor = 2x48x50xP25 = 120,000
Vacation pay = 2x2x48xP25 = 4,800
Misc. = P25000 x 12 = 300,000
Interest on capital= P500000x0.20 = 100,000
Net annual profit P 19,040

Since there is profit, the investment is justified.

Owner should invest.
 Sample
A company has a contract with a hauler to transport its naptha requirements
of 3,600,000 liter/year from a refinery in Batangas to its site in Paco at a cost
of P1.05/Liter. It is proposed that the company buys a tanker with a capacity
of 18,000 liters to service its requirements at a first cost of P8,000,000, life is
6 years and a salvage value of P800,000. Other expenses are as follows:
(a) Diesel fuel at P7.95/Li and tanker consumes 120 Li/round trip from Paco to
Batangas and back.
(b) Lube oil and servicing is P3,200/month.
(c) Labor including OT and fringe benefits for 1 driver and 1 helper is
P21,000/month.
(d) Annual taxes and insurance, 5% of first cost
(e) General maintenance/year is P40,000
(f) Tires cost P32,000 per set and will be renewed every 150 round trips.
What should the company do if a 15% interest rate on investment is included
in the analysis?
Solution:
Hauling cost = P1.05 x 3600000 = P3,780,000
Buy tanker:
Depreciation = (P8000000-P800000)/(F/A,15%,6)
Fuel = 3600000/18000x120xP7.95
Lube oil = P3200x12
Labor = P21,000x12
Taxes & Insu. = P8000000x0.05
Maintenance = P40,000
Tires = 3600000/(18000x15) x P32000
Annual cost = P1,786,442

Annual savings = P3780000-1786442=P1993550

Rate of return = P1993550/8000000x100=24.92%
The company should buy tanker.
Figure 5-7 Spreadsheet Solution, Example
5-13 (a) Direct Computation of IRR
Figure 5-6 Spreadsheet Solution, Example
5-12
 Sample Problems
1) A father, on the day his son is born, wishes to determine what lump
amount would have to be paid into an account bearing interest of 12%
per year to provide withdrawals of P2,000 on each of the son’s 18th, 19th,
20th, and 21st birthdays.
2) What is the present equivalent value of BP’s proposed payment
schedule? Recall that BP will pay USD3B at the end of Q3 2010 and
another USD2B in the fourth quarter of 2010. Twelve additional
payments of USD1.25B having been paid into the fund. The interest rate
is 3% compounded quarterly.
3) A new municipal refuse-collection truck can be purchased for $84,000.
Its expected useful life is 6 years, at which time its market value will be
zero. Annual receipts less expenses will be approximately $18,000 per
year over the 6 year study period. Use the PW method and a MARR of
18% to determine whether this is a good investment.
4) The winner of a PAGCOR lottery will receive P5,000 per week for the rest
of her life. If the winner’s interest rate is 6.5% per year compounded
weekly, what is the PW of this jackpot?
Solution:
1) P17 = A (P/A, 12%, 4) = F17; P0 = F17 (P/F, 12%, 17)
2) P = USD3B (P/F,3%,1) + USD2B (P/F,3%,2) + USD1.25B
(P/A,3%,12)(P/F,3%,2)
3) PW(18%) = −$84,000 + $18,000 (P/A, 18%, 6) = −$21,043.
Since PW < 0, this is not an acceptable investment
4) The weekly interest rate equals 6.5% / 52, or 0.125% per week.
The present worth of an indefinitely long payout period is P5,000 /
0.00125 = P4,000,000.