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Introduction

All engineering economy studies of capital projects

should consider the return that a given project will or
Evaluating a Single should produce. The basic question that we want to
answer is whether a proposed capital investment and its
Project associated expenditures can be recovered by revenue
Julius D. Obnamia, CIE, AAE (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

Present Worth (PW) method

PW (%) = PW – PW

inflows outflows
 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 PW0 (%)
the investor as their
 Benefit-Cost Ratio
period of capital
recovery
ratio of benefit and cost, B-C 9/20/2018 3 9/20/2018 4

ratio ≥ 1

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
PW DECISION RULE and the equipment will have a market value of Php50,000
If PW (i = MARR) ≥ 0, the project is economically justifiable. 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

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FUTURE WORTH (FW) METHOD

FW (%) = FW inflows – FW outflows

FW DECISION RULE
If FW (i = MARR) ≥ 0, the project is economically justifiable.

FWn (%)

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Sample Problem ANNUAL WORTH (AW) METHOD

 A piece of new equipment has been proposed by an

engineer to increase the productivity of a certain manual AW (%) = AW inflows – AW outflows
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

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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
AW DECISION RULE and the equipment will have a market value of Php50,000
If AW (i = MARR) ≥ 0, the project is economically justifiable. 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

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The Internal Rate of Return (IRR) Method

Internal Rate of Return (IRR)
The IRR method is the most widely used rate or return
method for performing engineering economic analyses. It is n n
sometimes called by several other names, such as investor’s  R  P / F , i '%, k    E  P / F , i '%, k 
k 0
k
k 0
k
method, discounted cash flow method, and profitability index.
This method solves for the interest rate that equates the n n
PW   Rk  P / F , i '%, k    Ek  P / F , i '%, k   0
equivalent worth of an alternative cash inflows (receipts or k 0 k 0
savings) to the equivalent worth of cash outflows (expenditures,
Where: Rk = net revenues or savings for the kth year
including investment costs). Equivalent worth may be computed Ek = net expenditures including any investment costs for the kth year
with any of the three methods discussed (PW, FW, or AW). The n = project life (or study period)
resultant rate is termed the internal rate of return (IRR).
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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
IRR DECISION RULE and the equipment will have a market value of Php50,000
If IRR ≥ MARR, the project is economically justifiable. 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.
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The External Rate of Return (ERR) Method

External Rate of Return
The reinvestment assumption of the IRR method may not be In general, three steps are used in calculating ERR.
valid in an engineering economy study. To remedy the weakness  All net cash outflows are discounted to time 0 (the
and disadvantages of IRR, some other rate of return method can present) at ε% per compounding period.
be used. One such method is the external rate of return (ERR).  All net cash inflows are compounded to period n at ε%.
It directly takes into account the interest rate external to a  The external rate of return, which is the interest rate that
project at which net cash flows generated by the project over its establishes equivalence between the two quantities, is
life can be reinvested (or borrowed). If this external determined.
reinvestment rate, which is usually the firm’s MARR, happens to  In equation form, the ERR is the at which
equal the project’s IRR, then ERR method produces identical to n n

those of the IRR method.  E  P / F , %, k  F / P, i '%, n    R  F / P, %, n  k 

k 0
k
k 0
k

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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
ERR DECISION RULE and the equipment will have a market value of Php50,000
If ERR ≥ MARR, the project is economically justifiable. 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.
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The Payback Period Method The Payback Period Method

 One of the primary concerns of most business people is  A common standard used to determine whether or not to
whether, and when, the money invested in a project can pursue a project is that a project does not merit
be recovered. The payback method screens projects one consideration unless its payback period is shorter than
the basis of how long it takes for net receipts to equal some specified period of time. (This time limit is largely
investment outlays. This calculation can take one of two determined by management policy.) If the payback period
forms by either ignoring time value of money is within the acceptable range, a formal project
considerations of including them. The former case is evaluation (such as PW analysis) may begin. It is
usually designated as the conventional payback method, important to remember that payback screening is not an
whereas the latter case is known as the discounted end in itself, but rather a method of screening out certain
payback method. obvious unacceptable investment alternatives before
progressing to an analysis of potentially acceptable ones.
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Payback Period Payback Period

 Discounted Payback Period Method

 Conventional Payback Period Method If the time value of money (i.e., the cost of
funds (interest) used to support the project) is
Initial cost considered, the modified payback period is referred
Payback Period =
Uniform annual benefit 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

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Sample Problem The Benefit-Cost Ratio Method

 A piece of new equipment has been proposed by an  The benefit-cost (B-C) ratio is defined as the
engineer to increase the productivity of a certain manual
welding operation. The investment cost is Php250,000 ratio of the equivalent worth of benefits to the
and the equipment will have a market value of Php50,000 equivalent worth of costs. The equivalent-worth
at the end of the study period of 5 years. Increased measure applied can be PW, FW, or AW, but
productivity attributable to the equipment will amount to customarily, either PW or AW is used. The B-C
Php80,000 per year after operating costs have been
subtracted from the revenue generated by the additional ratio is also known as the savings-investment
production. If the firm’s MARR is 20% per year, is this ratio (SIR) by some governmental agencies.
proposal a sound one? Use conventional and discounted
payback method to evaluate the economic soundness of
the investment.
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Benefit-Cost Ratio (B-C Ratio) Benefit-Cost Ratio (B-C Ratio)

Conventional B-C Ratio
PW (Benefits of the Proposed Project)  The numerator of the modified B-C ratio
B-C = expresses the equivalent worth of the benefits
PW (Total Cost of the Proposed Project)
minus the equivalent worth of the operating and
maintenance costs, and the denominator includes
Modified B-C Ratio only the initial investment costs (less any market
value).
PW(Benefits) - PW(Operating and Maintenance Cost)
B-C =  A project is acceptable when the B-C ratio is
Initial Investment -PW(Market Value) greater than or equal to 1.0.
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Sample Problem Assignment

 A piece of new equipment has been proposed by an  An initial capital of Php1,000,000 was put up for a new
engineer to increase the productivity of a certain manual business that will produce an annual income of
welding operation. The investment cost is Php250,000 Php600,000 for 5 years and will have a salvage value of
and the equipment will have a market value of Php50,000 Php20,000 at the time. Annual expenses for its operation
at the end of the study period of 5 years. Increased
productivity attributable to the equipment will amount to (salaries and wages, insurance, taxes) and maintenance
Php80,000 per year after operating costs have been amounts to Php300,000. If money is worth 10%
subtracted from the revenue generated by the additional compounded annually, is this investment profitable or not?
production. If the firm’s MARR is 20% per year, is this Use each of the following methods in your evaluation.
proposal a sound one? Use conventional and discounted a. FW method c. Discounted Payback method
payback method to evaluate the economic soundness of
the investment. b. IRR method d. Benefit-Cost Ratio method

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