Evaluating a Single
Project
Introduction
All engineering economy studies of capital projects
should consider the return that a given project will or
should produce. The basic question that we want to
answer is whether a proposed capital investment and its
associated expenditures can be recovered by revenue
(or savings) over time in addition to a return on the
capital that is sufficiently attractive in view of the risks
involved and the potential alternative uses.
Methods for Economic Evaluation
Present Worth (PW) method
Future Worth (FW) method $ ≥0
Annual Worth (AW) method
Internal Rate of Return (IRR) method
i ≥ MARR
External Rate of Return (ERR) method
Payback Period n that is favorable for
the investor as their
Benefit-Cost Ratio
period of capital
recovery
ratio of benefit and cost, B-C
ratio ≥ 1
PRESENT WORTH (PW) METHOD
PW (%) = PW inflows – PW outflows
PW0 (%)
PW DECISION RULE
If PW (i = MARR) ≥ 0, the project is economically justifiable.
Sample Problem
A piece of new equipment has been proposed by an
engineer to increase the productivity of a certain manual
welding operation. The investment cost is Php250,000
and the equipment will have a market value of Php50,000
at the end of the study period of 5 years. Increased
productivity attributable to the equipment will amount to
Php80,000 per year after 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 PW method in your analysis
Sample Problem
An initial capital of Php1,000,000 was put up for a new
business that will produce an annual income of
Php600,000 for 5 years and will have a salvage value of
Php20,000 at the time. Annual expenses for its operation
(salaries and wages, insurance, taxes) and maintenance
amounts to Php300,000. If money is worth 10%
compounded annually, is this investment profitable or not?
FUTURE WORTH (FW) METHOD
FW (%) = FW inflows – FW outflows
FWn (%)
FW DECISION RULE
If FW (i = MARR) ≥ 0, the project is economically justifiable.
Sample Problem
A piece of new equipment has been proposed by an
engineer to increase the productivity of a certain manual
welding operation. The investment cost is Php250,000
and the equipment will have a market value of Php50,000
at the end of the study period of 5 years. Increased
productivity attributable to the equipment will amount to
Php80,000 per year after 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 FW method in your analysis
Sample Problem
An initial capital of Php1,000,000 was put up for a new
business that will produce an annual income of
Php600,000 for 5 years and will have a salvage value of
Php20,000 at the time. Annual expenses for its operation
(salaries and wages, insurance, taxes) and maintenance
amounts to Php300,000. If money is worth 10%
compounded annually, is this investment profitable or not?
ANNUAL WORTH (AW) METHOD
AW (%) = AW inflows – AW outflows
AW DECISION RULE
If AW (i = MARR) ≥ 0, the project is economically justifiable.
Sample Problem
A piece of new equipment has been proposed by an
engineer to increase the productivity of a certain manual
welding operation. The investment cost is Php250,000
and the equipment will have a market value of Php50,000
at the end of the study period of 5 years. Increased
productivity attributable to the equipment will amount to
Php80,000 per year after 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 AW method in your analysis
Sample Problem
An initial capital of Php1,000,000 was put up for a new
business that will produce an annual income of
Php600,000 for 5 years and will have a salvage value of
Php20,000 at the time. Annual expenses for its operation
(salaries and wages, insurance, taxes) and maintenance
amounts to Php300,000. If money is worth 10%
compounded annually, is this investment profitable or not?
The Internal Rate of Return (IRR) Method
The IRR method is the most widely used rate or return
method for performing engineering economic analyses. It is
sometimes called by several other names, such as investor’s
method, discounted cash flow method, and profitability index.
This method solves for the interest rate that equates the
equivalent worth of an alternative cash inflows (receipts or
savings) to the equivalent worth of cash outflows (expenditures,
including investment costs). Equivalent worth may be computed
with any of the three methods discussed (PW, FW, or AW). The
resultant rate is termed the internal rate of return (IRR).
Internal Rate of Return (IRR)
n n
R ( P / F , i '%, k ) = E ( P / F , i '%, k )
k =0
k
k =0
k
n n
PW = Rk ( P / F , i '%, k ) − Ek ( P / F , i '%, k ) = 0
k =0 k =0
Where: Rk = net revenues or savings for the kth year
Ek = net expenditures including any investment costs for the kth year
n = project life (or study period)
IRR DECISION RULE
If IRR ≥ MARR, the project is economically justifiable.
Sample Problem
A piece of new equipment has been proposed by an
engineer to increase the productivity of a certain manual
welding operation. The investment cost is Php250,000
and the equipment will have a market value of Php50,000
at the end of the study period of 5 years. Increased
productivity attributable to the equipment will amount to
Php80,000 per year after 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 IRR method to evaluate the
economic soundness of the investment.
Sample Problem
An initial capital of Php1,000,000 was put up for a new
business that will produce an annual income of
Php600,000 for 5 years and will have a salvage value of
Php20,000 at the time. Annual expenses for its operation
(salaries and wages, insurance, taxes) and maintenance
amounts to Php300,000. If money is worth 10%
compounded annually, is this investment profitable or not?
The External Rate of Return (ERR) Method
The reinvestment assumption of the IRR method may not be
valid in an engineering economy study. To remedy the weakness
and disadvantages of IRR, some other rate of return method can
be used. One such method is the external rate of return (ERR).
