MODULE 3 – Basic Economy Study Methods 1

Engr. Caesar P. Llapitan

Topics
I. Introduction
II. The Minimum Attractive Rate of Return
III. The Present Worth Method
IV. The Future Worth Method
V. The Annual Worth Method
VI. The Internal Rate of Return Method
VII. External Rate of Return Method
VIII. The Payback Period
IX. The Benefit/Cost Ratio Method

Learning Objectives
At the end of this module, the students should be able to
1. discuss briefly the rationale of economic profitability and the methods used for such
analysis of a single proposed problem solution.
2. explain the principle of the minimum attractive rate of return
3. define PW, state its standard assumptions, and use it to measure the economic
attractiveness of a project or an alternative in cases with equal, unequal, and infinite
project lives.
4. evaluate the economic attractiveness of a project or an alternative in cases with equal,
unequal, and infinite project lives using the annual worth method.
5. evaluate project cash flows with the internal rate of return (IRR) measure

I. INTRODUCTION

Engineering economy studies of capital projects should consider the return that a given project
will or should produce.

A basic question addressed 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 expense 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.
A project focus will be taken as we introduce ways of gauging profitability.

There are five methods for evaluating the economic profitability of a single proposed problem
solution (i.e., alternative):
1. Present Worth (PW)
2. Future Worth (FW)
3. Annual Worth (AW),
4. Internal Rate of Return (IRR)
5. External Rate of Return (ERR)

 The first three methods convert cash flows resulting from a proposed problem solution
into their equivalent worth at some point (or points) in time by using an interest rate
known as the Minimum Attractive Rate of Return (MARR).

 The IRR and ERR methods compute annual rates of profit, or returns, resulting from an
investment and are then compared to the MARR.
 MODULE 3 – Basic Economy Study Methods 2
Engr. Caesar P. Llapitan

 The payback period is a measure of the speed with which an investment is recovered by
the cash inflows it produces. This measure, in its most common form, ignores time value
of money principles. For this reason, the payback method is often used to supplement
information produced by the five primary methods

Formulating Alternatives
Alternatives are one of two types:
1. Mutually exclusive (ME). Only one of the viable projects can be selected. Each viable
project is an alternative. If no alternative is economically justifiable, do nothing (DN) is
the default selection.
▪ A mutually exclusive alternative selection is the most common type in engineering
practice.
▪ Mutually exclusive alternatives compete with one another in the evaluation. All the
analysis techniques compare mutually exclusive alternatives.

2. Independent. More than one viable project may be selected for investment. (There may
be dependent projects requiring a particular project to be selected before another,
and/or contingent projects where one project may be substituted for another.)
▪ Independent projects are usually designed to accomplish different purposes, thus the
possibility of selecting any number of the projects. These alternatives do not
compete with one another; each project is evaluated separately, and the comparison
is with the MARR.

3. The DN alternative or project means that the current approach is maintained; nothing
new is initiated. No new costs, revenues, or savings are generated.
▪ The do-nothing (DN) option is usually understood to be an alternative when the
evaluation is performed. If it is absolutely required that one of the defined
alternatives be selected, do nothing is not considered an option. (This may occur
when a mandated function must be installed for safety, legal, or other purposes.)
Selection of the DN alternative means that the current approach is maintained; no
new costs, revenues, or savings are generated.

Note:
 Mutually exclusive alternatives compete with one another and are compared pairwise.
 Independent projects are evaluated one at a time and compete only with the DN
project.

It is important to classify an alternative’s cash flows as revenue-based or cost-based. All

alternatives evaluated in one study must be of the same type.
▪ Revenue. Each alternative generates cost and revenue cash flow estimates, and possibly
savings, which are treated like revenues. Revenues may be different for each alternative.
These alternatives usually involve new systems, products, and services that require
capital investment to generate revenues and/or savings. Purchasing new equipment to
increase productivity and sales is a revenue alternative.

▪ Cost. Each alternative has only cost cash flow estimates. Revenues are assumed to be
equal for all alternatives. These may be public sector (government) initiatives, or legally
mandated or safety improvements.
 MODULE 3 – Basic Economy Study Methods 3
Engr. Caesar P. Llapitan

II. THE MINIMUM ATTRACTIVE RATE OF RETURN

The Minimum Attractive Rate of Return (MARR) is usually a policy issue resolved by the top
management of an organization in view of numerous considerations. Among these
considerations are the following:
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 utility, or private industry)

MARR (hurdle rate)

▪ should be chosen to maximize the economic well-being of an organization, subject to
the types of considerations listed above

Factors Affecting Minimum Acceptable Rate of Return

1. Cost of capital
- It is what it costs a company to borrow money from all sources, loans, bonds,
common and preferred stock. A company must make a return greater than the cost
of capital to pay its debts and be profitable.

2. Availability of capital
- This depends on the health of the economy. In times when capital is in short supply,
higher interest rates are charged, and capital investment decisions may be delayed.

3. Competing investments
- Management may adjust this rate to screen from the immediate investment
considerations those ventures that are less attractive.

4. Difference in risks of investment

- The greater the risk, the higher the required return. Lastly, the length of time to
recover the investment in a venture is important. Management’s objective is to
recover the investment as quickly as possible because the economy is difficult to
predict the longer the time frame.

5. Difference in time to recover capital

- In today’s economy, industry will require a 25–35% return after taxes for low-risk
ventures at the early stages of consideration. As a secondary guide, a payout period
of up to 3 years is considered reasonable.

III. THE PRESENT WORTH METHOD

The PW method is based on the concept of 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. A positive
PW for an investment project is a dollar amount of profit over the minimum amount required
by investors. It is assumed that cash generated by the alternative is available for other uses that
earn interest at a rate equal to the MARR.
 MODULE 3 – Basic Economy Study Methods 4
Engr. Caesar P. Llapitan

 present worth of all   present worth of 

Net present worth (NPW) =  - 
 cash inflow items   cash outflow items 

For present worth analysis, the proper economic criteria are:

Situation Criterion
Fixed input Amount of money or other input Maximize present worth of
resources are fixed benefits or other outputs
Fixed output There is a fixed task, benefit, or Minimize present worth of
other output to be accomplished costs or other inputs
Neither input Typical, general case Maximize net present worth
nor output is (PW of benefits – PW of costs) or,
fixed more simply stated:
Maximize NPW

The consequences of each alternative must be considered for this period of time, which is
usually called the analysis period, planning horizon, or project life.

Three different analysis-period situations are encountered in economic analysis problems with
multiple alternatives:
1. The useful life of each alternative equals the analysis period.
2. The alternatives have useful lives different from the analysis period.
3. There is an infinite analysis period, n = .

A. Present Worth Analysis of Equal-Life Alternatives

If both alternatives are used in identical capacities for the same time period, they are termed
equal-service alternatives. Calculate the PW value at the stated MARR for each alternative.

For mutually exclusive alternatives the following guidelines are applied:

▪ One alternative:
Calculate PW at the MARR. If PW  0, the alternative is financially viable.

▪ Two or more alternatives:

- Calculate the PW of each alternative at the MARR. Select the alternative with the PW
value that is numerically largest, that is, less negative or more positive.

Note that the guideline to select one alternative with the lowest cost or highest revenue uses
the criterion of numerically largest. This is not the absolute value of the PW amount, because
the sign matters. The selections below correctly apply the guideline for two alternatives A and
B.

PWA PWB Selected Alternative

$ −2300 $ −1500 B
−500 +1000 B
+2500 +2000 A
+4800 −400 A

For independent projects, each PW is considered separately, that is, compared with the DN
project, which always has PW  0. The selection guideline is as follows:

One or more independent projects:

- Select all projects with PW  0 at the MARR.
 MODULE 3 – Basic Economy Study Methods 5
Engr. Caesar P. Llapitan

The independent projects must have positive and negative cash flows to obtain a PW value that
can exceed zero; that is, they must be revenue projects.

Examples:
1. A university lab is a research contractor to NASA for in-space fuel cell systems that are
hydrogen and methanol-based. During lab research, three equal-service machines need to
be evaluated economically. Perform the present worth analysis with the costs shown below.
The MARR is 10% per year.

Electric-Powered Gas-Powered Solar-Powered

First cost, $ −4500 3500 −6000
Annual operating cost
−900 −700 −50
(AOC), $/year
Salvage value S, $ 200 350 100
Life, years 8 8 8

Solution:
These are cost alternatives. The salvage values are considered a “negative” cost, so a + sign
precedes them. (If it costs money to dispose of an asset, the estimated disposal cost has a −
sign.)

The PW of each machine is calculated at i = 10% for n = 8 years. Let us use subscripts E, G,
and S.
PWE = -4500 − 900(P/A ,10%,8) + 200(P/F ,10%,8) = −$ 9,208
PWG = -3500 − 700(P/A ,10%,8) + 350(P/F ,10%,8) = −$ 7,071
PWS = -6000 − 50(P/A ,10%,8) + 100(P/F ,10%,8) = −$ 6,220

The solar-powered machine is selected since the PW of its costs is the lowest; it has the
numerically largest PW value.

2. A firm is considering which of two mechanical devices to install to reduce costs. Both devices
have useful lives of 5 years and no salvage value. Device A costs $1000 and can be expected
to result in $300 savings annually. Device B costs $1350 and will provide cost savings of $300
the first year but will increase $50 annually, making the second-year savings $350, the third-
year savings $400, and so forth. With interest at 7%, which device should the firm purchase?

Solution:
The analysis period can conveniently be selected as the useful life of the devices, or 5 years.
The appropriate decision criterion is to choose the alternative that maximizes the net
present worth of benefits minus costs.

