Engineering Economy

(0901420)

Muhammad T. Hatamleh, PhD

Department of Civil Engineering
Summer - Week 5
Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)
Chapter 5: Evaluating a Single Project
Topics to be covered this week:

• Evaluating a single project

• Equivalent worth methods
 Present worth (PW).
 Future worth (FW).
 Annual worth (AW).
• Applications PW: Bonds

Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)

Methods for evaluating a single project
Minimum Attractive Rate of Return (MARR): The lowest internal rate of return that the
organization would consider it to be a good investment.
• The Minimum Attractive Rate of Return (MARR) is usually a policy issue resolved by the top
management of an organization in view of numerous considerations.

Among these considerations are the following:

1. Amount, source, and cost of money available
2. Number and purpose of good projects available
3. Perceived risk of investment opportunities
4. Type of organization (i.e., government, public utility, or private industry)

Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)

Methods for evaluating a single project
 Present worth (PW) (most common method).
 Future worth (FW).

 Annual worth (AW).

 Internal rate of return (IRR).

 External rate of return (ERR).

 Payback period: least common method.

A project must provide a return that is equal to or greater than the Minimum Attractive Rate of
Return (MARR).

Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)

Methods for evaluating a single project

Unless otherwise specified, the end-of-period cash-flow convention and discrete

compounding of interest are used throughout this and subsequent chapters. A planning
horizon, or study (analysis) period, of N compounding periods (usually years) is used to
evaluate prospective investments throughout the remainder of this course.

Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)

Present worth (PW)
• All cash inflows and outflows are discounted to the present time at an interest rate
(generally MARR).

acceptable project (profit required by investors is satisfied or

exceeded).

Example: A project has a capital investment of $50,000 and returns $18,000 per year for 4
years. At a 12% MARR, is this a good investment?

Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)

PW Example
• It is important to observe that the higher the interest rate and the
farther into the future a cash flow occurs, the lower its PW is.

 PW of $1,000 Received at the End of Year k at an Interest Rate of

i% per Year

Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)

PW Example
A new heating system is to be purchased and installed for $110,000. This system will save
approximately 300,000 kWh of electric power each year for a 6-year period with no
additional O&M costs. Assume the cost of electricity is $0.10 per kWh, and company’s
MARR is 15% per year, and the market value of the system will be $8,000 at EOY 6. Using
the PW method, is this a good idea?

 Good investment
Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)
Present worth (PW)
There are two assumptions that we make when using PW:

 First, it is assumed that we know the future with certainty (For example, we presume to
know with certainty future interest rates and other factors).

 Second, it is assumed we can borrow and lend money at the same interest rate (i.e.,
capital markets are perfect).

Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)

Future Worth (FW)
Future Worth (FW) method is an alternative to the PW method

 Looking at FW is appropriate since the primary objective is to maximize the future

wealth of owners of the firm.

 FW is based on the equivalent worth of all cash inflows and outflows at the end of the
study period at an interest rate that is generally the MARR.

 Decisions made using FW and PW will be the same.

Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)

Future Worth (FW)

Example: A $45,000 investment in a new conveyer system is projected to improve

throughout and increase revenue by $14,000 per year for five years. The estimated
market value of the conveyer at the end of five years is $4,000. Using the FW method at a
MARR of 12%, is this a good investment?

Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)

Future Worth (FW)
Example: A $110,000 retrofitted space-heating system was projected to save $30,000 per
year in electrical power and be worth $8,000 at the end of the six-year study period. Use
the FW method to determine whether the project is still economically justified if the
system has zero market value after six years. The MARR is 15% per year.

• FW(15%) = −$110,000 (F/P, 15%, 6) + $30,000 (F/A, 15%, 6)

= −$110,000 (2.3131) + $30,000 (8.7537)
= $8,170.

Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)

Annual Worth (AW)
Annual Worth (AW) is another way to assess projects.

• Equal annual series equivalent to the cash inflows and outflows at a specific interest rate
(normally MARR).

• AW is equivalent to PW and FW.

• AW ≥ 0, project is economically justified.

Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)

Annual Worth (AW)
The AW of a project is annual equivalent revenue or savings minus annual equivalent
expenses, less its annual capital recovery (CR) amount.

Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)

Annual Worth (AW)
Example: 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 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.

Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)
Annual Worth (AW)
Example: Lockheed Martin is increasing its booster thrust power in order to win more
satellite launch contracts from European companies interested in opening up new global
communications markets. A piece of earth-based tracking equipment is expected to
require an investment of $13 million, with $8 million committed now and the remaining
$5 million expended at the end of year 1 of the project. Annual operating costs for the
system are expected to start the first year and continue at $0.9 million per year. The useful
life of the tracker is 8 years with a salvage value of $0.5 million. Calculate the CR and AW
values for the system, if the corporate MARR is 12% per year.

Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)

Annual Worth (AW)

I = 8 + 5(P/F, 12%, 1) = $12.46M; S = 0.5 M

CR = 12.46M(A/P, 12%, 8) - 0.5M(A/F, 12%, 8) = 12.46M(0.20130) - 0.5M(0.08130) = $2.47M

AW = - 0.9 -2.47 = $-3.37 million per year

Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)

Applications PW: Bonds
Bond value is a good example of present worth.
VN=C (P/F, i%, N) + r Z (P/A, i%, N)
Where:

Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)

Applications PW: Bonds
Example: A bond with a face value of $5,000 pays interest of 8% per year. This bond will be
redeemed at par value at the end of its 20-year life, and the first interest payment is due one year
from now.
(a) How much should be paid now for this bond in order to receive a yield of 10% per year on the
investment?
(b) If this bond is purchased now for $4,600, what annual bond yield would the buyer receive?

(a) VN=C (P/F, i%, N) + r Z (P/A, i%, N)

 The value of VN can be determined:

C = Z = $5,000, r= 8% , i= 10%, N=20

VN = $5,000(P/F, 10%, 20) + $5,000(0.08)(P/A, 10%, 20)

= $743.00 + $3,405.44 = $4,148.44.
Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)
Applications PW: Bonds
Example: A bond with a face value of $5,000 pays interest of 8% per year. This bond will be redeemed at par
value at the end of its 20-year life, and the first interest payment is due one year from now.
(a) How much should be paid now for this bond in order to receive a yield of 10% per year on the
investment?
(b) If this bond is purchased now for $4,600, what annual bond yield would the buyer receive?

(b) we are given VN = $4,600, and we must find the value of i%??
VN=C (P/F, i%, N) + r Z (P/A, i%, N)
C = Z = $5,000, r= 8% , i= ?? N=20

$4,600 = $5,000(P/F, i′%, 20) + $5,000(0.08)(P/A, i′%, 20). ;

• To solve for i′%, we can resort to an iterative trial-and-error procedure (e.g., try 8.5%, 9.0%)
to determine that
i′% = 8.9% per year.
Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)
Applications PW: Bonds
Example: A bond has a face value of $10,000 and matures in 8 years. The bond stipulates a
fixed nominal interest of 8% per year, but interest payments are made to the bondholder
every 3 months. The bondholder wishes to earn 10% nominal annual interest
(compounded quarterly). Assuming the redemption value is equal to the face value, how
much should be paid for the bond now?

Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)

Applications PW: Bonds
Example: What is the value of a 6%, 10-year bond with a par (and redemption) value of
$20,000 that pays dividends semi-annually, if the purchaser wishes to earn an 8%
return?

VN = $20,000 (P/F, 4%, 20) + (0.03)$20,000 (P/A, 4%, 20)

VN = $20,000 (0.4564) + (0.03)$20,000 (13.5903)
VN = $17,282.18

Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)

Chapter 5: Evaluating a Single Project
Topics to be covered:

• Applications PW: Capitalized worth

• Internal Rate of Return (IRR)
• External Rate of Return (ERR)

Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)

Applications PW: Capitalized worth
Capitalized worth is a special variation of present worth
 Capitalized worth (CW): special case of PW; where revenues or expenses occur over an
infinite length of time.
 If only expenses are considered, then it is called capitalized cost.

The capitalized worth method is especially useful in problems involving grants and public
projects with indefinite lives.

The CW of a series of end-of-period uniform payments A, with interest at i% per period, is

A(P/A, i%, N).

Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)

Applications PW: Capitalized worth
The capitalized worth of a project with interest rate i% per year: is the annual equivalent
of the project over its useful life divided by i.

The CW of a series of end-of-period uniform payments A, with interest at i% per period, is

A(P/A, i%, N).

 As N becomes very large (if the A are perpetual payments), the (P/A) term approaches
[1/i]. So, CW = A(1/i).

Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)

Applications PW: Capitalized worth
As N becomes very large (if the A are perpetual payments), the (P/A) term approaches
[1/i]. So, CW = A(1/i).

Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)

Applications PW: Capitalized worth
Example: a bridge was constructed at a cost of $1,900,000 and the annual upkeep cost is
$25,000. It is also estimated that maintenance will be required at a cost of $350,000 every
8 years. What is the capitalized worth of the bridge over its life assuming MARR = 8%?

