STUDY MATERIAL

B.Tech. (Mech.) IV Semester

Subject: ENGINEERING ECONOMY (ME-404)

Unit III:

METHODS FOR MAKING ECONOMY STUDIES

4.1 Introduction

Engineering or business projects require huge capital investments. Economy studies

are necessary to be conducted to establish whether a proposed capital investment and its
associated expenditures can be recovered over time in addition to a return on the capital that
is attractive in view of risks involved and opportunity costs of the limited funds. The concepts
of interest and money-time relationships of chapter 3 are quite useful in arriving at the
investment decision.

Since different projects involve different patterns of capital investment, revenue or

savings cash flows and expenditure or disbursement cash flows, no single method is perfect
for making economy studies of all types of projects. As a result, several methods for making
economy studies are commonly used in practice. All methods will produce equally
satisfactory results and will lead to the same decision provided the inherent assumptions of
each method are enforced.

This chapter explains the working mechanism of SIX basic methods for making
economy studies and also describes the assumptions and interrelationships of these methods.
In making economy studies of the proposed project, the appropriate interest rate to be used
for discounting purpose is taken to be equal to the minimum attractive rate of return
(M.A.R.R.) expected by the fund provider. The value of M.A.R.R. is established in view of
the opportunity cost of capital which reflects the return forgone as it is invested in one
particular project.

4.2 Basic Methods

The following SIX methods are commonly used for making economy studies:

Equivalent worth:

1. Present worth (P.W.)

2. Future worth (F.W.)
3. Annual worth (A.W.)

Rate of return:

1. Internal rate of return (I.R.R.)

2. External rate of return (E.R.R.)
3. Explicit reinvestment rate of return (E.R.R.R.)
4.3 Present Worth (P.W.) Method

In this method equivalent worth of all cash flows relative to some point in time called
present i.e. P.W. is computed. All cash inflows and outflows are discounted to the present
point in time at an interest rate that is generally M.A.R.R. using appropriate interest factor.
The following steps are used to calculate P.W.:

Step 1: Draw the cash flow diagram for the given problem

Step 2: Determine the P.W. of the given series of cash receipts by discounting these future
amounts to the present at an interest rate, i equal to M.A.R.R in the following
manner:

P.W. = F0(1+i)0 + F1(1+i)-1+F2(1+i)-2+…….+Fk(1+i)-k+…….+Fn(1+i)-n (4.1)

Step 3: Determine the P.W. of the given series of cash disbursement by discounting these
future amounts to the present at an interest rate, i equal to M.A.R.R using Equation
(4.1)

Step 4: Determine the net present worth, N.P.W. as:

N.P.W. = P.W. at step 2 - P.W. at step 3

(i) If N.P.W. > 0 the investment in the project is economically justified

(ii) If N.P.W. < 0 the investment in the project is economically not justified

(iii) If N.P.W. = 0 the investment in the project is economically barely justified

The following example illustrates the P.W. method

Example 4.1: Production Engineers of a manufacturing firm have proposed a new equipment
to increase productivity of a manual gas cutting operation. The initial investment (first cost)
is ₹ 5,00,000 and the equipment will have a salvage value of ₹ 1,00,000 at the end of its
expected life of 5 years. Increased productivity will yield an annual revenue of ₹ 2,00,000 per
year. If the firm’s minimum attractive rate of return is 15%, is the procurement of new
equipment economically justified? Use P.W. method.

Solution:

Step 1: The cash flow diagram for this problem is shown in Fig. 4.1
 Fig. 4.1: Cash flow diagram, Example, 4.1

Step 2: The P.W. of the series of cash receipts is computed as:

P.W. = ₹ 2,00,000(P/A, 15%, 5) + ₹. 1,00,000(P/F,15%,5)
= ₹ 2,00,000(3.3522) + ₹ 1,00,000(0.4972)
P.W. = ₹ 7,20,160
Step 3: The P.W. of the series of cash disbursements is computed as:
P.W. = ₹ 5,00,000
Step 4: N.P.W. = ₹ 7,20,160 - ₹. 5,00,000
N.P.W. = ₹ 2,20,160

Since N.P.W. > 0, this equipment is economically justified

Example 4.2: An investment of ₹ 1,05,815.4 can be made in a project that will produce a
uniform annual revenue of ₹ 53,000 for 5 years and then have a salvage value of ₹ 30,000.
Annual disbursements will be ₹ 30,000 each year for operation and maintenance costs. The
company’s minimum attractive rate of return is 10%. Show whether it is a desirable
investment by using the present worth method.

