LESSON 8

BASIC METHODS FOR MAKING ECONOMIC STUDIES

At the end of the lesson /chapter, students are able to:

1. Determine the basic patterns of making economic studies;

2. Analyze and apply the different patterns to problems
3. Apply Solve the different patterns to problems

Basic Methods or Pattern for Making Economy Studies

Rate of Return Method ( ROR)

The rate of return on the capital invested is given by the formula;

Net annual profit

Rate of Return = ----------------------- (6.1)
Capital investment

Rate of Return is a measure of the effectiveness of an investment of capital. It is

a financial efficiency. 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.
The applications of the rate of return method is controlled by the following
conditions:
a). A single investment of capital at the beginning of the first year of the project
life and

b). Identical revenue and cost data for each year.

c). The capital invested is the total amount of capital investment required to
finance the project, whether equity or borrowed

59
 The Annual Worth Method (AW)

In this method, interest on the original investments (sometimes called minimum

required profit) is included as a cost.

If the excess of the annual cash inflows over annual cash outflows is not
less than zero the proposed investment is justified or valid.

This 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 Method (PW)

This pattern for economy studies is 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.

The present worth method is flexible and can be used for any type of economy
study. It is used extensively in making economy studies in the public works field, where
long-lived structures are involved.

Present Worth (PW) is also called Discounted Cash Flow (DCF) or Present
Value. The interest value is also referred to as discount rate.

Present Worth Method = a process of obtaining the equivalent worth of future cash
flows back to some point in time.

To find the PW as a function of i% (per interest period) of a series of cash inflows

and outflows, it is necessary to discount future amounts to the present by using the

60
interest rate over the appropriate study period (years, for example) in the following
manner:
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.

PW Decision Rule: If PW (i = MARR) ≥ 0, the project is economically justified.

It is important to observe that the higher the interest rate and the farther into the
future a cash flow occurs, the lower its PW is.

The Future Worth Method (FW)

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.

Investment - salvage value

Payout Period (years) = ---------------------------------- (6.2)
Net annual cash flow

61
Example
1. An investment of Php270,000 can be made in a project that will produce a
uniform annual revenue of Php185.400 for 5 years and then have a salvage
value of 10% of the investment. Out of pocket costs for operation and
maintenance will be Php81,000 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?

Solutions:

By the Rate of Return Method:

Annual revenue = Php185,400

Annual Costs:

Salvage value = Php270,000 ( 0.10) = Php27,000

Php270,000 – 27,000
Depreciation = ---------------------------
F/A, 25%, 5

(1 + i)n - 1 (1 + .25)5 - 1
Where : F/A = -------------- = --------------- = 8.2070
i .25

Php243,000
Depreciation = --------------- = Php 29,609
8.2070

Operations and Maintenance = Php 81,000

Taxes and Insurance =

= 270,000 ( 0.04) = Php 10,800

--------------------
Total Annual cost = Php 121,409

Net Annual Profit = Annual Revenue - Annual Cost

62
 = Php185,000 - 121,409

= Php 63,991

Net Annual Profit

Rate of Return = ----------------------- x 100
Capital Investment

63, 991
= ----------- x 100 = 23.70 %
270,000

Since the rate of return is less than 25%, the investment is not justified.

By the Annual Worth Method

Annual revenue = Php185,400

Annual Costs:

270,000 - 27,000 243,000

Depreciation = ----------------------- = --------------
F/A, 25%, 5 8.2070

= Php 29, 609

Operations and Maintenance = Php 81,000

Taxes and Insurance =

= 270,000 ( 0.04) = Php 10,800

Interest on capital =

= Php270,000 (0.25) = Php 67,500

--------------------
Total Annual Cost = Php188,909

AW = Annual cash inflows - Annual cash outflows

Php185,400 - Php188,909 = - Php3,509 excess

63
Since the excess of annual cash inflows over annual cash outflows is less than zero (
-3,509), the investment is not justified.
By the Present Worth Method

PW of Cash inflows = Php185,400 ( P/A, 25%, 5) + 27,000 ( P/F, 25%, 5)

( 1 + i)n - 1 ( 1 + 0.25)5 - 1 2.0517578

Where: P/A = --------------- = ------------------- = ---------------- = 2.6893
i( 1 + i)n .25 ( 1 + .25)5 0.762939453

1 1
P/F = ----------------- = ------------- = 0.3277
( 1 + i)n (1.25)5

PW of Cash inflows = 185,400 ( 2.893) + 27,000( 0.3277)

= 498,596.22 + 8,847.90

= Php 507, 444.12

Annual cost ( excluding depreciation) = 81,000 + 270,000 (.04)

