BASIC ECONOMY

METHODS
ENGINEERING ECONOMY
Main material by Engr. JMH Montegrande
Main material from “Engineering Economy: 16th Edition”
William Sullivan and Elin M Wicks

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BASIC ECONOMY METHODS
Are made to determine whether an investment should be made
or not, based on the following criteria.

• Minimum Attractive Rate of Return

• Present Worth Method
• Future Worth Method
• Annual Worth Method

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MINIMUM ATTRACTIVE RATE OF RETURN
• Rate of return is a measure of an effectiveness of an investment
of the capital/ Financial Efficiency
𝑁𝐸𝑇 𝐴𝑁𝑁𝑈𝐴𝐿 𝑃𝑅𝑂𝐹𝐼𝑇
RATE OF RETURN =
𝐶𝐴𝑃𝐼𝑇𝐴𝐿 𝐼𝑁𝑉𝐸𝑆𝑇𝐸𝐷
*rate of return is an effective annual interest rate

• 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.

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MINIMUM
ATTRACTIVE
RATE OF RETURN

• 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.

𝑁𝐸𝑇 𝐴𝑁𝑁𝑈𝐴𝐿 𝑃𝑅𝑂𝐹𝐼𝑇

RATE OF RETURN =
𝐶𝐴𝑃𝐼𝑇𝐴𝐿 𝐼𝑁𝑉𝐸𝑆𝑇𝐸𝐷

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 METHODS TO PICK THE ALTERNATIVES
PRESENT WORTH FUTURE WORTH ANNUAL WORTH
METHOD METHOD METHOD
• It is a measure of how • It is based on the • The AW of a project is an
much money an equivalent worth of all equal annual series of
individual or a firm could cash inflows and outflows dollar amounts, for a
afford to pay for the at the end of the planning stated study period, that
investment in excess of horizon (study period) at is equivalent to the cash
its cost. an interest rate generally inflows and outflows at an
the MARR. interest rate that is
generally the MARR.
GENERAL STEPS
• Convert all cashflow to its present/future/annual value
• Apply the formula
• FOR PRESENT WORTH (PW) = PW of inflows – PW of outflows
• FOR FUTURE WORTH (FW) = FW of inflows – FW of outflows
• FOR ANNUAL WORTH (AW) = Revenue – Expenses – Capital recovery
• Decide if the project is economically justified.
 PRESENT WORTH METHOD
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
value of $5,000 at the end of a
study period 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 revenue
generated by the additional
production. A cash-flow diagram
for this investment opportunity is
given below. If the firm’s MARR is
20% per year, is this proposal a
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sound one? Use the PW method. BARRIOQUINTO
PRESENT WORTH METHOD

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 PRESENT WORTH METHOD
A retrofitted space-heating system is being considered for a small office building. The system can be purchased and installed
for $110,000, and it will save an estimated 300,000 kilowatt-hours (kWh) of electric power each year over a six-year period. A
kilowatt-hour of electricity costs $0.10, and the company uses a MARR of 15% per year in its economic evaluations of
refurbished systems. The market value of the system will be $8,000 at the end of six years, and additional annual operating
and maintenance expenses are negligible. Use the PW method to determine whether this system should be installed.

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FUTURE WORTH METHOD

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 FUTURE WORTH METHOD
An investment of $10,000 can be made that will produce a
uniform annual of $5,500 for five years and then have a
market (salvage) value of $2,000. Annual expenses will be
$3,150 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 FW method.

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 ANNUAL WORTH METHOD

For example, consider a device that will cost $10,000, last five years, and have a salvage (market) value of
$2,000. Thus, the loss in value of this asset over five years is $8,000. Additionally, the MARR is 10% per
year. The CR amount is:

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ANNUAL WORTH METHOD

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 ANNUAL WORTH METHOD
A corporate jet costs $1,350. The jet will be operated for
five years and then sold for $650,000. The MARR is 15%
per year. Determine the capital recovery cost of the jet.

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 OTHER METHODS
INTERNAL RATE EXTERNAL RATE OF PAYBACK BENEFIT-COST
OF RETURN RETURN METHOD RATIO
METHOD PERIOD
• The discount rate that • The discount rate that • The amount of time • The ratio that
makes the present makes the present that the capital concerns the total
value of the cash value of the cash flows investment can be revenue and the total
flows exactly equal the exactly equal the cost or cost incurred.
returned through
cost or initial initial investment, and
investment the cashflows can be revenue
reinvested.
• BREAKEVEN
INTEREST RATE
INTERNAL RATE OF RETURN
• Also called investor’s method, discounted cash-flow method, and profitability index
• The calculated discount rate that makes value = price.
• The discount rate that makes the present value of the cash flows exactly equal the cost or
initial investment
• Final answer is an “i-prime” (i’). If the i-prime is larger than the MARR, then the alternative is
economically justified.

BREAKEVEN INTEREST RATE

Can be solved by LINEAR INTERPOLATION and EXCEL
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INTERNAL RATE
LINEAR INTERPOLATION
OF RETURN
MARR $0.20
CAPITAL INVESTMENT $345,000.00
MARKET VALUE $115,000.00
ANNUAL REVENUES $120,000.00
ANNUAL EXPENSES $22,000.00
STUDY PERIOD 6 YEARS

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INTERNAL
EXCEL
RATE OF RETURN
MARR 0.2
CAPITAL INVESTMENT $25,000.00
MARKET VALUE $5,000.00
USEFUL LIFE 5
ANNUAL SAVINGS $8,000.00

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INTERNAL
EXCEL
RATE OF RETURN

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EXTERNAL RATE OF RETURN
• Calculated IRR is a measure of the profitability of the capital that remains internally invested from
period to period, and has not yet been recaptured or recovered by the investor
• It directly considers the interest rate (∈) external to a project at which net cash flows generated (or
required) by the project over its life can be reinvested (or borrowed).

