Engineering
Economy
UNIT 3
Basic Economy
Study Methods
• Understand the use of (Minimum
Attractive Rate of Return) MARR in
economy study;
• Evaluate an investment or project
through annual worth, present worth,
Objective future worth, internal rate of return,
external rate of return, discounted
payback period and cost/benefit ratio
method; and
• Evaluate economic alternatives using
methods discussed.
Is the project or investment worth pursuing?
• Capital required
• Expected annual income
• Expected annual expenses
• Net profit
• Rate of return
• Effects of intangible factors
• Risks
The Minimum Attractive
Rate of Return /
Hurdle Rate
Determining the MARR (Hurdle Rate)
The amount of money available for investment, and the source and cost
of these funds (equity or liability)
The number of good projects available for investment and their purpose
(essential or elective)
The amount of perceived risk associated with investment opportunities
and estimated cost of administering projects
The type of organization involved
Annual Worth
Method
Annual Worth Method
• An equal annual series of peso amounts, over a stated period (N),
equivalent to the cash inflows and outflows at interest rate that is
generally MARR
𝐴𝐴𝐴𝐴 𝑖𝑖𝑖 = 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 − 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 − 𝐶𝐶𝐶𝐶(𝑖𝑖𝑖)
𝐶𝐶𝐶𝐶 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑖𝑖𝑖𝑖 𝑡𝑡𝑡𝑡𝑡 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑜𝑜𝑜𝑜 𝑡𝑡𝑡𝑡𝑡 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖
𝐶𝐶𝐶𝐶 % = 𝐼𝐼(𝐴𝐴⁄𝑃𝑃, 𝑖𝑖𝑖, 𝑁𝑁) − 𝑆𝑆(𝐴𝐴⁄𝐹𝐹, 𝑖𝑖𝑖, 𝑁𝑁)
` CR =
𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤 𝐼𝐼 = 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 𝑓𝑓𝑓𝑓𝑓𝑓 𝑡𝑡𝑡𝑡𝑡 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝, 𝑜𝑜𝑜𝑜 𝑃𝑃𝑃𝑃 𝑜𝑜𝑜𝑜 𝑎𝑎𝑎𝑎𝑎𝑎 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎
𝑆𝑆 = 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣 𝑎𝑎𝑎𝑎 𝑡𝑡𝑡𝑡𝑡 𝑒𝑒𝑒𝑒𝑒𝑒 𝑜𝑜𝑜𝑜 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 𝑁𝑁
Annual Worth Method
E+CR E+CR E+CR E+CR E+CR E+CR E+CR
0 1 2 3 4 5 6 N
R R R R R R R
MARR=i
Decision Rule: If AW(i=MARR)≥0, the project is
economically justified.
Capital Recovery
I=initial
investment A1 = uniform amounts of initial investment
A1 A1 A1 A1 A1 A1 A1
MARR=i
0 1 2 3 4 5 6 N
A2 A2 A2 A2 A2 A2 A2
S=salvage
A2 = uniform amounts of salvage value value
A project is estimated to cost ₱100,000,000,
it will last 8 years and have a salvage value
of ₱10,000,000. The annual gross income is
expected to average ₱24,000,000 and
annual expenses, excluding depreciation,
will total ₱6,000,000. If capital is earning
10% before income taxes, determine if this
is a desirable project.
