Engineering Economy

Engineering Economy
  Topic 7 – Annuity

 Topic 8 – Gradient

 Topic 9 – Application of Money Time Relationship

 Topic 9.1 – Methods to Evaluate Profitability

 Topic 9.2 – Methods to Evaluate Liquidity

Engineering Economy
 MINIMUM ATTRACTIVE RATE OF
RETURN ( MARR )
Minimum Attractive Rate of Return (MARR) is
usually organization-specific and determined based
on the following:
1. Cost of money available for investment.
2. Number of good projects available for
investment.
3. Risks involved in investment opportunities.

Engineering Economy
 How to Use MARR

Use it as an interest rate to convert cash flows

into equivalent worth at some point in time. The
proposed problem solution (project or alternative)
is profitable if it generates sufficient cash flow to
recover the initial investment and earn an interest
rate that is at least as high as MARR.

Engineering Economy
Engineering Economy
 Methods to Evaluate Profitability

1. Present Worth (PW)

2. Future Worth (FW)
3. Annual Worth (AW)
4. Internal rate of Return (IRR)
5. External Rate of Return (ERR)

Engineering Economy
 Methods to Evaluate Liquidity

1. Simple Payback Period

2. Discounted Payback Period

Engineering Economy
 Present Worth (PW) Method

Based on concept of equivalent worth of all cash

flows relative to the present as a base.

All cash inflows and outflows discounted to present

at interest -- generally MARR.

PW is a measure of how much money can be

afforded for investment in excess of cost.

PW is positive if dollar amount received for

investment exceeds minimum required by investors.

Engineering Economy
 Present Worth (PW) Method

Discount future amounts to the present by using the

interest rate over the appropriate study period
PW =

i = effective interest rate, or MARR per com. period

k = index for each compounding period
Fk = future cash flow at the end of period k
N = number of compounding periods in study period
interest rate is assumed constant through project

The higher the interest rate and further into future a

cash flow occurs, the lower its PWa

Engineering Economy
 Present Worth (PW) Method

1. Compute the present equivalent of the

estimated cash flows using the MARR as the
interest rate.

2. If PW(MARR) ≥ 0, then the project is profitable.

If PW(MARR) < 0, then the project is not
profitable.

Engineering Economy
 Sample Problem - Present Worth
Consider a project that has the following cash flows
over a study period of 5 years:
Initial investment: $100,000
Annual revenues: $40,000
Annual expenses: $5,000
Salvage value: $20,000
MARR: 20%.
PW(20%)= -100,000 + (40,000-5,000)(P/A,20%,5) + 20,000(P/F,20%,5)
=$12,709.

Is this a profitable project? Yes! Because: We recovered $100,000

(investment). We earned an interest rate of 20% which was desired.
We even made a profit that has a present equivalent value of $12,709.

Engineering Economy
Engineering Economy
 Future Worth (FW) Method

FW is based on the equivalent worth of all cash inflows

and outflows at the end of the planning horizon at an
interest rate that is generally MARR.

The FW of a project is equivalent to PW

FW = PW ( F / P, i%, N )

If FW > 0, it is economically justified

FW ( i % ) = FW =

Engineering Economy
 Future Worth (FW) Method

1. Compute the future equivalent of the estimated

cash flows using the MARR as the interest rate.

2. If FW (MARR) ≥ 0, then the project is profitable.

If FW (MARR) < 0, then the project is not
profitable.

Engineering Economy
 Sample Problem - Future Worth
Consider a project that has the following cash flows
over a study period of 5 years:
Initial investment: $100,000
Annual revenues: $40,000
Annual expenses: $5,000
Salvage value: $20,000
MARR: 20%.

FW(20%)= -100,000(F/P,20%,5)+(40,0005,000)(F/A,20%,5) +20,000 =

$31,624.

Is this a profitable project? Yes! Because FW ≥ 0: We earned an interest

rate of 20% which was desired. We even made a profit that has a
future equivalent value of $31,624.
Engineering Economy
Engineering Economy
 Annual Worth (AW) Method

◘ AW is an equal annual series of dollar amounts,

over a stated period ( N ), equivalent to the cash
inflows and outflows at interest rate that is
generally MARR
◘ AW is annual equivalent revenues ( R ) minus
annual equivalent expenses ( E ), less the annual
equivalent capital recovery (CR)
AW ( i % ) = R - E - CR ( i % )
AW = PW ( A / P, i %, N )
AW = FW ( A / F, i %, N )
◘ If AW > 0, project is economically attractive
◘ AW = 0 : annual return = MARR earned

Engineering Economy
 Capital Recovery (CR)

CR is the equivalent uniform annual cost of the capital

invested

CR is an annual amount that covers:

- 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

Engineering Economy
 Capital Recovery (CR)