Solution:

Step 1: The cash flow diagram for this problem is shown in Fig. 4.2
 Fig. 4.2: Cash flow diagram, Example, 4.2

Step 2: The P.W. of the series of cash receipts is computed as:

P.W. = ₹ 53,000(P/A, 10%, 5) + ₹ 30,000(P/F,10%,5)
= ₹ 53,000(3.7908) + ₹ 30,000(0.6209)
P.W. = ₹ 2,19,539.4
Step 3: The P.W. of the series of cash disbursements is computed as:
P.W. = ₹ 1,05,815.4 + ₹ 30,000(P/A, 10%, 5)
= ₹ 1,05,815.4 + ₹ 30,000(3.7908)
P.W. = ₹ 2,19,539.4
Step 4: N.P.W. = ₹ 2,19,539.4 - ₹ 2,19,539.4
N.P.W. = ₹ 0

Since N.P.W. = ₹ 0, the project is shown to be barely justified.

4.3 Future Worth (F.W.) Method

This method involves computation of equivalent worth of all cash flows relative to
some point in time called future i.e. F.W. All cash inflows and outflows are discounted to the
future point in time at an interest rate that is generally M.A.R.R. using appropriate interest
factor. The following steps are used to calculate F.W.:

Step 1: Draw the cash flow diagram for the given problem

Step 2: Determine the F.W. of the given series of cash receipts by discounting these present
amounts to the future at an interest rate, i equal to M.A.R.R in the following
manner:

F.W.= P0(1+i)n+P1(1+i)n-1+P2(1+i)n-2+…….+Pk(1+i)n-k+…….+Pn(1+i)0 (4.2)

Step 3: Determine the F.W. of the given series of cash disbursement by discounting these
present amounts to the future at an interest rate, i equal to M.A.R.R using Equation
(4.2)

Step 4: Determine the net future worth, N.F.W. as:

N.F.W. = F.W. at step 2 - F.W. at step 3

(i) If N.F.W. > 0 the investment in the project is economically justified

(ii) If N.F.W. < 0 the investment in the project is economically not justified

(iii) If N.F.W. = 0 the investment in the project is economically barely justified

The following example illustrates the P.W. method

Example 4.3: Solve the problem given in Example 4.1 by F.W. method

Solution:

Step 1: The cash flow diagram for this problem is shown in Fig. 4.1
Step 2: The F.W. of the series of cash receipts is computed as:
F.W. = ₹ 2,00,000(F/A, 15%, 5) + ₹ 1,00,000
= ₹ 2,00,000(6.7424) + ₹ 1,00,000
F.W. = ₹ 14,48,480
Step 3: The F.W. of the series of cash disbursements is computed as:
F.W. = ₹ 5,00,000(F/P, 15%, 5)
= ₹ 5,00,000(2.0114)
F.W. = ₹ 10,05,700
Step 4: N.F.W. = ₹ 14,48,480 - ₹ 10,05,700
N.F.W. = ₹ 4,42,780

Since N.F.W. > 0, this equipment is economically justified

Example 4.4: Solve the problem given in Example 4.2 by F.W. method

Solution:

Step 1: The cash flow diagram for this problem is shown in Fig. 4.2
Step 2: The F.W. of the series of cash receipts is computed as:
F.W. = ₹ 53,000(F/A, 10%, 5) + ₹ 30,000
= ₹ 53,000(6.1051) + ₹ 30,000
F.W. = ₹ 3,53,570.3
Step 3: The F.W. of the series of cash disbursements is computed as:
F.W. = ₹ 1,05,815.4(F/P, 10%, 5) + ₹ 30,000(F/A, 10%, 5)
= ₹ 1,05,815.4(1.6105) + ₹ 30,000(6.1051)
F.W. = ₹ 3,53,568.7
Step 4: N.F.W. = ₹ 3,53,570.3 - ₹ 3,53,568.7
N.F.W. = ₹ 1.6 which is almost equal to 0

Since N.F.W. = 0, this equipment is economically barely justified

4.4 Annual Worth (A.W.) Method

The term A.W. refers to a uniform annual series of rupees amounts for a certain period of
time that is equivalent to a particular schedule of cash inflows i.e. receipts or savings and/or
cash outflows i.e. disbursements under consideration. The following procedures can be used
to determine the A.W. of a particular schedule of cash flows:

Procedure – 1: The following steps are used to calculate A.W.:

Step 1: Draw the cash flow diagram for the given problem

Step 2: Determine the P.W. of the given series of cash receipts by discounting these future
amounts to the present at an interest rate, i equal to M.A.R.R using Equation (4.1)

Step 3: Determine the P.W. of the given series of cash disbursement by discounting these
future amounts to the present at an interest rate, i equal to M.A.R.R using Equation
(4.1)

Step 4: Determine the net present worth, N.P.W. as:

N.P.W. = P.W. at step 2 - P.W. at step 3

Step 5: Consider N.P.W. obtained at Step 4 as present worth, P and determine its A.W. as:

A.W. = P(A/P, i%, n) (4.3)

(i) If A.W. > 0 the investment in the project is economically justified

(ii) If A.W. < 0 the investment in the project is economically not justified

(iii) If A.W. = 0 the investment in the project is economically barely justified

Procedure – 2: The following steps are used to calculate A.W.:

Step 1: Draw the cash flow diagram for the given problem

Step 2: Determine the F.W. of the given series of cash receipts by discounting these present
amounts to the future at an interest rate, i equal to M.A.R.R using Equation (4.2)

Step 3: Determine the F.W. of the given series of cash disbursement by discounting these
present amounts to the future at an interest rate, i equal to M.A.R.R using Equation
(4.2)

Step 4: Determine the net future worth, N.F.W. as:

N.F.W. = F.W. at step 2 - F.W. at step 3

Step 5: Consider N.F.W. obtained at Step 4 as future worth, F and determine its A.W. as:

A.W. = F(A/F, i%, n) (4.4)

(i) If A.W. > 0 the investment in the project is economically justified

(ii) If A.W. < 0 the investment in the project is economically not justified

(iii) If A.W. = 0 the investment in the project is economically barely justified

Procedure – 3: The following steps are used to calculate A.W.:

Step 1: Draw the cash flow diagram for the given problem

Step 2: Determine the P.W. of the given series of cash receipts by discounting these future
amounts to the present at an interest rate, i equal to M.A.R.R using Equation (4.1)

Step 3: Consider P.W. obtained at step 2 as present worth, P and determine its A.W. using
Equation (4.3)

Step 4: Determine the P.W. of the given series of cash disbursement by discounting these
future amounts to the present at an interest rate, i equal to M.A.R.R using Equation
(4.1)

Step 5: Consider P.W. obtained at step 4 as present worth, P and determine its A.W. using
Equation (4.3)

Step 6: Determine the annual worth A.W. as:

A.W. = A.W. at step 3 - A.W. at step 5

(i) If A.W. > 0 the investment in the project is economically justified

(ii) If A.W. < 0 the investment in the project is economically not justified

(iii) If A.W. = 0 the investment in the project is economically barely justified

Procedure – 4: The following steps are used to calculate A.W.:

Step 1: Draw the cash flow diagram for the given problem

Step 2: Determine the F.W. of the given series of cash receipts by discounting these present
amounts to the future at an interest rate, i equal to M.A.R.R using Equation (4.2)

Step 3: Consider F.W. obtained at step 2 as future worth, F and determine its A.W. using
Equation (4.4)
Step 4: Determine the F.W. of the given series of cash disbursement by discounting these
present amounts to the future at an interest rate, i equal to M.A.R.R using Equation
(4.2)

Step 5: Consider F.W. obtained at step 4 as future worth, F and determine its A.W. using
Equation (4.4)

Step 6: Determine the annual worth A.W. as:

A.W. = A.W. at step 3 - A.W. at step 5

(i) If A.W. > 0 the investment in the project is economically justified

(ii) If A.W. < 0 the investment in the project is economically not justified

(iii) If A.W. = 0 the investment in the project is economically barely justified

Procedure – 5: The following steps are used to calculate A.W.:

Step 1: Draw the cash flow diagram for the given problem

Step 2: Identify the equivalent annual receipts, R from the cash flow diagram drawn at step 1

Step 3: Identify the equivalent annual expenses, E from the cash flow diagram drawn at step
1

Step 4: Identify the initial investment (expenditure at point 0) and S is the salvage value
(cash inflow) at the end of useful life

Step 5: Determine the equivalent annual capital recovery amount, C.R. by using any one of
the following formulas:

(i) C.R. = P(A/P, i%,n) – S(A/F, i%, n)

(ii) C.R. = (P-S)(A/F, i%,n) + P(i%)

(iii) C.R. = (P-S)(A/P, i%,n) + S(i%)

Step 6: Determine A.W. as:

A.W. = R – E – C.R. (4.5)