PWA = 300(P/A, 7%, 5) = −1000 + 300(4.100) = $230

 MODULE 3 – Basic Economy Study Methods 6
Engr. Caesar P. Llapitan

PWB = −1350 + 300(P/A, 7%, 5) + 50(P/G, 7%, 5)

= −1350 + 300(4.100) + 50(7.647) = $262.4

Device B has the larger present worth and is the preferred alternative.

3. Wayne County will build an aqueduct to bring water in from the upper part of the state. It
can be built at a reduced size now for $300 million and be enlarged 25 years hence for an
additional $350 million. An alternative is to construct the full-sized aqueduct now for $400
million.
Both alternatives would provide the needed capacity for the 50-year analysis period.
Maintenance costs are small and may be ignored. At 6% interest, which alternative should
be selected?

Solution:
This problem illustrates staged construction. The aqueduct may be built in a single stage, or
in a smaller first stage followed many years later by a second stage to provide the additional
capacity when needed.

For the Two-Stage Construction

PW of cost = $300 million+ 350 million (P/F, 6%, 25)
= $300 million+ 81.6 million
= $381.6 million

For the Single-Stage Construction

PW of cost = $400 million

The two-stage construction has a smaller present worth of cost and is the preferred
construction plan.

4. A firm is trying to decide which of two weighing scales it should install to check a package-
filling operation in the plant. The ideal scale would allow better control of the filling
operation, hence less overfilling. If both scales have lives equal to the 6-year analysis period,
which one should be selected? Assume an 8% interest rate.

Uniform End-of-Useful-Life
Alternatives Cost
Annual Benefit Salvage value
Atlas scale $2000 $450 $100
Tom Thumb scale 3000 600 700

Solution:
Atlas Scale
PW of benefits − PW of cost = 450(P/A, 8%, 6) + 100(P/F, 8%, 6) − 2000
= 450(4.623) + 100(0.6302) − 2000
= 2080 + 63 − 2000 = $143

Tom Thumb Scale

PW of benefits − PW of cost = 600(P/A, 8%, 6) + 700(P/F, 8%, 6) – 3000
= 600(4.623) + 700(0.6302) − 3000
= 2774 + 441 − 3000 = $215

The salvage value of each scale, it should be noted, is simply treated as another positive cash
flow. Since the criterion is to maximize the present worth of benefits minus the present
worth of cost, the preferred alternative is the Tom Thumb scale.
 MODULE 3 – Basic Economy Study Methods 7
Engr. Caesar P. Llapitan

Classroom Activity 1
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 is 20% per year, is this proposal a sound one? Use the PW
method.
$5,000

$8,000 $8,000 $8,000 $8,000 $8,000

$25,000
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 whether this system should be installed.

B. Present Worth Analysis of Different-Life Alternatives

When the present worth method is used to compare mutually exclusive alternatives that
have different lives, the equal-service requirement must be met. The procedure of equal life
analysis is followed, with one exception:
▪ The PW of the alternatives must be compared over the same number of years and
must end at the same time to satisfy the equal-service requirement.

This is necessary, since the present worth comparison involves calculating the equivalent PW
of all future cash flows for each alternative. A fair comparison requires that PW values represent
cash flows associated with equal service.

The equal-service requirement is satisfied by using either of two approaches:

▪ LCM: Compare the PW of alternatives over a period of time equal to the least common
multiple (LCM) of their estimated lives.
▪ Study period: Compare the PW of alternatives using a specified study period of n
years. This approach does not necessarily consider the useful life of an alternative. The
study period is also called the planning horizon.

For either approach, calculate the PW at the MARR and use the same selection guideline as that
for equal-life alternatives. The LCM approach makes the cash flow estimates extend to the same
period, as required. For example, lives of 3 and 4 years are compared over a 12-year period.
 MODULE 3 – Basic Economy Study Methods 8
Engr. Caesar P. Llapitan

- The first cost of an alternative is reinvested at the beginning of each life cycle, and the
estimated salvage value is accounted for at the end of each life cycle when calculating
the PW values over the LCM period.

Additionally, the LCM approach requires that some assumptions be made about subsequent life
cycles. The assumptions when using the LCM approach are that
1. The service provided will be needed over the entire LCM years or more.
2. The selected alternative can be repeated over each life cycle of the LCM in exactly the
same manner.
3. Cash flow estimates are the same for each life cycle.

Example:
National Homebuilders, Inc., plans to purchase new cut-and-finish equipment. Two
manufacturers offered the estimates below.
Vendor A Vendor B
First cost, $ -15,000 -18,000
Annual M&O cost, $ per year -3,500 -3,100
Salvage value, $ 1,000 2,000
Life, years 6 9

a) Determine which vendor should be selected on the basis of a present worth comparison,
if the MARR is 15% per year.
b) National Homebuilders has a standard practice of evaluating all options over a 5-year
period. If a study period of 5 years is used and the salvage values are not expected to
change, which vendor should be selected?

Solution:
a) Since the equipment has different lives, compare them over the LCM of 18 years. For life
cycles after the first, the first cost is repeated in year 0 of each new cycle, which is the
last year of the previous cycle. These are years 6 and 12 for vendor A and year 9 for B.
The cash flow diagram is shown in Figure below. Calculate PW at 15% over 18 years.
 MODULE 3 – Basic Economy Study Methods 9
Engr. Caesar P. Llapitan

PWA = - 15,000 - 15,000(P/F,15%,6) + 1000(P/F,15%,6) - 15,000(P/F,15%,12)

+ 1000(P/F,15%,12) + 1000(P/F,15%,18) - 3,500(P/A,15%,18)
= - $ 45,036

PWB = - 18,000 - 18,000(P/F,15%,9) + 2000(P/F,15%,9)

- 2000(P/F,15%,18) - 3100(P/A,15%,18)
= - $ 41,384

Vendor B is selected, since it costs less in PW terms; that is, the PWB value is numerically
larger than PWA.

b) For a 5-year study period, no cycle repeats are necessary. The PW analysis is
PWA = - 15,000 - 3500(P/A,15%,5) + 1000(P/F,15%,5)
= - $ 26,236

PWB = - 18,000 - 3100(P/A,15%,5) + 2000(P/F,15%,5)

= - $ 27,397

Vendor A is now selected based on its smaller PW value. This means that the shortened
study period of 5 years has caused a switch in the economic decision.

Note:
A shortened study period will cause a switch in the economic decision. In situations such
as this, the standard practice of using a fixed study period should be carefully
examined to ensure that the appropriate approach, that is, LCM or fixed study period, is
used to satisfy the equal-service requirement.

What would one do, however, if the alternatives had useful lives of 7 and 13 years, respectively?
Here the least common multiple of lives is 91 years. An analysis period of 91 years hardly seems
realistic. Instead, a suitable analysis period should be based on how long the equipment is likely
to be needed. This may require that terminal values be estimated for the alternative at
some point prior to the end of their useful lives.

Examples
1. A diesel manufacturer is considering the two alternative production machines graphically
depicted in the Figure. Specific data are as follows.
Alternative 1 Alternative 2
Initial cost $50,000 $75,000
Estimated salvage value at end of useful life $10,000 $12,000
Useful life of equipment, in year 7 13
Estimated market value, end of 10-year analysis period $20;000 $15,000
 MODULE 3 – Basic Economy Study Methods 10
Engr. Caesar P. Llapitan

The manufacturer uses an interest rate of 8% and wants to use the PW method to compare these
alternatives over an analysis period of 10 years.

Solution:
In this case, the decision maker is setting the analysis period at 10 years rather than
accepting a common multiple of the lives of the alternatives, or assuming that the period of
needed service is infinite.

This is a legitimate approach - perhaps the diesel manufacturer will be phasing out this
model at the end of the 10-year period. In any event, we need to compare the alternatives
over 10 years.
PW (Alt. 1) = −50,000 + (10,000 − 50,000) (P/F, 8%,7) + 20,000(P/F, 8%, 10)
= −50,000 − 40,000(0.5835) + 20,000(0.4632)
= −$64,076

PW (Alt. 2) = −75,000 + 15,000(P/F, 8%, 10)

= −75,000 + 15,000(0.4632)
= −$69,442

To minimize PW of costs the diesel manufacturer should select Alt. 1.

2. A mechanical engineer has decided to introduce automated materials-handling equipment

for a production line. She must choose between two alternatives: building the equipment
or buying the equipment off the shelf. Each alternative has a different service life and a
different set of costs.
Alternative 1: Build custom automated materials-handling equipment.
First cost $15 000
Labor $3300 per year
Power $400 per year
Maintenance $2400 per year
Taxes and insurance $300 per year
Service life 10 years
 MODULE 3 – Basic Economy Study Methods 11
Engr. Caesar P. Llapitan

Alternative 2: Buy off-the-shelf standard automated materials-handling equipment.

First cost $25 000
Labor $1450 per year
Power $600 per year
Maintenance $3075 per year
Taxes and insurance $500 per year
Service life 15 years

If the MARR is 9 percent, which alternative is better?

Solution:
A fair comparison of the costs can be made only if equal lives are compared.
Let us apply the repeated lives method.
- If each alternative is repeated enough times, there will be a point in time where their
service lives are simultaneously completed. This will happen first at the time equal
to the least common multiple of the service lives.

The least common multiple of 10 years and 15 years is 30 years.

- Alternative 1 will be repeated twice (after 10 years and after 20 years), while
alternative 2 will be repeated once (after 15 years) during the 30-year period. At the
end of 30 years, both alternatives will be completed simultaneously.

Alternative 1: Build custom automated materials-handling equipment and repeat twice.

