CHAPTER III

ECONOMIC STUDY METHODS

THE MINIMUM ATTRACTIVE RATE OF RETURN

It is an interest rate that must

be earned for any project to
be accepted. It is
sometimes called hurdle
i
rate.

Projects that earn

> i Justifiable ✓
> x
Projects that earn i not justifiable

Projects that earn at least the MARR are desirable, since this means that the money is
earning at least as much as can be earned elsewhere. Projects that earn less than the
MARR are not desirable,

=
Projects that earn i justifiable ✓
 Below are the following considerations to set MARR?

1. The amount of money available for investment and the source and
costs of these funds

2. The number of good projects available for investment and their

purposes.
How is MARR
being set?
3. The amount of perceived risks associated with investment
opportunities

4. The type of organization involved

 1. Rate of Return (ROR) Method

2. Annual Cost Method (AC Method)

3. Present Worth Cost Method (PWC Method)

BASIC METHODS OF
INVESTMENT ANALYSIS
4. Future Worth Method (FW Method)

5. Payout Period Method

6. Benefit/Cost Ratio (B/C) Method

1. Rate of Return (ROR) Method

The rate of return is a measure of the financial efficiency of the investment. To justify the investment

of capital, it is conservatively estimated that a rate of return is equivalent to from 20-25% of the

investment is adequate. Uncertainties in the estimated income and expenses may reduce this

down to as low as 15% which is usually considered sufficient.

It is easy to calculate the rate of return by this method when there is a single lump investment

and uniform savings or returns at the end of each period during the life of the project.
Example

A project is estimated to cost P100,000 lasts 8 years and have a P10,000 salvage value. The annual gross
income is expected to average P24,000 and annual expenses, excluding depreciation will total P6,000.
If capital is earning 10% before income taxes, determine if this is a desirable investment? Use ROR
Method.
Example

An investment of P270,000 can be made in a project that will produce a uniform annual revenue of P185,400
for 5 years and then have a salvage value of 10% of the investment. Out-of-the-pocket costs for operation
and maintenance will be P81,000 per year. Taxes and insurance will be 4% of the first cost per year. The
company expects a capital to earn not less than 25% before income taxes. Is this a desirable investment?
Example

On land worth P800,000 an investor constructs a building worth P3,000,000 containing a theater, a
bank, stores, and offices. The owner estimates that the annual receipts from rentals will be P720,000 and
an annual expenses to cover taxes, insurance and maintenance of the building will be P80,000. He also
estimates that the land can be sold for P1,200,000, the building for P2,000,000 at the end of 20 years. If
his money is now earning 15% before taxes, will this property enough for the investment to be justified?
Use ROR Method.
2. Annual Cost Method (AC Method)
Example

A project capitalized for P50,000 invested in depreciable assets will earn a uniform, annual income
of P19,849 in 10 years. The costs for operation and maintenance total P9,000 a year, and taxes
and insurance will cost 4% of the first cost each year. If the company expects its capital to earn
12% before income taxes, is the investment worthwhile? Use AC Method
Example

A project is estimated to cost P100,000 lasts 8 years and have a P10,000 salvage value. The annual gross
income is expected to average P24,000 and annual expenses, excluding depreciation will total P6,000. If
capital is earning 10% before income taxes, determine if this is a desirable investment? Use AC Method.
3. Present Worth Cost (PWC) 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.

PW ≥ 0 Justifiable ✓

PW < 0 Not justifiable x

PW = Present worth of cash inflows – present worth of cash outflows

Example

An investment of P270,000 can be made in a project that will produce a uniform annual revenue of P185,400
for 5 years and then have a salvage value of 10% of the investment. Out-of-the –pocket costs for operation
and maintenance will be P81,000 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 taxes. Is this a desirable investment? Use present
worth (PW) Method.
Example

A project capitalized for P50,000 invested in depreciable assets will earn a uniform, annual income
of P19,849 in 10 years. The costs for operation and maintenance total P9,000 a year, and taxes
and insurance will cost 4% of the first cost each year. If the company expects its capital to earn
12% before income taxes, is the investment worthwhile? Use present worth (PW) Method.
3. Future Worth (FW) Method

The future worth method for economy studies is exactly comparable to the present worth
method except that all cash inflows and outflows are compounded forward 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.