(i) If A.W. > 0 the investment in the project is economically justified

(ii) If A.W. < 0 the investment in the project is economically not justified

(iii) If A.W. = 0 the investment in the project is economically barely justified

Example 4.5: Solve the problem given in Example 4.1 by A.W. method

Solution:

Procedure – 1: The N.P.W. has already been calculated in Example 4.1 and its value is ₹
2,20,160. Considering ₹ 2,20,160 as P, its A.W. is calculated by using Equation (4.3) as:

A.W. = ₹ 2,20,160(A/P, 15%,5)

= ₹ 2,20,160(0.2983)

A.W. = ₹ 65,673.73

Since A.W. > 0, this equipment is economically justified

Procedure – 2: The N.F.W. has already been calculated in Example 4.3 and its value is ₹
4,42,780. Considering ₹ 4,42,780 as F, its A.W. is calculated by using Equation (4.4) as:

A.W. = ₹ 4,42,780 (A/F, 15%,5)

= ₹ 4,42,780 (0.1483)

A.W. = ₹ 65,664.27

Since A.W. > 0, this equipment is economically justified

Procedure – 3: Step 1: The cash flow diagram for the given problem is shown in Fig. 4.1

Step 2: The P.W. of the given series of cash receipts has already been calculated in Example
4.1 and its value is ₹ 7,20,160

Step 3: Consider Rs. 7,20,160 as present worth, P and determine its A.W. using Equation
(4.3) as:

A.W. = ₹ 7,20,160(A/P, 15%, 5)

= ₹ 7,20,160(0.2983)

A.W. = ₹ 2,14,823.7

Step 4: The P.W. of the given series of cash disbursements has already been calculated in
Example 4.1 and its value is ₹ 5,00,000

Step 5: Consider ₹ 5,00,000as present worth, P and determine its A.W. using Equation (4.3)
as:

A.W. = ₹ 5,00,000(A/P, 15%, 5)

= ₹ 5,00,000(0.2983)

A.W. = ₹ 1,49,150

Step 6: Determine the annual worth A.W. as:

A.W. = A.W. at step 3 - A.W. at step 5

= ₹ 2,14,823.7 - ₹ 1,49,150

A.W. = ₹ 65,673.7

Since A.W. > 0, this equipment is economically justified

Procedure – 4: Step 1: The cash flow diagram for the given problem is shown in Fig. 4.1

Step 2: The F.W. of the given series of cash receipts has already been calculated in Example
4.3 and its value is ₹ 14,48,480

Step 3: Consider ₹ 14,48,480 as future worth, F and determine its A.W. using Equation (4.4)
as:

A.W. = ₹ 14,48,480(A/F, 15%, 5)

= ₹ 14,48,480(0.1483)

A.W. = ₹ 2,14,809.6

Step 4: The F.W. of the given series of cash disbursements has already been calculated in
Example 4.3 and its value is ₹ 10,05,700

Step 5: Consider ₹ 10,05,700 as future worth, F and determine its A.W. using Equation (4.4)
as:

A.W. = ₹ 10,05,700(A/F, 15%, 5)

= ₹ 10,05,700(0.1483)

A.W. = ₹ 1,49,145.3

Step 6: Determine the annual worth A.W. as:

A.W. = A.W. at step 3 - A.W. at step 5

= ₹ 2,14,809.6 - ₹ 1,49,145.3

A.W. = ₹ 65,664.3

Since A.W. > 0, this equipment is economically justified

Procedure – 5: The following steps are used to calculate A.W.:

Step 1: The cash flow diagram for the given problem is shown in Fig. 4.1

Step 2: From the cash flow diagram given at step 1 it is clear that the equivalent annual
receipts, R = ₹ 2,00,000

Step 3: From the cash flow diagram given at step 1 it is clear that the equivalent annual
expenses, E = 0
Step 4: From the cash flow diagram given at step 1 it is clear that the initial investment, P = ₹
5,00,000 and salvage value, S = ₹ 1,00,000

Step 5: The equivalent annual capital recovery amount, C.R. is calculated by using the
following formula:

C.R. = P(A/P, i%,n) – S(A/F, i%, n)

C.R. = ₹ 5,00,000(A/P, 15%, 5) - ₹ 1,00,000(A/F, 15%, 5)

= ₹ 5,00,000(0.2983) - ₹ 1,00,000(0.1483)

= ₹ 1,49,150 - ₹ 14,830

C.R. = ₹ 1,34,320

Step 5: A.W. is calculated as:

A.W. = R – E – C.R.