• If the bridge has an expected life of 50 years, what is the capitalized worth (CW) of the
bridge over a 100-year study period?

Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)

Applications PW: Capitalized worth
Betty has decided to donate some funds to her local community college.
Betty would like to fund an endowment that will provide a scholarship of
$25,000 each year in perpetuity, and also a special award, “Student of the
Decade,” each ten years (again, in perpetuity) in the amount of $50,000.
How much money does Betty need to donate today, in one lump sum, to
fund the endowment? Assume the fund will earn a return of 8% per year.

A = $50,000 (A/F, 8%,10) = $3,451.47

$25,000 +$3,451.47
CW = = $355,643.43
0.08

Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)

Internal Rate of Return (IRR)
• Most widely used rate of return method in engineering economic analysis.

• Also called the investor’s method, the discounted cash flow method, and the
profitability index.
• The IRR is the interest rate that equates the equivalent worth of an alternative’s cash
inflows (revenue, R) to the equivalent worth of cash outflows (expenses, E).

• The IRR is sometimes referred to as the breakeven interest rate.

IRR Decision Rule: If IRR ≥ MARR, the project is economically justified.

Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)

Internal Rate of Return (IRR)
The IRR is the interest i'% at which

𝑒𝑞𝑢𝑖𝑣𝑎𝑙𝑒𝑛𝑡 𝑤𝑜𝑟𝑡ℎ 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤𝑠 = 𝑒𝑞𝑢𝑖𝑣𝑎𝑙𝑒𝑛𝑡 𝑤𝑜𝑟𝑡ℎ 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑜𝑢𝑡𝑓𝑙𝑜𝑤𝑠

Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)

Internal Rate of Return (IRR)
Solving for the IRR is a bit more complicated than PW, FW, or AW.

Challenges in applying the IRR method:

1. It is computationally difficult without proper tools.
2. In rare instances multiple rates of return can be found.
3. The IRR method must be carefully applied and interpreted when comparing two more
mutually exclusive alternatives (e.g., do not directly compare internal rates of return).

Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)

Internal Rate of Return (IRR)
Example: A company is considering the purchase of a digital camera for the maintenance of design
specifications by feeding digital pictures directly into an engineering workstation. The capital
investment requirement is $345,000 and the estimated market value of the system after a six-year
study period is $115,000. Annual revenues attributable to the new camera system will be
$120,000, whereas additional annual expenses will be $22,000. You have been asked by
management to determine the IRR of this project and to make a recommendation. The
corporation’s MARR is 20% per year.

PW = 0 = −$345,000 + ($120,000 − $22,000)(P/A, i′%, 6) + $115,000(P/F, i′%, 6)

i′% = ?
 At i′ = 20%: PW = −$345,000 + $98,000(3.3255) + $115,000(0.3349) = +$19,413
Since the PW is positive at 20%, we know that i′ > 20%.
 At i′ = 25%: PW = −$345,000 + $98,000(2.9514) + $115,000(0.2621) = −$25,621
i′ ≈ 22.16%.
Spreadsheets IRR = 22.03% > MARR  Acceptable project
Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)
Internal Rate of Return (IRR)
Example: 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 market (salvage) value of $5,000 at the end of its expected life
of five years. Increased 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. Use a spreadsheet to evaluate the IRR of the proposed equipment. Is the
investment a good one? Recall that the MARR is 20% per year.
• The IRR for the proposed piece of equipment is 21.58%
• PW(MARR= 20%) = $934.29;
• FW(MARR= 20%) = $2,324.80;
• AW(MARR= 20%) = $312.40.

Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)

External Rate of Return (ERR)
three steps are used in the calculating procedure:
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, which is the interest rate that establishes equivalence between the two
quantities, is determined.

Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)

External Rate of Return (ERR)
Graphically, we have the following (the numbers relate to the three steps)

The ERR method has two basic advantages over the IRR method:
1. It can usually be solved for directly, without needing to resort to trial and error.
2. It is not subject to the possibility of multiple rates of return.

Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)

External Rate of Return (ERR)
Example: When ∈=15% and MARR = 20% per year, determine whether the project (whose
net cash-flow diagram appears next) is acceptable.

[$10,000 + $5,000(P/F, 15%, 1)](F/P, i′%, 6) = $5,000(F/A, 15%, 5);

i′% = 15.3%
The i′% is less than the MARR = 20%; therefore, this project would be
unacceptable according to the ERR method.
Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)
External Rate of Return (ERR)
Example: For the cash flows given below, find the ERR when the external reinvestment

Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)

 The end

Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)