Basic Methods

for ​Making

Economy Studies
Basic Methods or Patterns for making
economy studies
The Minimum Attractive Rate of
Return ​- The Minimum Attractive

Rate of ​Return (MARR), sometimes

called the ​hurdle rate, i​ s usually a

policy issue ​resolved by the top

management of an organization in

view of numerous considerations.

MARR is a reasonable rate of return
established for the evaluation and

selection of alternatives. A project is

not economically viable unless it is

expected to return at least the MARR.

The Rate of Return (ROR)
Method
net annual profit ​
Rate or return = ​ capital
invested ​Rate of Return is a measure
of effectiveness of an investment of
capital ​When this method is used, it is
necessary to decide whether the

computed ​rate of return is sufficient to

justify the investment. The

​ advantage
of this method is that it is easily
 understood by management ​and

investors. A​ single investment of

capital at the beginning of the first

year of the ​project life and identical

revenue and cost data for each year.

The capital invested is the total
amount of capital investment required

to ​finance the project, whether equity

or borrowed.
1​. The Internal Rate of Return
Method ​- sometimes referred to as
the ​breakeven interest rate, ​This
method solves for the interest rate
that equates the equivalent worth of
an alternative’s cash inflows (receipts
or ​savings) to the equivalent worth of
cash outflows (expenditures,
including ​investment costs). IRR
Decision Rule: If IRR ≥ MARR, the
project is economically justified. ​2.
The External Rate of Return
Method ​- It 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). If this ​external
reinvestment rate, which is usually
the firm’s MARR, happens to ​equal
the project’s IRR, then the ERR
method produces results identical to
those of the IRR method. ​ERR
Decision Rule: If ERR ≥ MARR, the
project is economically justified.
The Annual Worth (AW) Method
In this method, interest on the original

investment (minimum required ​profit)

is included as a cost. If the excess of

annual cash inflows over annual ​cash

outflows is not less than zero the

proposed investment if justified. This

​
method is covered by the same
limitations as the rate of return

pattern ​a single initial investment of

capital and uniform revenue and cost

throughout the life of the investment.

The Present Worth (PW) Method
The pattern for economy studies is
based on the concept of present

worth. ​If the present worth of the cash

flows is equal to, or greater than zero,

the ​project is justified economically.

The present worth method is flexible

and ​can be used for any type of

economy study.

The Future Worth (FW) Method

The future worth method for economy
studies is 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.

The Payback (Payout) Period
Method ​The payback period is
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. In computing

the total annual ​cost, depreciation

was not included because method

does not consider the time value of

money or interest.
investment − salvage value
Payout period years = ​
net annual cash flow
If annual profit is given:
Depreciable fixed capital
Payout period years = ​
investment

average profit per year + average depreciation per

year

Problem 1: ​An investment of

P270,000 can be made in a project
that will produce a uniform annual
revenue of P185,400 for 5 years and
then have a ​salvage value of 10% of
the investment. Out-of-pocket costs
for operation ​and maintenance will be
P81,000 per year. Taxes and
insurance will be 4% of the first cost
per year. The company expects
capital to earn not less than 25%
before income taxes. Is this a
desirable investment? What is the
payback period of the investment?
Problem 2: ​A businessman is
considering building a 25-unit
apartment in a place near a
progressive commercial center. He
felt that because of the location of the
apartment, it will be occupied 90% at
all time. He ​desires a rate of return of
20%. Other pertinent data are the
following:

Land investment P5,000,000 ​Building

investment P7,000,000 ​Study period

20 years ​Cost of land after 20 years

P20,000,000 Cost of building after 20

years P2,000,000 Rent per unit per

month P6,000 ​Upkeep per unit per

year P500 ​Property taxes 1%

Insurance 0.50%
Is this a good investment?
Problem 3: ​A man considering
investing P500,000 to open a semi-
automatic auto-washing business in a
city of 400,000 population. The
equipment can wash, on the average,
12 cars per hour, using two men to
operate it, and to do small amount of
hand work. The man plans to hire two
men, in addition to himself, and
operate the station in an 8-hour
basis, 6 days per week, 50 weeks per
year. He will pay his employees
P25.00 per ​hour. He expects to
charge P25.00 for a car wash.
Out-of-pocket ​miscellaneous cost
would be P8,500 per month. He
would pay his employees for 2 weeks
for vacations each year. Because ​of
the length of his lease, he must write
off his investment within 5 years. ​His
capital now is earning 15% and he
employed at a steady job that pays
P25,000 per month. He desires a rate
of return of at least 20% on his
investment. Would you recommend
the investment?
Problem 4: ​The MGC company has a
contract with a hauler to transport its