A.W. = ₹ 2,00,000 – ₹ 0 – ₹ 1,34,320

A.W. = ₹ 65,680

Since A.W. > 0, this equipment is economically justified

Note: It may be noted that the small difference in the values of A.W. obtained from the above
procedures is due to rounding off the values of factors in the interest table. However, the
result by all methods is same.

Example 4.6: Solve the problem given in Example 4.2 by A.W. method

Solution: Let us solve this problem by procedure – 5 discussed above.

Procedure – 5: The following steps are used to calculate A.W.:

Step 1: The cash flow diagram for the given problem is shown in Fig. 4.2

Step 2: From the cash flow diagram given at step 1 it is clear that the equivalent annual
receipts, R = ₹ 53,000

Step 3: From the cash flow diagram given at step 1 it is clear that the equivalent annual
expenses, E = ₹ 30,000

Step 4: From the cash flow diagram given at step 1 it is clear that the initial investment, P = ₹
1,05,815.4 and salvage value, S = ₹ 30,000

Step 5: The equivalent annual capital recovery amount, C.R. is calculated by using the
following formula:

C.R. = P(A/P, i%,n) – S(A/F, i%, n)

C.R. = ₹ 1,05,815.4(A/P, 10%, 5) - ₹ 30,000(A/F, 10%, 5)

= ₹ 1,05,815.4(0.2638) - ₹ 30,000(0.1638)

= ₹ 27,914.10 - ₹ 4,914

C.R. = ₹ 23,000.1

Step 5: A.W. is calculated as:

A.W. = R – E – C.R.

A.W. = ₹ 53,000 – ₹ 30,000 – ₹ 23,000.1

A.W. = -₹ 0.1 which is almost equal to 0

Since A.W. = 0, this equipment is economically barely justified

4.5 Internal Rate of Return (I.R.R.) Method

Out of all the rate of return methods, this method is widely used for making economy studies.
This method is also known by several other names such as investor’s method, discounted
cash flow method, receipts versus disbursements method, and profitability index. In this
method an interest rate, i’ called I.R.R. is computed and it is compared with M.A.R.R. to take
decision on the economic viability of the project. This method can be used only when both
positive and negative cash flows are present in the problem. I.R.R. is also defined as an
interest rate at which net present worth, N.P.W. is 0. The following steps are used to compute
I.R.R.:

Step 1: Draw the cash flow diagram for the given problem

Step 2: Determine the P.W. of the net receipts at an interest rate of i’ in the following
manner:

n
 Rk (P/F, i' %, k) (4.6)
k 0

where Rk = net receipts or savings for the kth year

n = project life

Step 3: Determine the P.W. of the net expenditures at an interest rate, i’ in the following
manner:

n
 Ek (P/F, i' %, k) (4.7)
k 0

where Rk = net expenditures including investments for the kth year

Step 4: Determine the net present worth, N.P.W. as:

 n n
N.P.W. =  Rk (P/F, i' %, k) -  Ek (P/F, i' %, k) (4.8)
k 0 k 0

Step 5: Set N.P.W. = 0 and determine the value of i’ %

Step 6: Compare the value of i’ % with M.A.R.R.

(i) If i’ % > M.A.R.R. the investment in the project is economically justified

(ii) If i’ % < M.A.R.R. the investment in the project is economically not justified

(iii) If i’ % = M.A.R.R. the investment in the project is economically barely justified

Note: The value of i’ % can also be determined as the interest rate at which net F.W. = 0 or at
which net A.W. = 0.

The following example illustrates the I.R.R. method:

Example 4.7: Solve the problem given in Example 4.1 by I.R.R. method

Solution:

Step 1: The cash flow diagram for the given problem is shown in Fig. 4.1.

Step 2: The P.W. of the net receipts at an interest rate of i’ is calculated as:

P.W. = ₹ 2,00,000(P/A, i’%, 5) + ₹ 1,00,000(P/F, i’%, 5)

Step 3: The P.W. of the net expenditures at an interest rate of i’ is calculated as:

P.W. = ₹ 5,00,000

Step 4: The net present worth, N.P.W. is obtained as:

N.P.W. = ₹ 2,00,000(P/A, i’%, 5) + ₹ 1,00,000(P/F, i’%, 5) - ₹ 5,00,000

Step 5: 0 = ₹ 2,00,000(P/A, i’%, 5) + ₹ 1,00,000(P/F, i’%, 5) - ₹ 5,00,000

Te equation given at step 5 normally involves trial-and-error calculations until the i’% is
found. However, since we do not know the exact value of i’%, we will probably try a
relatively low i’%, such as 5%, and a relatively high i’%, such as 40%.