Given:
I=100M E=6M annually MARR = 10%
0 1 2 3 4 5 6 7 8
S=10M
R=24M annually
Required: AW evaluation
.10 .10
Solution: AW = 24M − 6M − 100𝑀𝑀 − 10𝑀𝑀
1−(1+.10)−8 (1+.10)8 −1
𝐀𝐀𝐀𝐀 = ₱130,038.42
AW>0 thus project is desirable
Equivalent Uniform Annual Cost
E+CR E+CR E+CR E+CR E+CR E+CR E+CR
0 1 2 3 4 5 6 N
MARR=i
Decision Rule: low-valued EUAC(%) is preferred
Given:
Present Set-up
E=600,000kwh x ₱8.81 per kWh = ₱5,286,000
0 1 2 3 4 5 15
MARR = 15%
Proposed Set-up
I=20M E=800,000 + 600,000 + 0.06(20M) = 2,600,000
0 1 2 3 4 5 15
MARR = 15%
S=2M
Required: EUAC evaluation A food processing plant consumed 600,000
kWh of electric energy annually and pays an
Solution: average of ₱8.81 per kWh. A study is being
Present Set-up made to generate its own power to supply the
energy requirements. Installation would cost
EUAC=600,000kwh x ₱8.81 per kWh = ₱5,286,000
₱20,000,000. Annual operation and
Proposed Set-up
maintenance is ₱800,000. Other expenses of
.15 .15
EUAC = 2.6M + 20𝑀𝑀 − 2𝑀𝑀 ₱600,000 per year. Life of the power plant is
1−(1+.15)−15 (1+.15)15 −1
15 years with salvage value of 10% of
EUAC = ₱5,978,306.95 installation cost. Annual taxes and insurance is
The EUAC value of present set-up is closer to 0, 6% of first cost, and rate of interest is 15%.
thus the proposed power plant is not justifiable.
Determine if the power plant is justifiable.
Present Worth
Method
Present Worth Method
• Based on the concept of equivalent worth of all cash flows
relative to some base or beginning point in time called the
present
• A measure of how much money can be afforded for
investment in excess of cost
𝑁𝑁
𝑃𝑃𝑃𝑃 𝑖𝑖𝑖 = � 𝐹𝐹𝑘𝑘 (1 + 𝑖𝑖)−𝑘𝑘
𝑘𝑘=0
𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤 𝑘𝑘 = 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 𝑓𝑓𝑓𝑓𝑓𝑓 𝑒𝑒𝑒𝑒𝑒𝑒𝑒 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 0 ≤ 𝑘𝑘 ≤ 𝑁𝑁 ;
𝐹𝐹𝑘𝑘 = 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓 𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓 𝑎𝑎𝑎𝑎 𝑡𝑡𝑡𝑡𝑡 𝑒𝑒𝑒𝑒𝑒𝑒 𝑜𝑜𝑜𝑜 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 𝑘𝑘
Present Worth Method
• Based on the concept of equivalent worth of all cash flows
relative to some base or beginning point in time called the
present
• A measure of how much money can be afforded for
investment in excess of cost
𝑃𝑃𝑃𝑃 = 𝑃𝑃𝑃𝑃 𝑜𝑜𝑜𝑜 𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 − 𝑃𝑃𝑃𝑃 𝑜𝑜𝑜𝑜 𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜
Present Worth Method
E E E E E E E
0 1 2 3 4 5 6 N
Net
Present R R R R R R R
Worth MARR=i
Decision Rule: If PW(i=MARR)≥0, the project is
economically justified.
A project is estimated to cost ₱100,000,000,
it will last 8 years and have a salvage value
of ₱10,000,000. The annual gross income is
expected to average ₱24,000,000 and
annual expenses, excluding depreciation,
will total ₱6,000,000. If capital is earning
10% before income taxes, determine if this
is a desirable project.
Given:
I=100M E=6M annually MARR = 10%
0 1 2 3 4 5 6 7 8
S=10M
R=24M annually
Required: PW evaluation
1−(1+.10)−8 1−(1+.10)−8
Solution: PW = 24M − 6M − [100𝑀𝑀 −
.10 .10
−8 ]
10𝑀𝑀(1 + .10)
𝐏𝐏𝐏𝐏 = ₱693,745.36
PW>0 thus project is desirable
Given:
Present Set-up
E=600,000kwh x ₱8.81 per kWh = ₱5,286,000
0 1 2 3 4 5 15
MARR = 15%
Proposed Set-up
I=20M E=800,000 + 600,000 + 0.06(20M) = 2,600,000
0 1 2 3 4 5 15
MARR = 15%
S=2M
Required: PW evaluation A food processing plant consumed 600,000
kWh of electric energy annually and pays an
Solution: average of ₱8.81 per kWh. A study is being
Present Set-up made to generate its own power to supply
PW = −5,286,000
1−(1+.15)−15 the energy requirements. Installation would
.15 cost ₱20,000,000. Annual operation and
PW = − ₱30,909,198.34 maintenance is ₱800,000. Other expenses of
Proposed Set-up ₱600,000 per year. Life of the power plant is
1−(1+.15)−15 15 years with salvage value of 10% of
PW = −2,600,000 − 20𝑀𝑀 − 2𝑀𝑀(1 + .15)−15 installation cost. Annual taxes and insurance is
.15
PW = − ₱34,957,373.29 6% of first cost, and rate of interest is 15%.