naphtha requirements of 3,600,000 liter

per year from a refinery in Batangas to

its site in Paco at a cost of P1.05 per

liter. It is proposed that the company

buys a ​tanker with a capacity of 18,000

liters to service its requirements at first

cost ​P8,000,000 life is 6 years and a

salvage value of P800,000. Other

expenses are as follows: a. Diesel fuel

at P7.95 per liter and the tanker

consumes 120 liter per round ​trip from

Paco to Batangas and back. ​b.

Lubricating oil and servicing is P3,200

per month. c. Labor including overtime

and fringe benefits for one driver and

one helper is P21,000 per month. d.

Annual taxes and insurance 5% first

cost. ​e. General maintenance per year

is P40,000 ​f. Tires cost P32,000 per set

and will be renewed every 150 round

trips. What
​ should the MGC company
do if a 15% interest rate on investment

is ​included in the analysis?

Problem 5: ​A proposed project will
require the immediate investment of
P50,000 and is estimated to have
year-end revenues and costs as
follows:

Year Revenue Costs

1 P75,000 P60,000 2 P90,000
P77,500 3 P100,000 P75,000 4
P95,000 P80,000 5 P60,000 P47,500

Additional investment of P20,000 will

be required at the end of the second
year. The project would terminate at
the end of the 5​th ​year, and the assets
are estimated to have a salvage
value of P25,000 at that time. Is this a
good investment?
The Benefit-cost Ratio Method ​The
B-C ratio method involves the
calculation of a ratio of benefits to

costs. It ​is actually a ratio of

discounted benefits to discounted

costs. This
​ method is most commonly
used by government agencies for

analyzing the ​desirability of public

projects.
B ​ = ​benefits − disbenefits
◌ൗ C ​
costs
The 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 ​present worth, annual worth,

or future worth, but customarily,

either PW or AW is used. If B-C ratio

is > 1, the project can be justified or

acceptable
The B-C criterion
B = net benefits
= all the advantages, less the
disadvantages to the user ​C = net
costs
= all disbursements, less any savings
to the investor. For a project to be
acceptable, the difference (B-C)

between the net ​benefits and net

costs must be positive, the benefits

must exceed the ​costs.

If B<C the project should not be

implemented.
Problem 6: ​For the cashflow given
below, determine if it is an acceptable

alternative based on a benefit-cost

ratio. Assume the interest rate is

4.5%
Problem 7: ​The city of Columbia is
considering extending the runways of its

municipal ​airport so that commercial jets

can use the facility. The land necessary

for the runway extension is currently a

farmland that can be purchased for

$350,000. Construction costs for the

runway extension are projected to be

$600,000, and the additional annual

maintenance costs for the extension are

estimated to be $22,500. If the ​runways

are extended, a small terminal will be

constructed at a cost of $250,000. The

annual operating and maintenance costs

for the terminal are estimated at $75,000.

Finally, the projected increase in flights

will require the addition of two air traffic

controllers at an annual cost of $100,000.

Annual benefits of the runway extension

have been estimated as follows: $325,000
​
Rental receipts from airlines leasing

space at the facility ​$65,000 Airport tax

charged to passengers $50,000

Convenience benefit for residents of

Columbia ​$50,000 Additional tourism

dollars for Columbia Apply

​ the B–C ratio
method with a study period of 20 years

and a MARR of ​10% per year to

determine whether the runways at

Columbia Municipal Airport should be

extended.
Problem 8. ​To increase accessibility
to some beautiful scenery along ​the
Pan-Philippine Highway, a new
highway is being proposed for the
construction. The initial cost is
expected to be P9,600,000, with
annual ​maintenance cost of P36,000.
Every three years, minor
improvements ​costing P20,000 are
expected to be made. It is estimated
that income from tourists from foreign
countries will be P1,200,000
annually. Using a planning horizon of
30 years and interest rate of 10%,
determine if the highway should be
constructed. Analyze by (a) B-C
criterion (b) B/C method.
Problem 9: ​Determine the annual

benefit X for alternative B to have ​the

same benefit-cost ratio as alternative

A, assuming minimum attractive rate

of return of 12%.

Alternative A B
Cost P5,400 P7,300 ​Salvage value
P400 P600 ​Annual benefit P1,500 X
Life (years) 10 10