PW (1) = -15 000 - 15 000(P/F,9%,10) - 15 000(P/F,9%,20)
- (3300 + 400 + 2400 + 300)(P/A,9%,30)
= -15 000 - 15 000(0.42241) - 15 000(0.17843) - 6400 (10.273)
 -89 760

Alternative 2: Buy off-the-shelf standard automated materials-handling equipment and

repeat once.
PW (2) = -25 000 - 25 000(P/F,9%,15) - (1450 + 600 + 3075 + 500)(P/A,9%,30)
=-25 000 - 25 000(0.27454) - 5625(10.273)
= -89 649

Using the study period method of comparison, alternative 1 has the smaller present worth
and is, therefore, preferred.

For independent projects, use of the LCM approach is unnecessary since each project is
compared to the do-nothing alternative, not to each other, and satisfying the equal-service
requirement is not a problem. Simply use the MARR to determine the PW over the respective
life of each project and select all projects with a PW  0.

Exercises 1
1. A firm is considering which of two mechanical devices to install to reduce costs in a
particular situation. Both devices cost $1000 and have useful lives of 5 years and no salvage
value. Device A can be expected to result in $300 savings annually. Device B will provide cost
savings of $400 the first year but will decline $50 annually, making the second-year savings
 MODULE 3 – Basic Economy Study Methods 12
Engr. Caesar P. Llapitan

$350, the third-year savings $300, and so forth. With interest at 7%, which device should the
firm purchase?
2. Wayne County will build an aqueduct to bring water in from the upper part of the state. It
can be built at a reduced size now for $300 million and be enlarged 25 years hence for an
additional $350 million. An alternative is to construct the full-sized aqueduct now for $400
million. Both alternatives would provide the needed capacity for the 50-year analysis period.
Maintenance costs are small and may be ignored. At 6% interest, which alternative should
be selected?
3. A contractor has been awarded the contract to construct a 6-mile-Iong tunnel in the
mountains. During the 5-year construction period, the contractor will need water from a
nearby stream. He will construct a pipeline to convey the water to the main construction
yard. An analysis of costs for various pipe sizes is as follows:

Pipe Sizes (in.)

2 3 4 6
Installed cost of pipeline and pump $22,000 $23,000 $25,000 $30,000
Cost per hour for pumping $1.20 $0.65 $0.50 $0.40

The pipe and pump will have a salvage value at the end of 5 years, equal to the cost to remove
them. The pump will operate 2000 hours per year. The lowest interest rate at which the
contractor is willing to invest money is 7%. (The minimum required interest rate for
invested money is called the minimum attractive rate of return, or MARR.) Select the
alternative with the least present worth of cost.
4. An investor paid $8000 to a consulting firm to analyze what he might do with a small parcel
of land on the edge of town that can be bought for $30,000. In their report, the consultants
suggested four alternatives:

Alternatives Total Investment Uniform Net Terminal Value at

Including Land* Annual Benefit End of 20 yr
A Do nothing $0 $0 $0
B Vegetable market 50,000 5,100 30,000
C Gas station 95,000 10,500 30,00
D Small motel 360,00 36,000 150,000

*Includes the land and structures but does not include the $8000 fee to the consulting firm.
Assuming 10% is the minimum attractive rate of return, what should the investor. do?
5. A piece of land may be purchased for $610,000 to be strip-mined for the underlying coal.
Annual net income will be $200,000 per year for 10 years. At the end of the 10 years, the
surface of the land will be restored as required by a federal law on strip mining. The
reclamation will cost $1.5 million more than the resale value of the land after it is restored.
Using a 10%interest rate, determine whether the project is desirable.

C. Infinite Analysis Period: Capitalized Cost

Another difficulty in present worth analysis arises when we encounter an infinite analysis period
(n = ). In governmental analyses, a service or condition sometimes must be maintained for an
infinite period. The need for roads, dams, pipelines, and other components of national, state, or
local infrastructure is sometimes considered to be permanent. In these situations, a present
worth of cost analysis would have an infinite analysis period. We call this particular analysis
capitalized cost.

Capitalized cost is the present sum of money that would need to be set aside now, at some interest
rate, to yield the funds required to provide the service (or whatever) indefinitely. To accomplish
this, the money set aside for future expenditures must not decline. The interest received on the
 MODULE 3 – Basic Economy Study Methods 13
Engr. Caesar P. Llapitan

money set aside can be spent, but not the principal. When one stops to think about an infinite
analysis period (as opposed to something relatively short, like a hundred years), we see that an
undiminished principal sum is essential; otherwise one will of necessity run out of money prior
to infinity.

The formula to calculate CC is derived from the PW relation P = A (P/A, i %, n), where n = 
time periods. Take the equation for P using the P/A factor and divide the numerator and
denominator by (1 + i)n to obtain

 1 
P = A 1 − i
 ( 1 + i )n 
 

As n approaches , the bracketed term becomes 1/i. We replace the symbols P and PW with CC
as a reminder that this is a capitalized cost equivalence. Since the A value can also be termed
AW for annual worth, the capitalized cost formula is simply

A AW
CC = or CC = (1)
i i

AW = CC (i) (2)

▪ The capitalized cost is simple to apply when there are end-of-period disbursements A.

The cash flows (costs, revenues, and savings) in a capitalized cost calculation are usually of
two types:
a) recurring, also called periodic
- An annual operating cost of $50,000 and a rework cost estimated at $40,000 every
12 years are examples of recurring cash flows.

b) nonrecurring
- Examples of nonrecurring cash flows are the initial investment amount in year 0
and one-time cash flow estimates at future times, for example, $500,000 in fees 2
years hence.

The procedure to determine the CC for an infinite sequence of cash flows is as follows:
1. Draw a cash flow diagram showing all nonrecurring (one-time) cash flows and at least
two cycles of all recurring (periodic) cash flows.
2. Find the present worth of all nonrecurring amounts. This is their CC value.
3. Find the A value through one life cycle of all recurring amounts. (This is the same value
in all succeeding life cycles) Add this to all other uniform amounts (A) occurring in years
1 through infinity. The result is the total equivalent uniform annual worth (AW).
4. Divide the AW obtained in step 3 by the interest rate i to obtain a CC value. This is an
application of the Equation for CC.
5. Add the CC values obtained in steps 2 and 4.

Note:
Drawing the cash flow diagram (step 1) is more important in CC calculations than
elsewhere, because it helps separate nonrecurring and recurring amounts. In step 5 the
present worth of all component cash flows have been obtained; the total capitalized cost
is simply their sum.
 MODULE 3 – Basic Economy Study Methods 14
Engr. Caesar P. Llapitan

Examples
1. The Haverty County Transportation Authority (HCTA) has just installed new software to
charge and track toll fees. The director wants to know the total equivalent cost of all future
costs incurred to purchase the software system. If the new system will be used for the
indefinite future, find the equivalent cost (a) now, a CC value, and (b) for each year
hereafter, an AW value.

The system has an installed cost of $150,000 and an additional cost of $50,000 after 10 years.
The annual software maintenance contract cost is $5000 for the first 4 years and $8000
thereafter. In addition, there is expected to be a recurring major upgrade cost of $15,000
every 13 years. Assume that i = 5% per year for county funds.

Solution:
(a) The five-step procedure to find CC now is applied.
1. Draw a cash flow diagram for two cycles

2. Find the present worth of the nonrecurring costs of $150,000 now and $50,000 in year 10
at i = 5%. Label this CC1.

CC1 = −150,000 − 50,000(P/F, 5%, 10) = $ −180,695

3 and 4. Convert the $15,000 recurring cost to an A value over the first cycle of 13 years and
find the capitalized cost CC2 at 5% per year using Equation [1].
A = −15,000(A/F, 5%, 13) = $−847
CC2 = −847/0.05 = $−16,940

There are several ways to convert the annual software maintenance cost series to A and
CC values. A straightforward method is to, first, consider the $−5000 an A series with a
capitalized cost of
CC3 = −5000/0.05 = $−100,000

Second, convert the step-up maintenance cost series of $−3000 to a capitalized cost
CC4 in year 4, and find the present worth in year 0. (Refer to Figure for cash flow
timings.)
-3,000
CC4 = ( P/ F, 5%, 4 ) = $ - 49,362
0.05

5. The total capitalized cost CCT for Haverty County Transportation Authority is the sum of
the four component CC values.
CCT = −180,695 − 16,940 − 100,000 − 49,362 = $−346,997
 MODULE 3 – Basic Economy Study Methods 15
Engr. Caesar P. Llapitan

(b) Equation [2] determines the AW value forever.

AW = Pi = CCT(i) = $346,997(0.05) = $17,350

Correctly interpreted, this means Haverty County officials have committed the equivalent
of $17,350 forever to operate and maintain the toll management software.

2. A city plans a pipeline to transport water from a distant watershed area to the city. The
pipeline will cost $8 million and will have an expected life of 70 years. The city anticipates it
will need to keep the water line in service indefinitely. Compute the capitalized cost,
assuming7% interest.

Solution:
Method 1: Using the sinking fund factor to compute an infinite series
Here we have renewals of the pipeline every 70 years. To compute the capitalized cost, it is
necessary to first compute an end-of-period disbursement A that is equivalent to $8 million
every 70 years.

$8 million $8 million $8 million $8 million

0 70 140 n →

Capitalized
Cost
P

The $8 million disbursement at the end of 70 years may be resolved into an equivalent A.
$8 million

n = 70

A = F(A/F, i, n) = $8 million(A/F, 7%, 70) = $4960

Each 70-year period is identical to this one and the infinite series is
$8 million
A = 4960

…
n →

Capitalized
Cost, P
 MODULE 3 – Basic Economy Study Methods 16
Engr. Caesar P. Llapitan

Capitalized cost P = $8 million + A/i = $8 million + $ 4960/0.07 = $8,071,000

Method 2: Using the capital recovery factor to compute an infinite series

Instead of solving for an equivalent end-of-period payment A based on a future $8 million
disbursement, we could find A, given a present $8 million disbursement.