CR is also calculated by adding sinking fund amount

(i.e., deposit) to interest on original investment
CR ( i % ) = ( I - S ) ( A / F, i %, N ) + I ( i % )

CR is also calculated by adding the equivalent annual

cost of the uniform loss in value of the investment to
the interest on the salvage value
CR ( i % ) = ( I - S ) ( A / P, i %, N ) + S ( i % )

Engineering Economy
 Sample Problem - Annual Worth
Consider a project that has the following cash flows
over a study period of 5 years:
Initial investment: $100,000
Annual revenues: $40,000
Annual expenses: $5,000
Salvage value: $20,000
MARR: 20%.
AW(i%)= R – E - CR(i%)
AW(20%) = 40,000 - 5,000 - 30,752 = $4,249.62

Is this a profitable project? Yes! Because AW ≥ 0: We earned an

interest rate of 20% which was desired. We even made a profit that
has an annual equivalent value of $4,249.62.
Engineering Economy
 Practice Problem
Uncle Tom’s ranch is now for sale for $30,000.
Annual property taxes, maintenance and supplies,
and so on are estimated to continue to be $3,000
per year. Revenues from the ranch are expected to
be $10,000 next year then to decline by $400 per
year thereafter through the 10th year. If you bought
the ranch, you would plan to keep it for only 5 years
and at that time to sell it for the value of the land ,
which is$15,000. If your desires MARR is 12%,
should you become a rancher? Use PW,AW and FW

Engineering Economy
Engineering Economy
 Practice Problem

A piece of new equipment has been proposed by

engineers to increase the productivity of a certain
manual welding operation. The investment cost
$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 $8,000 per year after extra
operating costs have been subtracted from the
revenue generated by the additional production. If
the firm’s MARR is 20% per year, is the proposal a
sound one? Use the (1) PW (2) FW and (3) AW
Method. Draw the cash flow diagram.
Engineering Economy
 The investment cost $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 $8,000 per year after extra operating costs have
been subtracted from the revenue generated by the
additional production. If the firm’s MARR is 20% per year, is
the proposal a sound one? Use the (1) PW (2) FW and (3) AW
Method.

Engineering Economy
 Internal Rate of Return (IRR)

IRR solves for the interest rate that equates the

equivalent worth of an alternative’s cash inflows
(receipts or savings) to the equivalent worth of cash
outflows (expenditures)
Also referred to as:
• investor’s method
• discounted cash flow method
• profitability index
IRR is positive for a single alternative only if:
• both receipts and expenses are present in the cash
flow pattern
• the sum of receipts exceeds sum of cash outflows

Engineering Economy
 Internal Rate of Return (IRR)

The IRR method assumes recovered funds, if not

consumed each time period, are reinvested at i ‘ %,
rather than at MARR

The computation of IRR may be unmanageable

Multiple IRR’s may be calculated for the same

problem

The IRR method must be carefully applied and

interpreted in the analysis of two or more alternatives,
where only one is acceptable

Engineering Economy
 Internal Rate of Return (IRR)

IRR is i’ %, using the following PW formula:

 R k ( P / F, i’ %, k ) =  E k ( P / F, i’ %, k )
R k = net revenues or savings for the kth year
E k = net expenditures including investment costs for the kth
year
N = project life ( or study period )

If i’ > MARR, the alternative is acceptable

To compute IRR for alternative, set net PW = 0

PW =  R k ( P / F, i’ %, k ) -  E k ( P / F, i’ %, k ) = 0
i’ is calculated on the beginning-of-year unrecovered investment
through the life of a project

Engineering Economy
Engineering Economy
 Sample Problem - IRR
Consider a project that has the following cash flows
over a study period of 5 years:
Initial investment: $100,000
Annual revenues: $40,000
Annual expenses: $5,000
Salvage value: $20,000
MARR: 20%.
Solution : We will use trial-and-error and linear interpolation.

PW (il %) = -100, PW (il %) = -100, 000 + (40, 000 - 5, 000)(P/A, il %, 5) + 20,

000(P/F, il%, 5) = 0.

Engineering Economy
 Cont
Start trial-and-error
PW(20%)=12,709. Therefore, iI > 20%. (Remember
the inverse relation between PW and i)
PW(25%)=679.5. Therefore, iI > 25%.
PW(30%)=-9,368.48. Therefore, iI < 30%.
Use linear interpolation to find iI: 25% < iI < 30%.
i% PW i’ = 25.31%
Calcu-shift solve
25% 679.50
i’ 0 i’ = 25.38%
30% -9368.48

MARR(20%), therefore the project is profitable

If i’ > MARR, the alternative is acceptable
Engineering Economy
 External Rate of Return (ERR)

ERR directly takes into account the interest rate (  )

external to a project at which net cash flows
generated over the project life can be reinvested (or
borrowed ).