It directly takes into account the interest rate external to a
project at which net cash flows generated by the project over its
life can be reinvested (or borrowed). If this external
reinvestment rate, which is usually the firm’s MARR, happens to
equal the project’s IRR, then ERR method produces identical to
those of the IRR method.
External Rate of Return
In general, three steps are used in calculating ERR.
All net cash outflows are discounted to time 0 (the
present) at ε% per compounding period.
All net cash inflows are compounded to period n at ε%.
The external rate of return, which is the interest rate that
establishes equivalence between the two quantities, is
determined.
In equation form, the ERR is the at which
n n
E ( P / F , %, k )( F / P, i '%, n ) = R ( F / P, %, n − k )
k =0
k
k =0
k
ERR DECISION RULE
If ERR ≥ MARR, the project is economically justifiable.
Sample Problem
A piece of new equipment has been proposed by an
engineer to increase the productivity of a certain manual
welding operation. The investment cost is Php250,000
and the equipment will have a market value of Php50,000
at the end of the study period of 5 years. Increased
productivity attributable to the equipment will amount to
Php80,000 per year after 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 ERR method to evaluate the
economic soundness of the investment.
Sample Problem
An initial capital of Php1,000,000 was put up for a new
business that will produce an annual income of
Php600,000 for 5 years and will have a salvage value of
Php20,000 at the time. Annual expenses for its operation
(salaries and wages, insurance, taxes) and maintenance
amounts to Php300,000. If money is worth 10%
compounded annually, is this investment profitable or not?
The Payback Period Method
One of the primary concerns of most business people is
whether, and when, the money invested in a project can
be recovered. The payback method screens projects one
the basis of how long it takes for net receipts to equal
investment outlays. This calculation can take one of two
forms by either ignoring time value of money
considerations of including them. The former case is
usually designated as the conventional payback method,
whereas the latter case is known as the discounted
payback method.
The Payback Period Method
A common standard used to determine whether or not to
pursue a project is that a project does not merit
consideration unless its payback period is shorter than
some specified period of time. (This time limit is largely
determined by management policy.) If the payback period
is within the acceptable range, a formal project
evaluation (such as PW analysis) may begin. It is
important to remember that payback screening is not an
end in itself, but rather a method of screening out certain
obvious unacceptable investment alternatives before
progressing to an analysis of potentially acceptable ones.
Payback Period
Conventional Payback Period Method
Initial cost
Payback Period =
Uniform annual benefit
Payback Period
Discounted Payback Period Method
If the time value of money (i.e., the cost of
funds (interest) used to support the project) is
considered, the modified payback period is referred
to as the discounted payback period. In other
words, we may define the discounted payback
period as the number of years required to recover
the investment from discounted cash flows
Sample Problem
A piece of new equipment has been proposed by an
engineer to increase the productivity of a certain manual
welding operation. The investment cost is Php250,000
and the equipment will have a market value of Php50,000
at the end of the study period of 5 years. Increased
productivity attributable to the equipment will amount to
Php80,000 per year after 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 conventional and discounted
payback method to evaluate the economic soundness of
the investment.
Sample Problem
An initial capital of Php1,000,000 was put up for a new
business that will produce an annual income of
Php600,000 for 5 years and will have a salvage value of
Php20,000 at the time. Annual expenses for its operation
(salaries and wages, insurance, taxes) and maintenance
amounts to Php300,000. If money is worth 10%
compounded annually, is this investment profitable or not?
The Benefit-Cost Ratio Method
The benefit-cost (B-C) ratio is defined as the
ratio of the equivalent worth of benefits to the
equivalent worth of costs. The equivalent-worth
measure applied can be PW, FW, or AW, but
customarily, either PW or AW is used. The B-C
ratio is also known as the savings-investment
ratio (SIR) by some governmental agencies.
Benefit-Cost Ratio (B-C Ratio)
Conventional B-C Ratio
PW (Benefits of the Proposed Project)
B-C =
PW (Total Cost of the Proposed Project)
Modified B-C Ratio
PW(Benefits) - PW(Operating and Maintenance Cost)
B-C =
Initial Investment -PW(Market Value)
Benefit-Cost Ratio (B-C Ratio)
The numerator of the modified B-C ratio
expresses the equivalent worth of the benefits
minus the equivalent worth of the operating and
maintenance costs, and the denominator includes
only the initial investment costs (less any market
value).
A project is acceptable when the B-C ratio is
greater than or equal to 1.0.
Sample Problem
A piece of new equipment has been proposed by an
engineer to increase the productivity of a certain manual
welding operation. The investment cost is Php250,000
and the equipment will have a market value of Php50,000
at the end of the study period of 5 years. Increased
productivity attributable to the equipment will amount to
Php80,000 per year after 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 conventional and modified B-C
ratio method to evaluate the economic soundness of the
investment.
Sample Problem
An initial capital of Php1,000,000 was put up for a new
business that will produce an annual income of
Php600,000 for 5 years and will have a salvage value of
Php20,000 at the time. Annual expenses for its operation
(salaries and wages, insurance, taxes) and maintenance
amounts to Php300,000. If money is worth 10%
compounded annually, is this investment profitable or not?