A = P(A/P, i, n) = $8 million(A/P, 7%, 70) = $565,000

A = 565,000

…
n →

Capitalized
Cost, P

Capitalized cost P = A/i = = $565,000/0.07 = $8,071,000

▪ For the comparison of two alternatives on the basis of capitalized cost, use the
procedure above to find the A value and CCT for each alternative. Since the capitalized cost
represents the total present worth of financing and maintaining a given alternative forever,
the alternatives will automatically be compared for the same number of years (i.e., infinity).
The alternative with the smaller capitalized cost will represent the more economical
one.
▪ If a finite-life alternative (for example, 5 years) is compared to one with an indefinite or very
long life, capitalized costs can be used. To determine capitalized cost for the finite life
alternative, calculate the equivalent A value for one life cycle and divide by the interest rate

Classroom Activity 2
1. Maintenance money for a new building has been sought. Mr. Kendall would like to
make a donation to cover all future expected maintenance costs for the building. These
maintenance costs are expected to be $50,000 each year for the first 5 years, $70,000
each year for years 6 through 10, and $90,000 each year after that. (The building has an
indefinite service life.)
a) If the money is placed in an account that will pay 13% interest compounded
annually, how large should the gift be?
b) What is the equivalent annual maintenance cost over the infinite service life of the
building?
2. A newly constructed bridge costs $5,000,000. The same bridge is estimated to need
renovation every 15 years at a cost of $1,000,000. Annual repairs and maintenance are
estimated to be $100,000 per year.
a) If the interest rate is 5%, determine the capitalized cost of the bridge.
b) Suppose that, in (a), the bridge must be renovated every 20 years, not every 15
years. What is the capitalized cost of the bridge?
c) Repeat (a) and (b) with an interest rate of 10%. What have you to say about the
effect of interest on the results?
3. How much should one set aside to pay $50 per year for maintenance on a gravesite if
interest is assumed to be 4%? For perpetual maintenance, the principal sum must
remain undiminished after making the annual disbursement.
 MODULE 3 – Basic Economy Study Methods 17
Engr. Caesar P. Llapitan

Bond Value
A bond is an IOU where you agree to lend the bond issuer money for a specified length of time
(say, 10 years). In return, you receive periodic interest payments (e.g., quarterly) from the issuer
plus a promise to return the face value of the bond when it matures.

A bond provides an excellent example of commercial value as being the PW of the future net
cash flows that are expected to be received through ownership of an interest-bearing certificate.

For a bond, let

Z = face, or par, value;
C = redemption or disposal price (usually equal to Z);
r = bond rate (nominal interest) per interest period;
N = number of periods before redemption;
i = bond yield rate per period;
VN = value (price) of the bond N interest periods prior to redemption - this is a PW
measure of merit.

The commercial value (price) of a bond is the PW of all future net cash flows expected to be
received:
1. the period dividends [which are the face or par value (Z) times the bond rate (r)]
▪ constitute an annuity of N payments
2. the redemption price (C)

The PW of the bond is the sum of PWs of these two types of payments at the bond’s yield rate
(i%):

VN = C(P/F, i%,N) + rZ(P/A, i%,N)

Examples
1. What is the value of a 6%, 10-year bond with a par (and redemption) value of $20,000 that
pays dividends semi-annually, if the purchaser wishes to earn an 8% return?

Solution:
VN = $20,000 (P/F, 4%, 20) + (0.03) $20,000 (P/A, 4%, 20)
VN = $20,000 (0.4564) + (0.03) $20,000 (13.5903)
VN = $17,282.18

2. Stan Moneymaker has the opportunity to purchase a certain U.S. Treasury bond that
matures in eight years and has a face value of $10,000. This means that Stan will receive
$10,000 cash when the bond’s maturity date is reached. The bond stipulates a fixed nominal
interest rate of 8% per year, but interest payments are made to the bondholder every three
months; therefore, each payment amounts to 2% of the face value.

Stan would like to earn 10% nominal interest (compounded quarterly) per year on his
investment, because interest rates in the economy have risen since the bond was issued.
How much should Stan be willing to pay for the bond?

Solution:
The PW of future cash flows during the next eight years (the study period) must be
evaluated. Interest payments are quarterly.
 MODULE 3 – Basic Economy Study Methods 18
Engr. Caesar P. Llapitan

Because Stan Moneymaker desires to obtain 10% nominal interest per year on the
investment, the PW is computed at i = 10%/4 = 2.5% per quarter for the remaining 8(4) = 32
quarters of the bond’s life:

VN = C(P/F, i%,N) + rZ(P/A, i%,N)

VN = $10,000(P/F, 2.5%, 32) + $10,000(0.02) (P/A, 2.5%, 32)
= $4,537.71 + $4,369.84 = $8,907.55.

Stan should pay no more than $8,907.55 when 10% nominal interest per year is desired.

3. A bond with a face value of $5,000 pays interest of 8% per year. This bond will be redeemed
at par value at the end of its 20-year life, and the first interest payment is due one year from
now.
a) How much should be paid now for this bond in order to receive a yield of 10% per
year on the investment?
b) If this bond is purchased now for $4,600, what annual yield would the buyer receive?

Solution:
a) VN = C(P/F, i%,N) + rZ(P/A, i%,N)
VN = $5,000(P/F, 10%, 20) + $5,000(0.08) (P/A, 10%, 20)
VN = $743.00 + $3,405.44 = $4,148.44.

b) We are given VN = $4,600, and we must find the value of i%

VN = C(P/F, i%,N) + rZ(P/A, i%,N)
$4,600 = $5,000(P/F, i′%, 20) + $5,000(0.08)(P/A, i′%, 20)

To solve for i′%, we can resort to an iterative trial-and-error procedure (e.g., try 8.5%, 9.0%),
to determine that i′% = 8.9% per year.

Exercises 2
1. The annual income from a rented house is $12,000. The annual expenses are $3000. If the
house can be sold for $145,000 at the end of 10 years, how much could you afford to pay for
it now, if you considered 18% to be a suitable interest rate? (Answer: $68,155)
2. How much would the owner of a building be justified in paying for a sprinkler system that
will save $750 a year in insurance premiums if the system has to be replaced every 20 years
and has a salvage value equal to 10%ofits initial cost? Assume money is worth7%. (Answer:
$8156)
3. Jerry Stans, a young industrial engineer, prepared an economic analysis for some equipment
to replace one production worker. The analysis showed that the present worth of benefits
(of employing one less production worker) just equaled the present worth of the equipment
costs, based on a 10-year useful life for the equipment. It was decided not to purchase the
equipment.
A short time later, the production workers won a new 3-year union contract that granted
them an immediate 40¢-per-hour wage increase, plus an additional 25¢-per-hour wage
increase in each of the two subsequent years. Assume that in each and every future year, a
25¢-per-hour wage increase will be granted.
Jerry Stans has been asked to revise his earlier economic analysis. The present worth of
benefits of replacing one production employee will now increase. Assuming an interest rate
of 8%, the justifiable cost of the automation equipment (with a 10-year useful life) will
increase by how much? Assume the plant operates a single 8-hour shift, 250 days per year.
4. By installing some elaborate inspection equipment on its assembly line, the Robot Corp. can
avoid hiring an extra worker who would have earned $26,000 a year in wages and an
additional $7500 a year in employee benefits. The inspection equipment has a 6-year useful
 MODULE 3 – Basic Economy Study Methods 19
Engr. Caesar P. Llapitan

life and no salvage value. Use a nominall8% interest rate in your calculations. How much
can Robot afford to pay for the equipment if the wages and worker benefits would have been
paid
(a) At the end of each year
(b) Monthly
(c) Continuously
(d) Explain why the answers in (b) and (c) are larger than in (a).

Assume the compounding matches the way the wages and benefits would have been paid
(i.e., annually, monthly, and continuously, respectively).
5. A rather wealthy man decided he would like to arrange for his descendants to be well
educated. He would like each child to have $60,000 for his or her education. He plans to set
up a perpetual trust fund so that six children will receive this assistance in each generation.
He estimates that there will be four generations per century, spaced 25 years apart. He
expects the trust to be able to obtain a 4% rate of return, and the first recipients to receive
the money 10 years hence. How much money should he now set aside in the trust? (Answer:
$389,150)
6. The president of the E. L. Echo Corporation thought it would be appropriate for his firm to
"endow a chair" in the Department of Industrial Engineering of the local university; that is,
he was considering giving the university enough money to pay the salary of one professor
forever. That professor, who would be designated the E. L. Echo Professor of Industrial
Engineering, would be paid from the fund established by the Echo Corporation. If the
professor holding that chair will receive $67,000 per year, and the interest received on the
endowment fund is expected to remain at 8%, what lump sum of money will the Echo
Corporation need to provide to establish the endowment fund? (Answer: $837,500)
7. The local botanical society wants to ensure that the gardens in the town park are properly
cared for. They recently spent $100,000 to plant the gardens. They would like to set up a
perpetual fund to provide $100,000 for future replanting of the gardens every 10 years. If
interest is 5%, how much money would be needed to forever pay the cost of replanting?
8. An elderly lady decided to distribute most of her considerable wealth to charity and to retain
for herself only enough money to provide for her living. She feels that $1000 a month will
amply provide for her needs. She will establish a trust fund at a bank that pays 6% interest,
compounded monthly. At the end of each month she will withdraw $1000. She has arranged
that, upon her death, the balance in the account is to be paid to her niece, Susan. If she
opens the trust fund and deposits enough money to pay herself $1000 a month in interest as
long as she lives, how much will Susan receive when her aunt dies?
9. A trust fund is to be established for three purposes: (1) to provide $750,000 for the
construction and $250,000 for the initial equipment of a small engineering laboratory; (2) to
pay the $150,000 per year laboratory operating cost; and (3) to pay for $100,000 of
replacement equipment every 4 years, beginning 4 years from now.
At 6% interest, how much money is required in the trust fund to provide for the laboratory
and equipment and its perpetual operation and equipment replacement?
10. We want to donate a marble birdbath to the city park as a memorial to our cat, Fred, while
he can still enjoy it. We also want to set up a perpetual care fund to cover future expenses
"forever." The initial cost of the bath is $5000. Routine annual operating costs are $200 per
year, but every fifth year the cost will be $500 to cover major cleaning and maintenance as
well as operation.
(a) What is the capitalized cost of this project if the interest rate is 8%?
(b) How much is the present worth of this project if it is to be demolished after 75 years?
The final $500 payment in the 75th year will cover the year's operating cost and the site
reclamation.
11. Two different companies are offering a punch press for sate. Company A charges $250,000
to deliver and install the device. Company A has estimated that the machine will have
 MODULE 3 – Basic Economy Study Methods 20
Engr. Caesar P. Llapitan

