 All engineering economy studies of capital projects should consider the return that a

given project will or should produce.

 There is no single method for performing engineering economic analyses that is ideal
for all cases.
5 methods for evaluating the economic profitability of a single proposed problem
solution (i.e., alternatives):
1. Present Worth (PW) convert cash flows resulting from a proposed
problem solution into their equivalent worth at
2. Future Worth (FW) some point (or points) in time using MARR
3. Annual Worth (AW) (minimum attractive rate of return)
4. Internal Rate of Return (IRR) produce annual rates of profit, or returns, resulting from
5. External Rate of Return (ERR) an investment, and are then compared to the MARR
 Payback period is often used to supplement information produced by the 5 primary
methods for it ignores time value of money
 Minimum Attractive Rate of Return (MARR) – usually a policy issue resolved by the
top management of an organization in view of numerous considerations
Considerations for MARR:
1. The amount of money available for investment, and the source and cost of
these funds (i.e., equity funds or borrowed funds)
2. The number of good projects available for investment and their purpose (i.e.,
whether they sustain present operations and are essential or whether they
expand on present operations and are elective)
3. The amount of perceived risk associated with investment opportunities
available to the firm and the estimated cost of administering projects over
short planning horizons versus long planning horizons
4. The type of organization involved (i.e., government, public utility, or competitive
industry)
 MARR is sometimes called “hurdle rate” which should be chosen to maximize the
economic well-being of an organization
 Opportunity cost is one popular approach to establish MARR which results from
the phenomenon of capital rationing
Because opportunity costs are unseen
by definition, they can be easily
overlooked. Understanding the potential
missed opportunities when a business or
individual chooses one investment over
another allows for better decision
making.

Opportunity cost is a strictly internal cost used for

strategic contemplation; it is not included in
accounting profit and is excluded from external
financial reporting.
 MARR is sometimes called “hurdle rate” which should be chosen to maximize the
economic well-being of an organization
 Opportunity cost is one popular approach to establish MARR which results from
the phenomenon of capital rationing
 Capital rationing exists when the management decides to limit the total amount of
capital invested
 Capital rationing may arise when the amount of available capital is insufficient to
sponsor all worthy investment opportunities