If the external reinvestment rate, usually the firm’s

MARR, equals the IRR, then ERR method produces
same results as IRR method

Engineering Economy
 External Rate of Return (ERR)

1. All net cash outflows are discounted to the present

(time 0) at  % per compounding period.
2. All net cash inflows are compounded to period N
at  %.
3. ERR -- the equivalence between the discounted
cash inflows and cash outflows -- is determined.
The absolute value of the present equivalent worth
of the net cash outflows at  % is used in step 3.

A project is acceptable when i ‘ % of the ERR

method is greater than or equal to the firm’s
MARR
Engineering Economy
Engineering Economy
 Advantages of ERR over IRR

The ERR can be solved directly, without needing to

resort to trial and error. The ERR is not subject to
the possibility of multiple rates of return.

If the external investment rate (E) happens to equal

the project’s IRR, then the ERR method produces
results identical to those of the IRR method.

Engineering Economy
 Sample Problem - ERR
Consider a project that has the following cash flows
over a study period of 5 years:
Initial investment: $100,000
Annual revenues: $40,000
Annual expenses: $5,000
Salvage value: $20,000
 = MARR: 20%.
100, 000(FIP, i’%, 5) = 35, 000(FIA, 20%, 5) + 20, 000
(FIP, i’%, 5) = 2.8046
(1 + i’)5 = 2.8046 ⇒ i’ = 22.9%.

Therefor the project is profitable.

Engineering Economy
 Sample Problem - ERR
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

i’ = 12.26%
Calcu-shift solve

Engineering Economy
 Practice Problem

a. Determine the IRR of the project. Is it acceptable

b. What is the ERR for this project? Assume that marr= ε =
15% per year.
c. What is the simple payback period for this proposal?

Proposal A
Investment cost $10,000
Expected life 5 years
Market (salvage) value –$1,000
Annual receipts $8,000
Annual expense $4,000

Engineering Economy
 Proposal A
Investment cost $10,000
Expected life 5 years
Market (salvage) value –$1,000
Annual receipts $8,000
Annual expense $4,000
What is the ERR for this project? Assume that marr= ε = 15% per year.
What is the simple payback period for this proposal?

Engineering Economy
 Practice Problem

A project is estimated to cost $100,000, last 8 years,

and have a salvage value of $10,000. The annual
gross income is expected to average $24,000 and
annual expenses excluding depreciation is $6,000. If
capital is earning 10% before income taxes,
determine if this is desirable investment using PW,
AW and IRR

Engineering Economy
 Payback Period

The simple payback period is the number of years

required for cash inflows to just equal cash outflows.

It is a measure of liquidity rather than a measure of

profitability.

Engineering Economy
 Payback Period
Payback is simple to calculate.
The payback period is the smallest value of θ (θ ≤ N)
for which the relationship below is satisfied.

For discounted payback future cash flows are

discounted back to the present, so the relationship
to satisfy becomes

Engineering Economy
 Problems with the payback period
method.

It doesn’t indicate anything about project desirability

except the speed with which the initial investment is
recovered.

Recommendation: use the payback period only as

supplemental information in conjunction with one or
more of the other methods in this chapter.

Engineering Economy
 Year Net Cash flow Cumulative PW @ 0%

Engineering Economy
 Year Net Cash flow Cash flow Yr 0 @15% Cumulative PW @ 15%

Engineering Economy
 Sample – Payback Period
End of Net Cash Cumulative Cumulative
Year Flow PW at 0% PW at 6%
Finding the simple and
discounted payback 0 -$42,000 -$42,000 -$42,000
period for a set of cash
flows. 1 $12,000 -$30,000 -$30,679

The cumulative cash

flows in the table were 2 $11,000 -$19,000 -$20,889
calculated using the
formulas for simple and 3 $10,000 -$9,000 -$12,493
discounted payback.
4 $10,000 $1,000 -$4,572
From the calculations θ
= 4 years and θ' = 5 5 $9,000 $2,153
years.

Engineering Economy
 End of Net Cash Cumulative Cumulative
Year Flow PW at 0% PW at 6%

0 -$42,000 -$42,000 -$42,000

1 $12,000 -$30,000 -$30,679

2 $11,000 -$19,000 -$20,889

3 $10,000 -$9,000 -$12,493

4 $10,000 $1,000 -$4,572

5 $9,000 $2,153

Engineering Economy
 Homework
End of Net Cash Cumulative Cumulative
Year Flow PW at 0% PW at 6%

0 -$42,000 -$42,000 -$42,000

1 $12,000 -$30,000 -$30,679

2 $11,000 -$19,000 -$20,889

3 $10,000 -$9,000 -$12,493

4 $10,000 $1,000 -$4,572

5 $9,000 $2,153

Engineering Economy