maintenance and operating costs of $4000 a year and will provide an annual benefit of
$89,000. Company B charges $205,000 to deliver and install the device. Company B has
estimated maintenance and operating costs of the press at $4300 a year, with an annual
benefit of $86,000. Both machines will last 5 years and can be sold for $15,000 for the scrap
metal. Use an interest rate of 12%. Which machine should your company purchase, based
on the forgoing data?
12. A steam boiler is needed as part of the design of a new plant. The boiler can be fired by
natural gas, fuel oil, or coal. A decision must be made on which fuel to use. An analysis of
the costs shows that the installed cost, with all controls, would be least for natural gas at
$30,000; for fuel oil it would be $55,000; and for coal it would be $180,000. If natural gas is
used rather than fuel oil, the annual fuel cost will increase by $7500. If coal is used rather
than fuel oil, the annual fuel cost will be $15,000 per year less. Assuming 8% interest, a 20-
year analysis period, and no salvage value, which is the most economical installation?
13. A railroad branch line to a missile site is to be constructed. It is expected that the railroad
line will be used for 15 years, after which the missile site will be removed, and the land turned
back to agricultural use. The railroad track and ties will be removed at that time.
In building the railroad line, either treated OJ untreated wood ties may be used. Treated ties
have are installed cost of $6 and a 10-year life; untreated tie! are $4.50 with a 6-year life. If at
the end of 15 year the ties then in place have a remaining useful life of 4 years or more, they
will be used by the railroad elsewhere and have an estimated salvage value of $3 each. Any
ties that are removed at the end of their service life, or too close to the end of their service
life to be used elsewhere, can be sold for $0.50 each.
Determine the most economical plan for the initial railroad ties and their replacement for
the 15-year period. Make a present worth analysis assuming 8% interest.
14. A city has developed a plan to provide for future municipal water needs. The plan proposes
an aqueduct that passes through 500 feet of tunnel in a nearby mountain. Two alternatives
are being considered. The first proposes to build a full-capacity tunnel now for $556,000.
The second proposes to build a half-capacity tunnel now (cost = $402,000), which should be
adequate for 20 years, and then to build a second parallel half-capacity tunnel. The
maintenance cost of the tunnel lining for the full-capacity tunnel is $40,000 every 10 years,
and for each half-capacity tunnel it is $32,000 every 10 years.
The friction losses in the half-capacity tunnel will be greater than if the full-capacity tunnel
were built. The estimated additional pumping costs in the single half-capacity tunnel will
be $2000 per year, and for the two half-capacity tunnels it will be $4000 per year. Based on
capitalized cost and a 7% interest rate, which alternative should be selected?

IV. THE FUTURE WORTH METHOD

Because a primary objective of all-time value of money methods is to maximize the future wealth
of the owners of a firm, the economic information provided by the FW method is very useful in
capital investment decision situations. The FW 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).

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

Examples
1. Tiger Machine Tool Company is considering acquiring a new metal-cutting machine. The
required initial investment of $75,000 and the projected cash benefits over the project’s
three-year life are as follows:
 MODULE 3 – Basic Economy Study Methods 21
Engr. Caesar P. Llapitan

End of Year Net Cash Flow

0 -$75,000
1 24,400
2 27,340
3 55,760

Compute the NFW at the end of year 3 at i = 15 %.

Solution:
FW (15%) = -$75,000(F/P, 15%, 3) + $24,400(F/P, 15%, 2) + $27,340(F/P, 15%, 1) + $55,760
= $5,404

• Since FW (15%) > 0, the project is acceptable.

2. Higgins Corporation (HC), a Detroit-based robot-manufacturing company, has developed a

new advanced-technology robot called Helpmate, which incorporates advanced technology
such as vision systems, tactile sensing, and voice recognition. These features allow the robot
to roam the corridors of a hospital or office building without following a predetermined
track or bumping into objects. HC’s marketing department plans to target sales of the robot
toward major hospitals. The robots will ease nurses’ workloads by performing low-level
duties such as delivering medicines and meals to patients.
• The firm would need a new plant to manufacture the Helpmates; this plant could be
built and made ready for production in two years. It would require a 30-acre site, which
can be purchased for $1.5 million in year 0. Building construction would begin early in
year 1 and continue throughout year 2. The building would cost an estimated $10 million,
with a $4 million payment due to the contractor at the end of year 1, and with another
$6 million payable at the end of year 2.
• The necessary manufacturing equipment would be installed late in year 2 and would be
paid for at the end of year 2. The equipment would cost $13 million, including
transportation and installation. When the project terminates, the land is expected to
have an after-tax market value of $2 million, the building an after-tax value of $3 million,
and the equipment an after-tax value of $3 million.

For capital budgeting purposes, assume that the cash flows occur at the end of each year.
Because the plant would begin operations at the beginning of year 3, the first operating cash
flows would occur at the end of year 3. The Helpmate plant’s estimated economic life is six
years after completion, with the following expected after-tax operating cash flows in
millions:
 MODULE 3 – Basic Economy Study Methods 22
Engr. Caesar P. Llapitan

Calendar Year ‘06 ‘07 ‘08 ‘09 ‘10 ‘11 ‘12 ‘13 ‘14
End of Year 0 1 2 3 4 5 6 7 8
After-tax cash flows
A. Operating revenue $6 $8 $13 $18 $14 $8
B. Investment
Land -1.5 +2
Building -4 -6 +3
Equipment -13 +3
Net cash flow -$1.5 -$4 -$19 $6 $8 $13 $18 $14 $16

Compute the equivalent worth of this investment at the start of operations. Assume
that HC’s MARR is 15%.

Solution:
One easily understood method involves calculating the present worth and then
transforming it to the equivalent worth at the end of year 2.
• First, we can compute PW (15%) at time 0 of the project:

PW (15%) = -$1.5 - $4(P/F, 15%, 1) - $19(P/F, 15%, 2) + $6(P/F, 15%, 3)

+ $8(P/F, 15%, 4) + $13(P/F, 15%, 5) + $18(P/F, 15%, 6)
+ $14(P/F, 15%, 7) + $16(P/F, 15%, 8)
= $13.91 million

Then, the equivalent project worth at the start of operation is

FW (15%) = PW (15%) (F/P, 15%, 2) = $18.40 million

• A second method brings all flows prior to year 2 up to that point and discounts future
flows back to year 2. The equivalent worth of the earlier investment, when the plant
begins full operation, is

- $1.5(F/P, 15%, 2) - $4(F/P, 15%, 1) - $19 = -$25.58 million

which produces an equivalent flow as shown in the Figure. If we discount the future
flows to the start of operation, we obtain

FW (15%) = -$25.58 + $6(P/F, 15%, 1) + $8(P/F, 15%, 2) + … + + $16(F/P, 15%, 6)

= $18.40 million
 MODULE 3 – Basic Economy Study Methods 23
Engr. Caesar P. Llapitan

Comment: If another company is willing to purchase the plant and the right to manufacture
the robots immediately after completion of the plant (year 2), HC would set the price of the
plant at $43.98 million ($18.40 + $25.58) at a minimum.

Classroom Activity 3
1. Consider the following sets of investment projects, all of which have a three-year
investment life:
Period Project’s Cash Flow
(n) A B C D
0 - $12,500 -11,000 12,500 -13,000
1 5,400 -3,000 -7,000 5,500
2 14,400 21,000 -2,000 5,500
3 7,200 13,000 4,000 8,500

a) Compute the net present worth of each project at i = 15%.

b) Compute the net future worth of each project at i = 15%.
Which project or projects are acceptable?
2. Your R&D group has developed and tested a computer software package that assists
engineers to control the proper chemical mix for the various process manufacturing
industries. If you decide to market the software, your first-year operating net cash flow
is estimated to be $1,000,000. Because of market competition, product life will be about
4 years, and the product’s market share will decrease by 25% each year over the previous
year’s share. You are approached by a big software house which wants to purchase the
right to manufacture and distribute the product. Assuming that your interest rate is 15%,
for what minimum price would you be willing to sell the software?
 MODULE 3 – Basic Economy Study Methods 24
Engr. Caesar P. Llapitan

V. THE ANNUAL WORTH METHOD

In annual cash flow analysis, the goal is to convert money to an equivalent uniform annual cost
or benefit. The simplest case is to convert a present sum P to a series of equivalent uniform end-
of-period cash flows.

The AW of a project is an equal annual series of dollar 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, which is
defined in Equation (3). An annual equivalent value of R, E, and CR is computed for the study
period, N, which is usually in years. In equation form, the AW, which is a function of i%, is

AW(i%) = R − E − CR(i%) (3)

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

The AW value, which has the same interpretation as A used thus far, is the economic equivalent
of the PW and FW values at the MARR for n years. All three can be easily determined from each
other by the relation

AW = PW (A/P, i%, N) and AW = FW (A/F, i%, N)

The n in the factors is the number of years for equal-service comparison. This is the LCM or the
stated study period of the PW or FW analysis. Hence, it can be easily computed for a project
from these other equivalent values.