Capital rationing is the process through which companies decide how

to allocate their capital among different projects, given that their
resources are not limitless. The main goal is to maximize the return
on their investment.
 Present Worth (PW) Method - based 𝑃𝑊 𝑖% = ∑ 𝐹 (1 + 𝑖)
on the concept of equivalent worth of
all cash flows relative to some base or where:
beginning point in time called the i = effective interest rate or MARR
present
k = index for each compounding period
 PW Method discounts cash inflows and (0 ≤ k ≤ N)
cash outflows to the present point in
time at an interest rate that is generally 𝐹 = future cash flow at the end of
the MARR. period k (+ if inflow; - if outflow)
 The PW of an investment alternative is N = number of compounding periods
a measure of how much money an  Constant interest rate throughout the
individual or a firm could afford to pay life of the project (↑ 𝑀𝐴𝑅𝑅, ↓ 𝑃𝑊)
for the investment in excess of its cost.
 𝑃𝑊 ≥ 0, 𝑎𝑐𝑐𝑒𝑝𝑡𝑎𝑏𝑙𝑒
Ex.: An investment of Php 10,000 can be made in a
project that will produce a uniform annual revenue
of Php 5,310 for five years and then have a market
(salvage value) of Php 2,000. Annual expenses will
be Php 3,000 each year. The company is willing to
accept any project that will earn 10% per year or
more, on all invested capital. Show whether this is
a desirable investment by using the PW method.
𝑃𝑊 10% = −10,000 +
5,310 𝑃⁄𝐴, 10%, 5) + 2,000(𝑃⁄𝐹 , 10%, 5 −
3,000(𝑃⁄𝐴, 10%, 5)
𝑃𝑊 10% = −10,000 + 20,129 + 1,241 −
11,372 disregarded decimal values
𝑃𝑊 10% = 𝑃ℎ𝑝 0
𝐵𝑒𝑐𝑎𝑢𝑠𝑒 𝑡𝑜𝑡𝑎𝑙 𝑃𝑊 10% ≈
𝑃ℎ𝑝 0, 𝑡ℎ𝑒 𝑝𝑟𝑜𝑗𝑒𝑐𝑡 𝑖𝑠 𝑚𝑎𝑟𝑔𝑖𝑛𝑎𝑙𝑙𝑦 𝑎𝑐𝑐𝑒𝑝𝑡𝑎𝑏𝑙𝑒.
Ex.: A piece of new equipment has been proposed
by engineers to increase the productivity of a certain
manual welding operation. The investment cost is
Php 25,000, and the equipment will have a market
value of Php 5,000 at the end of a study period of 5
years. Increased productivity attributable to the
equipment will amount to Php 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 this proposal a
sound one? Use the PW method.
𝑃𝑊 20% = −25,000 + 5,000 𝑃⁄𝐹 , 20%, 5 +
8,000(𝑃⁄𝐴, 20%, 5)
𝑃𝑊 20% = −25,000 + 2,009.39 + 23,924.90
𝑃𝑊 20% = 𝑃ℎ𝑝 934.29
𝑌𝑒𝑠! 𝐵𝑒𝑐𝑎𝑢𝑠𝑒 𝑃𝑊 20% ≥
0, 𝑡ℎ𝑖𝑠 𝑒𝑞𝑢𝑖𝑝𝑚𝑒𝑛𝑡 𝑖𝑠 𝑒𝑐𝑜𝑛𝑜𝑚𝑖𝑐𝑎𝑙𝑙𝑦 𝑗𝑢𝑠𝑡𝑖𝑓𝑖𝑒𝑑.
 Future Worth (FW) Method – based on the equivalent worth of all cash inflows and
outflows at the end of the planning horizon (study period) at an interest rate that is
generally the MARR
 Future Worth (FW) Method – very useful in capital investment decision situations
for it provides economic information about the future wealth of the owners of the
firm
𝐹𝑊 = 𝑃𝑊(𝐹 ⁄𝑃, 𝑖%, 𝑁)
𝐹𝑊 𝑖% = ∑ 𝐹 (1 + 𝑖)
𝐹𝑊 ≥ 0, 𝑎𝑐𝑐𝑒𝑝𝑡𝑎𝑏𝑙𝑒
Ex.: A piece of new equipment has been proposed by
