ES 91

Engineering Economy
3rd Edition
Hipolito B. Sta Maria

Chapter 6:Basic Methods for Making

Economy Studies
Reference:
2012 Engineering Economy
Chapter 5 (Evaluating a Single Project), 15th Edition by
William G. Sullivan, Elin M. Wicks and C. Patrick Koelling
 Objective:
To discuss and critique contemporary
methods for determining project
profitability.
 Chapter 6:Basic Methods for Making
Economy Studies

1. Rate of Return (ROR) Method

2. The Annual Worth (AW) Method
3. The Present Worth (PW) Method
4. The Future Worth (FW) Method
5. The Payback (Payout) Method

To be attractive, a capital project must provide a return that exceeds

a minimum level established by the organization. This minimum
level is reflected in a firm’s Minimum Attractive Rate of Return
(MARR).
Elements that contribute to determining the MARR:
• Amount, source, and cost of money available
• Number and purpose of good projects available
• Perceived risk of investment opportunities
• Type of organization

The most-used method is the present worth method.

 1. The Rate of Return Method

• A measure of the effectiveness of an investment of capital; a

financial efficiency

𝑛𝑒𝑡 𝑎𝑛𝑛𝑢𝑎𝑙 𝑝𝑟𝑜𝑓𝑖𝑡

𝑅𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 =
𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑒𝑑

Internal Rate of Return (IRR)

• the most widely used rate of return method for performing
engineering economic analysis.
• It is also called the investor’s method, the discounted cash flow
method, and the profitability index.
• If the IRR for a project is greater than the MARR, then the
project is acceptable.
 1. The Rate of Return Method

Internal Rate of Return (IRR)

• the most widely used rate of return method for performing
engineering economic analysis.
• It is also called the investor’s method, the discounted cash flow
method, and the profitability index.
• If the IRR for a project is greater than the MARR, then the
project is acceptable.
• The IRR assumes revenues generated are reinvested at the
IRR—which may not be an accurate situation.
 1. The Rate of Return Method

External Rate of Return (ERR)

• The ERR takes into account the interest rate, ε, external to a
project at which net cash flows generated (or required) by a
project over its life can be reinvested (or borrowed). This is
usually the MARR.
• If the ERR happens to equal the project’s IRR, then using the
ERR and IRR produce identical results.
 2. The Annual Worth (AW) Method

• Interest on the original investment (sometimes called minimum

required profit) is included as a cost.
• If the excess of annual cash inflows is not less than zero, the
proposed investment is justified (valid).
• The AW of a project is annual equivalent revenue or savings
minus annual equivalent expenses, less its annual capital
recovery (CR) amount.
 3. The Present Worth (PW) Method

• Based on the concept of present worth

• If the present worth of the net cash flows is equal to, or greater
than zero, the project is justified economically
• Flexible; used extensively in making economy studies in the
public works field, where long-lived structures are involved
• Found by discounting all cash inflows and outflows to the
present time at an interest rate that is generally the MARR
• A positive PW for an investment project means that the project
is acceptable (it satisfies the MARR).
 4. The Future Worth (FW) Method

• Exactly comparable to the present worth method except that all cash
inflows and outflows are compounded forward to a reference point in
time called the future.
• If the future worth of the net cash flows is equal to, or greater than
zero, the project is justified economically.
• 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.
 5. The Payback (Payout) Method
• Commonly defined as the length of time required to recover the first
cost of an investment from the net cash flow produced by that
investment for an interest rate of zero.
• Simple, but possibly misleading
• The simple payback period is the number of years required for cash
inflows to just equal cash outflows.
• It is a measure of liquidity rather than a measure of profitability.
• It doesn’t indicate anything about project desirability except the
speed with which the initial investment is recovered.
• Recommendation: use the payback period only as supplemental
information in conjunction with one or more of the other methods.

𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 − 𝑠𝑎𝑙𝑣𝑎𝑔𝑒 𝑣𝑎𝑙𝑢𝑒

𝑃𝑎𝑦𝑜𝑢𝑡 𝑝𝑒𝑟𝑖𝑜𝑑 𝑦𝑒𝑎𝑟𝑠 =
𝑛𝑒𝑡 𝑎𝑛𝑛𝑢𝑎𝑙 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