Note:
Annual worth is also known by other titles. Some are equivalent annual worth (EAW),
equivalent annual cost (EAC), annual equivalent (AE), and equivalent uniform annual
cost (EUAC). The alternative selected by the AW method will always be the same as that
selected by the PW method, and all other alternative evaluation methods, provided they
are performed correctly.

When revenues are absent in Equation (3), we designate this metric as EUAC(i%) and call it
“equivalent uniform annual cost.” A low-valued EUAC(i%) is preferred to a high-valued
EUAC(i%).

When all cash flow estimates are converted to an AW value, this value applies for every year of
the life cycle and for each additional life cycle.

The AW method is especially useful in certain types of studies: asset replacement and retention
time studies to minimize overall annual costs; breakeven studies and make-or-buy decisions; and
all studies dealing with production or manufacturing costs where a cost /unit or profit/unit
measure is the focus.

If income taxes are considered, a slightly different approach to the AW method is used by some
large corporations and financial institutions. It is termed economic value added, or EVA. This
approach concentrates upon the wealth-increasing potential that an alternative offers a
corporation. The resulting EVA values are the equivalent of an AW analysis of after-tax cash
flows.
 MODULE 3 – Basic Economy Study Methods 25
Engr. Caesar P. Llapitan

A. Calculation of Capital Recovery and AW Values

The annual worth (AW) value for an alternative is comprised of two components: capital
recovery for the initial investment P (or I) at a stated interest rate (usually the MARR) and the
equivalent annual amount A. The symbol CR is used for the capital recovery component. In
equation form,

AW = CR + A (4)

▪ The P/A and P/F factors may be necessary to first obtain a present worth amount; then
the A/P factor converts this amount to the A value in Equation (4). (If the alternative is
a revenue project, there will be positive cash flow estimates present in the calculation of
the A value.)

The recovery of an amount of capital P committed to an asset, plus the time value of the capital
at a particular interest rate, is a fundamental principle of economic analysis.

Definition
The CR amount for a project is the equivalent uniform annual cost (EUAC) that the asset,
process, or system must earn (new revenue) each year to just recover the initial
investment plus a stated rate of return over its expected life. Any expected salvage value
is considered in the computation of CR.

It is an annual amount that covers the following two items:

1. Loss in value of the asset
2. Interest on invested capital (i.e., at the MARR)

Accordingly, CR is calculated as

CR = -P(A/P, i, n) + S(A/F, i, n) (5)

Example
Lockheed Martin is increasing its booster thrust power in order to win more satellite launch
contracts from European companies interested in opening up new global communications
markets. A piece of earth-based tracking equipment is expected to require an investment of
$13 million, with $8 million committed now and the remaining $5 million expended at the
end of year 1 of the project. Annual operating costs for the system are expected to start the
first year and continue at $0.9 million per year. The useful life of the tracker is 8 years with
a salvage value of $0.5 million. Calculate the CR and AW values for the system, if the
corporate MARR is 12% per year.

Solution:
• Capital recovery:
In $1 million units, determine P in year 0 of the two initial investment amounts, followed
by the capital recovery.
P = 8 + 5(P/F, 12%, 1) = $12.46

CR = -12.46(A/P, 12%, 8) + 0.5(A/F, 12%, 8)

= -12.46(0.20130) + 0.5(0.08130)
= - $ 2.47

- It means that each and every year for 8 years, the equivalent total net revenue
from the tracker must be at least $2,470,000 just to recover the initial present
 MODULE 3 – Basic Economy Study Methods 26
Engr. Caesar P. Llapitan

worth investment plus the required return of 12% per year. This does not include
the AOC of $0.9 million each year.

• Annual worth:

Since CR = - $2.47 million is an equivalent annual cost, as indicated by the minus sign,
total AW is

AW = -2.47 - 0.9 = - $3.37 million per year

- This is the AW for all future life cycles of 8 years, provided the costs rise at the
same rate as inflation, and the same costs and services are expected to apply for
each succeeding life cycle.

Capital Costs versus Operating Costs

When only costs are involved, the AE method is sometimes called the annual equivalent cost
(AEC) method. In this case, revenues must cover two kinds of costs: operating costs and
capital costs.

▪ Operating costs are incurred through the operation of physical plant or equipment
needed to provide service; examples include items such as labor and raw materials.
▪ Capital costs are incurred by purchasing assets to be used in production and service.

Normally, capital costs are nonrecurring (i.e., one-time) costs, whereas operating costs recur for
as long as an asset is owned.
- operating costs recur over the life of a project, so they tend to be estimated on an annual
basis
- capital costs tend to be one-time costs, so we must translate this one-time cost into its
annual equivalent over the life of the project

The annual equivalent of a capital cost is given a special name: capital recovery cost,
designated CR(i).

Two general monetary transactions are associated with the purchase and eventual retirement
of a capital asset: its initial cost (I) and its salvage value (S). Considering these sums, we calculate
the capital recovery factor as follows:

CR(i%) = I (A/P, i%, N) − S (A/F, i%, N) (6)

It involves finding the annual equivalent of the initial capital investment and then subtracting
the annual equivalent of the salvage value; where:
I = initial investment for the project
S = salvage (market) value at the end of the study period
 MODULE 3 – Basic Economy Study Methods 27
Engr. Caesar P. Llapitan

N = project study period

Note on the initial investment:

▪ In some cases, the investment will be spread over several periods. In such situations, I
is the PW of all investment amounts.

The following two equations are alternative ways of calculating the CR amount:

CR(i%) = (I − S)(A/F, i%,N) + I(i%) (7-a)

CR(i%) = (I − S)(A/P, i%,N) + S(i%) (7-b)

Since we are calculating the equivalent annual costs, we treat cost items with a positive sign.
Then the salvage value is treated as having a negative sign in Eq. (7-b).
- The first term, (I − S)(A/P, i, N), implies that the balance will be paid back in equal
installments over the N-year period at a rate of i.
- The second term, iS, implies that simple interest in the amount iS is paid on S until it is
repaid

Examples
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 is 20% per year, is this proposal a sound one? Use AW method

Solution:
Using Eq. (3): AW(i%) = R − E − CR(i%)
AW ( 20 % ) = $8,00 − $25,000 ( A / P ,20%,5 ) − $5,000 ( A / F ,20%,5 ) 
R−E
CR amount

= $ 312.40
Because its AW (20%) is positive, the equipment more than pays for itself over a period of
five years, while earning a 20% return per year on the unrecovered investment.
- the annual equivalent “surplus” is $312.40, which means that the equipment provided
more than a 20% return on beginning-of-year unrecovered investment.

We can confirm that the AW (20%) is equivalent to PW (20%) = $934.29 and FW (20%) =
$2,324.80:
AW (20%) = $934.29(A/P, 20%, 5) = $312.40
AW (20%) = $2,324.80(A/F, 20%, 5) = $312.40

2. A corporate jet costs $1,350,000 and will incur $200,000 per year in fixed costs (maintenance,
licenses, insurance, and hangar rental) and $277 per hour in variable costs (fuel, pilot
expense, etc.). The jet will be operated for 1,200 hours per year for five years and then sold
for $650,000. The MARR is 15% per year.
a) Determine the capital recovery cost of the jet.
b) What is the EUAC of the jet?

Solution:
a) CR = $1,350,000 (A/P, 15%, 5) − $650,000 (A/F, 15%, 5) = $306,310.
 MODULE 3 – Basic Economy Study Methods 28
Engr. Caesar P. Llapitan

b) The total annual expense for the jet is the sum of the fixed costs and the variable costs.

E = $200,000 + (1,200 hours) ($277/hour) = $532,400

EUAC (15%) = $532,400 + $306,310 = $838,710

3. Automobile leases are built around three factors: negotiated sales price, residual value, and
interest rate. The residual value is what the dealership expects the car’s value will be when
the vehicle is returned at the end of the lease period. The monthly cost of the lease is the
capital recovery amount determined by using these three factors.
a) Determine the monthly lease payment for a car that has an agreed-upon sales price
of $34,995, an APR of 9% compounded monthly, and an estimated residual value of
$20,000 at the end of a 36-month lease. An up-front payment of $3,000 is due when
the lease agreement (contract) is signed.
b) If the estimated residual value is raised to $25,000 by the dealership to get your
business, how much will the monthly payment be?

Solution
a) The effective sales price is $31,995 ($34,995 less the $3,000 due at signing). The monthly
interest rate is 9%/12 = 0.75% per month. So, the capital recovery amount is:
CR = $31,995(A/P, 0.75%, 36) − $20,000(A/F, 0.75%, 36)
= $1,017.44 − $486
= $531.44 per month.

b) The capital recovery amount is now $1,017.44 − $25,000 (A/F, 0.75%, 36) = $409.94 per
month. But the customer might experience an actual residual value of less than $25,000
and have to pay the difference in cash when the car is returned after 36 months. This is
the “trap” that many experiences when they lease a car, so be careful not to drive the car
excessively or to damage it in any way.

4. Consider a machine that costs $20,000 and has a five-year useful life. At the end of the five
years, it can be sold for $4,000 after tax adjustment. The annual operating and maintenance
(O&M) costs are about $500. If the firm could earn an after-tax revenue of $5,000 per year
with this machine, should it be purchased at an interest rate of 10%? (All benefits and costs
associated with the machine are accounted for in these figures.)

Solution:
The given data are:
I = $20,000, S = $4,000, O&M = $500, A = $5,000, N = 5 years and i = 10% per year

Solve for AE, and determine whether to purchase the machine.