Operation and maintenance = 81,000

Taxes and Insurance = 270,000(0.04) = 10,800

-----------
Total Annual Cost = Php 91,800

PW cash outflows = Php 270,000 + 91,800 ( P/A, 25%, 5)

= 270,000 + 91,800(2.6893)

= Php 516,877.74

Net Cash Flow = Cash in flows - cash outflow

= 507,444.12 - 516,877.74

= Php - 9,433.62

64
Since PW of the Net cash Flow is less than zero ( -9433.62) , the investment is not
justified.

By Future Worth Method

Salvage Value = 270,000 ( .10) = 27,000

FW of cash inflows = 27,000 + 185,400 ( F/A, 25%, 5 )

Where F / A = 8.2070 = 27,000 + 185,400 ( 8.2070)

FW = Php 1,5 48,577.80

FW of cash outflows = Php91,800 (F/A, 25%. 5 ) +

270,000 (F/P, 25%, 5)

= 91,800 ( 8.2070) + 270,000 ( 3.0518)

= 753,402.6 + 823,986

= Php 1,577,388.60

Where F/P = ( 1 + i)n = (1 + .25)5 = 3.0518

By the Pay back Period

Total annual Cost = Php 81,000 + 270,000 ( 0.04)

= Php 91,800

Net annual cash flows = 185,400 – 91,800 = Php 93,600

Investment – salvage value

Payback Period = ---------------------------------
Net annual Cash flows

270,000 - 27,000
= ------------------------
93,600

= 2,59 or 2.6 years.

65
In computing the total annual cost, depreciation was not included because the method
does not consider the time value of money or interest. The use of the payback period for
making investment decisions should be avoided as it may produce misleading results.
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 Php 5,000,000

Building investment 7,000,000
Study period 20 years
Cost of land after 20 years 20,000,000
Cost of building after 20 years 2,000,000
Rent per unit per month 6,000
Upkeep per unit per year 500
Property taxes 1%
Insurance 0.50%

Is this a good investment?

Solution :

Annual income:

Rental = (6,000) (12) ( 25) ( 0.9) = Php 1. 620,000

20,000,000 - 5,000,000
Land = ----------------------------
F/A, 20%, 20

( 1 + i)n - 1 ( 1 + 0.20)20 - 1
Where F/A = ------------- = ------------------ = 186.688
i 0.20

20,000,000 - 5,000,000
Land = ---------------------------- = Php 80,347.96
186.688

66
 Total Annual Income = Php 1,620,000 + 80,347.96

= Php 1,700,213.90

Annual Costs:
7,000,000 - 2,000,000 5,000,000
Depreciation = ---------------------------- = --------------
F/A, 20%, 20 186.688

= Php26,782.65

Upkeep = 500 (25) = 12,500

Taxes = 7,000,000 + 5,000,000

= 12,000,000( 0.01) = 120,000

Insurance = 7,000,000 ( 0.005) = 35,000

Total Annual Cost = 26,782.65 + 12,500 + 120,000 + 35,000

= Php 194,282.65

Net Profit = Annual Income - Annual Cost

= Php 1,700,213.90 - 194,282,65

= Php 1,505,931.25

1,505,931.25
Rate of Return = -------------------- x 100 = 12.55% < 20%
12,000,000

Therefore; the businessman should not invest.

67
Problems

1. A mechanical engineer is considering establishing his own small company. An

investment of Php 400,000 will be required which will be recovered in 15 years. It
is estimated that sales will be Php800,000 per year and that operating expenses
will be as follows:

Materials Php 160,000 per year

Labor 280,000 per year
Overhead 40,000 + 10% of sales per year
Selling expense 60,000 per year

The man will give up his regular job paying Php 216,000 per year and devote full
time to the business, this will result in decreasing labor cost by Php40,000 per
year, material cost by Php28,000 per year, and overhead cost by Php32,000 per
year. If the man expects to earn at least 20% of his capital, should he invest?

2. The ABC company is considering constructing a plant to manufacture a proposed

new product. The land costs Php15,000,000, the building costs Php30,000,000;
the equipment costs Php 12,500,000, and Php 5,000,000 working capital is
required. At the end of 12 years, the land can be sold for PHP 25,000,000, the
building for Php 12,000,000, the equipment for Php 250,000 and all of the
working capital recovered. The annual disbursements for labor, materials, and
all other expenses are estimated to cost Php 23,750,000. If the company
requires a minimum return of 25%, what should be the minimum annual sales for
12 years to justify the investment.

68
69