It can usually be solved for directly, without needing to resort

to trial and error.

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EXTERNAL RATE OF RETURN
MARR 0.2
CAPITAL INVESTMENT $25,000.00
MARKET VALUE $5,000.00
USEFUL LIFE 5
ANNUAL SAVINGS $8,000.00

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PAYBACK PERIOD OF ALTERNATIVES
𝐶𝑂𝑆𝑇 𝑂𝐹 𝑃𝑅𝑂𝐽𝐸𝐶𝑇 𝑂𝑅 𝐼𝑁𝑉𝐸𝑆𝑇𝑀𝐸𝑁𝑇 −𝑆𝐴𝐿𝑉𝐴𝐺𝐸 𝑉𝐴𝐿𝑈𝐸
PAYBACK PERIOD = 𝑅𝐸𝑉𝐸𝑁𝑈𝐸 𝑂𝑅 𝑁𝐸𝑇 𝐶𝐴𝑆𝐻𝐹𝐿𝑂𝑊

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 BENEFIT-COST RATIO OF ALTERNATIVES
𝐵𝐸𝑁𝐸𝐹𝐼𝑇𝑆
BCR = 𝐶𝑂𝑆𝑇

1000 1000 1000 1000 1000

0 1 2 3 4 5

2000 2000
INTEREST RATE = 4.5%

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BENEFIT-COST RATIO OF ALTERNATIVES
𝐵𝐸𝑁𝐸𝐹𝐼𝑇𝑆
BCR = 𝐶𝑂𝑆𝑇

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END OF BASIC ECONOMY METHODS
COMPARISON AND
SELECTION AMONG
ALTERNATIVES
ENGINEERING ECONOMY

Main material from “Engineering Economy: 16th Edition”

William Sullivan and Elin M Wicks

Prepared by: ENGR. EMY

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 CONDITIONS AND DECISION RULE
• THE ALTERNATIVES ARE MUTUALLY EXCLUSIVE
• THE ALTERNATIVE THAT REQUIRES THE MINIMUM INVESTMENT
OF CAPITAL AND PRODUCES SATISFACTORY RESULTS WILL BE
CHOSEN
• WILL BE CONSIDERED IN TWO TYPES OF CASHFLOWS: REVENUE
AND COST
• REVENUE : POSITIVE CASHFLOWS
• COST: NEGATIVE VASHFLOWS
• RULE 1: SELECT ALTERNATIVE THAT MAXIMIZES OVERALL PROFITABILITY
PW(i%) TO BE CHOSEN IS THE GREATEST POSITIVE

• RULE 2: IF REVENUES ARE NOT PRESENT OR ARE CONSTANT, SELECT ALTERNATIVE THAT
MINIMIZES TOTAL COST
PW(i%) TO BE CHOSEN IS LEAST NEGATIVE
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ENSURING A COMPARABLE BASIS
• OPERATIONAL PERFORMANCE FACTORS
• QUALITY FACTORS (REJECT RATES)
• USEFUL LIFE VS STUDY PERIOD

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SCENARIOS
• Analyzing investment alternatives by using equivalent worth
• Analyzing cost-only alternatives
• Analyzing alternatives with different reject rates

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 Analyzing investment alternatives by
using equivalent worth

MARR 0.1 0.1 0.1

PURCHASE PRICE $390,000.00 $920,000.00 $660,000.00
USEFUL LIFE 10 10 10
ANNUAL PRODUCTIVITY $69,000.00 $167,000.00 $133,500.00

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 Analyzing investment alternatives by
using equivalent worth (PW)
MARR 0.1 0.1 0.1
PURCHASE PRICE $390,000.00 $920,000.00 $660,000.00
USEFUL LIFE 10 10 10
ANNUAL PRODUCTIVITY $69,000.00 $167,000.00 $133,500.00

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 Analyzing investment alternatives by
using equivalent worth (FW)
MARR 0.1 0.1 0.1
PURCHASE PRICE $390,000.00 $920,000.00 $660,000.00
USEFUL LIFE 10 10 10
ANNUAL PRODUCTIVITY $69,000.00 $167,000.00 $133,500.00

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 Analyzing investment alternatives by
using equivalent worth (AW)
MARR 0.1 0.1 0.1
PURCHASE PRICE $390,000.00 $920,000.00 $660,000.00
USEFUL LIFE 10 10 10
ANNUAL PRODUCTIVITY $69,000.00 $167,000.00 $133,500.00

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Analyzing cost-only alternatives by
using equivalent worth
• RULE 1: SELECT ALTERNATIVE THAT
MAXIMIZES OVERALL PROFITABILITY
PW(i%) TO BE CHOSEN IS THE GREATEST POSITIVE

• RULE 2: IF REVENUES ARE NOT PRESENT OR

ARE CONSTANT, SELECT ALTERNATIVE THAT
MINIMIZES TOTAL COST
PW(i%) TO BE CHOSEN IS LEAST NEGATIVE

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Analyzing alternatives with different
reject rates
• RULE 1: SELECT ALTERNATIVE THAT
MAXIMIZES OVERALL PROFITABILITY
PW(i%) TO BE CHOSEN IS THE GREATEST POSITIVE

• RULE 2: IF REVENUES ARE NOT PRESENT OR

ARE CONSTANT, SELECT ALTERNATIVE THAT
MINIMIZES TOTAL COST
PW(i%) TO BE CHOSEN IS LEAST NEGATIVE

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