The first task is to separate cash flows associated with acquisition and disposal of the asset
from the normal operating cash flows.
- Since the operating cash flows – the $5,000 yearly revenue - are already given in
equivalent annual flows, we need to convert only the cash flows associated with
acquisition and disposal of the asset into equivalent annual flows.

CR (10%) = (I − S) (A/P, i%, N) + S(i%)

= ($20,000 - $4,000) (A/P, 10%, 5) + $4,000 (0.10)
= $4,620.76

O&M (10%) = $500

 MODULE 3 – Basic Economy Study Methods 29
Engr. Caesar P. Llapitan

AEC (10%) = CR (10%) + O&M (10%) = $5,120.76

AE (10%) = $5,000 - $5,120.76 = - $120.76

- This negative AE value indicates that the machine does not generate sufficient
revenue to recover the original investment, so we must reject the project. In fact,
there will be an equivalent loss of $120.76 per year over the life of the machine.

Comments:
- We may interpret the value found for the annual equivalent cost as asserting that
the annual operating revenues must be at least $5,120.76 in order to recover the cost
of owning and operating the asset. However, the annual operating revenues actually
amount to only $5,000, resulting in a loss of $120.76 per year. Therefore, the project
is not worth undertaking.

5. Heavenly Pizza, which is located in Toronto, fares very well with its competition in offering
fast delivery. Many students at the area universities and community colleges work part-time
delivering orders made via the web. The owner, Jerry, a software engineering graduate, plans
to purchase and install five portable, in-car systems to increase delivery speed and accuracy.
The systems provide a link between the web order-placement software and the On-Star
system for satellite-generated directions to any address in the area. The expected result is
faster, friendlier service to customers and larger income.

Each system costs $4600, has a 5-year useful life, and may be salvaged for an estimated $300.
Total operating cost for all systems is $1000 for the fi rst year, increasing by $100 per year
thereafter. The MARR is 10%. Perform an annual worth evaluation for the owner that
answers the following questions.
a) How much new annual net income is necessary to recover the investment at the
MARR of 10% per year?
b) Jerry estimates increased net income of $6000 per year for all fi ve systems. Is this
project financially viable at the MARR?
c) Based on the answer in part (b), determine how much new net income Heavenly
Pizza must have to economically justify the project. Operating costs remain as
estimated.

Solution:
a) The capital recovery amount calculated by Equation [6] answers the first question.
 MODULE 3 – Basic Economy Study Methods 30
Engr. Caesar P. Llapitan

CR = 5[4600(A/P ,10%,5)] - 5[300(A/F ,10%,5)]

= 5[4600(0.26380)] - 5[300(0.16380)]
= $ 5822

The five systems must generate an equivalent annual new revenue of $5822 to recover
the initial investment plus a 10% per year return.

b) The annual operating cost series, combined with the estimated $6000 annual income,
forms an arithmetic gradient series with a base amount of $5000 and G = - $ 100. The
project is financially viable if AW  0 at i = 10% per year. Apply Equation [64], where A
is the equivalent annual net income series.

AW = CR + A = + 5822 + 5000 - 100(A/G ,10%,5) = $ 1003

The system is not financially justified at the net income level of $6000 per year.

c) Let the required income equal R, and set the AW relation equal to zero to find the
minimum income to justify the system.
0 = -5822 + (R - 1000) – 100 (A/G ,10%,5)
R = -5822 + 1000 - 100(1.8101)
= $7003 per year

B. Annual Cash Flow Analysis

Input/Output Situation Criterion
Neither input nor Typical, general situation Maximize equivalent uniform annual
output is fixed worth (EUAW= EUAB − EUAC)
Fixed input Amount of money or other Maximize equivalent uniform
input resources is fixed benefits (maximize EUAB)
Fixed output There is a fixed task, benefit, or Minimize equivalent uniform annual
other output to be cost (minimize EUAC)
accomplished

Examples
1. A firm is considering which of two devices to install to reduce costs. Both devices have useful
lives of 5 years with no salvage value. Device A costs $1000 and can be expected to result in
$300 savings annually. Device B costs $1350 and will provide cost savings of $300 the first
year; however, savings will increase $50 annually, making the second-year savings $350, the
third-year savings $400, and so forth. With interest at 7%, which device should the firm
purchase?
 MODULE 3 – Basic Economy Study Methods 31
Engr. Caesar P. Llapitan

Solution:
Device A
EUAW = −1000(A/P, 7%, 5) + 300 = −1000(0.2439) + 300 = $56.1

Device B
EUAW = −1350(A/P, 7%, 5) + 300 + 50(A/G, 7%, 5) = −1350(0.2439)
+ 300 + 50(1.865)
= $64.00

To maximize EUAW, select Device B.

2. Three alternatives are being considered to improve an assembly line along with the “do-
nothing” alternative. Each of Plans A, B, and C has a 10-year life and a salvage value equal to
10% of its original cost.
Plan A Plan B Plan C
Installed cost of equipment $15,000 $25,000 $33,000
Material and labor savings per year 14,000 9,000 14,000
Annual operating expenses 8,000 6,000 6,000
End-of-useful life salvage value 1,500 2,500 3,300

If interest is 8%, which plan, if any, should be adopted?

Solution:
Since neither installed cost nor output benefits are fixed, the economic criterion is to
maximize EUAW = EUAB − EUAC.
Plan A Plan B Plan C
Equivalent uniform annual benefit (EUAB)
Material and labor per year $14,000 $9,000 $14,000
Salvage value (A/F, 8%, 10) 104 172 228
EUAB = $14,104 $9,172 $14,228
Equivalent uniform annual cost (EUAC)
Installed cost (A/P, 8%, 10) $ 2,235 $3,725 $ 4,917
Annual operating expenses 8,000 6,000 6,000
EUAC = $10,235 $9,725 $10,917
EUAW = EUAB − EUAC = $ 3,869 −$ 553 $ 3,311

Based on our criterion of maximizing EUAW, Plan A is the best of the four alternatives. Since
the do-nothing alternative has EUAW = 0, it is a more desirable alternative than Plan B.

C. Analysis Period
As with the PW method, there are three fundamental assumptions of the AW method that
should be understood. When alternatives being compared have different lives, the AW method
makes the assumptions that
1. The services provided are needed for at least the LCM of the lives of the alternatives.
2. The selected alternative will be repeated for succeeding life cycles in exactly the same
manner as for the first life cycle.
3. All cash flows will have the same estimated values in every life cycle.

Analysis Period Equal to Alternative Lives

- If the analysis period for an economy study coincides with the useful life for each
alternative, then the economy study is based on this analysis period.
 MODULE 3 – Basic Economy Study Methods 32
Engr. Caesar P. Llapitan

Analysis Period a Common Multiple of Alternative Lives

- When the analysis period is a common multiple of the alternative lives, a “replacement
with an identical item with the same costs, performance, and so forth” is frequently
assumed. This means that when an alternative has reached the end of its useful life, we
assume that it will be replaced with an identical item.
- Under these circumstances of identical replacement, we can compare the annual cash
flows computed for alternatives based on their own service lives.

Example
Two pumps are being considered for purchase. If interest is 7%, which pump should be
bought?
Pump A Pump B
Initial cost $7000 $5000
End-of-useful-life salvage value 1500 1000
Useful life, in years 12 6

Solution:
The annual cost for 12 years of Pump A can be found by using Equation (7-b):
EUAC = (P − S) (A/P, i, n) + Si
= (7000 − 1500) (A/P, 7%, 12) + 1500(0.07)
= 5500(0.1259) + 105 = $797

Now compute the annual cost for 6 years of Pump B:

EUAC = (5000 − 1000) (A/P, 7%, 6) + 1000(0.07)
= 4000(0.2098) + 70 = $909

For a common analysis period of 12 years, we need to replace Pump B at the end of its 6-year
useful life. If we assume that another pump B can be obtained, having the same $5000
initial cost, $1000 salvage value, and 6-year life, the cash flow will be as follows:

For the 12-year analysis period, the annual cost for Pump B is

EUAC = [5000 − 1000(P/F, 7%, 6) + 5000(P/F, 7%, 6) − 1000(P/F, 7%, 12)] × (A/P, 7%, 12)
= [5000 − 1000(0.6663) + 5000(0.6663) − 1000(0.4440)] × (0.1259)
= (5000 − 666 + 3331 − 444) (0.1259)
= (7211) (0.1259) = $909

The annual cost of B for the 6-year analysis period is the same as the annual cost for the 12-
year analysis period. This is not a surprising conclusion when one recognizes that the annual
cost of the first 6-year period is repeated in the second 6-year period.

Therefore, select Pump A.

 MODULE 3 – Basic Economy Study Methods 33
Engr. Caesar P. Llapitan

Analysis Period for a Continuing Requirement

- Since this is longer than the lives of the alternatives, we can make the best decision
possible given current information by minimizing EUAC or maximizing EUAW or
EUAB. At a later time, we will make another replacement and there will be more
information on costs at that time.

Example
Pump B in the previous Example is now believed to have a 9-year useful life. Assuming the
same initial cost and salvage value, compare it with Pump A using the same 7% interest rate.

Solution:
If we assume that the need for A or B will exist for some continuing period, the comparison
of costs per year for the unequal lives is an acceptable technique.

For 12 years of Pump A:

EUAC = (7000 − 1500)(A/P, 7%, 12) + 1500(0.07) = $797

For 9 years of Pump B:

EUAC = (5000 − 1000)(A/P, 7%, 9)+ 1000(0.07) = $684

For minimum EUAC, select Pump B.

Infinite Analysis Period

- At times we have an alternative with a limited (finite) useful life in an infinite analysis
period situation. The equivalent uniform annual cost may be computed for the limited
life. The assumption of identical replacement (replacements have identical costs,
performance, etc.) is often appropriate.

