ENGINEERI

NG
ECONOMIC ENGG
Economic Study Methods
404 S
Kristine Mariel B. Bejasa, REE
Lecturer
 ECONOMIC STUDY METHODS
All engineering studies of the capital project should consider the
return that a given project will or should produce. One basic question
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.
Because patterns of capital investment, revenue (or savings)
cash flows, and expenses cash flows can be quite different in various
projects, there is no single method for performing engineering
economic analyses that is ideal for all cases.
Consequently, several methods are commonly used:
1. Present Worth (PW)
2. Future Worth (FW)
3. Annual Worth (AW)
4. Internal Rate of Return (IRR)
5. External Rate of Return (ERR)
 ECONOMIC STUDY METHODS
Determining the Minimum Attractive Rate of Return (MARR)
The Minimum Attractive Rate of Return (MARR), sometimes called
the hurdle rate, should be chosen to maximize the economic well-
being of an organization subject to the following considerations:
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
 ECONOMIC STUDY METHODS
PRESENT WORTH METHOD
This method is based on the concept of the equivalent worth of
all cash flows relative to some base or beginning point in time called
the present. That is, all cash inflows and outflows are discounted to
the present point in time at an interest rate that is generally the
MARR.

To apply the PW method of determining a project’s economic

worthiness, we simply compute the present equivalent of all cash
flows using the MARR as the interest rate. If the present worth is
greater than or equal to zero, the project is acceptable.

Note: The higher the interest rate and the farther into the future
a cash flow occurs, the lower its PW is.
 ECONOMIC STUDY METHODS
EXAMPLE #1: 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
5000 is 20% per year, is this proposal a sound one?
Use the PW method. SOLUTION:
8000 8000 8000 8000 8000

Conclusion: Because PW(20%) ≥0, this

equipment is economically justified.
25k
 ECONOMIC STUDY METHODS
EXAMPLE #2: 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
SOLUTION: whether this system should be
installed.
Savings: 300,000kWh($0.10)= $30,000 8k
30k 30k 30k 30k 30k 30k

Years 0 .... 6
Conclusion: Because PW(15%) ≥0, the retrofitted
space heating system shall be installed.
110k
 ECONOMIC STUDY METHODS
FUTURE WORTH METHOD
This method is 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. Also, the FW of a project is
equivalent to its PW; that is, FW = PW(F/P, i%,N). If FW ≥ 0 for a
project, it would be economically justified.
 ECONOMIC STUDY METHODS
EXAMPLE #3: In Example 2, the $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.
SOLUTION:
30k 30k 30k 30k 30k 30k

Years 0 .... 6

110k

Conclusion: Because FW(15%) ≥0, the heating

system is still a profitable project even if it has
no market value at the end of the study
period.
 ECONOMIC STUDY METHODS
ANNUAL WORTH METHOD
The AW of a project is an equal annual series of amounts, for a
stated study period, that is equivalent to the cash inflows and
outflows at an interest rate that is generally the MARR. Hence, the
AW of a project is annual equivalent revenues or savings (R) minus
annual equivalent expenses (E), less its annual equivalent capital
recovery (CR) amount.

[ ] [ ]
𝑛
𝑖 (1+𝑖) 𝑖
𝐶𝑅= 𝐼 𝑛
−S 𝑛
(1+ 𝑖) − 1 (1+𝑖) −1
Initial investment x (Capital Salvage Value x (Sinking
recovery factor) fund factor)
 ECONOMIC STUDY METHODS
EXAMPLE #4: By using the AW method, determine whether the equipment
described in Example 1 should be recommended.5000

8000 8000 8000 8000 8000

25k
SOLUTION:

Conclusion: Because AW(20%) ≥0, this equipment is economically

justified.
 ECONOMIC STUDY METHODS
INTERNAL RATE OF RETURN METHOD
The IRR method (sometimes called as investor’s method, the
discounted cash flow method, or the profitability index) solves for the
interest rate that equates the equivalent worth of an alternative’s
cash inflows to the equivalent worth of cash outflows. Equivalent
worth may be computed using any of the three methods ( PW, FW,
AW). The resultant interest rate is termed the Internal Rate of Return
(IRR). The IRR is sometimes referred to as the breakeven interest
rate.
 ECONOMIC STUDY METHODS
EXAMPLE #5: AMT, Inc., is considering the purchase of a digital camera for the
maintenance of design specifications by feeding digital pictures directly into an
engineering workstation where computer-aided design files can be superimposed over
digital pictures. Differences between the two images can be noted, and corrections, as
appropriate, can then be made by design engineers. 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
SOLUTION using
corporation’s MARRlinear
is 20%interpolation
per year. :
let
P/A, (P/F, )

To use linear interpolation, we first need to try a few values for i′. A good starting point is to use
the MARR.

At %:
At %:
 ECONOMIC STUDY METHODS
SOLUTION using linear interpolation :
let

At %:
At %:

Now that we have both a positive and a negative PW, the answer is bracketed (20% ≤ i′% ≤ 25%). The
dashed curve in Figure is what we are linearly approximating. The answer, i′%, can be determined by using
the similar triangles represented by dashed lines in Figure.

Here, BA is the line segment B − A = 25% − 20%. Thus

22.16%

Because the IRR is greater than the MARR(20%), the project is acceptable.
 ECONOMIC STUDY METHODS
EXTERNAL RATE OF RETURN METHOD
The ERR method directly takes into account 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.

Steps in calculating the ERR:

1. Draw a net cash flow diagram.
2. Discount all the negative net cash flows to the project start.
3. Compound all the positive net cash flows to the project end.
4. Calculate the ERR as the interest rate that equates the two.
 ECONOMIC STUDY METHODS
EXAMPLE #6: (Refer to Ex1) 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
5000
attributable to the equipment will amount to $8,000 per year after extra operating
costs have been subtracted from8000 the 8000
value8000
of the
8000 additional
8000 production. Is the
investment a good one? Recall that the MARR is 20% per year.
SOLUTION:
5
let

$25,000(F /P, i′%, 5) = $8,000(F /A, 20%, 5) + $5,000

25k
(F /P, i′%, 5)

% Because i′ > MARR, the project is justified, but just barely.

 ECONOMIC STUDY METHODS
PAYBACK OR PAYOUT METHOD
This method is a measure of the speed with which investment is
recovered by the cash inflows it produces. The payback method
mainly indicates the project’s liquidity rather than its profitability. The
longer it takes to recover invested money, the greater the perceived
riskiness of a project. There are two types of Payback periods:

1. Simple Payback Period –ignores the time value of money and

all cash flows that occur after this period.

2. Discounted Payback Period – the time value of money is

calculated using an interest rate that is generally the MARR.
 ECONOMIC STUDY METHODS
EXAMPLE #7: A public school is being renovated for $13.5 million. The building
has geothermal heating and cooling, high-efficiency windows, and a solar
array that permits the school to sell electricity back to the local electric utility.
The annual value of these benefits is estimated to be $2.7 million. In addition,
the residual value of the school at the end of its 40-year life is negligible. What
are the simple payback period and internal rate of return for the renovated
school?
SOLUTION:
The simple payback period is

The IRR can be computed by the equation,

(P / A, i’%, 40)

i’% = 20% per year

References:
• Sullivan, William, et al.(2014), Engineering
Economy 16th Edition, Pearson Education, Inc.

• Blank, Leland T.(2014).Basic of Engineering

Economy, 2nd edition, Mc Graw-Hill, New York

• Sta. Maria, Hipolito B. (2000),Engineering

Economy Third Edition

THANK YOU!
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