engineers to increase the productivity of a certain manual
welding operation. The investment cost is Php 25,000, and
the equipment will have a market value of Php 5,000 at
the end of a study period of 5 years. Increased
productivity attributable to the equipment will amount to
Php 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 this
proposal a sound one? Use the FW method.
𝐹𝑊 20% = −25,000(𝐹 ⁄𝑃, 20%, 5) + 5,000 +
8,000(𝐹 ⁄𝐴, 20%, 5)
𝐹𝑊 20% = −62,208 + 5,000 + 59,532.80
𝐹𝑊 20% = 𝑃ℎ𝑝 2,324.80
𝑌𝑒𝑠! 𝐵𝑒𝑐𝑎𝑢𝑠𝑒 𝐹𝑊 20% >
0, 𝑡ℎ𝑖𝑠 𝑒𝑞𝑢𝑖𝑝𝑚𝑒𝑛𝑡 𝑖𝑠 𝑒𝑐𝑜𝑛𝑜𝑚𝑖𝑐𝑎𝑙𝑙𝑦 𝑗𝑢𝑠𝑡𝑖𝑓𝑖𝑒𝑑.
𝑜𝑟 𝐹𝑊 20% = 934.29(𝐹 ⁄𝑃, 20%, 5)
𝐹𝑊 20% = 𝑃ℎ𝑝 2,324.81
 Annual-Worth (AW) – equal annual where:
series of monetary amounts for a stated
study period that is equivalent to the R = annual equivalent revenues or savings
cash inflows and outflows at an interest E = annual equivalent expenses
rate that is generally the MARR.
𝐴𝑊 𝑖% = 𝑅 − 𝐸 − 𝐶𝑅 𝑖% CR = annual equivalent capital recovery
𝐶𝑅 = 𝐹𝐶(𝐴⁄𝑃, 𝑖%, 𝑁) − 𝑆𝑉(𝐴⁄𝐹 , 𝑖%, 𝑁) FC = first cost or initial investment
𝐶𝑅 = (𝐹𝐶 − 𝑆𝑉)(𝐴⁄𝐹, 𝑖%, 𝑁) + 𝐹𝐶(𝑖%) SV = salvage value
𝐶𝑅 = (𝐹𝐶 − 𝑆𝑉)(𝐴⁄𝑃, 𝑖%, 𝑁) + 𝑆𝑉(𝑖%) N = project study period
 When revenues are absent, designate this
metric as equivalent uniform annual cost 𝐴𝑊 = 𝑃𝑊(𝐴⁄𝑃, 𝑖%, 𝑁) 𝑜𝑟
(EUAC) (↓ 𝑏𝑒𝑡𝑡𝑒𝑟)
𝐴𝑊 = 𝐹𝑊(𝐴⁄𝐹, 𝑖%, 𝑁)
 Capital recovery – equivalent uniform
annual cost of the capital invested 𝐴𝑊 ≥ 0, 𝑎𝑐𝑐𝑒𝑝𝑡𝑎𝑏𝑙𝑒
covering loss of value of the asset and
interest on invested capital
Ex.: An investment of Php 10,000 can be made in a
project that will produce a uniform annual revenue
of Php 5,310 for five years and then have a market
(salvage value) of Php 2,000. Annual expenses will
be Php 3,000 each year. The company is willing to
accept any project that will earn 10% per year or
more, on all invested capital. Show whether this is
a desirable investment by using the AW method.
𝐴𝑊 𝑖% = 𝑅 − 𝐸 − [(𝐹𝐶 −
𝑆𝑉)(𝐴⁄𝑃, 𝑖%, 𝑁) + 𝑆𝑉(𝑖%)]
𝐴𝑊 10% = 5,310 − 3,000 − [(10,000 −
2,000) 𝐴⁄𝑃 , 10%, 5 + 2,000(0.10)]
𝐴𝑊 10% = 𝑃ℎ𝑝 0 𝑑𝑖𝑠𝑟𝑒𝑔𝑎𝑟𝑑𝑒𝑑 𝑑𝑒𝑐𝑖𝑚𝑎𝑙 𝑣𝑎𝑙𝑢𝑒𝑠
𝐵𝑒𝑐𝑎𝑢𝑠𝑒 𝐴𝑊 10% ≈
𝑃ℎ𝑝 0, 𝑡ℎ𝑒 𝑝𝑟𝑜𝑗𝑒𝑐𝑡 𝑖𝑠 𝑚𝑎𝑟𝑔𝑖𝑛𝑎𝑙𝑙𝑦 𝑎𝑐𝑐𝑒𝑝𝑡𝑎𝑏𝑙𝑒.
Ex.: A piece of new equipment has been proposed by
engineers to increase the productivity of a certain
manual welding operation. The investment cost is Php
25,000, and the equipment will have a market value of
Php 5,000 at the end of a study period of 5 years.
Increased productivity attributable to the equipment
will amount to Php 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 this proposal a sound
one? Use the AW method.
𝐴𝑊 𝑖% = 𝑅 − 𝐸 − [(𝐹𝐶 − 𝑆𝑉)(𝐴⁄𝑃, 𝑖%, 𝑁) + 𝑆𝑉(𝑖%)]
𝐴𝑊 20% = 8,000 − [ 25,000 − 5,000 𝐴⁄𝑃 , 20%, 5 +
5,000(0.20)]
𝐴𝑊 20% = 𝑃ℎ𝑝 312.41
𝑌𝑒𝑠! 𝐵𝑒𝑐𝑎𝑢𝑠𝑒 𝐴𝑊 20% ≥
0, 𝑡ℎ𝑖𝑠 𝑒𝑞𝑢𝑖𝑝𝑚𝑒𝑛𝑡 𝑖𝑠 𝑒𝑐𝑜𝑛𝑜𝑚𝑖𝑐𝑎𝑙𝑙𝑦 𝑗𝑢𝑠𝑡𝑖𝑓𝑖𝑒𝑑.