The PW of present set-up is closer to 0, thus the Determine if the power plant is justifiable.
proposed power plant is not justifiable.
Future Worth
Method
Future Worth Method
• Based on the equivalent worth of all cash inflows and outflows
at the end of the planning horizon (N) at an interest rate that is
generally the MARR
• Useful in capital investment decision situations
𝐹𝐹𝐹𝐹 = 𝐹𝐹𝐹𝐹 𝑜𝑜𝑜𝑜 𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 − 𝐹𝐹𝐹𝐹 𝑜𝑜𝑜𝑜 𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜
Future Worth Method
• Based on the equivalent worth of all cash inflows and outflows
at the end of the planning horizon (N) at an interest rate that is
generally the MARR
• Useful in capital investment decision situations
𝑁𝑁
𝐹𝐹𝐹𝐹 𝑖𝑖𝑖 = � 𝐹𝐹𝑘𝑘 (1 + 𝑖𝑖)𝑁𝑁−𝑘𝑘
𝑘𝑘=0
𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤 𝑘𝑘 = 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 𝑓𝑓𝑓𝑓𝑓𝑓 𝑒𝑒𝑒𝑒𝑒𝑒𝑒 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 0 ≤ 𝑘𝑘 ≤ 𝑁𝑁 ;
𝐹𝐹𝑘𝑘 = 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓 𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓 𝑎𝑎𝑎𝑎 𝑡𝑡𝑡𝑡𝑡 𝑒𝑒𝑒𝑒𝑒𝑒 𝑜𝑜𝑜𝑜 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 𝑘𝑘
Future Worth Method
Net
Future
E E E E E E E Worth
0 1 2 3 4 5 6 N
R R R R R R R
MARR=i
Decision Rule: If FW(i=MARR)≥0, the project is
economically justified.
A project is estimated to cost ₱100,000,000,
it will last 8 years and have a salvage value
of ₱10,000,000. The annual gross income is
expected to average ₱24,000,000 and
annual expenses, excluding depreciation,
will total ₱6,000,000. If capital is earning
10% before income taxes, determine if this
is a desirable project.
Given:
I=100M E=6M annually MARR = 10%
0 1 2 3 4 5 6 7 8
S=10M
R=24M annually
Required: FW evaluation
(1+.10)8 −1 (1+.10)8 −1
Solution: FW = 24M − 6𝑀𝑀 −
.10 .10
8
100𝑀𝑀(1 + .10) −10𝑀𝑀
𝐅𝐅𝐅𝐅 = ₱1,487,104.80
FW>0 thus project is desirable
Given:
Present Set-up
E=600,000kwh x ₱8.81 per kWh = ₱5,286,000
0 1 2 3 4 5 15
MARR = 15%
Proposed Set-up
I=20M E=800,000 + 600,000 + 0.06(20M) = 2,600,000
0 1 2 3 4 5 15
MARR = 15%
S=2M
Required: FW evaluation A food processing plant consumed 600,000
kWh of electric energy annually and pays an
Solution: average of ₱8.81 per kWh. A study is being
Present Set-up made to generate its own power to supply
FW = −5,286,000
(1+.15)15 −1 the energy requirements. Installation would
.15 cost ₱20,000,000. Annual operation and
FW = − ₱251,510,051.80 maintenance is ₱800,000. Other expenses of
Proposed Set-up ₱600,000 per year. Life of the power plant is
(1+.15)15 −1 15 years with salvage value of 10% of
FW = −2,600,000 − 20𝑀𝑀(1 + .15)15 −2𝑀𝑀 installation cost. Annual taxes and insurance is
.15
FW = − ₱284,450,300.80 6% of first cost, and rate of interest is 15%.