At i’% = 5%: ₹ 2,00,000(P/A,5%, 5) + ₹ 1,00,000(P/F, 5%, 5) - ₹ 5,00,000

₹ 2,00,000(4.3295) + ₹ 1,00,000(0.7835) - ₹ 5,00,000 = + ₹ 4,44,250

At i’% = 40%: ₹ 2,00,000(P/A, 40%, 5) + ₹ 1,00,000(P/F, 40%, 5) - ₹ 5,00,000

₹ 2,00,000(2.035) + ₹ 1,00,000(0.1859) - ₹ 5,00,000 = - ₹ 74,410

Since we have both a positive and a negative P.W. of net cash flows, linear interpolation can
be used as given below to find an approximate value of i’%
 40%  5% i '%  5%

Rs. 4,44,250  (Rs. 74,410) Rs. 4,44,250  Rs. 0

Rs. 4,44,250
i '%  5%  (40%  5%)
Rs. 4,44,250 - (-Rs. 74,410)

i’% = 34.98%

Step 6: Since the value of i’ % = 34.98% > M.A.R.R. = 15% the investment in the project is
economically justified

Example 4.8: Solve the problem given in Example 4.2 by I.R.R. method

Solution:

Step 1: The cash flow diagram for the given problem is shown in Fig. 4.2.

Step 2: The P.W. of the net receipts at an interest rate of i’ is calculated as:

P.W. = ₹ 53,000(P/A, i’%, 5) + ₹ 30,000(P/F, i’%, 5)

Step 3: The P.W. of the net expenditures at an interest rate of i’ is calculated as:

P.W. = ₹ 1,05,815.4 + ₹ 30,000(P/A, i’%, 5)

Step 4: The net present worth, N.P.W. is obtained as:

N.P.W. = ₹ 53,000(P/A, i’%, 5) + ₹ 30,000(P/F, i’%, 5) - ₹ 1,05,815.4 - ₹ 30,000(P/A, i’%, 5)

Step 5: 0 = ₹ 53,000(P/A, i’%, 5) + ₹ 30,000(P/F, i’%, 5) - ₹ 1,05,815.4 - ₹ 30,000(P/A, i’%,

5)

Te equation given at step 5 normally involves trial-and-error calculations until the i’% is
found. However, since we do not know the exact value of i’%, we will probably try a
relatively low i’%, such as 5%, and a relatively high i’%, such as 12%.

At i’% = 5%: ₹ 53,000(P/A, 5%, 5) + ₹ 30,000(P/F, 5%, 5) - ₹ 1,05,815.4 - ₹ 30,000(P/A,

5%, 5)

₹ 53,000(4.3295) + ₹ 30,000(0.7835) - ₹ 1,05,815.4 – ₹ 30,000(4.3295) = + ₹

17,268.1

At i’% = 12%: ₹ 53,000(P/A, 25%, 5) + ₹ 30,000(P/F, 25%, 5) - ₹ 1,05,815.4 - ₹ 30,000(P/A,

25%, 5)

₹ 53,000(3.6048) + ₹ 30,000(0.5674) - ₹ 1,05,815.4 – ₹ 30,000(3.6048) = - ₹

5,883
Since we have both a positive and a negative P.W. of net cash flows, linear interpolation can
be used as given below to find an approximate value of i’%

12%  5% i '%  5%

Rs.17,268.1  (Rs. 5,883) Rs.17,268.1  Rs. 0

Rs.17,268.1
i '%  5%  (12%  5%)
Rs.17,268.1 - (-Rs. 5,883)

i’% = 10.22% which is approximately equal to 10%

Step 6: Since the value of i’ % = M.A.R.R. the investment in the project is barely justified

Note: Let us check whether the value of N.P.W. at i’ = 10% is 0

N.P.W. = ₹ 53,000(P/A, i’%, 5) + ₹ 30,000(P/F, i’%, 5) - ₹ 1,05,815.4 - Rs. 30,000(P/A, i’%,

5)

At i’% = 10%

N.P.W. = ₹ 53,000(P/A, 10%, 5) + ₹ 30,000(P/F, 10%, 5) - ₹ 1,05,815.4 - ₹ 30,000(P/A,

10%, 5)

= ₹ 53,000(3.7908) + ₹ 30,000(0.6209) - ₹ 1,05,815.4 - ₹ 30,000(3.7908)