Based on this assumption, the same EUAC occurs for each replacement of the limited-life
alternative. The EUAC for the infinite analysis period is therefore equal to the EUAC computed
for the limited life. With identical replacement,

EUAC (infinite analysis period) = EUAC (for limited life n)

A somewhat different situation occurs when there is an alternative with an infinite life in a
problem with an infinite analysis period:

EUAC (infinite analysis period) = P(A/P, i, ) + Any other annual costs

When n = , we have A = Pi and, hence, (A/P, i, ) equals i.

EUAC (infinite analysis period) = Pi + Any other annual costs

Example
In the construction of an aqueduct to expand the water supply of a city, there are two
alternatives for a particular portion of the aqueduct. Either a tunnel can be constructed
through a mountain, or a pipeline can be laid to go around the mountain. If there is a
permanent need for the aqueduct, should the tunnel or the pipeline be selected for this
particular portion of the aqueduct? Assume a 6% interest rate.
 MODULE 3 – Basic Economy Study Methods 34
Engr. Caesar P. Llapitan

Tunnel Through Mountain Pipeline Around Mountain

Initial cost $5.5 million $5 million
Maintenance 0 0
Useful life Permanent 50 years
Salvage value 0 0

Solution:
Tunnel
For the tunnel, with its permanent life, we want (A/P, 6%, ∞). For an infinite life, the capital
recovery is simply interest on the invested capital. So (A/P, 6%, ∞) = i, and we write
EUAC = Pi = $5.5 million (0.06)
= $330,000

Pipeline
EUAC = $5 million (A/P, 6%, 50)
= $5 million (0.0634) = $317,000

For fixed output, minimize EUAC. Select the pipeline.

Further Readings:
▪ Using Spreadsheets to Analyze Loans
Newman, Donald G, Ted G. Eschenbach and Jerome P. Lavelle (2004) Engineering
Economic Analysis, 11th Edition, pages 203 - 206

D. Evaluating Alternatives by Annual Worth Analysis

Many decision makers prefer the AW method because it is relatively easy to interpret when they
are accustomed to working with annual income statements and cash-flow summaries.

For mutually exclusive alternatives, whether cost- or revenue-based, the guidelines are as
follows:

One alternative:
▪ If AW (i = MARR) ≥ 0, the requested MARR is met or exceeded and the alternative is
economically justified.

Two or more alternatives:

▪ Select the alternative with the AW that is numerically largest, that is, less negative or
more positive. This indicates a lower AW of cost for cost alternatives or a larger AW of
net cash flows for revenue alternatives.

As long as the AW evaluated at the MARR is greater than or equal to zero, the project is
economically attractive; otherwise, it is not. An AW of zero means that an annual return exactly
equal to the MARR has been earned.

Examples:

E. Applying Annual-Worth Analysis

F. Life-Cycle Cost Analysis

 MODULE 3 – Basic Economy Study Methods 35
Engr. Caesar P. Llapitan

VI. THE INTERNAL RATE OF RETURN METHOD

The IRR method is the most widely used rate-of-return method for performing engineering
economic analyses. It is sometimes called by several other names, such as the investor’s method,
the discounted cash-flow method, and the profitability index.

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). Equivalent worth may be computed using any of the three methods
discussed earlier. The resultant interest rate is termed the Internal Rate of Return (IRR). The IRR
is sometimes referred to as the breakeven interest rate.

For a single alternative, from the lender’s viewpoint, the IRR is not positive unless (1) both receipts
and expenses are present in the cash-flow pattern, and (2) the sum of receipts exceeds the sum of
all cash outflows. Be sure to check both of these conditions in order to avoid the unnecessary
work involved in finding that the IRR is negative. (Visual inspection of the total net cash flow
will determine whether the IRR is zero or less.)

Using a PW formulation, we see that the IRR is the i′% at which

N N


k=0
Rk ( P / F,i' %,k ) =  E ( P / F,i' %,k )
k=0
k (5)

where: Rk = net revenues or savings for the kth year

Ek = net expenditures, including any investment costs for the kth year
N = project life (or study period)

Once i′ has been calculated, it is compared with the MARR to assess whether the alternative in
question is acceptable. If i′ ≥ MARR, the alternative is acceptable; otherwise, it is not.

IRR Decision Rule: If IRR ≥ MARR, the project is economically justified

A popular variation of Equation (5) for computing the IRR for an alternative is to determine the
i′ at which its net PW is zero. In equation form, the IRR is the value of i′ at which

N N
PW = 
k=0
Rk ( P / F,i' %,k ) -  E ( P / F,i' %,k ) = 0
k=0
k (5-a)

The method of solving Equations (5) and (5-a) normally involves trial-and-error
calculations until the i′% is converged upon or can be interpolated.

For an alternative with a single investment cost at the present time followed by a series of
positive cash inflows over N, a graph of PW versus the interest rate typically has the general
convex form shown in the Figure below.
▪ The point at which PW = 0 in Figure 1 defines i′%, which is the project’s IRR. The value
of i′% can also be determined as the interest rate at which FW = 0 or AW= 0.
 MODULE 3 – Basic Economy Study Methods 36
Engr. Caesar P. Llapitan

Figure 1 Plot of PW versus Interest Rate

Another way to interpret the IRR is through an investment-balance diagram.

Figure 2 Investment-Balance Diagram Showing IRR

- The Figure shows how much of the original investment in an alternative is still to be
recovered as a function of time

- The downward arrows represent annual returns, (Rk − Ek) for 1 ≤ k ≤ N, against the
unrecovered investment, and the dashed lines indicate the opportunity cost of interest,
or profit, on the beginning-of-year investment balance.

- The IRR is the value of i′ that causes the unrecovered investment balance to exactly equal
zero at the end of the study period (year N) and thus represents the internal earning rate
of a project. It is important to notice that i′% is calculated on the beginning-of-year
unrecovered investment through the life of a project rather than on the total initial
investment.

VII. THE EXTERNAL RATE OF RETURN METHOD

It directly considers 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.

In general, three steps are used in the calculating procedure.

 MODULE 3 – Basic Economy Study Methods 37
Engr. Caesar P. Llapitan

- First, all net cash outflows are discounted to time zero (the present) at ∈% per
compounding period.
- Second, all net cash inflows are compounded to period N at ∈%.
- Third, the ERR, which is the interest rate that establishes equivalence between the two
quantities, is determined. The absolute value of the present equivalent worth of the net
cash outflows at ∈% (first step) is used in this last step. In equation form, the ERR is the
i′% at which

N N


k=0
Ek ( P / F,ε%,k )( F / P,i' %, N ) =  R ( F / P,ε%, N - k )
k=0
k (6)

where Rk = excess of receipts over expenses in period k

Ek = excess of expenditures over receipts in period k
N = project life or number of periods for the study
∈ = external reinvestment rate per period

ERR Decision Rule: If ERR ≥ MARR, the project is economically justified

VIII. THE PAYBACK (PAYOUT) PERIOD METHOD

All methods presented thus far reflect the profitability of a proposed alternative for a study
period of N. The payback method, which is often called the simple payout method, mainly
indicates a project’s liquidity rather than its profitability. Historically, the payback method has
been used as a measure of a project’s riskiness, since liquidity deals with how fast an investment
can be recovered. A low valued payback period is considered desirable. Quite simply, the
payback method calculates the number of years required for cash inflows to just equal cash
outflows. Hence, the simple payback period is the smallest value of θ(θ ≤ N) for which this
relationship is satisfied under our normal EOY cash-flow convention. For a project where all
capital investment occurs at time 0, we have

( R
k=1
k - Ek ) - I  0 (7)

IX. COST/BENEFIT RATIO METHOD

Criterion:
The benefit-cost ratio for an alternative is defines as

B PWB
B – C ratio = =
C PWC

Or equivalently,

B EUAC ( equivalent uniform annual benefit )

=
C EUAC ( equivalent uniform annual cost )

And the ratio must be  1.

Procedure for incremental analysis

 MODULE 3 – Basic Economy Study Methods 38
Engr. Caesar P. Llapitan

Two cases are possible:

Case A:
- If all alternatives have either the same benefit or cost, choose that alternative with
the largest B-C ratio, provided that the ratio is greater than or equal to unity. If none,
choose the do-nothing alternative. Net benefit will be maximized.

Case B:
- If neither benefit nor cost is the same for all alternatives, conduct incremental
benefit-cost analysis:

1. Compute PWB and PWC (or EUAB and EUAC) for each alternative.
2. Discard any alternative having B/C < 1.0.
3. Order the remaining alternative from lowest cost to highest cost, and number the
projects 1, 2, … , P.
4. For projects 1 and 2, compute

 B PWB2 − PWB1
=
C PWC2 − PWC1

Or

 B EUAB2 − EUAB1
=
C EUAC2 − EUAC1

If B/C  1.0, select project 2 as best so far.

If B/C < 1, select project 1 as best so far.

5. Compute B/C between the best project so far and the next most costly project not yet
tested.
If B/C  1.0, select the more costly project as best so far.
If B/C < 1, keep the lesser cost project as best so far.

6. Repeat step 5 until all projects have been tested. The surviving project is the best.

References
1. Blank, L., Tarquin, A. (2012) Engineering Economy. 7th Edition. McGraw-Hill, Inc.
2. Chan S Park (2004) Contemporary Engineering Economics. 4th Edition Pearson
Education South Asia, PTE Ltd.
3. Newman, Donald G, Ted G. Eschenbach and Jerome P. Lavelle (2004) Engineering
Economic Analysis, 11th Edition. Oxford University Press, Inc.
4. Sullivan, William G., et al. (2015) Engineering Economy. 16th Edition. Pearson Higher
Education, South Asia, PTE Ltd.
5. Ted G. Eschenbach (2003) Engineering Economy – Applying Theory to Practice, 3rd
Edition. Oxford University Press, Inc.