The FW of present set-up is closer to 0, thus the Determine if the power plant is justifiable.
proposed power plant is not justifiable.
Internal Rate of
Return
Internal Rate of Return Method
• Also called the investor’s method, the discounted cash-flow
method, and the profitability index
• Solves for the interest rate that equates the equivalent worth
of an alternative’s cash inflows to the equivalent worth of cash
outflows
𝑁𝑁 𝑁𝑁
� 𝑅𝑅𝑘𝑘 (𝑃𝑃⁄𝐹𝐹, 𝑖𝑖 ′ %, 𝑘𝑘) = � 𝐸𝐸𝑘𝑘 (𝑃𝑃⁄𝐹𝐹, 𝑖𝑖 ′ %, 𝑘𝑘),
𝑘𝑘=0 𝑘𝑘=0
𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤 𝑅𝑅𝑘𝑘 = 𝑛𝑛𝑛𝑛𝑛𝑛 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 𝑜𝑜𝑜𝑜 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 𝑓𝑓𝑓𝑓𝑓𝑓 𝑡𝑡𝑡𝑡𝑡 𝑘𝑘𝑘𝑘𝑘 𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦;
𝐸𝐸𝑘𝑘 = 𝑛𝑛𝑛𝑛𝑛𝑛 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒, 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 𝑎𝑎𝑎𝑎𝑎𝑎 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑓𝑓𝑓𝑓𝑓𝑓 𝑡𝑡𝑡𝑡𝑡 𝑘𝑘𝑘𝑘𝑘 𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦
Internal Rate of Return Method
• Also called the investor’s method, the discounted cash-flow
method, and the profitability index
• Solves for the interest rate that equates the equivalent worth
of an alternative’s cash inflows to the equivalent worth of cash
outflows
𝑁𝑁𝑁𝑁𝑁𝑁 = 𝑃𝑃𝑃𝑃 𝑜𝑜𝑜𝑜 𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 − 𝑃𝑃𝑃𝑃 𝑜𝑜𝑜𝑜 𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜
NPV = 0; thus PW of cash inflows = PW of cash outflows
Internal Rate of Return Method
E E E E E E E
i’%=IRR
0 1 2 3 4 5 6 N
Net
R R R R R R R
Present
Worth
Decision Rule: If IRR≥MARR, the project is
economically justified.
A project is estimated to cost ₱100,000,000,
it will last 8 years and have a salvage value
of ₱10,000,000. The annual gross income is
expected to average ₱24,000,000 and
annual expenses, excluding depreciation,
will total ₱6,000,000. If capital is earning
10% before income taxes, determine if this
is a desirable project.
Given:
I=100M E=6M annually MARR = 10%
0 1 2 3 4 5 6 7 8
S=10M
R=24M annually
Required: IRR evaluation
1 − (1 + 𝑖𝑖𝑖)−8 1 − 1 + 𝑖𝑖 ′ −8
Solution: 24M = −6𝑀𝑀
𝑖𝑖𝑖 𝑖𝑖 ′
− 100𝑀𝑀 − 10𝑀𝑀(1 + 𝑖𝑖𝑖)−8
𝐢𝐢𝐢 = 10.18% 10.18%>10% thus project is desirable
In building their plant, the officers of the Maxims
Leather Company is considering a plant in Davao
City where the plant would cost ₱20,000,000.
Revenues will be ₱5,000,000 for the first 3 years
and will increase to ₱6,000,000 on 4th year to 10th
year. Annual Labor would cost ₱1,200,000 and
annual overhead ₱400,000. Taxes and insurance
would total 5% of the first cost of the plant. If the
company’s capital is already earning 20%, is this a
good investment?