N.P.W. = 0

Thus i’ = 10% which is equal to the given M.A.R.R. and therefore, the investment in the
project is barely justified

4.6 External Rate of Return (E.R.R.) Method

The following steps are involved in the E.R.R. method:

Step 1: Draw the cash flow diagram for the given problem

Step 2: Consider an external interest rate, ‘e’, equal to given M.A.R.R. However, if a specific
value of ‘e’ is given then take ‘e’ equal to that value. ‘e’ is, indeed, an external interest rate at
which net cash flows generated or required by a project over its life can be reinvested or
borrowed outside the firm.. If this external reinvestment rate happens to be equal to the
project’s I.R.R., then E.R.R. method produces results same as that of I.R.R. method.

Step 3: Discount all cash outflows (negative cash flows/expenditures) to period 0 (the
present) at e% in the following manner:

n
 Ek (P/F, e %, k) (4.9)
k 0

where Ek is excess of expenditures over receipts in period k

 n is project life or number of periods for the study.

Step 4: Compound all cash inflows (positive cash flows/receipts) to period n (the future) at
e% in the following manner:

n
 Rk (F/P, e %, n  k) (4.10)
k 0

where Rk is excess of receipts over disbursements in period k

Step 5: Equate Eqn. (4.9) and Eqn. (4.10) as:

n n
 Ek (P/F, e %, k) =  Rk(F/P, e %, n  k) (4.11)
k 0 k 0

Step 6: The L.H.S. of Eqn. (4.10) represents present worth whereas, its R.H.S. represents
future worth. Therefore, the two sides can not be equal. Introduce the factor (F/P, i’%, n) on
to the L.H.S. to bring a balance between two sides of equation in the following manner:

n n
 Ek (P/F, e %, k) (F/P, i ' %, n) =  Rk(F/P, e %, n  k) (4.12)
k 0 k 0

where i’ % is the external rate of return (E.R.R.)

Step 7: Determine the value of i’ % by solving Eqn. (4.12) and compare it with the M.A.R.R.

(i) If i’ % > M.A.R.R. the investment in the project is economically justified

(ii) If i’ % < M.A.R.R. the investment in the project is economically not justified

(iii) If i’ % = M.A.R.R. the investment in the project is economically barely justified

The following examples illustrate the E.R.R. method:

Example 4.9: Solve the problem given in Example 4.1 by E.R.R. method

Solution:

Step 1: The cash flow diagram for the given problem is shown in Fig. 4.1.

Step 2: Since a specific value of ‘e’ is not given take ‘e’ = M.A.R. = 15%

Step 3: In this problem ₹ 5,00,000 is the only cash outflow and it occurs at period 0.
Therefore, the result of this step is ₹ 5,00,000.

Step 4: All cash inflows (positive cash flows/receipts) are compounded to period n (the
future) at e% in the following manner:

₹ 2,00,000(F/A, 15%, 5) + ₹ 1,00,000

Step 5: The result of this step is given as:

₹ 5,00,000 = ₹ 2,00,000(F/A, 15%, 5) + ₹ 1,00,000

Step 6: The L.H.S. of the equation given at step 5 represents present worth whereas, its
R.H.S. represents future worth. Therefore, the two sides can not be equal. Introduce the factor
(F/P, i’%, n) on to the L.H.S. to bring a balance between two sides of equation in the
following manner:

₹ 5,00,000(F/P, i’ %, 5) = ₹ 2,00,000(F/A, 15%, 5) + ₹ 1,00,000

Step 7: The Eqn. given at step 6 is solved as:

₹ 5,00,000(F/P, i’ %, 5) = ₹ 2,00,000(6.7424) + ₹ 1,00,000

₹ 5,00,000(F/P, i’ %, 5) = ₹ 14,48,480

(F/P, i’ %, 5) = ₹ 14,48,480/₹ 5,00,000

(F/P, i’ %, 5) = 2.897

(1 + i’ )5 = 2.897

1 + i’ = 1.237

i’ = 1.237 – 1 = 0.237 = 23.7%

Since the value of i’ % = 23.7% > M.A.R.R. = 15% the investment in the project is
economically justified.

Example 4.10: Solve the problem given in Example 4.2 by E.R.R. method

Solution:

Step 1: The cash flow diagram for the given problem is shown in Fig. 4.2.