FW ≥ 0 Justifiable ✓

FW < 0 Not justifiable x

FW = Future worth of cash inflows – Future worth of cash outflows

Example

An investment of P270,000 can be made in a project that will produce a uniform annual revenue of
P185,400 for 5 years and then have a salvage value of 10% of the investment. Out – of – the pocket
costs for operation and maintenance will be P81,000 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? Use Future Worth (FW) method.
Example

A project capitalized for P50,000 invested in depreciable assets will earn a uniform, annual income
of P19,849 in 10 years. The costs for operation and maintenance total P9,000 a year, and taxes
and insurance will cost 4% of the first cost each year. If the company expects its capital to earn
12% before income taxes, is the investment worthwhile? Use Future Worth (FW) Method.
Payout Period

This method determines the number of years within which the invested capital can be recovered
out of the net incoming cash flow. In applying this method, the net incoming cash flow must
include all taxes. Thus denoting by T the annual income tax, we have,
Example

An investment of P270,000 can be made in a project that will produce a uniform annual revenue of
P185,400 for 5 years and then have a salvage value of 10% of the investment. Out – of – the pocket
costs for operation and maintenance will be P81,000 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. What is
the payback period?
Example

A public school is being renovated for P13.5 million. The building has geothermal heating and cooling,
high-efficiency windows, and a solar array that permits the school to sell electricity back to the local
electric utility. The annual value of these benefits is estimated to be P2.7 million. In addition, the residual
value of the school at the end of its 40-year life is negligible. What is the simple payback period?
BENEFIT/COST RATIO also called SAVINGS-INVESTMENT RATIO (SIR)

The method of selecting alternatives that is most commonly used by government agencies for
analyzing the desirability of public projects is the benefit/cost ratio (B/C Ratio). The B/C method of
analysis is based on the ratio of the benefits to cost associated with a particular project.

𝑩ൗ = 𝑨𝒏𝒏𝒖𝒂𝒍 𝑩𝒆𝒏𝒆𝒇𝒊𝒕𝒔 − 𝑨𝒏𝒏𝒖𝒂𝒍 𝑫𝒊𝒔𝒃𝒆𝒏𝒆𝒇𝒊𝒕𝒔

𝑪 𝑨𝒏𝒏𝒖𝒂𝒍 𝑪𝒐𝒔𝒕𝒔 − 𝑨𝒏𝒏𝒖𝒂𝒍 𝑺𝒂𝒗𝒊𝒏𝒈𝒔

Benefits are advantages, expressed in terms of pesos which happen to the owner. On the other
hand, when the project under consideration involves disadvantages to the owner, these are
known disbenefits. The costs are the anticipated expenditures for construction, operation,
maintenance, etc. A B/C ratio greater than or equal to 1.0 indicates that the project under
consideration is economically advantageous.
B-C CRITERION

For a project to be acceptable, the difference (B – C) between the net benefits and net costs must
be positive, that is, the benefits must exceed the costs. It is obvious that if B<C, then the project should
not be implemented.

B = net benefits = all the advantages, less the disadvantages to the user
C = net costs = all disbursements, less any savings to the investor

Where several alternatives are to be compared by this criterion, the quantity (B – C) is calculated for

each alternative, and the one with maximum value is selected.

Example

A government project has the following estimates:

Annual benefits P500,000
Annual disbenefits P450,000
Annual Costs P350,000
Annual Savings P340,000
a. Calculate the B/C ratio.
b. Mistakenly treating disbenefits as costs and savings as benefits, determine the B/C ratio.
c. Calculate (B-C).
Example

A non-profit educational research organization is contemplating an investment of P1,500,000 in grants

to develop new ways to teach people the rudiments of profession. The grants would extend over a ten-
year period and would achieve an estimated savings (considered as benefits) of P500,000 per year in
professors’ salaries, student tuition, and other expenses. The program would be an addition to on-going
and planned activities, thus an estimated P100,000 a year would have to be released from other
program to support the educational research, a rate of return of 15% is expected. Is this a good
program? Use B/C.
Example

To increase accessibility to some beautiful scenery along the Pan-Philippine Highway, a new highway is
being proposed for construction. The initial cost is expected to be P9,600,000 with an annual
maintenance cost of P36,000. Every three years, minor improvements costing P20,000 are expected to
be made. It is estimated that income from tourists from foreign countries will be P1,200,000 annually.
Using a planning horizon of 30 years and interest rate of 10%, determine if the highway should be
constructed using;
a. B-C Criterion
b. B/C Method