Given:
I=20M E=1.2M+400K+0.5(20M) = 2.6M annually Solution:
1 − (1 + 𝑖𝑖𝑖)−3 1 − (1 + 𝑖𝑖𝑖)−7
5M + 6M (1 + 𝑖𝑖𝑖)−3
0 1 2 3 4 5 6 7 8 9 10
𝑖𝑖𝑖 𝑖𝑖𝑖
MARR = 20%
1 − 1 + 𝑖𝑖 ′ −10
= 2.6𝑀𝑀 + 20𝑀𝑀
R=5M
𝑖𝑖 ′
R=6M
Required: IRR evaluation i’ = 8.24%
8.24%<20% not a good investment
External Rate of
Return
External Rate of Return Method
• A simplified modification of the IRR that resolves some issues
with the IRR (reinvestment assumption, possible multiple
interest rates)
• Used whenever multiple IRRs are possible
𝑁𝑁 𝑁𝑁
� 𝐸𝐸𝑘𝑘 (𝑃𝑃⁄𝐹𝐹, ∈ %, 𝑘𝑘)(𝐹𝐹 ⁄𝑃𝑃, 𝑖𝑖 ′ %, 𝑁𝑁) = � 𝑅𝑅𝑘𝑘 (𝐹𝐹 ⁄𝑃𝑃, ∈ %, 𝑁𝑁 − 𝑘𝑘),
𝑘𝑘=0 𝑘𝑘=0
𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤 𝑅𝑅𝑘𝑘 = 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 𝑜𝑜𝑜𝑜 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 𝑖𝑖𝑖𝑖 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 𝑘𝑘;
𝐸𝐸𝑘𝑘 = 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 𝑜𝑜𝑜𝑜 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 𝑖𝑖𝑖𝑖 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 𝑘𝑘;
∈= 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 𝑝𝑝𝑝𝑝𝑝𝑝 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝
Steps in calculating the ERR:
1. All net cash outflows are discounted to time zero (the
present) at ∈% per compounding period
2. All net cash inflows are compounded to period N at ∈%.
3. The ERR (i’), which is the interest rate that establishes
equivalence between the two quantities is determined
𝑁𝑁 𝑁𝑁
� 𝐸𝐸𝑘𝑘 (𝑃𝑃⁄𝐹𝐹, ∈ %, 𝑘𝑘)(𝐹𝐹 ⁄𝑃𝑃, 𝑖𝑖 ′ %, 𝑁𝑁) = � 𝑅𝑅𝑘𝑘 (𝐹𝐹 ⁄𝑃𝑃, ∈ %, 𝑁𝑁 − 𝑘𝑘),
𝑘𝑘=0 𝑘𝑘=0
𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤 𝑅𝑅𝑘𝑘 = 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 𝑜𝑜𝑜𝑜 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 𝑖𝑖𝑖𝑖 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 𝑘𝑘;
𝐸𝐸𝑘𝑘 = 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 𝑜𝑜𝑜𝑜 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 𝑖𝑖𝑖𝑖 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 𝑘𝑘;
∈= 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 𝑝𝑝𝑝𝑝𝑝𝑝 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝
External Rate of Return Method
E i’%=ERR
0 1 2 3 4 5 6 N
Decision Rule: If ERR≥MARR, the project is
economically justified.
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
salvage value of 5,000 at the end of its expected life of five
years. Increase productivity attributable to the equipment will
amount to 8,000 per year after extra operating costs have been
subtracted from the value of the additional production. Is the
investment a good one? Recall that the MARR is 20% per year.
Given: Subtract Expenses to Revenues Solution:
I=25K 5
(1 + .20) −1
25,000(1 + 𝑖𝑖𝑖)5 = 8,000 + 5,000
.20
0 1 2 3 4 5
S=5K 𝐢𝐢𝐢 = 20.88%
MARR = 20%
R=8K annually
20.88%>20% thus project is desirable
Required: ERR evaluation
A project is estimated to cost ₱100,000,000,
it will last 8 years and have a salvage value
of ₱10,000,000. The annual gross income is
expected to average ₱24,000,000 and
annual expenses, excluding depreciation,
will total ₱6,000,000. If capital is earning
10% before income taxes, determine if this
is a desirable project.