Step 2: Since a specific value of ‘e’ is not given take ‘e’ = M.A.R. = 10%

Step 3: All cash outflows (negative cash flows/expenditures) are discounted to period 0 (the
present) at e% in the following manner:

Rs. 1,05,815.4 + Rs. 30,000(P/A, 10%, 5)

Rs. 1,05,815.4 + Rs. 30,000(3.7908)

Rs. 2,19,539.4

Step 4: All cash inflows (positive cash flows/receipts) are compounded to period n (the
future) at e% in the following manner:

₹ 53,000(F/A, 10%, 5) + ₹ 30,000

₹ 53,000(6.1051) + ₹ 30,000
₹ 3,53,570.3

Step 5: The result of this step is given as:

₹ 2,19,539.4 = ₹ 3,53,570.3

Step 6: The L.H.S. the equation given at step 5 represents present worth whereas, its R.H.S.
represents future worth. Therefore, the two sides can not be equal. Introduce the factor (F/P,
i’%, n) on to the L.H.S. to bring a balance between two sides of equation in the following
manner:

₹ 2,19,539.4(F/P, i’ %, 5) = ₹ 3,53,570.3

Step 7: The Eqn. given at step 6 is solved as:

₹ 2,19,539.4(F/P, i’ %, 5) = ₹ 3,53,570.3

(F/P, i’ %, 5) = ₹ 3,53,570.3/₹ 2,19,539.4

(F/P, i’ %, 5) = 1.61

(1 + i’ )5 = 1.61

1 + i’ = 1.0999

i’ = 1.0999 – 1 = 0.0999 = 9.99% which is almost equal to 10%

Since the value of i’ % = 9.99% = M.A.R.R. = 10% the investment in the project is barely
justified.

4.7 Explicit Reinvestment Rate of Return (E.R.R.R.) Method

The following steps are involved in the E.R.R.R. method:

Step 1: Draw the cash flow diagram for the given problem

Step 2: Determine the value of E.R.R.R. from the following relationship

(R  E)  (P  S)( A / F , e %, n)
E.R.R.R. 
P

where R is equivalent annual receipts

E is equivalent annual expenditures

P is the initial investment (expenditure at point 0)

S is the salvage value (cash inflow) at the end of useful life

e % is the external interest rate which is taken equal to M.A.R.R. if not given
specifically

Step 3: Compare the value of E.R.R.R. with M.A.R.R.

(i) If E.R.R.R. > M.A.R.R. the investment in the project is economically justified

(ii) If E.R.R.R. < M.A.R.R. the investment in the project is economically not justified

(iii) If E.R.R.R. = M.A.R.R. the investment in the project is economically barely justified

The following examples illustrate the E.R.R.R. method:

Example 4.11: Solve the problem given in Example 4.1 by E.R.R.R. method

Solution:

Step 1: The cash flow diagram for the given problem is shown in Fig. 4.1.

Step 2: From the cash flow diagram given at step 1 it is clear that the equivalent annual
receipts, R = ₹ 2,00,000; the equivalent annual expenses, E = 0; the initial investment, P = ₹
5,00,000; salvage value, S = ₹ 1,00,000; n = 5 and e % = M.A.R.R. = 15%. Thus,

(Rs. 2,00,000  Rs. 0)  (Rs. 5,00,000  Rs.1,00,000)( A / F , 15 %, 5)

E.R.R.R. 
RS. 5,00,000

(Rs. 2,00,000)  (Rs. 4,00,000)(0.1483)

E.R.R.R. 
RS. 5,00,000

E.R.R.R. = 0.28136 = 28.14%

Step 3: Since E.R.R.R. > M.A.R.R. the investment in the project is economically justified.

Example 4.12: Solve the problem given in Example 4.1 by E.R.R.R. method

Solution:

Step 1: The cash flow diagram for the given problem is shown in Fig. 4.2.

Step 2: From the cash flow diagram given at step 1 it is clear that the equivalent annual
receipts, R = ₹ 53,000; the equivalent annual expenses, E = ₹ 30,000; the initial investment, P
= ₹ 1.05,815.4; salvage value, S = ₹ 30,000; n = 5 and e % = M.A.R.R. = 10%. Thus,

(Rs. 53,000  Rs. 30,000)  (Rs.1,05,815.4  Rs. 30,000)( A / F , 10 %, 5)

E.R.R.R. 
RS. 1,05,815.4

(Rs. 23,000)  (Rs. 75,815.4)(0.1638)

E.R.R.R. 
RS.1,05,815.4

E.R.R.R. = 0.0999 = 9.99% which is almost equal to 10%

Step 3: Since E.R.R.R. = M.A.R.R. the investment in the project is barely justified.