Given: Subtract Expenses to Revenues
I=100M MARR = 10%
0 1 2 3 4 5 6 7 8
S=10M
R=18M annually
Required: ERR evaluation
8
(1 + .10) −1
Solution: 100𝑀𝑀(1 + 𝑖𝑖𝑖)8 = 18M + 10M
.10
𝐢𝐢𝐢 = 10.07% 10.07%>10% thus project is desirable
In building their plant, the officers of the Maxims
Leather Company is considering a plant in Davao
City where the plant would cost ₱20,000,000.
Revenues will be ₱5,000,000 for the first 3 years
and will increase to ₱6,000,000 on 4th year to 10th
year. Annual Labor would cost ₱1,200,000 and
annual overhead ₱400,000. Taxes and insurance
would total 5% of the first cost of the plant. If the
company’s capital is already earning 20%, is this a
good investment?
Given: Subtract Expenses to Revenues
I=20M Solution:
20M(1 + 𝑖𝑖𝑖)10
0 1 2 3 4 5 6 7 8 9 10 (1 + .20)7 −1 (1 + .20)3 −1
MARR = 20% = 3.4𝑀𝑀 + 2.4M (1 + .20)7
.20 .20
R=2.4M
R=3.4M i’ = 14.16%
Required: ERR evaluation
14.16%<20% not a good investment
Discounted Payback
Period
Discounted Payback Period Method
• Tells how long it takes cash inflows from a project to
accumulate to equal (or exceed) the project’s cash outflows
• Measures project’s liquidity; use as supplemental information
𝜃𝜃𝜃
� (𝑅𝑅𝑘𝑘 −𝐸𝐸𝑘𝑘 )(𝑃𝑃⁄𝐹𝐹, 𝑖𝑖𝑖, 𝑘𝑘) − 𝐼𝐼 ≥ 0,
𝑘𝑘=1
𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤 𝐼𝐼 = 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 𝑎𝑎𝑎𝑎 𝑡𝑡𝑡𝑡𝑡 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡;
𝑖𝑖𝑖 = 𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀;
𝜃𝜃 ′ = 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣 𝑡𝑡𝑡𝑡𝑡𝑡𝑡 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 𝑡𝑡𝑡𝑡𝑡 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒
Discounted Payback Period Method
I
E E E E E E E
0 1 2 3 4 5 6 N
Net R R R R R R R
Present i’%=MARR
Worth
𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑎𝑎𝑎𝑎 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 𝑜𝑜𝑜𝑜 𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦
𝑃𝑃𝑃𝑃 = 𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦 𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 +
𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑 𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦
EOY Net Cash Flow PW Cumulative PW Given:
I=100M E=6M annually
0 -₱100,000,000 -₱100,000,000 -₱100,000,000
0 1 2 3 4 5 6 7 8
1 ₱18,000,000 16,363,636.36 - 83,636,363.64 MARR = 10% S=10M
2 ₱18,000,000 14,876,033.06 - 68,760,330.58
R=24M annually
3 ₱18,000,000 13,523,666.42 - 55,236,664.16
4 ₱18,000,000 12,294,242.20 - 42,942,421.97 Required: PP
5 ₱18,000,000 11,176,583.82 - 31,765,838.15
Solution:
6 ₱18,000,000 10,160,530.74 - 21,605,307.41 12,368,461.28
PP = 7+
7 ₱18,000,000 9,236,846.13 - 12,368,461.28 13,062,206.65
8 ₱28,000,000 PP = 7.95 years
13,062,206.65 693,745.36
A project is estimated to cost ₱100,000,000, it will last 8 years and have
a salvage value of ₱10,000,000. The annual gross income is expected
to average ₱24,000,000 and annual expenses, excluding depreciation,
will total ₱6,000,000. If capital is earning 10% before income taxes,
determine the payback period.
Benefit-Cost Ratio
Benefit-Cost Ratio Method
• An indicator showing the relationship between the relative
costs and benefits of a proposed project, expressed in
monetary or qualitative terms
𝑃𝑃𝑃𝑃 𝑜𝑜𝑜𝑜 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵
𝐵𝐵𝐵𝐵𝐵𝐵 =
𝑃𝑃𝑃𝑃 𝑜𝑜𝑜𝑜 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶
Benefit-Cost Ratio Method
E E E E E E E
0 1 2 3 4 5 6 N
Net
Present
Worth
R R R R R R i% R
Decision Rule: If BCR>1, the project is
economically justified.
A project is estimated to cost ₱100,000,000,
it will last 8 years and have a salvage value
of ₱10,000,000. The annual gross income is
expected to average ₱24,000,000 and
annual expenses, excluding depreciation,
will total ₱6,000,000. If capital is earning
10% before income taxes, determine if this
is a desirable project.
Given:
I=100M E=6M annually MARR = 10%
0 1 2 3 4 5 6 7 8
S=10M
R=24M annually
Required: BCR evaluation
1−(1+.10)−8
Solution: 24M
.10
+10𝑀𝑀(1+.10)−8
BCR = 1−(1+.10)−8
100𝑀𝑀+6M
.10
𝐁𝐁𝐁𝐁𝐁𝐁 = 𝟏𝟏. 𝟎𝟎𝟎𝟎𝟎𝟎 1.005>1 thus project is desirable
In building their plant, the officers of the Maxims
Leather Company is considering a plant in Davao
City where the plant would cost ₱20,000,000.
Revenues will be ₱5,000,000 for the first 3 years
and will increase to ₱6,000,000 on 4th year to 10th
year. Annual Labor would cost ₱1,200,000 and
annual overhead ₱400,000. Taxes and insurance
would total 5% of the first cost of the plant. If the
company’s capital is already earning 20%, is this a
good investment?
Given:
I=20M E=1.2M+400K+0.5(20M) = 2.6M annually Solution:
1−(1+.20)−3 1−(1+.20)−7
5M +6M (1+.20)−3
.20 .20
0 1 2 3 4 5 6 7 8 9 10
BCR = 1−(1+.20)−10
MARR = 20% 20𝑀𝑀+2.6𝑀𝑀
.20
R=5M BCR = 0.745
R=6M
Required: BCR evaluation
0.745<1 not a good investment
“Knowledge will give you power,
but character respect.”
Bruce Lee
Method Equations
Single Payment Method 𝐹𝐹 = 𝑃𝑃(1 + 𝑖𝑖)𝑛𝑛
𝑃𝑃 = 𝐹𝐹(1 + 𝑖𝑖)−𝑛𝑛
PW Ordinary Annuity 1−(1+𝑖𝑖)−𝑛𝑛
PW = A
𝑖𝑖
FW Ordinary Annuity (1+𝑖𝑖)𝑛𝑛 −1
FW = A
𝑖𝑖
Deferral factor (1 + 𝑖𝑖)−𝑘𝑘 if present worth
(1 + 𝑖𝑖)𝑘𝑘 if future worth
1−(1+𝑖𝑖)−𝑛𝑛 𝐺𝐺 1−(1+𝑖𝑖)−𝑛𝑛 𝑛𝑛
PW = A + −
Arithmetic Gradient 𝑖𝑖 𝑖𝑖 𝑖𝑖 1+𝑖𝑖 𝑛𝑛
(1+𝑖𝑖)𝑛𝑛 −1 𝐺𝐺 (1+𝑖𝑖)𝑛𝑛 −1
FW = A + − 𝑛𝑛
𝑖𝑖 𝑖𝑖 𝑖𝑖
1−(1+𝑔𝑔)𝑛𝑛 (1+𝑖𝑖)−𝑛𝑛
PW = A
Geometric Gradient 𝑖𝑖−𝑔𝑔
(1+𝑖𝑖)𝑛𝑛 −(1+𝑔𝑔)𝑛𝑛
FW = A
𝑖𝑖−𝑔𝑔
Method Equations Decision Rule
Annual Worth AW = Revenues – Expenses – Capital Recovery If AW >= 0, project
Method AW = R − E − 𝐼𝐼
𝑖𝑖
− 𝑆𝑆
𝑖𝑖 is economically
1−(1+𝑖𝑖)−𝑛𝑛 (1+𝑖𝑖)𝑛𝑛 −1 justified
Equivalent EUAC = E + CR Low-valued
Uniform Annual EUAC = E + 𝐼𝐼
𝑖𝑖
− 𝑆𝑆
𝑖𝑖 EUAC(%) is
Cost 1−(1+𝑖𝑖)−𝑛𝑛 (1+𝑖𝑖)𝑛𝑛 −1 preferred
Present Worth PW = Revenues – Expenses – Capital Recovery If PW >=0, project
Method 1−(1+𝑖𝑖)−𝑛𝑛 1−(1+𝑖𝑖)−𝑛𝑛 is economically
PW = R −E − [𝐼𝐼 −
−𝑛𝑛
𝑖𝑖 𝑖𝑖 justified
𝑆𝑆(1 + 𝑖𝑖) ]
Future Worth FW = Revenues – Expenses – Capital Recovery If FW >=0, project
Method (1+𝑖𝑖)𝑛𝑛 −1 (1+𝑖𝑖)𝑛𝑛 −1 is economically
FW = R −E − 𝐼𝐼(1 + 𝑖𝑖)𝑛𝑛 −𝑆𝑆
𝑖𝑖 𝑖𝑖 justified
Method Equations Decision Rule
Internal Rate of PW = Revenues – Expenses – Capital Recovery; where PW = 0 If IRR >=MARR,
Return PW Revenues = PW of Expenses + PW of Capital Recovery project is
economically
justified
External Rate of 1. Subtract Expenses to Revenues to get excess If ERR >=MARR,
Return 2. Outflows to Present Time project is
3. Inflows to Future Time economically
4. Solve i’; 𝑃𝑃𝑃𝑃𝐼𝐼 = 𝑃𝑃𝑃𝑃𝑂𝑂 , 𝐹𝐹𝐹𝐹𝐼𝐼 = 𝐹𝐹𝐹𝐹𝑂𝑂 justified
Discounted 1. Determine n years Project is desirable if
Payback Period 2. Create a table (EOY | Net Cash Flow | PW | Cumulative payback period is
PW) within the target
3. Solve for PP: payback period
𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑎𝑎𝑎𝑎 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 𝑜𝑜𝑜𝑜 𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦
PP = year before full recovery +
𝑛𝑛𝑛𝑛𝑛𝑛 𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑 𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦
Benefit – Cost BCR =
𝑃𝑃𝑃𝑃 𝑜𝑜𝑜𝑜 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 If BCR > 1, project is
𝑃𝑃𝑃𝑃 𝑜𝑜𝑜𝑜 𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜
Ratio economically
justified
Pvtotal = ₱414,427.59; good investment
(total PV should be greater than the investment)
a. G = ₱13.26
b. A = ₱172.13
c. G = ₱4.07
A = ₱21,849.50
Pvtotal = ₱139,369.09; (Investment cost will be justified if it is less than the Present Value
of the Total Savings throughout the 10-year period)
Fvtotal = ₱648,245.24
PW = ₱39,385,598.81;
sound investment
AW = ₱-1,718,985.16;
Not a sound investment
i’ = 0.4572; Justifiable investment
PP = 3.58 years
AWa = ₱1,522, 499.35 PWa = ₱6,508, 810.18 FWa = ₱40,300, 837.11 i’ = 22.53% PP= 6.63yrs BCR= 1.07
AWb = ₱2,189, 430.43 PWb = ₱9,179, 125.96 FWb = ₱56,834, 728.54 i’ = 21.87% PP= 7.27yrs BCR= 1.08
AWc = ₱844, 317.29 PWc = ₱3,539,776.69 FWc = ₱21,917,364.24 i’ = 21.02% PP= 8.84yrs BCR= 1.03